Download Mecpoc Symposium design

F r a n k l i n
C o l l e g e
s w i t z e r l a n d
i n t e r n a t i o n a l e C o n o M i C s y M P o s i u M
3rd MeCPoC syMPosiuM ProCeedings
aP r il 2 0 , 2 010 , l u ga n o
g
lobal
Crisis,
PoliCy Failures,
and the road
to ProsPerity
s P o n s o r e d by
M e CP oC,
the
Mosler eConoMiC PoliCy Center
M eCPoC , M osler e ConoMiC P oliCy C enter
Mecpoc (Mosler Economic and Policy Center) promotes and encourages education and research in new concepts
and methods of economic policy analysis. Activities include an annual symposium, a summer scholarship, and
other opportunities for undergraduate students to discover alternative views in economic policymaking.
The proceedings of the Mecpoc Symposium consist of papers submitted by the guest speakers and transcripts of
the speakers’ remarks.
Con t e n ts
2
s y M P o s i u M P a r t i C i Pa n t s
4
where will the Money CoMe FroM? a strange Case
Andrea Terzi, Franklin College Switzerland
oF
Money illusion
12
g e t t i n g o u t o F r e C e s s i o n ? s t r at e g i e s F o r s u s ta i n a b l e g r o w t h
Gennaro Zezza, Università degli Studi di Cassino, Italy
23
P r ag M at i C a n d d o g M at i C k e y n e s i a n i s M : t h e r e l e va n C e
t h i n k i n g t o day
Keynote Speaker: Peter Clarke, Cambridge University
31
Questions
33
w h at P o l i C i e s F o r g l o b a l P r o s P e r i t y ?
Antonio Foglia and Andrea Terzi interview Warren Mosler, Center for Full Employment and
Price Stability at the University of Missouri, Kansas City (participating via videoconferencing)
FroM the
oF
keynes’s
Floor
-2-
sy M P os iuM Part iCiPan ts
Peter Cl arke
Peter Clarke (keynote speaker) was formerly Master of Trinity Hall, Cambridge (2000-2004), and simultaneously served as Professor of Modern British History (1991-2004). He has written widely on many aspects of twentieth-century British history and is the author of the well-known volume in the Penguin
History of Britain Series, Hope and Glory: Britain 1900-2000 (2004). His interest in Keynes was first seen
in his book The Keynesian Revolution in the Making,1924-36 (Oxford UP, 1988) which excited much
attention from historians and economists alike, as did his collected essays, subsequently published as The
Keynesian Revolution and its Economic Consequences (Edward Elgar, 1997). He was elected a Fellow of
the British Academy in 1989. He is the author of nine books, of which the most recent is Keynes: the twentieth century’s most influential economist (London: Bloomsbury; New York: Bloomsbury USA). Peter
Clarke contributes occasional opinion pieces to the Financial Times. He is married to the Canadian author Maria Tippett, and they divide their time between Cambridge and the house they have built on Pender Island, British Columbia.
antonio Foglia
Antonio Foglia (moderator) is a member of the Board of Directors of Banca del Ceresio, a private bank in
Lugano, Switzerland. After earning a degree in economics from the Università Bocconi in Milan, he worked
in Tokyo, New York, and London to complete his training and has been professionally involved in private
banking and with hedge funds since the mid-1980's. In addition to co-managing several leading multimanager hedge funds, including Leveraged Capital Holdings N.V., the world's oldest offshore multimanager fund, Foglia is also a director of several hedge funds, including some belonging to George Soros'
Quantum Group. Foglia, the representative of the Ticino Banking Association on the Foundation Board
of the Swiss Finance Institute, which coordinates cooperation among Swiss universities in the field, is also
a member of the International Advisory Board of the Central European University Business School.
wa r r e n M o s l e r
Warren Mosler is the cofounder and Distinguished Research Associate of the Center for Full Employment and Price Stability at the University of Missouri in Kansas City (UMKC). CFEPS has supported
economic research projects and graduate students at UMKC, the London School of Economics, New
School University, Harvard University, and the University of Newcastle. Mosler is also a key founder of
EPIC – the Coalition of Economic Policy Institutions – and a founding member and manager of the III
Funds, which manages $1 billion.
andrea terzi
Andrea Terzi is a Professor of Economics and coordinator of the Mecpoc project at Franklin College
Switzerland. A student of Paul Davidson while at Rutgers University, Terzi has focused on macroeconomics, monetary theory, central banking operations, and financial market behavior. He joined Franklin
College in 1986. He has also taught at Rutgers University, the Institute for International Studies in Florence, the Collegio Europeo di Parma, and the Università Cattolica del Sacro Cuore in Milan and has
been Jean Monnet Fellow at the European University Institute in Florence. Terzi has published both in
American and European scholarly journals, and his most recent book, Euroland and the World Economy:
Global Player or Global Drag? (Palgrave Macmillan), co-edited with Jörg Bibow, centers on a key question for the future of Europe: will the single currency project contribute to world economic dynamism or
will it be dependent on the vigor and vitality of others?
-3-
gennaro zezza
Gennaro Zezza is an Associate Professor in Economics at the University of Cassino in Italy and a research
scholar at the Levy Economics Institute in New York. There he is part of the Levy Institute Macroeconomic
Modelling Team, which has been producing medium-term projections of the U.S. and world economy
since 1999. He teaches economics and econometrics at the undergraduate and graduate levels, and has
published in books and scientific journals on heterodox macroeconomics, international economics, and
wellbeing.
-4-
wh e r e wil l t h e M on e y CoM e F roM ? a s t r an g e C as e oF M on e y il lus ion
Andrea Terzi,
Franklin College Switzerland
Coordinator, Mecpoc
Emergency measures aimed at restoring demand
The title of this conference brings together three terms. The first is global crisis. Although dating its beginning may be tricky, this developed in its most frightening expression in the fall of 2008, when a deadly
cocktail of freefalling financial and commodity prices, frozen money markets, and plunging business orders produced the nightmare of an economy close to meltdown. Second, policy failures. Before the crisis,
they created the conditions for what the G20 defined at the Pittsburgh Summit of 2009 “the greatest
challenge to the world economy in our generation.” Yet, there is little consensus on what policies should
be blamed: bank supervision failures? The Fed raising interest rates too early? The Fed keeping rates too
low? The U.S. Treasury running an excessive (or too low, rather?) budget deficit? International coordination unable to address global imbalances? Finally, the third term is road to prosperity: how to achieve sustainable growth that makes full use of the material and human resources a nation has at its disposal. The
crisis has seriously hampered this latter process, and the policies so far embraced have not been paving the
way to prosperity: they only (nearly) restored the pre-crisis growth rate, yet the output gap is far from
closed. At the beginning of this year, the number of jobless in the world was estimated to have reached
nearly 212 million people, or 6.6 percent of the world labor force, according to the International Labor
Organization (2010). Thus, the crisis is far from over, and the policies implemented around the world, notably in the two largest economic regions (the U.S. and Europe), have not yet proved to be fully effective.
Within this broad context, this paper does not aim to assess “the hows and whys” of the global crisis.
Rather, it considers one single, unquestionable consequence of the disruptions of financial markets and
banks: the impairment of the private sector’s balance sheets that triggered a collapse of aggregate demand.
While there is broad consensus that a lack of demand caused the global recession, it remains controversial how aggregate demand can be quickly restored.
When, in the fall of 2008, demand plunged, economic policy orthodoxy was caught off-guard. In a “sky is
falling” climate, the U.S. administration and the Federal Reserve orchestrated a gigantic rescue plan for the
country’s financial system, including capital injections, purchase of assets, Treasury lending, raising guarantees, central bank liquidity provision, and a fiscal package. The once-acclaimed pivotal role of monetary
policy, commonly centered on some form of inflation targeting, gave way to massive government and central bank efforts to prevent the meltdown of markets, banks, and the economy. Since then, fiscal packages,
in varied sizes, have been adopted throughout the world after years of proclaimed fiscal deficit containment. Even economists who had long considered expansionary fiscal policies as ineffective and ultimately
unsafe conceded that this was the only game in town. Although breaking with a widely accepted paradigm,
government interference with banks’ balance sheets and expansionary fiscal policy was justified by the urgency of rescuing the system from meltdown and the need to kick-start the economy.
Greg Mankiw’s call for plain demand management policy (“What Would Keynes Have Done?” New York
Times, November 28, 2008) is a good example of how economists came to approach the crisis in late
2008. His message was straightforward: the cause of the economic downturn is insufficient aggregate demand; this condition reverses when some event triggers a rise in demand; demand has four components;
little is expected to happen to consumption, investment, or exports; this leaves the government as the demander of last resort: if monetary policy could not stop the plunge, there would only remain a government
spending plan, what Mankiw called “a good short-run fix” that would “fit well with Keynesian theory.” Yet,
Mankiw was less than enthusiastic when making this call for a return to Keynes. In his view, this would
-5-
pass on the burden of “unfunded promises” to the next generation, causing difficulties in future public finances and yet, for Mankiw, such policy was justified, in the short run, by the emergency.
“Short-run fix” Keynesians vs. “sound money” Hayekians
When the U.S. and most other governments in the world urgently approved fiscal stimulus programs, the
problem with orthodox economists supporting such plans was how to reconcile their policy advice with
theoretical models. For the latter, fiscal policy has little, if any, expansionary effects, while fiscal deficits ultimately absorb financial resources from the private sector.
This tension between modeling and giving advice might be explained following Mankiw’s account of the
dual role of “scientists” and “engineers” in macroeconomics. While the former are the theoreticians who
have had “only minor impact on the practical analysis of monetary and fiscal policy” (Mankiw, 2006, p. 42),
the “engineers” are those who ultimately devise policies to cope with the business cycle, thrusting aside
the “rigor” of science. Yet, this explanation leaves open the question of whether rising public debt can indeed steadily rescue markets. If mainstream theory has no place for fiscal stimulus, several queries inevitably arise: Is it safe to make exception to theoretical principles? If replacing private debt with public
debt is not a long-run solution, how far should we push the limits of public debt tolerance in the short run?
After all, it was only the feeling of staring into the abyss that pushed the limits of debt tolerance (not
clearly defined anyway) a bit further. For “short-run fix” Keynesians, exceptional times require exceptional
responses, including liquidity injections and public spending. Visibly, such actions ought to be reversed before harm exceeds benefit, and the current controversial question of timing the “exit strategy” is inevitably
tied to this ambiguity.
Other economists, following a more Hayekian (as opposed to Keynesian) perspective, have questioned
such ambiguity and criticized the “short-run fix” approach as an unnecessary and unsafe turnaround of economic principles. John Taylor, in this strand, argued that government action has caused and prolonged the
crisis. For Taylor, the “theory that a short-run government spending stimulus will jump-start the economy
is based on old-fashioned, largely static Keynesian theories” that “do not adequately account for the complex dynamics of a modern international economy or for expectations of the future that are now built into
decisions in virtually every market” (Wall Street Journal, November 25, 2008).
For the sake of convenience, I shall, albeit a bit loosely, refer to two popular views of the consequences of
a fiscal stimulus: “short-run fix” Keynesians have backed government attempts to restore demand through
public spending in the short run to be gradually unwound as soon as economic recovery is on its way,
while “sound money” Hayekians claim that the crisis should not be an excuse to run unprecedented
deficits. For “sound money” Hayekians, government intervention slows down the inevitable process of adjustment after a boom-and-bust episode. Their main argument is that deficit spending does not stimulate
growth, but instead leads to unsound money, and this lowers the capacity of the economy to resurrect itself. In their minds, there is no reason to bend economic rules to respond to cyclical conditions.
Let me briefly compare and contrast the two views portrayed above. The chief difference is found in the
approach to the question of the ability of government to accurately recognize and effectively address the
problems with successful measures. Keynesians believe it can, when properly advised. The Hayekian critique is that market order is the most efficient tool to restore the road to prosperity. In his 1974 Nobel
Prize lecture, Hayek wrote that no single actor (including government) possesses “the knowledge and the
power which enable us to shape the processes of society entirely to our liking.” This is at odds with the
notion that government spending action can indeed play an essential role in steering the economy away
from the marshes of the crisis and towards prosperity.
In their customary role as engineers of the world economy, international organizations combined both
-6-
concerns when advising to undertake demand-side polices to avoid another depression while maintaining
money soundness. The International Monetary Fund has backed fiscal responses while warning of their possible unpleasant consequences and has raised the question of “how much room does fiscal policy have to
continue its supportive action” and recommended that governments “balance two opposite risks: The risk
of prolonged depression and stagnation… [and] the risk of a loss of confidence in government solvency”
(Fiscal Implications of the Global Economic and Financial Crisis, IMF Staff Position Note, 2009, pp. 3940). Today, a number of nations are facing precisely the question of whether the short-run fix should continue or be declared over and whether they should continue to tolerate high deficits as long as
unemployment rates remain high or begin now to reverse the trend and reduce budget deficits. Governments appear to be again at a crossroads between the “Keynesian” and the “Hayekian” paths to prosperity.
But although they differ with respect to the confidence in the ability of governments to manage the economy and in the merits of public spending, the two positions seem alike with respect to the consequences
of budget deficits. They both share the principle that budget deficits have ugly long-run effects. Their difference is one of degree, of how long governments can breach the rule of sound money and still avoid permanent damage: while one side believes that in an emergency the benefit of pump-priming the economy
exceeds any temporary harm from the deficit, the other side views the deficit as inevitably leading to trouble. Ultimately, “short-run fix Keynesians” are just more tolerant with respect to how far we can push
emergency policies and how soon such policies should unwind for an “exit strategy.” In spite of this difference, both seem to believe that the numbers that measure the gap between tax revenue and government spending (called “budget deficit”) matter on their own, in that they have a real impact on the
economy through their effects on “money soundness.”
In the remainder of this paper, I will focus on an alternative approach to both views considered above and
argue that the belief that budget deficits inevitably have a long-run negative effect is based on a misunderstanding of the characteristics of modern monetary economies.
Real and nominal values: The lessons of Smith and Keynes
Giving priority to a balanced budget as a key condition for monetary soundness and real growth is an example of “money illusion,” granting the nominal values of government deficits a direct consequence in
terms of real resources they don’t have. This is well revealed in the question that is often associated with
any proposed fiscal action that increases the deficit: Where’s the money to come from?
When governments rescue companies with capital injections, or provide guarantees, or spend in excess of
tax revenue, they do commit financial resources. Don’t they have to obtain these resources from either tax
revenue or through borrowing, thus drawing from either current or future financial resources of the private sector? Doesn’t this inevitably reduce the standard of living of present and/or future generations?
These questions have been given alarming answers: fiscal stimulus in the U.S. has been associated with an
upcoming fiscal crisis, with borrowing from China, and with mortgaging future generations.
I claim here that this unwarranted causal link drawn from public sector monetary payments and the standard of living of a nation results from an optical illusion and ignores the legacies of Adam Smith and John
Maynard Keynes, as I will show next.
An important foundation of economics is the understanding of the difference between real and nominal
values. On this point, the first lesson is found in Adam Smith’s The Wealth of Nations. For Smith (1776),
the monetary values that we observe in the market cannot measure the real costs of employing real resources to obtain market products. The wealth of a nation is measured not by the value of money or money
in circulation, but by its capacity to produce goods and services. It is now a fundamental tenet that only
by comparison of monetary values can we measure real values: the cost of labor is not the absolute amount
-7-
of salary paid, but is the salary paid compared to the value of the product made possible by that labor; the
price of something is not its price in absolute amount of units, but its relative price in terms of another
product; the value of output over time cannot be compared with absolute values, but with deflated values, etc. Smith’s lesson is that the real wealth of a nation can be measured only after removing the veil of
money: it consists of the material and human resources available at any given time.
The second important lesson on the difference between real and nominal values is found in Keynes’s General Theory. Keynes stresses that only monetary returns prove success or failure of economic decisions in
a monetary economy, and agents make decisions on the basis of expectations of monetary flows. Agents’
awareness of future possible surprises when making decisions under uncertainty affects their behavior.
Most fundamentally, this induces them to store part of their wealth in a liquid form (financial savings) as
a way to keep options open, storing the power to make payments until an undefined future date. Actual
and expected monetary flows thus shape economic outcomes and can place a more stringent constraint
on output than the available real resources.
The views of Smith and Keynes are sometimes erroneously represented as conflicting, yet they are quite
complementary. When considered jointly, they teach us how to truly avoid money illusion in our interpretation of the world. From Smith, we learn that production and employment are limited only by national
resources. Thus, in the hardship of post-war reconstruction, or post-crisis recovery, a nation faces no real
constraint other than the full employment of its existing resources. From Keynes, we learn that the desire
for financial savings is both reasonable (for individuals – at the micro level – because it meets the desire
to tame uncertainty) and problematic (for the nation – at the macro level – because it removes demand
and production incentives) and is likely to add a monetary constraint to output and employment.
Keynes never confused money with real values: as long as we have unused resources, prosperity is “around
the corner” but cannot be attained until we remove the monetary constraint. He offered an excellent discussion of this in his 1940s’ analysis of the economic challenge facing Britain and the world. At the time
of Britain’s gigantic spending effort for post-war reconstruction, Keynes was faced precisely with this question: where is the money to come from? To this he answered in truly Smithian style: the wealth of a nation is not its money; it is the “bricks and mortar and steel and concrete and labor and architects” (Keynes,
1980, p. 308).
Yet, Keynes was well aware of how deeply engrained the belief was (and, alas, still is) that money is a constraint not only for the individual but for the nation as well, as if money had to be considered a real asset
that the nation may or may not possess, while this was clearly no longer the case after the end of the gold
standard. Indeed, Keynes’s answer to the question “where is the money to come from?” entails that money
is a social object, a nonconvertible credit of the nation state.
This means that no run on the central bank, or the government, is logically possible, unless the nation for
some reason imposes on itself an obligation of guaranteeing the national money with some other real asset
(or somebody else’s credit). A community that aspires to maximizing its overall welfare should use money
as a tool for prosperity. While the gold standard introduces the artificial constraint of the existing stock of
gold available, in an economy where the state issues money without any promise of conversion into anything else than the state currency itself, the only constraint that matters, in the short run or in the long run,
is the limit of available real resources. Yet, the economy may fall short of reaching that limit when policy
actions are ineffective in removing the monetary constraint, thus causing what Keynes considered the
most urgent question economics should address: “a condition where there is a shortage of houses, but
where nevertheless no one can afford to live in the houses that there are” (Keynes, 1936, p. 322). In other
words, a monetary economy may generate a situation of “poverty in the midst of plenty,” where agents cannot achieve their production possibilities because of a monetary obstacle that prevents them from fully
using the existing resources of the nation.
-8-
At the time Keynes was engaged in this discussion, Abba Lerner (1943) had just written an excellent piece
on the logic and the reality of the constraint of feeding the economy with public spending or tax cuts. In
a letter to James Meade discussing the use of fiscal policy to maintain full employment, Keynes claims to
be in agreement with Lerner’s notion that deficit spending is limited only by real resources. Keynes writes
a revealing comment in this regard: “Lerner’s argument is impeccable. But, heaven help anyone who tries
to put it across to the plain man at this stage of the evolution of ideas” (Keynes, 1980, p. 320). Keynes was
quite aware that the true nature of money outside the gold standard, or any other self-imposed constraint,
can be politically frightening and should be handled with great care. Nevertheless, he was quite clear in
his comments on budgetary considerations about how to create employment in post-war Britain:
The Committee give the impression that, whilst the measures they propose
to avoid unemployment are admittedly necessary and advisable, a price has
to be paid for them in the shape of budgetary deficits and perhaps a
consequent weakening in international confidence in our position. Exactly
the opposite is the truth… Is it supposed that slumps increase the national
wealth? … How slow dies the inbred fallacy that it is an act of financial
imprudence to put men to work! (Keynes, 1980, pp. 366-7)
The challenge to the dominant views on money was the most controversial aspect of Keynes’s theory. Although dismissed by the IS-LM Keynesians, this has been the major thrust of Post-Keynesian scholars (like
Paul Davidson and Hy Minsky). More recently, in several groundbreaking papers, Warren Mosler1 has tirelessly contended that all we need to conquer unemployment and inflation is to properly understand how
our monetary system works. Once we master it, the limit to fiscal deficits clearly appears to be nothing
else than what is required to achieve full employment and price stability.
If a market system is compatible with full employment and sustainable growth, why do we have so little
of these? Keynes believed in the power of ideas. One wonders, however, to what extent it is a matter of
logic and to what extent it is a question of lack of political willingness to create a sustainable full-employment society, where the raising of human dignity may well produce social consequences that specific
powerful constituencies would rather shun. By the same token, one cannot expect to overcome the political obstacles until the principle is accepted as a matter of logic.
What follows is a simple accounting framework aimed at clarifying some fundamental relations between
the private and the public sector when the latter is the monopolist, unconstrained supplier of currency.
Understanding where private financial savings come from
Let me first provide the background for the accounting illustration that follows by making the following
observations.
1. Following up on the above discussion about Smith and Keynes, an economic policy that would be
“sound” in real terms is one that removes any obstacles to the full use of all available human and material
resources while maintaining price stability, thus maximizing the long-run standard of living.
2. Monetary conditions should be considered “sound” not in the abstract of nominal figures, but when
they provide the conditions for (real) economic soundness. The goal of national welfare is to be achieved
in real, not nominal, terms.
3. The ability of each private unit (household or firm) to make payments is constrained by its access to
funding that can be provided only by access to income, borrowing, or asset-selling. No one can (legally)
get something for nothing.
1
See Mosler (1997, 2010).
-9-
4. Government is the monopolist issuer of currency. Unlike the private sector, its payments are unconstrained, unless government self-limits its ability to make payments by tying its own hands, either by committing to redeem its own liability with real assets (e.g., the gold standard) or someone else’s financial
assets (e.g., pegging a foreign currency at a fixed rate), or by creating laws and regulations (such as a balanced-budget amendment). In the absence of self-imposed constraints, any government payment (be it for
the acquisition of goods, services, assets, or for the payment of subsidies, interest rates, and other liabilities) consists of crediting the beneficiary with a bank account balance. Except for the negligible real costs
of this banking operation, payment is never backed by real resources owned by the government and is made
possible only by the process of dispensing new “credit points” (dollars) to the payee.
5. Aggregate demand by the private sector is subject to fluctuations and generates ups and downs in the
business cycle: when the private sector feels its savings are more than adequate, it will keep spending (and
the number of jobs) high, and when savings are considered too small, it will attempt to restore them by
cutting spending (and jobs). While it is a quite reasonable act for individual units, saving is problematic in
a macroeconomic sense because it drags down aggregate demand.
6. Although each unit in the private sector believes it can freely determine how much it saves, this is
clearly not true for the consolidated private sector: any additional dollar saved inevitably lowers somebody
else’s revenue (by exactly one dollar). If each of us can reasonably assume to be in control of our flow of
savings, this is not the case for the economy as a whole. The macroeconomic constraint to the flow of private savings is described below.
Each table shows total payments and receipts for different economic sectors: the private sector (households
and firms), the public sector (central and local governments), and the foreign sector (households, firms,
and governments abroad). Table 1 shows the formation of financial savings in the private sector when the
government budget is balanced and external trade is also balanced. For the consolidated private sector,
every expense is inevitably revenue to someone else. Because total revenue of the private sector is identical to total expenses (E), the flow of net financial savings of the private sector is zero. Under these conditions (balanced budget and balanced trade flows), private units can attempt to increase their savings
only at the expense of other (dissaving!) units.
Table 2 shows the formation of private sector’s financial savings assuming that the nation runs a trade surplus. Net financial savings for the consolidated private sector are now positive and equal to the trade surplus of the nation. The flow of financial savings is matched by the loss of goods and services delivered
abroad and consumed by foreigners. In other words, total net private savings (equal to the trade balance)
are the counterpart of surrendering goods and services to foreigners. Notice that domestic private savings
by one nation are inevitably offset by negative private savings (i.e., a trade deficit) in another nation, so
net private savings are still zero for the consolidated private sector in the entire world economy!
Table 3 shows the formation of private sector’s financial savings when the government budget shows a negative balance. Private net financial savings are positive and equal to the budget deficit. Indeed, the simple
accounting used here shows that the private sector can receive a net flow of financial savings only by interacting with another sector when its receipts exceed expenditures. This requires, as a matter of logic, that
the other sector’s expenditures exceed receipts. Thus, savings are generated by our trading partners, or
our government, running a deficit with us.
T
T
-10-
Table 1. Consolidated private sector (when G=T and X=M)
PRIVATE DOMESTIC SECTOR
(1)Total payments
E
(2)Total receipts
E
Net financial savings =
(2) – (1)
E–E=0
Table 2. Consolidated private domestic and foreign sectors (when G=T and X>M)
PRIVATE
DOMESTIC
SECTOR
PRIVATE
FOREIGN
SECTOR
(1)Total payments
E+M
X
(2)Total receipts
E+X
M
Net financial savings =
(2) – (1)
X–M
M–X
Table 3. Consolidated private and public sectors (when G>T and X=M).
PRIVATE
DOMESTIC
SECTOR
PUBLIC
SECTOR
(1)Total payments
E+T
G
(2)Total receipts
E+G
T
Net financial savings =
(2) – (1)
G–T
T-G
Conclusions and limits of the analysis
A growing public deficit has the power to revive the private sector through increasing its net financial savings. As long as resources are not fully used, government deficit encounters no forced limit if we continue
to assume that government has the power to issue currency with no obligation to redeem another nongovernment asset (gold or a foreign currency). During a recession, when the private sector lowers demand
to restore savings at the desired level, letting public deficits rise is the best way to restore private savings.
It is no surprise that the U.S. economy did not enter a deeper depression, thanks to Obama’s fiscal package, and yet the limited size of the package, as well as the subsequent concerns voiced about the deficits,
A
limited its effectiveness. And it is no surprise that China’s growth rate has remained high after a massive
fiscal package. And it is no surprise that Euroland is struggling at dismal growth rates in the (failing) attempt to achieve fiscal discipline by limiting budget deficits for their own sake.
Critics of fiscal measures have argued that they work only by “printing money” and this contrasts with the
evident truth that you cannot get something for nothing. If the considerations developed above are cor-
O
-11-
rect, however, this “evident truth” should be spelled out differently: the monopolist money issuer can always get something for nothing as long as it succeeds in forcing the private sector to accept its liabilities;
and, at the same time, it remains true that the economy as a whole cannot get something for nothing, for
the level of output and the standard of living are inevitably constrained by the available resources. By engaging in deficit spending, the government is simply using money as a public good to the benefit of the
private sector when this comes across a lack of saving situation. The accounting developed above shows
that government deficits create, not destroy, private savings.
Obsession with fiscal discipline as a situation where the public budget is balanced stems from “money illusion”: confusing nominal with real values, mistaking money for a real asset. Fiscal balance as a goal for
its own sake implies that we accept unemployment and reduced standards of living. Instead, fiscal sustainability means that fiscal measures must provide the private sector with the desired nominal savings.
True fiscal discipline should really be aimed at “real economy stabilization” and entail a public deficit that
supports the private sector’s desire for financial savings consistent with full employment and price stability.
There are two main limitations of the above analysis. First, it assumes that public policy is aimed at achieving full employment. At the same time Keynes was developing his arguments for fiscal actions, Michael
Kalecki warned that business leaders and rentiers will strongly oppose full-employment policies to avoid
rising wages and prices. So there may be a political question that pure logic does not address. Second, it
assumes that governments can efficiently engage in the process of calibrating the size of the deficit to the
needs of the economy.
These limitations stimulate the need for more research in finding the most effective and dependable means
to adjust fiscal deficits according to the needs of the economy and how to best include all economic constituencies in the interest for a full-employment policy.
Yet, using the deficit as a tool to control private savings has the power of being perfectly consistent with
traditional big-government Keynesians and small-government Hayekians. For it is the deficit that matters
for private savings, not the size of public spending. Thus, a fiscal deficit policy of this kind works equally
well in nations where the public sector is a small or a big slice of GDP.
References:
Keynes, John M. 1936. The General Theory of Employment Interest and Money, London: Macmillan.
Keynes, John M. 1980. “Activities 1940-1946 Shaping the Post-War World: Employment and Commodities,” Collected Writings of J.M. Keynes, edited by Donald Moggridge, Vol XXVII, London: Macmillan.
-12-
g e t t in g out oF r e Ce s s ion ? s t r at e g ie s F or s us tain ab l e g row t h
Gennaro Zezza
Università degli Studi di Cassino, Italy
Let me start by thanking Franklin College, and especially Andrea Terzi, for inviting me here.
I am happy that Andrea Terzi’s presentation covered some theoretical aspects of what I am going to say,
thereby providing an introduction with more emphasis on theory, while I will concentrate more on the
empirical aspects of what happened in the U.S., according to our view, and what is likely to happen in the
foreseeable future for given policies.
Today I will briefly go through what is, in my view, the mainstream interpretation of the current crisis,
which started in 2007, and then move on to our own interpretation, which is supported by a simple model
of the U.S. economy which allows us to track the path of the economy for given policies. We will see that
some unsustainable processes have been at work for a long time, one of which is related to the changes in
the distribution of income. I will conclude with an analysis of what is likely to happen and what strategies
can be implemented to restore sustainable growth.
The mainstream interpretation
I believe it is interesting to note that, as late as 2008, Olivier Blanchard (2008) reported that – at the time
he was writing – macroeconomists had finally agreed on a “consensus model” of how the economy works.
It is interesting, because such model was unable to provide any suggestion about what was going to happen. This consensus model, sometimes called “New Consensus” (NC), can be reduced to three equations
(see Box 1). I will not go into the technical details, but the main ideas are the following:
1. Households are rational and forward-looking, so that in the simplest model they can plan for their expenditure and saving for their (infinite) life span;
2. In contrast with previous mainstream models, markets may not be perfect or perfectly competitive, so
that prices do not move quickly enough to ensure equilibrium (they are “sticky”). Inflation depends on the
“output gap,” the deviations of the volume of production from its long-run equilibrium level;
3. Since markets are not perfect and inflation can arise, there is a need for monetary policy which should
follow a simple rule: the interest rate must be increased when inflation is above target or when the output deviates from target, which is defined as the level of production consistent with the target level of inflation. This is the so-called “Taylor rule.”
There is no role in this model for fiscal policy: the government sector is not even modelled, in the belief
that the economy can grow in equilibrium without any government intervention.
Models of this kind have been adopted on an increasing scale, as Blanchard notes, and their empirical
equivalents, usually in the class of Dynamic Stochastic General Equilibrium (DSGE) models, have been
and are still used by central banks and forecasting centers around the world.
Box 1. The New Consensus Model
1)!
2)!
3)!
x : output gap!
! : inflation!
i : nominal interest rate!
E denotes expected values, and a star (*) the target level for a variable.!
See Tamborini et al. (2009) and Woodford (2003)!
!
-13-
Now, if you believe that the core of the economy works as in the New Consensus model, how may a crisis emerge? There may be three possible answers:
1. If an extraordinary event (like a black swan, which shows up very rarely) occurs, the expectations of
households will be completely wrong, spending decisions will be revised dramatically, etc. The model will
fail to predict the crisis because it is based on expectations of not-so-improbable events. If this is the case,
markets will self-adjust without any need for government intervention, and the economy will resume potential growth once expectations have been properly revised;
2. The second possible reason for a crisis is policy failure. If monetary authorities do not follow the Taylor rule properly, growth can be compromised and a crisis can develop. This is what authors from the
“Chicago School,” including John Taylor (2009), have been claiming after the crisis. According to them,
the Federal Reserve set the interest rate too low, so excess liquidity led to speculation, etc. It is interesting
to note that John Taylor himself, in an interview in Germany in the summer of 2007, stated that central
banks were behaving properly, everything was under control, and the world economy was growing. Only
two months later the stock market crashed, and it was clear that the economy was entering a recession.
So, the creator of the Taylor rule was having trouble using his own model, and it is curious that he now
blames central bankers for the same kind of mistakes he made.
3. Last, some economists argue that, yes, the core NC model is inadequate because it does not take into
account the recent evolution of financial markets, and it therefore was helpless in helping predict a crisis
arising from a shock on financial markets. This was the thesis put forward last year in Trento, Italy, at the
annual “Festival dell’economia,” where economists were put on trial for failing to foresee what had happened, and the proposal at the end of the discussion was that the core model needs to be developed further, but its core properties – rational and forward-looking households, etc. – should not be questioned.
If this is the view of the crisis emerging from the mainstream theory, what – if any – policies must be put
in place? Everybody agrees that problems arose because of lack of regulation in financial markets: there
was asymmetry in information and moral hazard, since institutions providing subprime mortgages to insolvent households were able to bundle these risky financial assets into derivatives, the composition of
which was not transparent, and this operation shifted risk from the original lender to the buyer of the derivatives, encouraging even riskier behavior. So, regulate better. There was some consensus for the central
bank to provide liquidity to banks, to avert the risk that a liquidity crisis of solvent institutions could generate insolvency because of panic which froze access to interbank credit. There was some consensus on the
fact that incentives for managers in the financial sector were such as to encourage risky behavior, although
there is little consensus on the fact that the government should intervene in determining compensations
of managers in the private sector. Finally, there was some support for a temporary fiscal stimulus to sustain aggregate demand, although economists from the Chicago School claimed that this would not only
be ineffective, but would actually decrease private sector demand by allocating resources to the production of public goods and away from the production of private goods.
Summing up, in my view the vast majority of macroeconomists believed that very little should be done
by the government and that the economy will self-adjust in a reasonable time, getting back by itself to a
sustainable growth path to prosperity.
An alternative view
I don’t agree with this view. In our work at the Levy Institute of Economics in the U.S., we adopt a completely different theoretical approach based on the ideas of Keynes and Tobin, and developed over the years
by Wynne Godley and, more recently, Marc Lavoie. Models in this tradition are known as “stock-flow consistent” (SFC) since they always explicitly link decisions taken during one period (flows) such as expen-
-14-
diture, income, saving, to the accumulation of real and financial assets and liabilities (stocks) such as capital, debt, and wealth for all sectors of the economy. In addition, they belong to the post-Keynesian tradition in that they do not assume rational behavior, but rather adopt specific hypotheses on how different
social groups (workers, consumers, firms…) operate and verify such hypotheses – and model results –
against what happens in the real world.
Using this approach and the Levy model, back in 1999 Wynne Godley started to publish a series of reports
arguing that economic growth in the United States was characterized by seven unsustainable processes
which would eventually start a crisis. In our view, the 2001 stock market crash and the recession that followed were the result of these imbalances, but fiscal policy – at the time – was promptly used to fill the
gap in aggregate demand, avoiding a more severe recession, but without addressing any of the underlying
problems. Since these imbalances were not tackled, they reinforced themselves up to the 2007 crisis.
At this point, somebody may argue that if we started to predict a crisis back in 1999, sooner or later we
would have been right! This is known as the “stopped clock syndrome,” from the fact that a stopped clock
always provides the right time twice a day. Fortunately for us, Bezemer (2009) investigated who correctly
predicted the 2007 recession by using some stringent criteria. He found only twelve research groups that
satisfied his criteria of having predicted the crisis early using a model and publishing their results, and the
work of Wynne Godley at the Levy Institute was one of such groups. But an even more important result
of Bezemer’s analysis was that many of those who could see the crisis coming shared a similar model,
based on the joint analysis of real and financial markets, and the Levy Institute was the only research group
to have one of such models not simply at the theoretical level, but also estimated for the United States.
This joint analysis is closely related to what Andrea Terzi sustained in his presentation: equilibrium in real
markets requires that investment and saving are balanced, but you also need to understand what happens
to saving in financial markets. Basically, for any sector, if receipts exceed expenditure you have saving, and
the sector will be acquiring real or financial assets with such saving, and any acquisition of financial assets
by a sector must be matched by an equivalent new liability for a different sector. On the contrary, if a sector wishes to spend more than it receives, it has to run down its assets or borrow – increasing its net liabilities.
Models incorporating these relationships turned out to be more effective in predicting the crisis than the
NC model, and this spurred interest – in central banks and international organizations, but so far largely
outside the academic community – in the analysis of financial balances for each sector in the economy.
Data on the flow of funds – the allocation of saving to assets and the creation of liabilities – are being collected and analyzed with greater interest.
Seven unsustainable processes
So, what were these unsustainable processes? We will go through them quite quickly, given our time constraint. Basically, private saving – the sum of household and business saving – was getting lower relative to
investment, and as a consequence the private sector started to borrow on an increasing scale. Monetary policy – back in 1999, but we will see what happened more recently – was too expansionary. Asset prices –
equity prices in 1999 and housing prices in 2006 – were growing too fast. In 1999, in the Clinton era, fiscal policy was aimed at achieving a surplus. And the U.S. had a large and growing external deficit, which
was generating a large and growing debt against U.S. trading partners. These are the processes highlighted
by Godley in 1999, and we will argue that there was another unsustainable process going on related to
changes in the distribution of income.
Let’s go through these processes in more detail. Most of them are related to the accounting identity linking financial balances for all sectors in the economy which is a slightly more elaborate version of the relationship discussed by Andrea Terzi earlier.
-15-
(Sh – Ir) + (P – In) = GD + BP (1
where Ir is residential investment, In non-residential investment, P profits for all firms, and GD the government deficit including public investment. The first bracket measures the net acquisition of financial assets (NAFA) by the household sector, the net increase in financial assets of this sector less the increase in
liabilities. The second bracket measures NAFA for the business sector: if investment exceeds profits, firms
have to borrow, i.e., increase their net liabilities.
Our identity is stating a very simple principle which is always true: if a sector is borrowing, another sector is lending. If one sector increases its debt, another sector is increasing its net assets. But our identity is
also linked to the different components of aggregate demand: consumption, investment, government
spending, and net exports. So, what happens when a component of aggregate demand increases, thereby
generating economic growth?
If private investment is increasing, one of the two terms on the left (and possibly both) will decrease, and
this will imply changes in the balances on the right. In this case, growth generated by an increase in investment usually determines a reduction both in government deficits – because of increased tax revenues
– and in the external balance – because of an increase in imports. Private saving will also increase with investment, so investigating the causal links among the terms in our identity requires a more complex model.
Another source of growth can be an increase in net exports, for example following devaluation. In this case,
private saving will increase, and the government deficit should be smaller. Finally, if government deficit increases, stimulating aggregate demand, this will also change private saving and the external balance.
In all cases, when a financial balance is negative for a sector, this implies that the sector is a net borrower.
So, if households want to buy more (new) houses than the value of their saving, they have to borrow from
other sectors. The stock of liabilities of households will increase relative to the value of their financial assets, and since this is a measure of financial fragility, we have an increase in the financial fragility of U.S.
households which can bring problems of sustainability in the growth path.
Let’s see what happened in the U.S. In Figure 1 we report the two components of the net acquisition of
financial assets for the private sector as a whole, namely net investment by households and firms (the red
solid line) and private sector saving (the black dotted line), which is the sum of household saving and
undistributed profits, both measured as percentage of GDP. As you can see, up to the 1990s aggregate saving was sufficient to finance aggregate investment, but saving started to decline in the mid-1980s and eventually became smaller than investment. At this point, the private sector needed additional external finance
from other sectors to finance its expenditure decisions.
Figure 1. Private sector saving and invesment
-16-
Figure 2. Private non financial sector: debt and borrowing
This is confirmed by the analysis of private sector borrowing and debt, reported in Figure 2 as a percentage of GDP. From 1991, private sector borrowing – the red solid line – increased steadily relative to GDP,
implying an increase in private sector debt relative to GDP – the black dashed line. Before the start of the
2007 recession, private sector debt had reached more than 180 percent of GDP. These are the first three
processes which cannot be sustained indefinitely: a fall in aggregate saving, a rise in borrowing, and a rise
in debt for the private sector.
Figure 3. Personal saving, borrowing, investment and debt
-17-
Figure 4. US external asset position and $ exchange rate
In Figure 3 we! go into the details of what happened to the household sector. Here household saving is the
black solid line and residential investment the blue dashed line. You can notice that saving was a sufficient
source of finance for investment up to 1995. The red dashed line represents the net increase in mortgages,
and it is clear that up to the 1990s households were financing their investments with both external finance
and saving. In 1995 saving was no longer sufficient to finance investment, and new mortgages started to
increase relative to income. When the housing bubble started, new mortgages exceeded the value of investment: households were taking mortgages to finance speculation arising from the increase in the market price of existing houses rather than having new houses built. These processes, of course, implied an
increase in households’ debt relative to income which reached almost 130 percent of disposable income
before the crisis started.
In Figure 4 we report the consequences of these processes for the external balance. If you are consuming
more than your income, as the U.S. private sector was doing, it must be the case that you are buying more
goods and services from abroad than you are selling, or, in other words, that net exports are negative. An
external imbalance in the current account will imply a growing foreign debt, which is reported in Figure
4 with two different measures: the black dashed line is obtained by cumulating the U.S. external balance,
showing that U.S. debt with foreigners is now above 50 percent of GDP. The red solid line measures U.S.
foreign debt at current market prices, revealing one of the privileges of the U.S. economy, which is able to
borrow in its own currency: a devaluation of the U.S. dollar will thus leave the value of U.S. debt unchanged in dollars while increasing the value of U.S. financial assets abroad. This is why foreign debt at market price has a smaller value in terms of GDP after the devaluation of the dollar. As noted above, any debt
is matched by a corresponding credit, so whenever the U.S. dollar devalues, countries who are net creditors of the U.S. will experience a capital loss. This is now the case for China: the Chinese economy has relied on a weak exchange rate to penetrate the U.S. and other markets, registering a large trade surplus, in
particular with the U.S. The Chinese surplus on current account has been matched by large acquisitions
of U.S. Treasury bills by the Chinese central bank in order to neutralize the effects of the trade surplus on
the exchange rate. A devaluation of the dollar will cause a large drop in the value of U.S. assets held by
the Chinese central bank, again generating possible problems of instability.
-18-
Figure 5. Monetary policy
Another process analysed by Godley in 1999, and still relevant today, is linked to monetary policy. We have
seen before that the policy of the Federal Reserve is blamed by some mainstream entities as the main reason for the current recession. In my view, monetary policy was not the ultimate cause of the recession, but
was very relevant for the timing of events. We have seen before that private sector debt, as well as household debt, was rising steadily. After the 2001 stock market crash, monetary policy was eased, with interest rates going down in real terms (the blue dashed line in Figure 5). This implied that the debt burden
was stable relative to income: the debt burden is given by the amount of money you have to pay each
month out of your debt, and the increase in overall debt was roughly matched by the decrease in interest
rates. At one stage, with increases in the price of oil in international markets, the Fed became concerned
again about inflation and started to increase interest rates. This implied an increase in the debt burden, the
inability of some households to keep up with their payments, a fall in the market price for homes, and the
start of the subprime mortgage collapse which spread to other financial markets and other countries
through the securitization process we described earlier.
Figure 6. Asset prices
The final unsustainable process we mentioned at the beginning is related to asset prices. In Figure 6 we
report a measure of the change in the market price of equities and homes relative to the growth rate of
the economy. Equity prices seem to follow a quite erratic cycle up to 1994, crossing the zero line at irregular intervals, and then from 1994 to the stock market crash of 2001 we had an unusual period of
strong growth, which corresponds to the “new economy” bubble period. With the end of this bubble, spec-
-19-
ulation shifted to the housing market: the black dashed line in Figure 6 shows that housing market prices,
for the first time, experienced a long period of (relative) positive growth until the crash which triggered
the current recession.
Summing up, this is how the crisis started, in my view: the U.S. economy was growing following a model
which required borrowing; borrowing implied a growing debt relative to income; when interest payment
on debt started to increase over income the crisis was triggered.
But, why did the private sector, and particularly households, start to borrow on this scale? Why didn’t
they reduce their expenditure if their income was not growing fast enough? A mainstream economist may
reply that households were financially constrained before the 1990s: they would have wanted to spend
more, but they did not have access to credit because of imperfections in financial markets. As financial markets created new instruments to deal more efficiently with risk – as mainstream theory claims – these
households got access to credit and could choose a better allocation of their expenditure over their expected lifetime. Since they believed their income would increase in the future, it was rational for them to
borrow more, and it was rational and efficient for the financial sector to lend more. So, nothing should have
gone wrong. But we have seen that things did go wrong, households became insolvent, the subprime mortgage market collapsed, etc., so it was not simply a matter of mistaken expectations about future income.
Figure 7. Income limits for each quintile and top 5% of households
In our view, an alternative explanation has to do with changes in the personal distribution of income. In
Figure 7 we report a possible measure, given by the income limits of each quintile and the top 5 percent
of the income distribution, measured net of inflation. It is clear from the data in Figure 7 that the bottom
quintiles have gained almost nothing in real terms since the 1970s, while real wellbeing at the top of the
income distribution has increased considerably.
Why has the distribution changed? One reason is a shift in political opinion which gained ground in the
1980s and the 1990s according to which a shift in the distribution towards the top quintile as well as a
shift in the functional distribution of income from wages to profits should increase aggregate saving and
therefore aggregate investment, increasing output and providing a better standard of living for the bottom
quintiles as well. Marginal tax rates were reduced considerably, and there was a large change in wages of
management relative to those of other workers. This view has a theoretical background in the mainstream
theory, which assumes that financial markets operating efficiently will translate an increase in aggregate
saving into an increase in aggregate investment, intermediating from those who save to those who want
-20-
to borrow and have the best investment opportunities.
What should post-Keynesians expect from the shift in the distribution of income? It is reasonable to assume that the top quintile of the income distribution has the ability to save more out of its income than
the bottom quintile, and therefore these changes should increase aggregate saving for the household sector. But we have shown before, in Figure 3, that exactly the opposite has happened: aggregate saving has
decreased.
An explanation which is gaining more consensus for the apparent puzzle of the decline in the saving rate
is based on the idea that households want to defend their relative standard of living. We have seen that
the median U.S. household had a stagnating real wage, but they were observing an increase in the standard
of living of the top quintile, and they wanted to “keep up”: buy an SUV, a flat screen TV, etc. What could
they do? It has been suggested that the first answer was the increase in female participation in the labor
market. When this process reached its limit, Americans started to work longer hours per week. When this
was no longer enough, they started to borrow.
Where are we now?
Have these processes been inverted by the recession? The chart in Figure 8 provides two measures of the
purchasing power of households, obtained from the National Accounts. It is clear that aggregate wages are
still falling in real terms, and therefore the recession is not over, but real disposable income is rising. This
is due to the increase in profits and to the fiscal stimulus which has at least in part taken the form of a support to disposable income. Up to now, the recovery is therefore due to fiscal policy.
Figure 8. Real disposable income and wages
Our last simulation exercise with the Levy Institute model, reported in Figure 9, shows what is likely to
happen under the “current state of the law.” If no changes in legislation are put in place, the reduction in
tax rates introduced under the Bush administration will expire and extraordinary expenditures under the
fiscal stimulus will come to an end so that government deficit will be reduced considerably and the external balance will improve. We are assuming that households – that are no longer borrowing – will not
change their behavior in the simulation period.
These (lack of) policies will have beneficial consequences for private sector debt, which will drop relative
to income, for government debt, and for the external debt. But the price to pay will be high, since the unemployment rate will remain above 10 percent. We will have smaller deficits and debts at the cost of a
long recession.
-21-
If we want to avoid these costs, what can be done in the short run? As Andrea Terzi suggested earlier, in
the short run a prolonged fiscal stimulus will sustain aggregate demand, lowering unemployment, at the
cost of a large government deficit, which in turn will imply an increase in public debt over GDP. In our
view, the U.S. government can sustain a deficit much better than the private sector.
Figure 9. U.S. Main Sector Balances and Unemployment
As we have seen, some of the unsustainable processes have been reversed. The private sector is no longer
running a deficit, and the external balance is improving – mainly because the U.S. is growing less than her
trading partners. But speculation has not ended. The chart in Figure 10 reports an index for the equity market along with an index for the commodity market. As we can see, the two indices are now growing fast
together, a sign that the liquidity which has been injected into the economy to have banks restore credit
to productive investment is being channelled to such markets for speculative reasons. A new bubble may
be forming.
What can therefore be done in the medium term to reduce the risk of growth based – again – on speculative bubbles and instability? So far, the U.S. government has been effective, using fiscal policy to sustain
employment. Policies aimed at increasing net exports may help but are not easy to implement. China and
India are now growing rapidly again, but the share of U.S. exports to these countries is small, so the U.S.
(or Europe) will have a limited impact from growth in these areas. There are no signs yet of restored confidence in the U.S. to stimulate domestic investment, which would be the only sustainable source of growth
in the medium term. And, although many commentators agree on the negative effects of income distribution on aggregate demand, little or nothing is being done on this side. Therefore, a prolonged fiscal policy seems to be the best option for the short term, and sustainable growth in the medium term will come
back only when domestic investment is restored: any strategy aimed at increasing the profitability of domestic investment in strategic sectors will be beneficial, in particular if it helps the country reduce her dependency on imported oil.
To conclude, a quick note on Europe. Some countries – notably Germany – are adopting export-led growth
models: they intend to move out of the recession not because the purchasing power of domestic workers
is increased, but because they are able to sell more to foreigners. This strategy requires that other countries are willing to get a deficit vis-à-vis Germany, and since the bulk of Germany’s exports goes to other
countries in the eurozone, such a strategy requires that other countries will increase their net debt against
Germany. I don’t think this will be a sustainable path for the euro area. Thank you.
-22-
Figure 10. Price indexes for equities and commodities
References:
Bezemer, Dirk J. 2009. “No One Saw This Coming”: Understanding Financial Crisis through Accounting
Models, available at http://som.eldoc.ub.rug.nl/FILES/reports/2009/09002/09002_Bezemer.pdf
Blanchard, Olivier J. 2008. "The State of Macro," NBER Working Paper # 14259, August.
Tamborini, Roberto, Trautwein, Hans-Michael, and Roni Mazzocchi. 2009. “The Two Triangles: What Did
Wicksell and Keynes Know about Macroeconomics that Modern Economists Do Not (Consider)?” presented at “The World Economy in Crisis—The Return of Keynesianism?” Berlin, October 30-31, 2009.
Available at http://www.boeckler.de/pdf/v_2009_10_30_tamborini_trautwein_mazzocchi.pdf
Taylor, J.B. 2009. “How government created the financial crisis,” Wall Street Journal, Feb. 9.
Woodford, Michael. 2003. Interest and Prices: Foundations of a Theory of Monetary Policy, Princeton and
Oxford: Princeton University Press.
Zezza, Gennaro (forthcoming). “Income distribution and borrowing: growth and financial balances in the
U.S. economy,” in Arestis, P., Sobreira, R., and J. L. Obrero (forthcoming). The Financial Crisis: Origins and
Implications, Palgrave Macmillan.
-23-
PragMatiC and dogMatiC keynesianisM: the relevanCe oF keynes’s thinking today
Keynote Speaker:
Peter Clarke, Cambridge University
The Great Depression of the 1930s obviously touches a nerve with us because little more than a year ago
we seemed to be looking into the same bottomless pit. The chain of events triggered in late 1929 by a dramatic collapse in stock prices on Wall Street—the Great Crash—and leading to a Great Depression that
engulfed the world economy for years on end suddenly leapt off the pages of the history books with an
urgent sense of relevance to us now. Pessimists asked, What is to stop it all happening again? Optimists
asked, What can we learn to stop it from doing so?
A year or so later, there are unmistakable signs of economic recovery, although of a fragile kind. The optimists and the pessimists have to some extent shifted position. Some of the pessimists who despaired of
doing anything to avert a slump now exultantly credit the resilience of market forces with the recovery
while blaming big government for impeding it. Some of the optimists who supported government intervention now say gloomily that the recovery is so slow because the stimulus measures were too small.
These are old arguments, echoing those of the Great Depression itself. Here is one obvious reason why the
name of John Maynard Keynes (1883-1946) emerges so frequently, so inexorably, and so controversially
in our discussions of the present recession. But an equally obvious word of caution is in order. Many people ask, What would Keynes say today? It’s actually a silly question. Either he would now be 126 years old
and very bemused at the world around him or, if we imagine him at half that age, 1946 would be the year
of his birth, not that of his death. In that case, he would (like us) have escaped the experiences that actually formed him and his thinking: World War I and its aftermath; the international problems of the restored gold standard and the slump of the 1920s in Britain; the Great Depression of the 1930s and the New
Deal in America; World War II and Britain’s virtual bankruptcy—from which it was saved by Lend-Lease
and the dollar loan of 1945 (only recently paid off to the U.S. and Canada); the Bretton Woods agreements, setting up postwar international financial institutions.
All of these were events in which John Maynard Keynes himself played a major role. They were formative
events which surely affected his thinking as an economist. So I insist on talking about “the historical Keynes”
rather than a timeless Keynes whose name can be appropriated for our own passing concerns. There is, in
short, a word for people who tell us with enormous confidence what Keynes would say today—ventriloquists.
Keynes had great faith in the power of ideas. His remarks at the conclusion of the General Theory are well
known but still worth quoting again:
The ideas of economists and political philosophers, both when they are
right and when they are wrong, are more powerful than is commonly
understood. Indeed the world is ruled by little else. Practical men, who
believe themselves to be quite exempt from any intellectual influences, are
usually the slaves of some defunct economist. Madmen in authority, who
hear voices in the air, are distilling their frenzy from some academic scribbler
of a few years back. [JMK, VII, p. 383]
Our theme is really the Defunct-Economist Syndrome. Let me drop a few more names—of other defunct
economists who can plausibly rival Keynes’s claim to be the most influential economist of the twentieth
century. Their ideas may have an intrinsic importance but the context in which those ideas were formed
and received should never be ignored. As regards both the inception and the reception of economic ideas
in the twentieth century, we should keep in mind the eighteenth-century maxim: “Reason is the slave of
the passions.”
-24-
If academic economists are asked to name Keynes’s real intellectual rivals within their discipline in the
twentieth century, they will often mention two figures, both originally Viennese: Joseph Schumpeter, later
based at Harvard; and Friedrich von Hayek, successively based in Vienna, at the London School of Economics, in Chicago, and finally back in Salzburg. But in terms of influence, it would be preposterous to ignore the claims of Milton Friedman, an iconic figure in the Chicago School of Economics which first
challenged Keynesianism in the 1950s and from the 1980s largely displaced it in many American universities.
Some have argued that the postwar Age of Keynes was succeeded (by the end of the twentieth century)
by the Age of Schumpeter. Certainly there was a major swing in economic fashion by the 1980s in a world
that reeled under inflationary shocks for which Keynesianism was often blamed. On this reading, it was
the posthumous triumph of the Schumpeterian vision of “creative destruction”—a process through which
capitalism must be allowed to renew itself without interference or inhibition from government intervention, since the consequential inequities of this process are quite petty compared with its vast power to enrich the whole community.
A similar story, again in counterpoise to Keynes, can be constructed about the reputation of Hayek. His
subtle intuition about the efficacy of market signals as a vast system for gathering and disseminating more
information than any planner could handle is indeed a central insight. But it took a political revolution in
the age of Thatcherism and Reaganomics to provide the ideological context for Hayek’s rehabilitation. This
belated recognition, it must be said to his credit, was in terms that rather embarrassed the fastidious old
man. But perhaps that is the price of fame.
Contemporary economists who have never actually read any of the works of Keynes—or of his great twentieth-century rivals, Schumpeter or Hayek or Friedman—nonetheless confidently invoke their names for
their own purposes. Economists today speak of a Schumpeterian process of creative destruction, or the
Hayekian vision of the wisdom of the market, or the Friedmanite view of the power of monetary policy
in governing an economy not by regulating demand but via the supply side.
In short, the slaves of these defunct economists use these eponymous labels in a stylized way—as do scientists working in all sorts of different fields, identifying concepts that everyone in the field recognizes. I
am not going to make a pointless complaint about this sort of professional shorthand, which helps us all
get our bearings quickly without reinventing the wheel daily. But when economists get their names into
circulation in this big league, the reason is not just intellectual and academic: it concerns influence. Economists are influential not just because of their strictly scientific or professional contribution to economics, but often because of a public policy dimension and an appropriation of their names for vulgarized and
simplistic distortions of their original meaning.
I do not wish to appear too fastidious here or to claim a unique exemption from the process I am identifying. Perhaps it is inevitable when big ideas are made operational as the stuff of politics and policy. Perhaps no thinkers can ever govern the ultimate reception of their ideas. I think Keynes himself recognized
this when he stated in 1935: “When my new theory has been duly assimilated and mixed with politics and
feelings and passions, I can’t predict what the final upshot will be in its effects on actions and affairs”
[JMK, XXVIII, p. 42].
I hope that what I have been saying justifies the fact that in my recent book on Keynes I jump straight into
a survey of what I call his “roller-coaster reputation”—a phenomenon that needs much more than academic
economics to explain it. Perhaps I can best illustrate this by reference to some salient historical moments.
Keynes’s name first attracted wide public attention, on both sides of the Atlantic, in 1920. Still under 40,
he was an economist at Cambridge University—never a “Professor” in the British sense—who had served
in the British Treasury during World War I. He had done nothing to make himself famous as an academic
-25-
economist when he achieved fame on another scale altogether as the author of The Economic Consequences of the Peace (1919). It was a highly readable tract which not only exposed the defects of the recent Versailles Peace Treaty but did so in the style of Keynes’s friend in the Bloomsbury group, Lytton
Strachey, who had had similar success in the previous year with his irreverent and witty essays, Eminent
Victorians.
Keynes’s Economic Consequences offered far more than an economic analysis—though I think its essential economic argument has yet to be refuted by revisionist historians. It could be read as a moral fable,
straight out of the pages of Henry James, in which New World innocence met Old World disillusionment.
Keynes drew an inimitable picture of the naively idealistic Woodrow Wilson as an innocent abroad, putty
in the hands of the cynical Clemenceau and the wily Lloyd George—and memorably quipped that the
old Presbyterian, once bamboozled, could not be “debamboozled.” The book was a bestseller not only in
Britain but even more in the U.S., where it sold 70,000 copies in a year. The New York Times printed a
full-page review, roundly denouncing it: “in the English-speaking countries it is capable of doing immense
mischief…” (March 28, 1920).
Keynes subsequently remained in the spotlight, not least in the United States. So he already had a platform and an audience on both sides of the Atlantic when he re-entered public debate as an economist with
his controversial proposal for tackling unemployment with “a drastic remedy.” In the Britain of the mid1920s—already beset by mass unemployment—orthodoxy relied on the self-acting mechanisms of the
gold standard and free trade to do the trick. Such arguments came to a head with Winston Churchill’s decision to put the sterling back on the gold standard in 1925 at the historic exchange rate of US$4.86. To
Keynes, the new parity was both completely unrealistic and perfectly avoidable—hence his polemical
pamphlet: The Economic Consequences of Mr. Churchill (1925), published in the U.S. as The Economic
Consequences of Sterling Parity. (My suggestion that this change of title was because Americans knew
about Mr. Keynes but not about this Mr. Churchill, though not to be taken literally, has a serious point).
The point is that Keynes was already fighting in a big league. His advocacy of public works in Britain, in
a campaign where he now publicly backed Lloyd George, gave him a partisan political image (as a left Liberal). He called for public works as part of a package to administer a stimulus as a means of promoting recovery, explicitly commending “the stimulus which shall initiate a cumulative prosperity” [JMK, XIX, p.
223]. And he did so while he was still essentially orthodox in his economic theory, what he called “classical economics.”
Keynes did not initially challenge the theoretical proposition that, in the long run, market forces would
produce equilibrium; but he thought it irresponsible simply to sit back idly and wait. As he first put it in
his Tract on Monetary Reform (1923): “In the long run we are all dead” [JMK, IV, p. 65]. In policy, then,
Keynes appealed to social justice and to common sense, faced with real-world imperfections in the market processes, above all because prices were not as flexible as the classical model presupposed. They were,
as economists learned to say, “sticky” in the real world; in particular, wages were sticky when workers refused to take pay cuts. Stickiness could either be bemoaned as a temporary infraction of economic laws
or it could be acknowledged as a real-world constraint on policy options. Keynes, with his practical turn
of mind, opted for the latter view.
This is what we can call Pragmatic Keynesianism. And these essentially pragmatic arguments about policy did not demand any conversion to what I distinguish as Dogmatic Keynesianism—using dogmatic in
its sense of doctrinal. For this was a doctrinal or theoretical position which Keynes himself did not propagate publicly until the General Theory (1936).
There were other prominent economists who never became converted to Dogmatic Keynesianism, like his
eminent Cambridge colleagues A.C. Pigou and Dennis Robertson. Yet both Pigou and Robertson supported Keynes in the years before 1936 over unemployment policy. Others, like Lionel Robbins at the Lon-
-26-
don School of Economics, magnanimously conceded in retrospect that they had been wrong to oppose
Keynes in their pragmatic policy advice; but this did not make them doctrinal or Dogmatic Keynesians. It
is clear, then, that Keynes was far from alone as an exponent of Pragmatic Keynesianism and for the very
good reason that adherence to Dogmatic Keynesianism was not required in order to support the relevance
of what he was advocating in public policy.
Keynes went from bad to worse in the eyes of his critics when he showed himself ready to question not
just the gold standard and the sanctity of a balanced budget, but the good old Liberal doctrine of free
trade, too. Hence the gibe: “Where five economists are gathered together, there will be six conflicting opinions and two of them will be held by Keynes!” [Clarke (2009), p. 5].
The year 1933 was the bottom of the slump—not least the slump in Keynes’s reputation, it could be argued. But in the U.S. it also saw the election of Franklin Delano Roosevelt as President, proclaiming: “We
have nothing to fear but fear itself.” Keynes warmed to this message and supported FDR’s New Deal with
its many bold initiatives (many of them contradictory). Indeed its ideological opponents denounced him
as the evil genius of the New Deal in an alleged slide to socialism. Much has been written about Keynes’s
supposed influence on FDR—too little perhaps on FDR’s influence on Keynes in identifying confidence
as the key issue. For this became a major theme of the General Theory (1936). This is an interesting inversion of the assumption that economic policy is simply a vulgarization of ideas that derive from economic
theory. Or, to put the point in the language I am using today, perhaps dogmatic analysis can sometimes derive from insights that are pragmatic in origin.
What the General Theory tells us is that classical economics is fatally flawed—theoretically flawed. In particular it cannot explain unemployment except as, in some sense, voluntary, because of wage stickiness.
Thus, through jams and hitches and imperfections of this kind, the price mechanism of the free market is
prevented from achieving equilibrium. (The same reasoning surely underlies Chicago School doctrines
about rational choice under efficient markets, of course.) Workers choose to be unemployed when they resist wage cuts that would otherwise enable them to keep their jobs. Yet sometimes only a few apparently
volunteer for unemployment in this way, whereas at other times millions apparently do so. Why? Because,
says Keynes, in classical analysis full employment is not explained but simply assumed. Equilibrium is
thus the holy grail of classical economics, even if it is a quest continually thwarted by the wicked world in
which we live.
But Keynes disclosed a fundamentally different view. He frontally challenged the standard account of the
hydraulics of the economy and its process of equilibration. There is no holy grail, he claimed, because
equilibrium can indeed be achieved, but at less than full employment. So the economy, rather than being
“in balance,” is then “at rest,” with no market forces to shift it. Hence the case for a stimulus to set the market back on track. Effective demand drives the economy; and investment really drives effective demand;
so the role of the state is to ensure that investment is sufficient, especially at times when the market seems
paralysed by its own fears and inertia prevents necessary adjustments.
In presenting this analysis, the General Theory is not just telling us how to cope with a slump in a pragmatic way; it is also suggesting—this is the doctrinal or dogmatic aspect—why a free-market economy will
require remedial intervention. And there is actually more to Keynes’s argument than this rather hydraulic
account of it would suggest. For he could be taken to say that what prevents the market from clearing, as
it should, is simply the irrationality of the fear that haunts us in bad times. In which case, rational decision
making may be temporarily impeded or thwarted but can still be relied upon in the long run. But there is,
I suggest, a further dimension to Keynes’s revolution in economic theory: a dimension that I shall explore
later.
First, however, a little more biography, a little more history, a little more context. Whatever Keynes’s influence upon the New Deal, early or late, it was only with the war crisis of 1940 that he came to favor in
-27-
his own country. Suddenly he was no longer just an academic, however famous, but a policymaker himself, in the highest echelon of the British Treasury. The gadfly critic was adopted by the establishment; he
became Lord Keynes of Tilton in 1942. At home in Britain, Churchill’s wartime coalition government
committed itself in 1944 to maintaining “a high and stable level of employment.” The Keynesian logic of
this policy gained bipartisan acceptance. This was the so-called “Keynesian consensus.”
Much the same commitment was made in the U.S., though many Republicans remained shy of the new
doctrine, at least until the 1960s. The cover story of Time magazine at the end of 1965 supplied the popular imprimatur, crediting no less than Professor Milton Friedman of Chicago, “the nation’s leading conservative economist,” with the headline phrase: “We are all Keynesians now” (December 31, 1965).
Subsequently and incorrectly attributed to President Nixon, this remark became the epitaph for an era.
By the 1960s, it can be said, the General Theory had come to acquire scriptural authority and, like scripture, was more often cited than read.
Hubris paved the way for nemesis. As the 1970s unfolded, the combination of mounting inflation plus
mounting unemployment—“stagflation”—was a nightmare combination which self-professed Keynesians
seemed unable to explain, still less remedy. Incomes policy was a policy device with a pedigree that could
indeed be traced to Keynes’s evidence to the MacMillan Committee in 1930. But as a Keynesian policy it
proved a dead-end on both sides of the Atlantic. Instead, monetary solutions were sought, focused on interest rates and the supply of credit. One remarkable aspect of the controversy about these issues is how
far the argument was personalized. It was in this context that the name that came to rival that of Keynes
was not so much that of Schumpeter (dead since 1950) or even Hayek (still going strong at the time). It
was Professor Milton Friedman, the front man of the “Chicago School” of Economics, who seized the hour.
He duly became a Nobel laureate in 1976.
So if we talk of the most influential economists of the 20th century, Friedman too must be considered. Like
Keynes, and unlike Schumpeter or Hayek, he was explicitly a publicist for a controversial policy agenda.
Friedman may not always have been right but he was certainly always forthright. Again Time magazine
gave him a platform: “Keynesian economics doesn’t work. But nothing is harder for men than to face facts
that threaten to undermine strongly held beliefs” (January 10, 1969). Friedman was thus Keynes-throughthe-looking-glass, not least in distilling complex arguments into pithy slogans with immediate political
appeal. In Britain the new political economy of Thatcherism took up the Friedmanite doctrine of monetarism, allied with an ethic of fiscal restraint (good housekeeping). Thatcher’s closest advisers had the simple watchword: Keynes is dead. Just as Thatcherism overthrew the Keynesian consensus in Britain, so the
election of Ronald Reagan in 1980 brought a new economic regime to the U.S., ostensibly celebrating
Friedman (though failing to balance the budget). Government, in Reagan’s epochal formula, was not the
answer but was itself the problem.
Faith in the universal efficacy of the market thus became the new creed, unchallenged by the election of
either Clinton or Blair. Sustained by historically high growth rates from the mid-1990s, this was an era that
had little time for the arguments that had dominated the previous half-century. Keynesian economics was
now disparaged, for peddling remedies that were simply not needed, so long as the economy was left to
cure itself through the liberating impact of unrestrained market forces. As Robert Lucas, the current doyen
of the Chicago School, put it in 1980: “One cannot find good under-forty economists who identify themselves or their work as Keynesian… At research seminars, people don’t take Keynesian theorizing seriously
any more: the audience starts to whisper and giggle to one another” [Cassidy (2009), p. 97].
But then came the great meltdown of 2008. Again, it was obviously the economic context that jolted the
madmen in authority into a reassessment of the relevant academic scribblers. For about 30 years Keynes’s
reputation had languished; in about 30 days this defunct economist was rediscovered and rehabilitated.
There are really two distinct reasons why Keynes is relevant today. One is that he can throw us a lifebelt
-28-
when the ship is sinking. His writings can still suggest to us how to save ourselves by resorting to unorthodox measures, notably a fiscal stimulus. But reading Keynes can also help us understand why the ship
started to sink in the first place. In the General Theory we are led to understand why, otherwise incomprehensibly, market forces failed to deliver the goods, failed to offer self-correction, failed to cope with a
self-inflicted crisis of confidence.
This is a dimension of Keynes’s thinking that was largely overlooked in the “golden age” of Keynesianism
after World War II. Keynes had a polemical strategy in the General Theory, setting up classical economics
as what his friend Dennis Robertson called “a composite Aunt Sally of uncertain age.” Here the whirligig
of time duly brought in its revenges. After Keynes’s death the self-appointed keepers of the Keynesian
flame showed a jealous zeal that almost snuffed it out. The Keynesianism that was credited with working
wonders in the 1960s—and then discredited in the 1970s—was itself a composite Aunt Sally of uncertain
age. In that era Keynesian demand management was all the rage. “Fine tuning” of aggregate demand was
conceived in simple hydraulic terms, pumping flows around the system, or trading off employment against
inflation; the “Phillips curve” was supposedly the way to read off the effects. This was a simplistic model
which Friedman made the butt of his demolition job on Keynesianism, and the Keynesians of that era cannot escape reproach here.
But the General Theory also points to a psychology of economic activity as the key to understanding how
markets work. Keynes tells us that economics is actually bedeviled by radical uncertainty in a way that orthodox economists have refused to recognize. Under these conditions, rational behavior, based on our most
reasonable estimate of the future, is simply not enough to save us from irrational outcomes that virtually
nobody intended to bring about. Moreover, not only is the “classical” economics, against which Keynes rebelled, premised on the model of benign rational decision making: much the same remains true of the
“new classical” analysis of recent years. Orthodox economists have thus continued to allow for risk only in
terms of probabilities that we can cope with because they can be measured and offset.
The General Theory suggests an alternative view. Some of our knowledge of the future is certain, some not.
Events that are probable (and can thus be measured or estimated or modelled) are not the problem. The
crucial distinction is between what is probable and what is uncertain. Probability, like the toss of a series
of coins, can be estimated in a secure way with a few statistics and a bell-shape curve. Risks there may be—
but if they are known risks, they can be insured against by those who know.
The mature Keynes tells the story most cogently in an article he wrote explaining himself in 1937, virtually his last essay in theoretical economics. He points to “the fact that our knowledge of the future is fluctuating, vague and uncertain” as a fundamental reason why we cannot make rational predictions about
events that are irreducibly in the lap of uncertainty, like the chances of the outbreak of a future war (or,
we might add, the eruption of a volcano in Iceland). About such nontrivial matters, “there is no scientific
basis on which to form any calculable probability whatever. We simply do not know” [JMK, XIV, pp. 11314].
In that case, we are thrown back upon making the best of a bad job on the basis of hunch, common sense,
precedent, convention, superstition, magic, whatever. But we can get by—this is real life, after all—if we
know what we are doing. And did the “masters of the universe” on Wall Street or in the City of London,
who supposed that they had tamed risk through clever programming, know what they were doing? Hardly.
But worse than that is not to know that you do not know.
This is surely important, and it is good to see this point made independently by others in recent books, notably by Robert Skidelsky [Skidelsky (2009), esp. pp. 83, 188]. But it is not, I think, the sole reason why
the General Theory still speaks to us—a criticism that I note Joseph Stiglitz has recently made of Skidelsky’s view in the London Review of Books (April, 2010). Personally, I argue that another organizing insight
is at least as important: the dichotomy between individual choice and aggregate outcome in a market.
-29-
The General Theory’s “paradox of thrift” is only one aspect of this problem: the way that a precautionary
flight into saving by everyone simultaneously, because it reduces demand in the economy, will reduce the
value of the savings too. But Keynes was pointing to a problem of more general application which seems
to lack an agreed name, though other variants are the fallacy of composition or the tragedy of the commons. So is the “prisoner’s dilemma,” of which game theorists have made so much in recent years (though
it strikes me as a needlessly artificial elaboration of the essential point).
A homely example is the theater, where we would each get a better view if we stood up, but if all stand
up at once we end up, not with a better view, but with less comfort all round. And a fire panic in the theatre is even worse, if we each seek to save ourselves by all rushing for the doors at once. For the fallacy is
to suppose that what each person can do, all can do simultaneously. And that too tells us how and why
markets can fail. Here I am closer to John Cassidy, whose incisive book, How Markets Fail, deploys the term
“rational irrationality” to good effect [Cassidy (2009), esp. p. 210]. We do not need to categorize individuals as necessarily irrational in their own behavior. The real dilemma makes us all prisoners of games in
which strategies that seem rational to individuals may prove collectively self-defeating.
These are insights that, in my view, make it highly rewarding to revisit Dogmatic Keynesianism. But instead of making this my peroration, I will conclude on a more pragmatic note. For we need to acknowledge one difficulty in communing with the spirit of a “timeless Keynes”: that he was famous in his own
lifetime for changing his mind. If he was challenged, his reply was: “When the facts change, I change my
mind—what do you do, sir?” (James Meade is my own source here). Nobody was less bound by orthodoxies. Keynes was always ready to abandon old ideas, including his own, when he came up with better
ones, either better suited to changing conditions (mainly policy) or better in logic and insight (mainly theory).
So I think it may be a mistake to stake everything on Keynes’s claim to have made a theoretical breakthrough, important as that remains. We should not simply celebrate Dogmatic Keynesianism at the expense
of Pragmatic Keynesianism, if only because Keynes himself inserted into his doctrines so much of his own
pragmatism. In an essay on Alfred Marshall, Keynes approvingly quoted from his old teacher’s inaugural
lecture: “I do not assign any universality to economic dogmas. It is not a body of concrete truth, but an engine for the discovery of concrete truth” [JMK, X, p. 196].
When we ask why the Great Crash led to the Great Depression 80 years ago and how our situation today
is different, part of the answer is surely that some of the relevant lessons have been absorbed. Some people may still labor under the impression that our recent crisis was caused by big government, when all the
evidence is that of market failure which it has fallen to big government to remedy. Indeed the impressive
degree of consensus internationally, notably in the G20, in giving fiscal stimulation to a flagging economy
is surely a key reason why the threat of a second Great Depression seems to have been averted.
So we should note with satisfaction what we now hear from Chicago, where Robert Lucas was credited
with the wry remark that “we are all Keynesians in the foxhole.” Even more satisfactory, of course, was
the decision of Richard Posner, previously a prominent member of the Chicago School, to pick up a copy
of the General Theory for the first time—with almost Damascene impact, it seems. More pragmatically,
take Ben Bernanke, a pupil of Milton Friedman, now chairman of the Fed, with his highly flexible view of
policy, ready to support not just monetary easing, with its Friedmanite pedigree, but fiscal stimulus too,
the distinctively Keynesian policy response.
Keynes himself never set up as the pope of a new religion. In 1944 on a visit to Washington, D.C., after
one dinner where he was lionized by an admiring throng of younger American economists, he said at
breakfast the next morning: “I was the only non-Keynesian there” [Clarke (2009) p. 168]. And what would
Keynes say today? I have perhaps said enough on his behalf.
-30-
Works cited:
Moggridge, Donald (with Sir Austin Robinson). The Collected Writings of John Maynard Keynes, 30 vols.
(Cambridge University Press for the Royal Economic Society): cited as JMK, with volume number in
roman numerals, followed by page references, to the following volumes:
JMK, IV: A Tract on Monetary Reform (1923)
JMK, VII: The General Theory of Employment, Interest and Money (1936)
JMK, X: Essays in Biography (1933 text plus additions)
JMK, XIV: The General Theory and After, Part II
JMK, XIX: Activities, 1922-1929
JMK, XXVIII: Social, Political and Literary Writings
Cassidy, John. 2009. How Markets Fail: The Logic of Economic Calamities, London and New York: Farrar,
Straus and Giroux.
Clarke, Peter. 2009. Keynes: The Twentieth Century’s Most Influential Economist, London and New York:
Bloomsbury.
Skidelsky, Robert. 2009. Keynes: The Return of the Master, London and New York: PublicAffairs.
-31-
Questions FroM the Floor
Sanja Dudukovic: It was a pleasure for me to listen to such a good presentation. My question is related to
your discussion of Keynes. I appreciated your explanation about the problems with rational choice and the
efficiency of markets, but what do you think of Keynes’s notion of equilibrium?
Peter Clarke: A lot depends here on what we mean by equilibrium. In the General Theory Keynes changed
his position from that which he had adopted previously in his other big book, A Treatise on Money, two
volumes which he published six years previously. There his whole analysis is to explain why a disequilibrium position can be maintained, meaning a disequilibrium between savings and investment. In terms of
the formal structure of the General Theory the big change that Keynes makes by 1936 is to say (faced with
the criticism he was getting from his economics colleagues): “All right, savings and investment can indeed
come into equilibrium; they must be identical in accounting terms at least.” But he is concerned with a
position where the equilibrium that the economy achieves in this sense is not one of full employment. That
is the new point he challenges, and it was the sense in which the economy is in equilibrium, is at rest, is
not moving anymore, has no forces within it which will move it and yet it can coexist with unemployment.
That is the vision, the rather alarming vision, he discloses in the General Theory and that is how I would
put the point.
Georges Rocourt: My question is predicated upon your rather careful reading of much of the books as well
as the pamphlets of Keynes, and it has to do with your notion of the pragmatic Keynes which intrigues me.
Is there evidence in any of the pragmatic writings, so to speak, that Keynes ever thought about the
Hayekian insight of the fact that government simply in some instances doesn’t work as an efficient organization, and any instances where he might have looked at a particular situation and said, “This doesn’t
seem to be working the way it might”; in other words, the pragmatic Keynes looking at the carrying out
of his stimulus ideas. Is there any evidence of that in his writings that you are aware of?
Peter Clarke: There’s certainly an acceptance of imperfection and this comes through very strongly in his
advocacy of the New Deal. He seizes very quickly on what FDR is doing from 1933 onwards in making
himself a very public champion of the New Deal but certainly in private too. He criticizes the U.S. government for making all sorts of mistakes and also says: “This is bound to happen, this is what we have to
put up with,” but he is really justifying, and I suppose that in terms of the bigger equation the intolerable
thing is to do nothing, to sit back in doctrinal purity while remediable ills are there that public policy
could help to remedy even if it makes a lot of mistakes, even if it creates other systems of waste along the
way. I think that’s a consistent thread here, and I think that’s where he differs fundamentally from Hayek.
That can be seen later by the time Hayek publishes his tract The Road to Serfdom, in the correspondence
to which there was allusion earlier today, when Keynes purports to be offering Hayek a lot of philosophical support in what he is saying but differs with him quite fundamentally on the point of whether we need
more planning. Hayek says that because a government will be floored in its knowledge and in its goals and
in its ability to do things we simply mustn’t go down this road while Keynes says, almost with a shrug, we
will be safe going down this road because the net impact of government will be beneficial in producing a
more efficient economy and a more just society. I think that is the real distinction in our view between
Keynes and Hayek which persists.
-32-
Floyd Parsons: There is one thing you just alluded to, this matter of virtue, one aspect of Keynes’ development that might take us back to the beginning, the matter of the moral theory that is related somewhat
to Bloomsbury: could you maybe just briefly comment on that dimension of Keynes’s mentality if you
will, this relationship to, say, G. E. Moore, etc., that in the foundation of the Bloomsbury group itself there
might be an aspect of a moral theory there which you didn’t actually bring to the floor in your synoptic
discussion?
Peter Clarke: You’re quite right in thinking that in a talk which was supposed to last 45 minutes I kept clear
of that particular minefield. Keynes published one of his wonderful essays, called “My Early Beliefs,” in
which he talked about himself as a student before World War I in Cambridge and about his friends in
Cambridge and in Bloomsbury who shared his beliefs. He introduced a phrase which has often been quoted
against him: “We were immoralists.” Many people have been very quick to jump on this and say this shows
of course the arrogance of the hedonistic people that they, in their privileged position, were, simply claiming to do what the hell they liked and damn the social consequences. Now Keynes, as quite often, was
being too clever by half here. What he meant by immoralist was not that he rejected the claims of morality – social morality – but that he claimed a right to judge in terms of probabilities whether it was right
on occasion to defy generally accepted precepts that were urged in the name of morality. He claimed precisely because he was a student of probability (on which indeed his academic thesis for election as a fellow in King’s College was based) that he could justify this sort of position. I’m just touching here on a very
technical debate that has been explored by philosophers and historians of ideas, but I think it does illuminate something that is perhaps more graphically illustrated by a remark Keynes once made to one of his
very, very closest friends, Virginia Woolf, in the 1930s: “You know, Virginia, we had the best of both worlds
because we grew up formed by a basically Christian morality and although we later could perfectly well
see that Christianity was all nonsense and could discard it by ourselves, we had the best of both worlds,”
as it were, accepting the moral residue, the moral framework that it had given. I think that to understand
Keynes by throwing views about morality and social ethics out of the window, to see him as either hedonistic as a young man or simply a technocrat as an older man, is simply to miss a very important dimension. As one of his younger colleagues, Austin Robinson, said in his obituary of Keynes in the Economic
Journal in 1946: “Although Keynes seemed so modern and so shocking in so many ways, if you scratched
the surface, underneath you could see an almost Victorian sense of moralism coming through.”
-33-
what PoliCies For global ProsPerity?
Antonio Foglia and Andrea Terzi interview Warren Mosler, Distinguished Research Associate of the Center for Full Employment and Price Stability, University of Missouri, Kansas City (participating via videoconferencing).
Antonio Foglia (AF): I have known Warren from his previous life as an investor, where he definitely proved
his skills. Now he is an economist and, as all economists, he thinks he has a recipe to fix the world. He is
also becoming a politician, so he now has another reason for having a recipe to fix the world, and we are
definitely most interested in learning what his recipes are today, at a very special conjuncture in the world.
Warren, thanks for being connected with us this evening. I know you are in Connecticut now. We are in
Switzerland, so I think a more general point of view of the world is probably more of interest to all of us
although I understand that you might be more current on how to fix the U.S., as that is where you hope
to have an impact soon.
Andrea Terzi (AT): Hello from the Franklin Auditorium, Warren. The floor is yours.
Warren Mosler (WM): Thank you. Well, the most obvious observation is that unemployment is evidence
of a lack of aggregate demand, so what the world is lacking is sufficient aggregate demand.
In the United States, my prescription includes 1) what we call a payroll tax holiday, i.e., a tax reduction, 2) a
revenue distribution to the states by the federal government, and 3) a federally funded $8.00-per-hour job for
anyone willing and able to work.
For the eurozone, I propose a distribution from the European Central Bank to the national governments of perhaps as much as 20 percent of GDP to be done on a per capita basis so it will be fair to all the member nations.
The interesting thing is that it would not increase spending, or demand, or inflation, because spending is
already constrained by the Stability and Growth Pact (SGP), and so nations would still be required to
keep spending down to whatever the E.U. requires, but what it does do is to eliminate the debt and financing issues, and it takes away the credit risk from the eurozone. The other thing it does is to give the
E.U. a far more powerful tool for enforcing its requirements. What happens is that anyone who does not
comply with the E.U.’s requirements would risk losing this annual payment. Right now, anyone who does
not comply gets fined, but, as we know, fines are not easy to enforce.
AF: I think that after three hours of Keynesian presentations today I didn’t expect anything other than an
extra vote for more aggregate demand stimulation, on one side, and the irrelevance of printing more money,
on the other side. Somehow, though, I do personally remain concerned, and don’t fully understand how,
in the long run, this will not have side effects as people begin to actually expect the fact that more money
is going to be printed and more demand is going to be stimulated in less and less productive ways (because
it is basically government spending rather than private spending). If I look at history there is little evidence
of how you get out from the sort of Keynesian policy that you are proposing, which is certainly very effective in stopping a depression from developing (and we are grateful that policy makers did that), but I
don’t understand how you then stop those policies and how the exit from those policies can happen in
the medium and long term.
WM: Okay, you put up a lot of things there. So I’ll start from the beginning. First of all, for the U.S. I’m
talking about restoring income for people working for a living, which will raise the sales in the private sector right now, so it’s not a question of government. You talk about stimulus, but I’m not talking about
adding stimulus. I’m talking about removing drag. You can’t get something for nothing. If you have somebody running and a plastic bag falls over his head that slows him down, you can remove that plastic bag.
We are still limited by our productive potential, and what we have now are restrictive policies that are
keeping us from achieving it. Restrictive policies are demand leakages. In the U.S., there is a powerful incentive not to spend your income as this goes into a pension fund, and in Europe you have the same types
-34-
of things that reduce aggregate demand. The only way any sector can successfully “net save” is if another
sector goes into deficit, so what the government is doing when it lowers taxes or increases spending, depending on what the case may be, is filling the hole in demand created by the demand leakages.
My proposal for the E.U. doesn’t increase anyone’s spending. All it does is this: As long as countries are in
compliance with spending limits set by the E.U., they receive the allocation. As soon as they are not in compliance, they risk losing this payment, in which case the market will severely punish them and cut them
off. So, to address your questions, I am not advocating any excess spending stimulus beyond just making
up for the drags created by what I call “saving desires” and “demand leakages” which are largely a function of the institutional structure.
Let me just say it one more way. A country like the U.S. has to determine what the right size of government is. For example: what is the right size for the legal system? You don’t want to have to wait two years
to get a court date, but you don’t want to have people calling you up asking you to come to court right
away just because there are a lot of vacancies, so maybe the right waiting period is, say, 60 days. So you
then size your legal system and your legal employees for that kind of public service.
Equally, you have to size the military for what the mission is. You have to size the whole government. Once
you’ve sized your government properly, you then have to determine the correct level of taxes that is needed to sustain the level of private-sector activity that you want, and invariably those taxes are going to be less than the
size of the government. So, even if you want a smaller government, which is fine, you then have to have taxes
that are even lower. Why? Because that’s the only way you are going to accommodate your private sector
on its savings desires.
AT: I know where you are coming from, Warren, and I’m sure you realize that your proposal that the ECB
distribute money to European governments makes many people here in Europe jump out of their seats,
for two reasons. One: the ECB is prevented by statute from financing national governments; and two: people fear that this is further additional printing of money and creating inflation. Would you mind going
back to your proposal and explaining to me and the audience, step by step, what this distribution really
means, where this money comes from, and where it is going, in this score-keeping exercise that is the true
character of a monetary economy?
WM: Right, exactly. So, yes, it would require unanimous approval of E.U. governments. What I’m saying
is that European governments have accounts at the ECB. Under my proposal, the ECB would put a credit
balance into government accounts. So what will happen is that the balance in their accounts will go up.
Just because a balance on a national bank account goes up, it does not mean there is any additional spending.
It is spending that causes inflation, not just the existence of a credit balance on a central bank computer. But
what would then happen is that in the normal course of spending, borrowing, and debt management, this
balance would be worked down. Not by an increased volume of spending and not by a change in anything
else, but it would just be worked down because, for example, when the Greek bonds matured, the government would be able to continue its normal spending (this would be limited by compliance with the
SGP and other international agencies) without having to refinance its bonds. But once the credit balance
is used up, then Greece would continue its normal refinancing, but with a level of debt reduced by about
20 percent GDP the first year.
So again, this has no effect on the real economy, no effect on real spending. The only effects are that there
would be fewer Greek securities outstanding and that Greek debt levels would be lower and coming
down, which would facilitate their continued funding once the credit balance is used up. So it’s purely, as
you stated, an operational consideration and not a real economic consideration, and, yes, people would be
afraid of things that they don’t understand. But anyone who understood central banking from the inside
at the operational level would realize that this would have absolutely no effect on inflation, employment,
and income in a real economy, other than to facilitate the normal funding of national governments.
-35-
AT: Are you saying that the effect of such annual distribution would be like the effect of the discovery of
a new gold mine every year in a country under the gold standard?
WM: Well, no, it’s different, because on a gold standard what we call the money supply is constrained in
any case, whereas when you get to a currency it’s the opposite: the currency itself is never constrained. So
you have a whole different dynamic.
Let me just expose my point from a slightly different point of view. The reason the E.U. can’t simply guarantee all the nations and the ECB can’t simply guarantee all the national governments is because if they
did, whoever “deficit spends” the most, wins. You would get a race to the bottom, of extreme moral hazard, that quickly winds up in impossible inflation. So there has to be some kind of mechanism to control
government deficit spending for the member nations. They did it through the SGP that sets the 3 percent
limit, and there’s no way around that dilemma. It can’t be done through market forces. It has to be done
through the SGP. What they did is to leave the national government on a stand-alone basis so there would
be market discipline, but we’ve seen that that does not work either. They’ve got to get back to a situation
where they are not subject to the mercy of market forces but at the same time they don’t want the moral
hazard of some unlimited fiscal expansion where anybody can run a 5-, 10-, 20-percent deficit with inflationary effects.
My proposal eliminates the credit risk at the national government level, so they are no longer restrained
by the markets in their ability to borrow, but it makes them dependent on annual distributions from the
ECB in order to maintain this freedom to fund themselves.
And because they are dependent on the ECB’s annual check, the ECB has a policy to then be able to remove that check to impose discipline on these countries. By having this policy tool to withhold payments
rather than implementing fines, the E.U. would be in a much stronger position to enforce the deficit limits it needs to prevent the race to the bottom of nations.
AT: Your proposed ECB distribution would have the immediate effect of reducing the interest rate spread
between German and Greek bonds. However, if the 3-percent deficit constraint remains in place, there is
not much hope of prosperity in Europe. Do you agree?
WM: Right. The demand management would be based on the SGP: if they decide a 3-percent deficit is
not adequate for the level of aggregate demand, they may go up to 4, 5, or 6 percent or whatever level
they choose. It’s always a political decision for them, and it’s always going to be a political decision. If
they choose something too low, then they’re going to have higher unemployment. If they choose something too high, they’re going to have inflation.
And so it’s going to be a political choice, no matter how you look at. But the thing is, how do you enforce
the political choice? Right now they can’t enforce it. Right now, they’ve been enforcing it through the fining of member nations. But it doesn’t work. So they’ve lost their enforcement tool.
The other problem they have is this: because of the credit sensitivity of the national governments, when
countercyclical deficits, which are needed to restore aggregate demand, output, and employment, go up
like now, what happens is that the deficits challenge the creditworthiness of the national governments. This
is an impossible situation with national governments risking default because of the insolvency risk. They
are in a completely impossible position to accomplish any of their goals.
Whereas, reversing the situation, i.e., going from “fines as discipline” to “withholding payments as discipline,” puts them in a position that is manageable. It still requires wise management for the correct level
of deficits, for the correct level of aggregate demand, but at least it’s possible. Right now, it’s unstable
equilibrium, and what I am proposing switches it to a stable equilibrium, as they used to say in engineer-
-36-
ing class.
AF: If I understand correctly, the essence of the policies that you are suggesting, both in the U.S. and in
Europe, involve a certain level of deficit spending and debt accumulation. Then one could expect the dollar/euro exchange rate not to move much because people would probably tend to dislike both currencies
the same way. How would you see the interaction of these two areas with emerging markets that are in a
totally different economic environment and cycle, and whose currencies are actually currently on the rise?
WM: Right. If you look at nations like India and even Brazil, they all have high interest rates and high
deficits that help them get through. China, as well, maintains an extremely high deficit offsetting its internal savings desires. China may have overdone it, and it has to face an inflation problem, but this is a different story. I think that the U.S. is in a far better situation than the eurozone right now, because our
budget deficits do not represent the sustainability issues or credit issues.
The E.U. has put its member nations in the same position as the U.S. states, as if Germany or Greece were
like Connecticut or California. They put all their member nations in the same position as state governments
but without the federal government spending that the U.S. uses to help them out. This puts the whole burden of sustaining aggregate demand on European member nations. To find an analogy in the U.S., if the
U.S. had to run a trillion-and-a-half-million-dollar deficit last year at the federal level, and if the only way
that could have happened was at the state level, the U.S. would have been in much the same position as
the E.U., with all our states right on the edge of default. So because we have our deficit at the federal level,
instead of state level, we are in a much stronger position than the E.U. right now.
In the conference you may have already reviewed the mechanics of how nations like the U.S. or the U.K.
do their public spending, but let me do it very quickly. When the United States spends money that it
doesn’t tax, it credits the reserve account of whoever gets that money. A reserve account at the central bank
is nothing more than a checking account.
Let me now use the example of China so I can combine the problem of external debt with deficit spending at the same time. China gets its dollars by selling goods and services in the United States. When China
gets paid, the dollars go into its checking account at the Federal Reserve Bank, and when China buys Treasury securities, all that happens is that the Federal Reserve transfers the funds from their checking account
at the Federal Reserve to their securities accounts at the Federal Reserve. U.S. Treasury securities are accounted much like savings accounts at a normal commercial bank. When they do that, it’s called “increasing the national debt,” although when it’s in their checking account it doesn’t count as national debt.
The whole point is that the spending of dollars by the federal government is nothing more than the Federal Reserve Bank changing numbers off in someone’s reserve account. The person doing this at the Treasury doesn’t care if funds are in the reserve account at the central bank; it makes no difference at all,
operationally. There is no operational connection between spending, taxing, and debt management. Operationally, they are completely distinct. And the way any government like the United States or the U.K.
or Japan pays off its debt is the same: just transfer funds from someone’s security accounts back to the reserve accounts at your own central bank; that’s it. And this happens every week with hundreds of billions
of dollars. None of this acts as an operational constraint on government spending. There is no solvency issue.
There is no default condition in the central banks’ computer.
Now, when you get to the E.U., it all changes because all this has been moved down to the national government level, and it’s not at some kind of federal level the way it is in the United States. There is no default risk for the U.S., for the U.K., or for Japan, where the debt is triple that of the U.S. and double that
of Greece. It is all just a matter of transferring funds from one account to another in your own central bank.
AT: I’m glad you touched upon the question of China accumulating credits with the U.S., because this is
poorly understood. Money that Chinese earn by sending merchandise to the United States are credits in
-37-
the U.S., and these credit units are nonredeemable, so Chinese owners can do nothing with these things
unless they use them to buy American products, and if they do, those units become profits for American
firms. But there is also another possibility, which sometimes raises concerns in the larger public, and this
is what happens if China should choose to get rid of these dollars by selling the U.S. securities they own.
While the amount of dollars owned by foreigners doesn’t change, the price of the dollar would in fact decline. If China sells off American debt, dollar depreciation may be substantial.
WM: Operationally it’s not a problem because if they bought euros from the Deutsche Bank, we would
move their dollars from their account at the Fed to the Deutsche Bank account at the Fed. The problem
might be that the value of the dollar would go down. Well, one thing you’ve got to take note of is that the
U.S. administration is trying to get China to revaluate currency upward, and this is no different from selling off dollars, right? So, what you are talking about (selling off dollars) is something the U.S. is trying to
force to happen, would you agree with that?
AT: Yes!
WM: Okay, so we’re saying that we’re trying to force this disastrous scenario—that we must avoid at all
costs—to happen. This is a very confused policy. What would actually happen if China were to sell off dollars? Well, first of all, the real wealth of the U.S. would not change: the real wealth of any country is everything you can produce domestically at full employment plus whatever the rest of the world sends you
minus what you have to send them, which we call real terms of trade. This is something that used to be
important in economics and has really gone by the wayside. And the other thing is what happens to distribution. While it doesn’t directly impact the wealth of the U.S., the falling dollar affects distribution
within U.S., distribution between those who profit from exports and those who benefit from imports.
And that can only be adjusted with domestic policy. So, number one, we are trying to make this thing happen that we are afraid of, and number two, if it does happen, it is a demand-distribution problem, and there
are domestic policies to just make sure this happens the way we want it to.
AT: Would you like to elaborate on another theme of today’s symposium? How do you see the income
distribution effects of the U.S. fiscal package? Is it going in the right direction in your opinion?
WM: Well, we had 5-percent growth on the average maybe for the last two quarters while unemployment
has continued to go up. If GDP is rising, and people in the world are getting hurt, and real wages are continuing to fall, then who is getting the real growth? Well, everybody else. And so what we’ve seen from a
Democratic administration is perhaps the largest transfer of real wealth from low-income to high- income
groups in the history of the world. Now, I don’t think that was the intention of the policies, but it has certainly been a result, and it comes from a government that does not understand monetary operations and
a monetary system and how it works.
AT: Warren, what would be your first priority, the one action that you would enforce immediately to improve the current situation?
WM: The United States has a punishing regressive tax which we call payroll taxes. These take out a fixed
percent of our income, 15 percent (7.5 percent paid by employees and 7.5 percent by employers), so it
starts from the very first dollar you earn, and the cap is $108,000 a year. I would immediately declare a
payroll tax holiday, suspend the collection of these taxes. This would fix the economy immediately from
the bottom up. A person making $50,000 a year would see an extra $325 a month in his pay check, simply by having the government stop subtracting these funds from his or her pay.
Our economy has always worked best if people working for a living have enough take-home pay to be able
to buy the goods and services that they produce. Right now in the United States people working for a living are so squeezed they can pay for gasoline and for food and that’s about it, maybe a little bit of their
insurance payments, and so we’ve had an economic and social disaster. The cause of the financial crisis has
-38-
been people unable to make their payments. The only difference between a Triple-A loan and “toxic assets” is whether people are making their payments or not. And you can fund the banks and restore their
capital and do everything else, but it doesn’t help anyone making their payments. We’re two years into this
and we’re still seeing delinquencies moving up, although they levelled off a little bit, at unthinkably high
levels. Hundreds of thousands of people getting thrown out of their homes—that’s the wrong way for a
Democratic administration to address a financial crisis.
To fund a bank, simply stop taking the money away from people working for a living so they can make their
payments and fix the financial crisis from the bottom up. All that businesses and banks need and want at
the end of the day is a market for their products; they want people who can afford to make their payments
and buy their products. So my first policy would deliver exactly that, which is what I think we need to take
the first big step to reverse what’s going on.
AT: The action you proposed, the payroll tax holiday, entails some form of discretionary fiscal policy, and
this raises two questions. First, discretionary fiscal policy has been discredited. Economists like to model
politicians’ behavior in a way that we cannot trust their decisions because they just aim at winning the next
elections. So how do we make sure that discretionary fiscal policy would be used correctly to achieve full
employment and avoid inflation?
WM: My proposal is not talking about discretionary spending. It’s about cutting taxes and restoring income
for people who are actually working for a living, who are the people that at the end of the day we all depend on for our lifestyle, so it is not an increase in government spending, it is a tax cut on people working
for a living. The only reason this hasn’t happened is because of what I call “the innocent fraud” (from my
book, The seven deadly innocent frauds, available on my website), that the government has run out of
money, the government is broke, the federal government has to get funding, has to get revenues from those
who pay tax, or it has to borrow from China and leave it to our children to pay back. This is complete myth,
and it is the only barrier between us and prosperity. Now, in terms of using excess capacity and creating
inflation, the theory says, yes, it can happen, though I’ve never seen it in my 40 years in the financial markets.
As they say, in order to get out of a hole, first you have to stop digging, right? Right now, we’ve got an enormous amount of excess capacity in the United States. Unemployment is at 10 percent only because they
changed the way they define it. Using the old method, we have up to 22 percent unemployment.
The payroll tax holiday would both increase spending power and lower costs, so we would get a little bit
of deflationary effect as spending starts. Should there be a time when we see that demand starts threatening the price level, then it could come to a point where it makes sense to raise taxes, but not to pay for
China, not to pay for social security, not to pay for Afghanistan (we just need to change the numbers up
in bank accounts), but to cool down demand. We have to understand that taxes function to regulate aggregate demand and not to fund expenditures.
AT: Discretionary fiscal policy also includes discretionary changes in taxes, not only discretionary changes
in spending, so how do we make sure that the political ruling class will raise taxes when needed?
WM: Well, right now they’re raising taxes, so they don’t seem to have much of a reluctance to do that, and
they also understand that voters have an intense dislike for inflation. It’s not justified by the economic
analysis, it’s just an emotional dislike for inflation. They believe it’s the government robbing people of
their savings and they believe it’s morally wrong. And so they are always under intense pressure to make
sure that inflation does not get out of control or they are going to lose their jobs. But that’s the checks and
balances in a democracy. It’s what the population votes for. And the American population has shown itself to vote against inflation time and time again. The population decides they want more or less inflation;
it boils down to whether you believe in democracy or you don’t. And I’m on the side to believe in democ-
-39-
racy.
AT: In terms of democracy, this choice is not available to Europeans right now. The ECB has been given
an institutional mandate of price stability, and the decision of what’s more evil, inflation or unemployment,
has been removed from voters’ preferences on the grounds that price stability is the premise for growth
and full employment!
But I’m afraid our time is over. Warren, thank you very much. Although the volcano in Iceland prevented
you from attending today, at least we had this opportunity to discuss via teleconference.
WM: Was the volcano a result of the financial crisis over there?
AF: It was a way for Iceland to take revenge on the Brits!
Warren, we thank you very much for making this conference possible and thank you for your time. I encourage anybody who is interested to go to your website to get a view of your most recent ideas, and all
the best from this side of the Atlantic on your campaign.
WM: Thank you. If anyone has more questions just write to my email address: [email protected]
and I’ll be happy to correspond with anyone looking for more information.
AT: Thank you Warren.
WM: Okay, thank you all!