MMT 6: Unemployment and inflation

July 9, 2018

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This is the sixth in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.

The Classical dichotomy

Classical economists gave unemployment and inflation distinct explanations. They weren’t relating the two by focusing on questions like how the government can create more jobs without triggering inflation. Economists have called this compartmentalization the “Classical dichotomy.”

In Classical economics, how many workers were employed depended on the supply and demand of labor, reconciled by the price mechanism. The greater the demand for labor, the higher the price (the wage); but the greater the supply of labor, the lower the price. If wages were too high, the supply of workers willing to work would exceed the demand from employers willing to pay that wage; if wages were too low, the demand for workers would exceed the supply of people willing to work. So in any labor market, there was an equilibrium price point where labor supply equaled labor demand, and that’s how much labor would be employed. Any unemployed workers who remained were those who chose not to work at the going rate. The market had spoken, and everything was as it had to be.

How much was produced with the employed labor depended on the productivity of labor, which depended in turn on the technologies in use.

Inflation had its own dynamic. The general price level for goods and services depended on the amount of money in circulation (and how fast it circulated) relative to the actual output of goods and services. Money was just a medium of exchange. If more money was available to spend on a given level of output, then prices must be higher. “The later Classical economists believed that if the supply of money was, for example, doubled, that there would be no impact on the real performance of the economy. All that would happen is that the price level would double.”

The policy implication of the Classical dichotomy was that government, as the issuer of the currency, could control inflation by managing the money supply, but unemployment was a different matter. The level of employment was set by the invisible hand of the market, and government had little to say about it.

Aggregate demand and the unemployment-inflation trade-off

The massive unemployment of the 1930s forced economists to rethink the Classical position. Unemployment had to involve more than a voluntary decision not to work at the prevailing wage. And as for policy, there had to be something we could do about it. All was not as it had to be. The new Keynesian economics saw the problem as a failure of aggregate demand, and government could take action to alleviate it.

Suppose that businesses decide to cut back on investment because they lose confidence that the market can absorb further increases in production. As I covered in MMT 2, investment is one of the independent variables that determine aggregate demand, national output and income. A drop in investment produces an even greater drop in output and income because of multiplier effects. Each $100 billion drop in investment can easily produce a $200 billion drop in GDP and GNI. Firms lay off workers, unemployment soars, and consumers have less money to spend, encouraging still more cutbacks in investment.

In that situation, lower incomes also mean that the government is collecting less in taxes. That softens the blow for households, but it may encourage governments to cut spending to keep their budgets balanced. That government austerity makes matters worse, since government spending has its own multiplier effect on national income and output. Keynesian theory recommends the opposite policy. Government should increase spending in hard times in order to increase aggregate demand and get the country back to work.

Stimulating the economy with government spending makes the most sense when an economy is suffering from underutilized capacity, as it was during the Great Depression. Once the economy has moved closer to full employment, continued stimulus runs the risk of pushing aggregate demand so high that it presses against a limited supply. That would push prices up, creating “demand-pull inflation.” (In the MMT interpretation, supply can respond to demand and keep prices stable until the economy nears full productive capacity. In graphic terms, the supply curve is seen as pretty flat until prices turn sharply up when that point is reached.)

The policy implication here is that unemployment and inflation are inversely related. Too little aggregate demand creates unemployment, but too much aggregate demand creates inflation. This trade-off was quantified by the introduction of the “Phillips curve” in the 1950s. Policymakers hoped to find a happy medium with neither too much inflation nor too much unemployment.

Stagflation and the monetarist response

In the 1970s, the inverse relationship between unemployment and inflation seemed to break down. The economy experienced both high unemployment and inflation at the same time, a condition that came to be called “stagflation.”

University of Chicago economists under the leadership of Milton Friedman proposed an explanation. He argued that if the government, in its efforts to promote full employment, overstimulated demand, the resulting inflation could end up increasing unemployment as well.

First, he claimed that there is a natural rate of unemployment, which is determined by the underlying structure of the labour market and the rate of capital formation and productivity growth. He believed that the economy always tends back to that level of unemployment even if the government attempts to use fiscal and monetary policy expansion to reduce unemployment.

What would bring unemployment back to its “natural level” was the inflation expectations of workers. Once they came to expect that inflation would keep eroding their purchasing power, they would become less willing to work at the prevailing wage level. This is reminiscent of the Classical idea that unemployment is a personal choice.

Friedman was influential in getting economists to give up fighting unemployment and focus their attention solely on fighting inflation through tight monetary policy.  A certain level of unemployment is natural and government shouldn’t try to change it.

[The] post World War II [Keynesian] consensus was steadily eroded away over the next 40 odd years….Mainstream macroeconomics reverted back to the pre-Keynesian notions of voluntary unemployment and effectively abandoned the concept of true full employment.

A conflict theory of inflation

Modern Monetary Theorists are more in tune with Keynes than with Friedman. As they see it, when government makes fighting inflation the centerpiece of its economic policy, it overlooks policy options that really could reduce unemployment. In effect, it also sides against labor in the class struggle and impedes the efforts of labor to achieve high employment and good wages.

MMT proposes a conflict theory of inflation. Keynes recognized that inflation could be triggered by rising costs as well as rising aggregate demand. MMT acknowledges this “cost-push” inflation and incorporates it into its conflict theory. Increased costs could come from the wage demands of workers, or from the cost of other resources used in production.

Inflation is “the product of distributional struggle over real income shares, reflecting the relative bargaining strength of workers and employers.” Workers want a big enough share of income to maintain or increase their purchasing power. Firms want a big enough share of revenue to cover their costs, including labor costs, and to make enough profit to satisfy their owners or shareholders.

If both sides feel they are benefiting from the shares they have, inflation is avoidable:

If the desired real output shares of the workers and firms is [sic] consistent with the available real output desired, then there is no incompatibility and there will be no inflationary pressures. The available real output would be distributed each period in the form of wages and profits, which satisfy the respective claimants.

If, on the other hand, either side wants to increase its income faster than general economic growth justifies, that cuts into the other’s share of the income. If workers demand wage increases not justified by higher productivity, employers will resist those demands, or else try to pass the costs onto their customers through price increases. General price increases can offset wage increases, leaving workers no better off than before. Price increases that are not matched by wage gains reduce the worker’s share of national income. Inflationary spirals of wages and prices can be initiated from either side. Remember that we are thinking in the aggregate. What matters is what firms and workers are fighting for and getting in the economy as a whole, not just in any one company.

Changes in the relative bargaining power of business and labor may trigger these struggles as well as determine the outcomes. In the early twentieth century, workers responded to the concentration of power in large firms by forming unions to bargain with those firms collectively. “When employers are dealing with workers individually, they have more power than when they are dealing with one bargaining unit (trade unit), which represents all workers in their workplace.” Organized labor made wage gains, but not without a struggle.

Another thing that strengthens labor’s bargaining power is an economy operating at high capacity and employing a lot of labor. Workers can then press their demands for higher wages with less fear of being laid off or replaced. During the postwar economic boom, highly unionized workers were able to obtain a larger share of the national income than they had gotten before, or they have gotten since.

Raw material price shocks such as the 1970s jump in oil prices can both slow the economy and intensify workplace conflict. Workers paying higher gas prices push harder for higher wages. Businesses facing higher costs of production raise prices. If the price shock both slows the economy and generates wage-price spirals, the result is stagflation.

When the Federal Reserve raised interest rates to fight inflation in the 1980s, that raised the cost of borrowing for businesses seeking to expand. That kept the economy operating in low gear, and also increased the resistance of employers to wage increases. The slow economy made workers more vulnerable to layoffs and weakened their bargaining power.

Inflation has been more-or-less under control since then, but workers have faced a perfect storm of sluggish economic growth, competition from cheap foreign labor, declining manufacturing industries, plunging union membership, chronically high unemployment, stagnating real wages, and a declining share of the national wealth and income.

MMT hopes to do better, by identifying a policy that can boost economic growth and achieve full employment, but still keep inflation in check.


Modern Monetary Theory and Practice

July 2, 2018

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William Mitchell, L. Randall Wray and Martin Watts. Modern Monetary Theory and Practice: An Introductory Text. Callaghan, Australia: Centre of Full Employment and Equity: 2016.

Blogging about a textbook is not something I normally do. This text represents a perspective that is especially relevant to current economic policy discussions, and the proposal for a “job guarantee” in particular. That’s been getting a lot of attention both on Wall Street and in progressive policy circles, two realms that don’t usually find much common ground. Here’s a short Huffington Post article on that issue.

Most people are vaguely aware that there are theories underlying the various policy proposals they hear, but they have trouble connecting the dots between theory and policy in any explicit way. We have all heard politicians say that cutting taxes will stimulate the economy, raising interest rates will control inflation, putting high tariffs on imports will save American jobs, or that allowing higher government deficits will impoverish future generations. We need to know how many serious economists agree with such claims.

This is a textbook on macroeconomics, the study of the workings of the economy as a whole, as opposed to microeconomics, the study of economic units like business firms or households. “Macroeconomics focuses on a selected few outcomes at the aggregate level and is rightly considered to be the study of employment, output and inflation in an international context.” I can’t cover this whole textbook–and I’m sure my readers don’t want me to–but I will try in this and the next few posts to explain how a contemporary group of economic theorists arrive at their policy recommendations.

The neoclassical orthodoxy

Let’s begin with a few basic assumptions. The authors describe two broad approaches to macroeconomics. They distinguish the more orthodox tradition, commonly called “neoclassical,” from a heterodox tradition with no single agreed-on name. They call it the “Keynesian/Institutionalist/Marxist approach. In this text, I see a lot more Keynes than Marx.

Keynesian and institutionalist perspectives were very popular in the early twentieth century, but the more orthodox approach had a resurgence in the 1970s as economists and policymakers shifted their focus from boosting employment and wages to fighting inflation. Theories in the neoclassical tradition have dominated public policy since then, but the authors of this text are among those trying to change that.

The neoclassical orthodoxy defines economics as “the study of the allocation of scarce resources among unlimited wants.” The non-government sector of the economy, which neoclassicists like to call the “free market,” has a natural, rational way of functioning that is both efficient and fair. Individuals pursue their self-interest, trying to maximize their utility–their use of the things they want. They compete in the market for various resources, goods and services, exchanging the things they have for the things they don’t have, using money as a medium of exchange. As they do so, they arrive at price points where supply meets demand and everything is efficiently allocated. If the price of a welder’s labor is too low because the supply of welders exceeds the demand, then that encourages workers to enter occupations where their labor is needed. In the end, what you get will reflect the market value of what you give.

Neoclassical theories acknowledge the role of government but limit it. Government has to perform certain basic functions like protecting national security and enforcing law and order. But when it intervenes in the market to set wages or promote one industry over another, it’s more likely to produce distortions and inefficiencies than to make the economy work better.

Although neoclassical economics provides an elegant model of how an idealized, perfectly-competitive economy might work, less orthodox economists question how well it applies to any real economy, especially a modern one:

Claims are sometimes made that a “free market” economy comprised of individuals seeking only their own self interest can operation “harmoniously” as if guided by an “invisible hand.”…In fact, economists had rigorously demonstrated by the 1950s that the conditions under which such a stylised economy could reach such a result couldn’t exist in the real world. In other words, there is no scientific basis for the claim that “free markets” are best.

In any case, these claims, even if true for some hypothesised economy, are irrelevant for the modern capitalist economies that actually exist. This is because all modern capitalist economies are “mixed”, with huge corporations (including multinational firms), labour organisations and big government.

Modern monetary theory

Modern monetary theory (MMT) relies on a less orthodox definition of economics: “the study of social creation and social distribution of society’s resources.” It does not assume any one natural way to run an economy, since economic organization depends on variable cultural norms and social institutions. Right away, this way of thinking makes more sense to sociologists like me.

Societies haven’t always favored self-interested competition over social cooperation, as the neoclassicists consider natural. That assumption may reflect the preferences of early English capitalists who wanted to pursue their self-interest unencumbered by traditional constraints imposed by English kings and their “feudal lord cronies.”

In the modern economy with its large and dominant organizations, prices are not set through free competition among many small economic actors, but mostly by big players with superior market power or political clout. The price you can get for your labor, for example, is not necessarily the price that will employ it most productively. It may be the price fixed by powerful employers who profit by keeping wages low, or by agreeing to devalue certain classes of workers, such as women or minorities. That leads to unnecessarily low incomes, low aggregate demand, and an underutilization of labor that hurts both the economy and society in general.

People working together in society can cooperate to create resources such as a skilled and fully employed labor force. And people can also influence how social benefits are to be distributed among employers, workers, and others, such as by supporting collective bargaining rights. Government is a major player in these decisions, not as some alien force that interferes with the economy, but as a means of taking collective action to influence economic outcomes. Collective action can produce aggregate outcomes more favorable than self-interested individuals could have achieved working independently.

The “key goal of macroeconomics” is “using the available macroeconomic resources including labour to the limit.” The authors relate the value they place on labor to the United Nations Declaration on Human Rights, which asserts that “everyone has the right to work, to free choice of employment, to just and favorable conditions of work and to protection against unemployment.” Lack of access to employment impedes full participation in society and undermines many of the other rights asserted in the Declaration. It is also associated with a long list of personal and social pathologies, such as physical and mental health problems, crime, and drug abuse.

From this perspective, macroeconomics and enlightened public policy are inseparable. Policymakers need to get it right because the stakes are very high.

Coming up…

What I will be trying to do in the next few posts is describe in fairly plain English how modern monetary theorists think the economy works. I will emphasize, as the authors do, the many forms of government influence: spending and its impact on output and income; taxation and transfer payments; the creation and management of money; and financial balances interconnecting government and non-government sectors. What I like about macroeconomics is that a few fundamental principles yield surprising insights.

Then I will turn to the the authors’ critique of recent public policy and their recommendations for new directions.


The Clash of Economic Ideas (part 2)

May 15, 2013

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Chapter 5 of Lawrence White’s book is devoted to “The Great Depression and Keynes’s General Theory.” I will also incorporate some ideas from later chapters that are relevant to Keynesian economics.

Keynes and Hayek disagreed fundamentally over the ability of the market economy to sustain full employment and economic growth without deliberate government stimulus. Hayek believed that the income generated by economic production would automatically stimulate further production, because the income would either support consumption or new investment. Either consumer goods or capital goods would be produced. Keynes, on the other hand, did not believe that income that people saved rather than consumed would necessarily support new investment. An increase in what he called the “propensity to save” might just reduce consumption without increasing investment, resulting in a lack of “aggregate demand” and a reduction in production and employment. Some Keynesians would say that a big reason for an excess of saving and a lack of demand is an income distribution favoring rich savers over lower-income spenders, but that argument was not essential to Keynes’s original theory. His point was simply that production didn’t necessarily create the demand needed to generate further production.

Keynes understood the Great Depression as a vicious circle of low demand and low production, with no short-run market solution. Hayek saw economic slumps as self-correcting as long as central banks properly managed the money supply. “Despite the reservations and objections of orthodox (often older) economists, Keynes’s theory quickly caught on among younger economists and completely eclipsed Hayek’s theory.” Keynesian theory dominated economic thought in Great Britain and the United States until the 1970s.

According to Keynesian economics, government spending in excess of taxes could increase aggregate demand and stimulate the economy. Only if the economy were already operating at full employment would that spending merely replace other kinds of spending with no net gain in aggregate demand and national output. At less than full employment, government spending would lead to a net gain in GDP (the size of which could be expressed by the “multiplier” ΔY/ΔG–the ratio of the change in GDP to the change in government spending). Keynesians rejected the classical economic view that running a deficit is as foolish for a nation as it is for a household. Otto Eckstein argued that a national debt is different from a household debt because “we owe it to ourselves.” In theory, we can repay it out of the larger income that deficit spending generates. This argument was more convincing before other countries began financing a large portion of our debt.

Critics of Keynesian economics such as James M. Buchanan argued that government spending had to burden either current or future taxpayers, and that the theory encouraged fiscal irresponsibility: “Keynesian economics has turned the politicians loose; it has destroyed the effective constraint on politicians’ ordinary appetites. Armed with the Keynesian messages, politicians can spend and spend without the apparent necessity to tax.”

Keynesian economist Paul Samuelson provided an additional rationale for government spending in his theory of “public goods.” As described by White, “the theory…views government as a faithful agent hired by the citizenry to provide desired goods and services having characteristics such that the market economy provides too little of them.” This elaborated on an idea already present in the writings of classical and neoclassical economists. Private entrepreneurs may not find it in their self-interest to produce something even if the public values it enough to pay for it. For example, they may not be able to make a profit financing basic research or general intellectual activity (as opposed to applied research to develop specific products), and yet the public may well wish to finance universities with their tax dollars. The problem for the entrepreneur is to “capture all of the potential gains from production and trade,” which is hard to do for ideas that spread freely. The failure to do so is a type of market failure known as a “Pareto inefficiency,” named for the Italian economic Vilfredo Pareto. Arthur Pigou related the problem to the concept of externality discussed in the previous post. Just as markets sometimes reward individuals for doing things that have negative externalities (social costs), they also fail to reward individuals for doing things that have positive externalities (social benefits). Public goods theory says that the government has a responsibility to discourage the first type of behavior and promote the second.

Critics of public goods theory have tried to show how goods and services that are commonly regarded as public could conceivably be provided by markets under the right conditions. In 1960, Ronald Coase argued that externality problems are often property rights problems, and the solution is often to expand the rights of producers to make sure they profit from socially useful activity. In the classic case he studied, radio broadcasting could become a profitable activity only when broadcasters owned the frequencies on which they broadcast so they were free of interference. The argument can be extended to justify many forms of privatization. On the other hand, some goods seem irrevocably public. Maintaining a favorable global climate requires public action, since no business can own the climate enough to have a profit motive to protect it.

Non-Keynesian economists, especially James M. Buchanan and Gordon Tullock, have tried to counter public goods theory with “public choice” theory. It questions the very idea that government spending can work for the benefit of all. What is more likely to happen is that:

 …[I]ndividuals can use the powers of government for special-interest programs, or “rent-seeking,” gaining benefits for some at the expense of others….On an issue where the taxpaying majority is poorly organized, a well-organized special interest group may use plausible arguments (and campaign contributions) to persuade legislators to grant it monopolistic privileges or to tax the general public for the group’s benefit.

This is reminiscent of Adam Smith’s criticism of mercantilist government, favoring some economic interests over others instead of letting the market decide what’s best. Of course, a public goods theorist would question the assumption that what is most profitable is really best for society.

White concludes his treatment of public choice theory with the observation, “By rebuilding the intellectual case for the limited-government constitutionalism of the American founders, Buchanan and Tullock might today be called patron saints of the constitutionalist wing of the Tea Party movement.” This remark dramatizes the close association between economics and politics. Is the Tea Party trying to restore limited government and economic freedom, or is it trying to render government too impotent to stand up to powerful private interests and carry out needed economic reforms?


The Leaderless Economy

February 1, 2013

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Peter Temin and David Vines. The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It (Princeton University Press, 2013)

This is a work of both Keynesian macroeconomic theory and economic history, emphasizing the connections between the internal workings of national economies and the external relations among them in the global economy. “Economic theory provides a framework for understanding the relations between internal and external balances, and economic history shows the context in which these relations assume importance.” Since the book is directed at noneconomists as well as economists, the authors seem to assume that readers want more history than theory. They refrain from discussing their economic models very directly, providing only a sketchy introduction in the first chapter and then a somewhat more logical presentation in the Appendix. I would have preferred they explain their models more fully at the outset. As it is, they tell the story of “The British Century and the Great Depression” in Ch. 2, and then describe Keynes’s evolution as a theorist and a policymaker in Ch. 3, before going on to “The American Century and the Global Financial Crisis” in Ch. 4. Given the wealth of historical detail, the reader is hard-pressed to understand the events described without yet having a firm grasp of the theory that’s supposed to explain them!

For that reason, I will attempt to describe the economic models first, and then rely on them to illuminate the economic developments.

Temin and Vines summarize their perspective this way: “The aim of policy in a well-managed economy must be to ensure both external balance–which requires that exports are sufficient to pay for imports–and internal balance–which requires that resources be fully utilized. It is clear that to achieve both objectives at the same time requires a difficult balancing act.” Economists have long seen economic processes as balancing acts, especially the reconciling of supply and demand in a particular market through a pricing mechanism. The British economist John Maynard Keynes made great advances in understanding balancing processes involving two markets at once. This is the tradition the authors draw on to understand the connections between domestic and international markets.

Temin and Vines present two models of bi-market relationships in the Appendix, both of which derive from the work of Keynes, as interpreted and developed by James Meade.

The Hicks IS/LM Model

This model describes the simultaneous balancing of supply and demand in two markets within the same economy, the market for goods and the market for money.

The market for goods is balanced when the supply (Gross Domestic Product) is equal to all the forms of demand: Consumption, Investment, Government Spending and Net Exports. GDP is also equivalent to national income, and the forms of demand can be thought of as allocations of income.

In the Hicks model, the balance of supply and demand is expressed as the balance of Savings and Investment. That works because some income is saved rather than spent on consumption, government or imports, and the same amount must show up as investment in order for the supply-demand equation to balance.

The second market, the market for money, is balanced when the Real Money Supply equals the Liquidity Preference (the demand for cash). Liquidity preference includes the demand for cash for transactions as well as the demand for cash savings. Liquidity preference is closely tied to the Interest Rate (the price of money). The demand for cash pushes interest rates up, but on the other hand, high interest rates encourage people to lend money rather than keeping it in cash.

A change within either market triggers balancing processes in both markets. The possible system states are displayed in a graph with GDP on the horizontal axis and Interest Rate on the vertical axis. A change in either variable creates a new point of “general equilibrium,” the point at which supply would balance demand in both markets simultaneously. The relationships between the two variables are described by two curves, the LM curve and the IS curve, and the point of equilibrium is where they cross.

The Liquidity Preference-Money Supply (LM) Curve describes a direct relationship between GDP and Interest rate. The higher the GDP, the higher the interest rate needed to balance the supply and demand of money. A higher GDP increases the demand for money for transactions, putting upward pressure on the interest rate. But rising interest rates reduce the speculative demand for money; the desire to keep savings in cash declines because of the high interest available to lenders. So a change in GDP results in a new equilibrium in the money market, where money demand once again equals money supply, but cash for spending has increased relative to cash for lending, other things being equal (money supply assumed to be unchanged).

The Investment-Savings (IS) Curve describes an inverse relationship between Interest Rate and GDP. The higher the interest rate, the lower the level of production at which demand balances supply. Higher interest rates discourage people from borrowing in order to spend on either capital or consumer goods. The economy contracts and a new equilibrium is established at a lower level of both supply and demand. Similarly, lower interest rates encourage borrowing, spending, and a higher level of supply and demand.

The point at which the two curves cross is the point of general equilibrium. Other points represent situations of excess supply or demand in either the goods market or the money market, or both.

How can there be two different relationships—one direct and one inverse—between the same two variables, GDP and Interest Rate? Think of it like the relationship between a predator and its prey, such as foxes and rabbits. A larger rabbit population can support a larger fox population (direct relationship), but a larger fox population trims the rabbit population (inverse relationship). The result is a balance of nature in which neither population can become too large relative to the other. Similarly, rising interest rates both result from GDP growth and place limits on it.

That doesn’t mean that the economy tends toward a steady state, however. The equilibrium can be a moving equilibrium, where variables remain in some balance while moving together. In a growing economy, supply and demand can increase together in both the goods market and the money market. GDP and national income grow, but interest rates can remain stable if the increasing demand for money is offset by a steadily increasing money supply. For that to happen, however, the markets for goods and money must sustain a delicate mutual balancing act. Since some of the growth in income is saved rather than spent, growth in the aggregate demand for goods requires increases in investment as well as consumption.  (Recall that Savings must equal Investment for supply and demand to balance.) But GDP growth encourages higher interest rates because of the increasing demand for money, and high interest rates discourage borrowing for investment and consumption. So economic growth requires the money supply to increase just fast enough to balance GDP growth and money demand; if not, the GDP growth won’t be sustained and the economy will have to contract. On the other hand, if money supply outruns GDP growth, interest rates fall, consumers borrow and spend too freely, and that results in inflation. A delicate mutual balancing act indeed!

The Hicks model helps clarify the role of government, which is a central feature of Keynesian economics. If the economy were self-regulating and always near general equilibrium, there wouldn’t be much for government to do, except balance the budget and slowly increase the money supply to accommodate growth. Increasing government spending would just raise interest rates, discouraging producers and consumers from borrowing and spending. (This is the basis for the old idea, criticized by Keynes, that government spending just crowds out private investment.) And increasing the money supply too quickly would just be inflationary (too many dollars chasing too few goods). But Keynes was interested in policies to repair economies that are not in equilibrium. If the economy is in recession, with interest rates too high, money too tight and aggregate demand insufficient to absorb productive capacity, a more expansionary fiscal policy or looser monetary policy may provide needed stimulus. Writing during the Great Depression, Keynes was well aware that economies could get seriously out of balance, and that public policy made a difference for better or for worse.

The Swan IB/EB Model

This model relates internal balancing within the domestic market for goods to external balancing of imports and exports in international trade. It is the model most directly relevant to the authors’ discussion of the global economic crisis.

As in the Hicks model, the internal goods market is balanced when demand matches productive capacity, maintaining full employment without inflation. The external goods market is balanced when exports are just large enough to pay for imports, with neither a trade surplus nor a deficit.

Once again, a change within either market triggers balancing processes in both markets. Graphic presentations differ, but the Temin and Vines version plots Domestic Demand on the horizontal axis and Real Exchange Rate on the vertical axis. (Since at equilibrium output equals demand, it is not a big change to plot Domestic Demand where GDP was in the Hicks model. It’s still equal to Consumption, Investment, Government Spending, and Net Exports.) The Real Exchange Rate is the price of the country’s currency on world markets. (Technically that is the nominal–stated–rate of exchange adjusted for the ratio of domestic prices to foreign prices, since either a higher nominal rate of exchange or higher domestic prices make a country’s goods more expensive on world markets.) The exchange rate is inversely related to global competitiveness, since a high exchange rate makes it harder to sell goods abroad.

The Internal Balance (IB) Curve describes a direct relationship between Domestic Demand and Real Exchange Rate. The higher the domestic demand, the higher the exchange rate at which demand will balance supply. Higher domestic demand tends to push up prices, making the real exchange rate higher even if the nominal rate remains the same. The nominal rate would also go up if a lot of the demand is coming from foreign buyers, pushing up net exports and the price of the currency foreigners need to buy them. But a higher exchange rate makes exports more expensive and imports cheaper, which brings the demand for domestic goods back down toward supply.

The External Balance (EB) Curve describes an inverse relationship between Real Exchange Rate and Domestic Demand. The higher the real exchange rate, the lower the level of domestic demand at which imports will balance exports. At equilibrium, the income earned from exports provides the means to buy imports. If a country’s currency is very strong (high exchange rate), that encourages a trade deficit by making exports expensive and imports cheap. But that trade deficit lowers the national income, depressing the demand for imports. Lower demand offsets the higher exchange rate and restores the balance of trade.

Once again, the point of general equilibrium is the point at which the two curves cross. In this graphic presentation, points to the right of the upwardly sloping IB curve represent inflation, and to the left unemployment. Points above the downwardly sloping EB curve represent trade deficit, and points below the curve represent surplus. The one point that is on both curves is the equilibrium.

In the Hicks model of internal markets, GDP growth stimulates a higher interest rate, which in turn limits GDP growth. In the Swan model of internal and external markets, domestic demand stimulates a higher exchange rate for the domestic currency, which in turn limits domestic demand. That doesn’t mean that demand for a country’s products can’t grow at all; it just means that growth is constrained by certain “other things being equal” conditions, in this case the success of competing economies in creating demand for their products. If all countries are increasing their production of desirable goods by the same amount, demand can rise everywhere and exchange rates don’t have to change to anyone’s disadvantage.

Now consider two trading partners, one whose goods are more in demand than the other. The one whose goods are more in demand is a net exporter with a trade surplus, and the other is a net importer with a trade deficit. The balancing processes should go like this: High demand for the exporter’s goods should increase its real exchange rate, making its exports more expensive and bringing the demand back down. In the other country, low demand for its goods should reduce its real exchange rate, making its exports cheaper and bringing demand up. Where exchange rates are free to adjust, trade imbalances should be self-limiting.

However, countries often resist adjustments to exchange rates. Some countries, like China, deliberately maintain a cheap currency to make it easy for other countries to buy their exports. Other countries, like the US, enjoy the buying power that a strong currency provides. And countries in the European Monetary Union share a common currency whose exchange rate may be set too high or too low for the economic health of a particular member state. In theory, real exchange rates can change through price inflation or deflation, even if nominal rates remain the same, but those changes may not be welcome either. Wage or price cuts that would make American goods more competitive may be resisted by labor or business.

Without appropriate currency adjustments, trade imbalances may persist, turning a net importer into a debtor nation and a net exporter into a creditor nation. Temin and Vines are especially interested in how these persistent external imbalances affect the internal balancing acts of nations, often resulting in economic crises. How would a country with a persistent trade deficit maintain internal balance, that is, full employment without inflation? How would it keep its industries operating at full capacity if foreigners aren’t buying its goods and its own citizens are buying a lot of imports? It could offset the low global demand for its products by increasing other components of aggregate demand. It could direct a larger proportion of its national income toward spending rather than saving. Its consumers could buy domestic as well as foreign goods by saving less, borrowing more and spending more. Government could encourage consumer spending by cutting taxes and holding interest rates low, as well as by keeping its own spending in excess of government revenue. Foreign saving and lending could help finance borrowing by consumers and government, as well as provide investment capital to compensate for the low rate of domestic saving. In this way, a debtor nation could grow its economy for a time. But when economic growth based on increasing indebtedness proved unsustainable, a severe contraction would occur. (Does any of this sound familiar?)

Temin and Vines argue that internal balance and external balance must be considered together. The story they tell about the global economy is largely a story of international trade imbalances perpetuated by unwise policy responses, which greatly complicate and ultimately overwhelm efforts to maintain balanced economies running at full capacity. I think that their perspective adds an important dimension to discussions of the recent financial crisis.