I read an article in the Financial Times earlier this week (September 23, 2023) -…
Today’s Australian newspaper, sadly our national daily carries a story – Stimulating our way into trouble – by Griffith University professor (and ex-federal treasury official) Tony Makin. I pity the students who have to study with him. The article continues the News Limited campaign against the government stimulus package and demonstrates the extent that is prepared to use the services of so-called experts (that is, titled mainstream economists) who seem prepared to grossly mislead the readership to advance their ideological strategy. Whatever it takes seems to be the strategy. Anyway, once again the mainstream macroeconomics textbook is called upon to make policy statements.
Tony Makin is already in the running for the billy blog worst Op-Ed column of 2009 award which I will announce at the end of the year. I think this article reinforces his hold on that award. Possibly the worst article of all time.
For a professional economist such as myself the Makin article is very funny – because it is so bad – sort of like those old movies – such as Santa Claus conquers the Martians, which is a particular favourite. But the message it provides is potent to those who are wavering on the issue and do not understand the technical framework that Makin is using as an authority for his parlous argument.
In short, this sort of spurious reasoning sounds reasonable, is highly dangerous but also spurious to the core.
Makin begins by noting that:
SINCE late last year numerous contributors to this page, me included, have argued that the Keynesian spend and borrow response to the economic downturn embraced by the federal and state governments has been seriously flawed in theory and practice.
Yes a veritable cacophony of shrill conservatives who haunt the pages of The Australia and who are wheeled out on a daily basis to scare the readership who, unfortunately, do not know better. This is not a newspaper that tolerates broad perspective.
Anyway, Makin decides to approach this from a theoretical basis saying that:
The 23 per cent increase in the current account deficit in the September quarter arising from a fall in exports and rise in imports provides direct evidence of this.
To understand why, we need only invoke undergraduate textbook theory of how fiscal policy operates in an open economy with a floating exchange rate.
This theory tells us that a growing budget deficit due to increased government spending of the kind we have seen puts upward pressure on domestic interest rates, all other things being equal.
First, lets be clear on what happened to the external accounts in the September quarter. It is true that the Current Account balance went from a deficit of -13,133 million AUD to -16,183 million in the September quarter a reduction of 23 per cent.
Almost all of the change was driven by the balance on goods and services. The decline in net exports “This is expected to detract 1.8 percentage points from growth in the September quarter 2009 volume measure of GDP” (Source).
The ABS data tells us that “the net goods deficit rose $3,847m to $4,767m” and the “net services deficit rose $377m to $641m”. Exports fell by 6 per cent while imports rose by 2 per cent.
In terms of the rising imports, capital goods rose by 6 per cent and accounted for more than 66 per cent of the rise in imports. A 3 per cent rise in intermediate and other merchandise goods accounted for a smaller proportion. Capital goods and intermediate gods reflect the growing investment that is now appearing in the Australian economy.
The change in consumption imports accounted for only 5 per cent of the total rise in imports in the September quarter.
So that looks like an economy that is dependent on imported capital equipment which is in the early stages of an investment boom. The declining exports reflect soft conditions in world markets which are of-course exogenous to Australia.
Then consider Makin’s call to authority – the “undergraduate textbook theory of how fiscal policy operates in an open economy with a floating exchange rate”. The theory he is alluding to tells you very little about the way the real world actually operates.
To see this it is best to first rehearse his argument that fiscal policy expansion drives up interest rates.
Need I say it but using the same textbook theory a rise in private investment spending or net exports will have exactly the same impact on interest rates. That is, any spending growth would deliver the same outcome.
Anyway, in attempting to establish his proposition, Makin says that interest rates rise:
… because increased government spending increases the overall demand for money in the economy which, for a given supply of money as determined by the Reserve Bank of Australia, tends to raise domestic interest rates above foreign interest rates.
This is an extraordinary piece of cheek.
The mainstream theory of money and monetary policy that Makin is appealing to asserts that the money supply (volume) is determined exogenously by the central bank. That is, they have the capacity to set this volume independent of the market. The monetarist portfolio approach claims that the money supply will reflect the central bank injection of high-powered (base) money and the preferences of private agents to hold that money. This is the so-called money multiplier.
So the central bank is alleged to exploit this multiplier (based on private portfolio preferences for cash and the reserve ratio of banks) and manipulate its control over base money to control the money supply.
To some extent these ideas were a residual of the commodity money systems where the central bank could clearly control the stock of gold, for example. But in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.
The theory of endogenous money is central to the horizontal analysis in MMT. When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).
While there have been many contributors to the literature on endogenous money, my favourite work is the evolving writing of Marc Lavoie, who is at the University of Ottawa and who I have a lot of time for. The core articles are:
- Lavoie, M. (1984) ‘The endogeneous flow of credit and the Post Keynesian theory of money’, Journal of Economic Issues, 18, 771-797.
- Lavoie, M. (1992) Foundations of Post-Keynesian Economic Analysis, Aldershot, Edward Elgar.
- Lavoie, M. (1996) ‘Horizontalism, structuralism, liquidity preference and the principle of increasing risk’, Scottish
Journal of Political Economy, 43, 275-300.
- Marc Lavoie’s excellent 2001 working paper Endogenous Money in a Coherent Stock-Flow Framework also provides a free way of getting into some of the later evolution of the work. But this paper is not easy.
Lavoie wrote in 1984 (page 774):
When entrepreneurs determine the effective demand, they must plan the level of production, prices, distributed dividends, and the average wage rate. Any production in a modern or in an “entrepreneur” economy is of a monetary nature and must involve some monetary outlays. When production is at a stationary level, it can be assumed that firms have at their disposal sufficient cash to finance their outlays. This working capital, in the aggregate, constitutes credits that have never been repaid. When firms want to increase their outlays, however, they clearly have to obtain extended credit lines or else additional loans from the banks. These flows of credit then reappear as deposits on the liability side of the balance sheets of banks when firms use these loans to remunerate their factors of production.
The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit.
So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.
Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans.
The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base (bank reserves) as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.
With the season approaching, I recalled a lovely 1970 quote by Nicholas Kaldor (in ‘The New Monetarism’, Lloyds Bank Review, July, 1-17) about what would happen if the central bank tried to restrict credit:
There would be chaos for a few days, but soon all kinds of money substitutes would spring up: credit cards, promissory notes, etc., issued by firms or financial institutes which would circulate in the same way as bank notes … a complete surrogate money-system and payments-system would be established, which would exist side by side with “official money”.
There are all sorts of disputes in this literature – some arcane, most interesting – as to whether the money supply is infinitely elastic (that is, not sensitive to the interest rate) or not. The nuances in the debate do not alter the fundamental insight. The central bank does not control the money supply.
The conclusion is clear: central banks use short-term interest rates as their usual policy instrument and largely ignore the monetary aggregates that are endogenously determined. These aggregates provide very little information that the evolution of GDP and employment growth provide anyway. And the real aggregates are what policy is concerned with anyway.
You may like to read what the RBA says about its monetary policy role. You will read nothing at all about how there is a “given supply of money” which the RBA determines. A visit to any central bank WWW site will tell you a similar story in a multitude of languages.
In terms of the implementation of monetary policy, the RBA says that:
From day to day, the Bank’s Domestic Markets Department has the task of maintaining conditions in the money market so as to keep the cash rate at or near an operating target decided by the Board. The cash rate is the rate charged on overnight loans between financial intermediaries. It has a powerful influence on other interest rates and forms the base on which the structure of interest rates in the economy is built … Changes in monetary policy mean a change in the operating target for the cash rate, and hence a shift in the interest rate structure prevailing in the financial system … The Reserve Bank uses its domestic market operations (sometimes called ‘open market operations’) to keep the cash rate as close as possible to the target set by the Board, by managing the supply of funds available to banks in the money market.
The cash rate is determined in the money market as a result of the interaction of demand for and supply of overnight funds. The Reserve Bank’s ability to pursue successfully a target for the cash rate stems from its control over the supply of funds which banks use to settle transactions among themselves. These are called exchange settlement funds, after the accounts at the Reserve Bank in which banks hold these funds.
If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall. Conversely, if the Reserve Bank supplies less than banks wish to hold, they will respond by trying to borrow more in the cash market to build up their holdings of exchange settlement funds; in the process, they will bid up the cash rate.
Note that this is a discussion about manipulating bank reserves (in Australian parlance “exchange settlement funds”). Note also the last paragraph they clearly tell us that the “cash position” of the monetary system (that is, the volume of bank reserves) are critical for determining the movement in the cash rate and the RBA’s ability to maintain control over it.
Notice that when there are excess reserves the banks “try to shed funds” and this has a “tendency for the cash rate to fall” (and vice versa). Modern monetary theory (MMT) tells us that net government spending adds to bank reserves which create the same tendency for the cash rate to fall. That tendency is arrested by liability management operations conducted by the central bank.
[Editor’s note: three themed blogs is a Trilogy but I couldn’t find an expression for two themed blogs and my very literate partner wasn’t able to enlighten me. So given bi = 2 and I am bill – I am thus calling my recent series on bank reserves a billogy].
You will note that in MMT there is very little spoken about the money supply. In an endogenous money world there is very little meaning in the aggregate.
The central bank does publish data on various measures of “money”. They publish data for:
- Currency – Private non-bank sector’s holdings of notes and coins.
- Current deposits with banks (which exclude Australian and State Government and inter-bank deposits).
- The M1 measure – Currency plus bank current deposits of the private non-bank sector.
- The M3 measure – M1 plus all other ADI deposits of the private non-ADI sector. So a broader measure than M1.
- Broad money – M3 plus non-deposit borrowings from the private sector by AFIs, less the holdings of currency and bank deposits by RFCs and cash management trusts.
- Money base – Holdings of notes and coins by the private sector, plus deposits of banks with the Reserve Bank and other Reserve Bank liabilities to the private non-bank sector.
Note that ADI are Australian deposit-taking institutions; AFI are Australian financial intermediaries; and the RFCs are Registered Financial Corporations. Here is the RBA’s excellent glossary for future reference.
The following graph shows the monthly evolution of M3 and Broad Money in Australia since August 1976 up until October 2009. While I don’t hold much store in these aggregates, the same cannot be said for the textbook models that Makin is trying to suggest to his readers are important. There is no way one could argue that the money supply is fixed even over a short period.
The next graph just shows the monthly percentage changes in M3 for Australia (%). The growth rate is variable and reflects the various factors that endogenous growth theorists have identified as being influential in driving the credit cycle.
Makin’s depiction of the monetary system is clearly just plain wrong! And he holds himself out as a professor of economics. That is just a disgrace.
So having dealt with that we consider the rest of Makin’s argument which attempts to tie interest rate rises to our current account position.
It is clear that the budget deficits are not driving the rising interest rates. To claim this you would have witnessed significantly rising and high interest rates in Japan in the 1990s and US interest rates should be rising more quickly than Australia’s given its deficit is significantly larger as a percentage of GDP.
The RBA set the interest rate. It has a pavlovian rule that tells it to push up rates if it expects inflation to emerge. At present it is saying the cash rate is below its neutral rate – so according to their logic – stimulatory. It is merely (within its own logic) moving the rate slowly up to its neutral position again. Please read this selection of blogs – Search string for neutral interest rates – for more discussion on this point.
While previous blogs I have written (see search string above) criticise this concept, the RBA is not tightening rates because there is a shortage of money as asserted by Makin. They are being defensive in terms of their charter to fight inflation first.
Anyway, Makin then says:
Rising interest rates in turn induce foreign capital inflow and strengthen the exchange rate. This worsens Australia’s competitiveness in relation to its trading partners, resulting in lower exports and higher imports.
The explanation of our appreciating exchange rate is significantly more complex than this. For a start, any terms of trade effects on trade are lagged and would not be showing up in the September quarter data.
Further, a significant driver of our exchange rate are the commodity prices (particularly base metals) which have showed some signs of recovery in recent months (Source).
Our trading prospects are also heavily dependent on the state of the world economy and this has reduced our net export contribution (an income effect) more significantly than the relative price effects arising from exchange rate changes (which are yet to be felt).
But as I noted above, the rising imports are a sign that investment is picking up strongly which suggests a positive reaction to the fiscal stimulus.
Makin then reinvents a further myth:
… the twin deficits phenomenon is back: the consolidated budget deficit of the federal and state governments appears to be causing higher trade and current account deficits.
“Appears to be”. On what evidence would we be able to conclude that? Makin certainly provides none. How would he explain the rising current account deficit when the federal budget was in surplus for 10 out of 11 years between 1996 and 2007?
While there is a clear relationship between these national account balances (the so-called sectoral balances) the causality is tricky. Certainly, a fiscal expansion will stimulate aggregate demand which will increase output growth and some of the demand will leak into imports. The fact that the substantial driver of import growth is investment demand (capacity building) would suggest that the fiscal expansion is not leading exclusively to a binge on imported K-Mart plastic junk.
But given Australia’s external account (current account) is typically in deficit, then the only way the economy can continue to growth (and recover from the slump) as the private domestic sector increases its saving ratio to restore the precarious nature of household balance sheets following the credit binge (induced, in part, by the federal surpluses), is via federal deficits.
That is the causality – slump in private spending, GDP contraction, automatic stabilisers drive the budget deficit up, government reacts by discretionary net spending to underwrite GDP growth, income rises and so do imports. That seems like a good story to me.
Makin then gets desperate:
… ultimately, foreign funding of the current account deficit has to be linked to highly productive investment spending. Otherwise, foreign investors will take fright, the current account deficit will become unsustainable, and the nation’s credit-rating will be downgraded, leading to a further spike in interest rates.
So we are left with the scare mongering. Australia has run large deficits regularly during the fixed exchange rate period and the fiat currency period. We have never had an unsustainable current account – whatever that is nor have we ever received a credit-rating downgrade – as if that would matter anyway.
It is true that the rising exchange rate will make it harder for manufacturing to compete – but that has nothing to do with the fiscal position. It reflects our very unbalanced export sector where mining, agriculture and industrial traded-goods face very different world demand conditions. Of late, our minerals demand has been huge and this is putting an exchange rate squeeze on the other traded-goods activities.
And further, if foreign investors really take fright what will happen. According to Makin’s theory this would cause our exchange rate to depreciate which should satisfy him anyway.
A ridiculous piece of commentary. But it gave me the chance to talk a bit about monetary aggregates and endogenous money theory and acknowledge the work of Marc Lavoie.