A Primer On General Equilibrium, or Why Money Matters

This post is meant to be a short summary of how to think about macroeconomics in terms of general equilibrium. During my conversations with Michael Darda this past summer, it became painfully apparent that clients tend to struggle with how to put money and goods markets together. As a result, I thought I should put together a little piece on my basic approach to thinking through these kinds of "across market" effects, and why it matters for some of the policy debates of our day.

Any macroeconomy can be broken down into two main markets: a real market for current goods and services, and a financial market for claims on future goods and services. For brevity, I will reduce the model for financial assets to the market for money, which, because of money's role as a store of value and medium of exchange, captures the notion of "claims on goods". To simplify further, I take all the markets for goods and reduce them down to one composite market, say, for apples. From this caricature, we can start thinking about how markets fit together.

In normal times, people receive apples and money from the sky in the form of endowments (i.e. their wealth), and they make decisions about how to balance their cash and apple balances. Apples are transacted, bellies are filled, and life is good.

But suddenly, a recession hits. What does this look like? By definition, a recession is when there is a general glut of goods that aren't consumed. In this toy economy, this corresponds to a situation in which some people have apples but choose not to eat them! This may seem peculiar, but remember that the market for apples in this model represents a composite of all goods markets. So it could be the case that while everybody has apples, some want Red Delicious while others are looking for the tartness of Granny Smith. In more formal economic models, this is glibly incorporated by requiring that people do not consume their own endowment and instead trade for consumption. In any case, apples aren't eaten and we have a rotten general glut.

But this seems peculiar -- aren't markets supposed to clear? Not necessarily. Prices don't always adjust instantly, so we can have excess supplies and excess demands. However, economists do have a way to constrain what this non-clearing state looks like. In particular, according to Walras' law, assuming everybody spends all of their wealth, if there are excess supplies (i.e. too much produced) in some markets, then they must add up to excess demands (i.e. too little produced) in other markets. In other words, even if supply does not equal demand in each market, supplies must add up to demands across markets.

The requirement that everybody spends their endowment is crucial. It means that Walras' law doesn't apply just to the market for apples because not everybody spends all their wealth on apples. Instead, some people may put their wealth in money. But once we include the money market, we do have the condition that everybody spends their endowment, and therefore Walras' law does apply to the entire macroeconomy of apples and money.

This leads to the most important conclusion from general equilibrium theory as related to monetary economics:

If there is an excess supply of goods, it must be the result of excess demand for money.

The goods market by itself is not enough to generate a recession with a general glut of goods. Only when there is the possibility of excess demand in money markets can recessions actually occur. Therefore the market for money is what gives a macroeconomy its business cycle feel. This is why money is so important for macro -- fluctuations in the money market are the proximate cause for any general fluctuation in the goods market. This is why, as Miles Kimball says, money is the "deep magic" of macro.

While this "apples and money" approach is the canonical presentation of general equilibrium, it is not the unique representation. For another interpretation, think about what the financial market really is. Since it represents the entire universe of claims on future goods, finance can be understood as a veil between the present and the future. So instead of focusing on the relationship between goods and financial markets at one point in time, we can cut out the middle man and instead think of general equilibrium as a sequence of goods markets that occur across multiple points in time. In this version, there is no financial market per se, but buying an apple in "tomorrow's goods market" represents buying a financial contract in the canonical model. Therefore, instead of thinking about the markets for goods and money, we can instead think about the markets for goods today and tomorrow.



The same excess supply and demand relationship works in this model. If there is an excess supply of goods today, then it must mean that there's an excess demand for goods tomorrow. So in this version of the model, the reason apples aren't eaten today is because people want to wait and eat apples tomorrow. So we get a corollary to the above conclusion:

If there is an excess supply of goods today, it must be the result of an excess demand for goods tomorrow.

Each of these stories has its own strength. Since the first goods-money model includes actual money, it can help us understand how the price level is determined through monetary neutrality. On the other hand, since general equilibrium is only concerned about relative prices, and since individual dollars are not transacted in the second story, the second story has no "goods/money" relative price -- i.e. the second story cannot pin down an aggregate price level. However, the second story does a better job of being explicit about intertemporal choice. And for now, this intuition about relative prices between the past and the future will be powerful enough that I will focus on this second approach.

So if recessions are caused by an excess demand for goods tomorrow, how does policy fix a recession? Here, our microeconomic intuition will suffice. If we want to reduce excess demand for a good tomorrow, all we need to do is raise its price relative to today. And since the price of an apple tomorrow is just the amount of money I need to save to afford it tomorrow, lowering the rate of interest between today and tomorrow is sufficient to raise the relative price of tomorrow's apple and get me to consume today. Note that this has an analogue in the first "goods/money" story. By lowering the interest rate on financial assets (and expanding the supply of money), this makes financial assets less worthwhile to hold. People then pivot away towards the goods market, and the general glut is consumed.

If recessions are generated by this process, the interest rate story shows why monetary policy can be politically difficult. Monetary policy, in this model, just tries to change the relative price of consumption today and tomorrow to resolve the general glut. But just when people most want to save, the interest rate falls and it becomes more expensive to do so! This is part of the more general political difficulty of the price system. Under a price system, the most desired objects are the most expensive. While this may be unpleasant, it's certainly efficient and necessary for avoiding recessions.

Now, one question that arises is why the real rate of interest doesn't automatically equilibrate to solve these excess demand problems. This is actually a very good question, and is the reason why monetary economics is so important. The primary explanation is that the Federal Reserve may not move fast enough to provide enough money to serve as claims on tomorrow's goods, and therefor the real rate spikes when a crisis hits. This is why we invest so many resources into studying monetary economics, because it is the proximate cause of most recessions.

So here we close the loop. From a relatively simple model, we now have a theory of employment (apple recession), interest (relative prices), and money (in the canonical representation).

Now we get to the fun part -- applying this framework to some of the policy debates of the day.

Let's start with monetary policy. By visualizing a macroeconomy through a sequence of markets, it becomes apparent why forward guidance matters. Even if the interest rate for today is zero, future interest rates may not be. Therefore, by promising to hold rates low for an extended period of time, that makes future apples more expensive relative to current apples. Now, the exact adjustment path may not be ideal, but so as long as we lower the interest rate enough to create enough excess supply in the future, we will be able to restore demand today.

Interestingly enough, quantitative easing is not in this picture. However, that's a long conversation that will receive its own post in the future.

We can also think about fiscal policy in this framework. If a recession is just a sign that there's excess demand for goods tomorrow, then for fiscal policy to work, it must convince people to bring some of their future consumption into the present. The conventional old-Keynesian approach to this (i.e. the Intro macro approach), is to argue that by giving people more money today, that makes them want to consume more today, which then directly solves the recession. But the actual mechanism is more subtle, and the efficacy of fiscal policy is entirely determined by its effect on intertemporal choice.

The Ricardian critique of fiscal policy also pops out of this framework. Ricardian equivalence, roughly speaking, argues that since consumers will take the future costs of taxation into account, therefore fiscal policy will have little effect. In this model, this future cost of taxation means people don't reduce their excess demand for goods tomorrow. Because they know the government will take away those apples, the agents are trying to save up so as to have enough to eat when tomorrow comes. Therefore the whole Ricardian effects/positive multiplier debate again just comes down to whether fiscal policy is actually effective at changing the patterns of consuming today and tomorrow.

In this context, the Federal Lines of Credit proposal from Miles Kimball makes a lot of sense. By extending lines of credit to those people who need it most, Federal Lines of Credit can persuade people to reduce their demand for goods tomorrow in favor of goods today.

I'm not entirely satisfied with this model. In particular there are the glaring omissions of rigorous foundations for inflation or intertemporal production. However, I do think it does serve as a baseline for understanding why intertemporal choice is so important for understanding macro, and I hope to expand on it in future posts.

Pictures were drawn in Paper 53.

China's Circularity Problem

In the context of future looking monetary policy, the circularity problem refers to the problem that central banks face when they try to use market signals to guide policy. The general problem is that the market signals may include expectations of future policy in addition to their expectations of future shocks, so that the market signals fool the central bank into pursuing inappropriate policy. For example, if the private sector believes there will be a large shock to consumer demand in the future, but also believes that the central bank will fully offset the shock, then market expectations of inflation may not change. If the central bank looks at the inflation expectations and concludes that there is no threat to aggregate demand, the central bank may end up not offsetting the shock, and the markets fall in response.

The most recent example of this in U.S. financial markets is the Fed taper. Before the Fed taper talks, the general expectation was that quantitative easing would continue into the indefinite future and that there would be no premature tightening. As a result, the stock market seemed very resilient because there were expectations of strong growth conditional on Fed easing. The Fed misinterpreted these expectations as independent of the Fed's policy of QE and decided to tighten.

However, fiscal authorities can also face the same circularity problem. If an economy is highly dependent on government spending, then real economic conditions may be determined conditional on expected future fiscal easing. And if the fiscal authority sees the strong current economic conditions as a justification for austerity, then this too may cause a fall in growth in the same way that a premature monetary contraction can slow growth.

The Chinese government is currently facing this fiscal policy circularity problem. In an interview on June 18th with the IMF mission chief for China Markus Rodlauer, he notes that high frequency data such as retail sales, investment growth all point to moderate growth. Even thought the PMI may have faltered a little bit, it's well within historical ranges. Rodlauer takes this and makes the conclusion that there's really no need for stimulus. 

While he may be right, it is also likely that the Chinese government could fall into a fiscal circularity problem. Especially since Chinese fiscal policy has the ability to reallocate a large amount of resources, much of business is conducted on the basis of expectations of future government policy. Under these conditions, concluding that economic conditions are strong on the basis of high frequency data may cause the fiscal authority to be too sluggish in responding to a slowdown in growth.

Micro and Macro Benefits Should Stay Separate

Recent posts by Mark Thoma and Michael Roberts have spurred me to think more about how to evaluate fiscal policies at the zero lower bound. Both Thoma and Roberts make arguments that because crowding out is less severe at the zero lower bound, certain government investments become much more desirable. For Thoma, this policy is increased infrastructure investment, whereas Roberts focuses more on investments in environmental policy. As such, Roberts asks: “how do we more generally evaluate the costs and benefits of public policies in a depressed economy?” This post will be an attempt at answering that question. My core thesis is that while government investment can be more desirable at the zero lower bound, it is no more desirable when the economy is at the zero lower bound than when it is not.

Why is the zero lower bound important anyways? One argument against fiscal policy is that government spending can crowd out private spending, leaving net expenditure unchanged. This can happen through two ways. First, it can happen through direct channels -- when the government builds a new school, this may crowd out a private school that was built in the region. Second, there is an interest rate channel. To finance the new spending, the government has to borrow from financial markets, crowding out private borrowing and thereby attenuating any positive effect of fiscal policy. However, when the economy is at the zero lower bound, private investment is typically weak and interest rates are low. These conditions mean that government spending will likely result in “crowding in” as multiplier effects stimulate more activity. This was the major argument behind the  DeLong and Sumner paper about fiscal policy at the zero lower bound. Therefore government investment spending carries a “double dividend” at the zero lower bound; it boosts output, long run growth, while also avoiding crowding out effects.

I see two major problems with this argument. First, it ignores the Sumner Critique about monetary policy offset. If monetary policy controls the nominal growth path of an economy, then there’s no point in trying to get more aggregate demand with government investments. Any multiplier effect will just be canceled out by the monetary authority passively tightening in response. While we haven’t seen as much tightening in the U.S. economy, we have seen this process work in reverse. Even as the government has severely tightened fiscal policy, signs of aggregate demand have held surprisingly steady. A comparison with Europe -- a continent going through a similarly savage bout of austerity -- leads us to conclude that monetary policy still has a wide latitude in determining aggregate demand even at the zero lower bound. Japan’s recent spike in growth has also shown that monetary policy can have an effect even after a long period of zero rates. This contradicts the assumption made in the DeLong and Summer paper that assumes monetary policy becomes powerless at the zero lower bound, means that any multiplier effects of government investment are minimal. Therefore multiplier or “crowding in” effects do not serve as a sound basis for evaluating government investment.

Now suppose for some reason that the monetary authority has imperfect credibility and cannot pull the economy out of the zero lower bound. Does government investment become more attractive as a result? Still no. This is because the proper benchmark is not the absence of government spending, but rather the next best government spending option. When considering all these investment proposals, we should remember that the government could always spend its money on “firework shows” or “alien defenses”. This (inefficient) policy scheme would capture all the multiplier expenditure effects with none of the long run growth effects. But as a result, the dividend of using government investment are no greater at the zero lower bound than when interest rates are positive.

Some others have made the even more radical argument that the zero lower bound means aggregate supply reducing policies, such as more stringent environmental regulations, can actually have macro benefits at the zero lower bound by increasing inflation. However, a look at forecast data in Japan around the time of the tsunami and in the U.S. around the time of the Libyan oil shocks shows that adverse supply shocks are, well, adverse. Output doesn't rise in response to supply shocks -- even at the zero lower bound.

So where do we end up? While the “double dividend” hypothesis might be a strong political argument for government investment, the core, apolitical economic analysis suggests that the zero lower bound does not make investment more desirable than usual. As a result, focus needs to be directed towards identifying the efficiency costs of low investment, not low output -- focus on the Harberger triangles, not the Okun gaps.

Debt Is Not Damning. Debt is Just Debt

This post is meant to add a little few final goodies to the work I did with Miles Kimball on the Reinhart and Rogoff results. In short, Miles and I took another look at the RR dataset as prepared by Herndon et al. and found that the long run effects of debt on growth were vanishingly small. The major innovation driving our finding was to look not at contemporaneous growth, but rather at growth 5 to 10 years out in either direction. We ended up finding that while low past growth does a good job of predicting high current debt, current debt does a rather poor job predicting low future growth.

The column had a very strong response, and as such we each had a few follow up posts. Immediately after the first article, Miles started addressing new points brought up by various commentators, and these can be seen here. I later wrote about controlling for the possibility that policy makers would manipulated their debt levels in expectation of future growth rates, and Miles had a post on the importance of taking enough lags of growth rates into account. We pursued these ideas further in another Quartz article that featured (in my opinion) a very good looking scatterplot that lets you see the individual countries that contribute to the regression results.

Since part of this controversy was over data sharing practices, I made sure to make all the code available in the Data section of my blog.

Before presenting the original article, I want to add two more pictures to the debate. The first is a scatter plot that breaks down the relationships between future growth, past growth, and debt by both country and time -- something that Evan Soltas asked for when the article was released. These diagrams show that even when the observations are grouped by decade, the general conclusion that debt does not slow future growth  still holds. This plot also allows you to see which countries are the influential outliers. With any luck, this granularity can inspire some more posts about what the experiences of those individual countries can teach us about debt and growth.

To me, what is most stark about these plots is that the Solow growth model implies both panels should have downward sloping lines. Since debt levels usually rise as countries approach the technological frontier and start welfare states, we should expect debt to be negatively correlated with growth -- both past and future. Therefore the nearly flat slopes in the left panel really do suggest debt's effect on future growth is quite small.

As a second plot on this point, I want to present a version of the debt/gdp buckets plot because that nonparametric approach  was a big part of the RR debt/growth message. It turns out that as soon as we look at future growth, the buckets no longer show much of a slowdown at all at moderate levels of growth. However, the buckets maintain the robust negative relationship between past growth and current debt. Even though this image might be provocative, I would  recommend not reading too much into it. The standard errors should be quite large and are not included, and none of these bar charts adjust for past growth.

And now, the full text of the article. If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Quartz column and the following copyright notice:

© May 29, 2013: Miles Kimball and Yichuan Wang, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

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After Crunching Reinhart and Rogoff’s Data, We Found No Evidence High Debt Slows Growth

Miles Kimball and Yichuan Wang

Leaving aside monetary policy, the textbook Keynesian remedy for recession is to increase government spending or cut taxes. The obvious problem with that is that higher government spending and lower taxes tend to put the government deeper in debt. So the announcement on April 15, 2013 by University of Massachusetts at Amherst economists Thomas Herndon, Michael Ash and Robert Pollin that Carmen Reinhart and Ken Rogoff had made a mistake in their analysis claiming that debt leads to lower economic growth has been big news. Remarkably for a story so wonkish, the tale of Reinhart and Rogoff’s errors even made it onto the Colbert Report. Six weeks later, discussions of Herndon, Ash and Pollin’s challenge to Reinhart and Rogoff continue in earnest in the economics blogosphere, in the Wall Street Journal, and in the New York Times.

In defending the main conclusions of their work, while conceding some errors, Reinhart and Rogoff point out that even after the errors are corrected, there is a substantial negative correlation between debt levels and economic growth. That is a fair description of what Herndon, Ash and Pollin find, as discussed in an earlier Quartz column, “An Economist’s Mea Culpa: I relied on Reinhardt and Rogoff.” But, as mentioned there, and as Reinhart and Rogoff point out in their response to Herndon, Ash and Pollin, there is a key remaining issue of what causes what. It is well known among economists that low growth leads to extra debt because tax revenues go down and spending goes up in a recession. But does debt also cause low growth in a vicious cycle? That is the question.

We wanted to see for ourselves what Reinhart and Rogoff’s data could say about whether high national debt seems to cause low growth. In particular, we wanted to separate the effect of low growth in causing higher debt from any effect of higher debt in causing low growth. There is no way to do this perfectly. But we wanted to make the attempt. We had one key difference in our approach from many of the other analyses of Reinhart and Rogoff’s data: we decided to focus only on long-run effects. This is a way to avoid getting confused by the effects of business cycles such as the Great Recession that we are still recovering from. But one limitation of focusing on long-run effects is that it might leave out one of the more obvious problems with debt: the bond markets might at any time refuse to continue lending except at punitively high interest rates, causing debt crises like that have been faced by Greece, Ireland, and Cyprus, and to a lesser degree Spain and Italy. So far, debt crises like this have been rare for countries that have borrowed in their own currency, but are a serious danger for countries that borrow in a foreign currency or share a currency with many other countries in the euro zone.

Here is what we did to focus on long-run effects: to avoid being confused by business-cycle effects, we looked at the relationship between national debt and growth in the period of time from five to 10 years later. In their paper “Debt Overhangs, Past and Present,” Carmen Reinhart and Ken Rogoff, along with Vincent Reinhart, emphasize that most episodes of high national debt last a long time. That means that if high debt really causes low growth in a slow, corrosive way, we should be able to see high debt now associated with low growth far into the future for the simple reason that high debt now tends to be associated with high debt for quite some time into the future.

Here is the bottom line. Based on economic theory, it would be surprising indeed if high levels of national debt didn’t have at least some slow, corrosive negative effect on economic growth. And we still worry about the effects of debt. But the two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth.

The graphs at the top show show our first take at analyzing the Reinhardt and Rogoff data. This first take seemed to indicate a large effect of low economic growth in the past in raising debt combined with a smaller, but still very important effect of high debt in lowering later economic growth. On the right panel of the graph above, you can see the strong downward slope that indicates a strong correlation between low growth rates in the period from ten years ago to five years ago with more debt, suggesting that low growth in the past causes high debt. On the left panel of the graph above, you can see the mild downward slope that indicates a weaker correlation between debt and lower growth in the period from five years later to ten years later, suggesting that debt might have some negative effect on growth in the long run. In order to avoid overstating the amount of data available, these graphs have only one dot for each five-year period in the data set. If our further analysis had confirmed these results, we were prepared to argue that the evidence suggested a serious worry about the effects of debt on growth. But the story the graphs above seem to tell dissolves on closer examination.

Given the strong effect past low growth seemed to have on debt, we felt that we needed to take into account the effect of past economic growth rates on debt more carefully when trying to tease out the effects in the other direction, of debt on later growth. Economists often use a technique called multiple regression analysis (or “ordinary least squares”) to take into account the effect of one thing when looking at the effect of something else. Here we are doing something that is quite close both in spirit and the numbers it generates for our analysis, but allows us to use graphs to show what is going on a little better.

The effects of low economic growth in the past may not all come from business cycle effects. It is possible that there are political effects as well, in which a slowly growing pie to be divided makes it harder for different political factions to agree, resulting in deficits. Low growth in the past may also be a sign that a government is incompetent or dysfunctional in some other way that also causes high debt. So the way we took into account the effects of economic growth in the past on debt—and the effects on debt of the level of government competence that past growth may signify—was to look at what level of debt could be predicted by knowing the rates of economic growth from the past year, and in the three-year periods from 10 to 7 years ago, 7 to 4 years ago and 4 to 1 years ago. The graph below, labeled “Prediction of Debt Based on Past Growth” shows that knowing these various economic growth rates over the past 10 years helps a lot in predicting how high the ratio of national debt to GDP will be on a year by year basis. (Doing things on a year by year basis gives the best prediction, but means the graph has five times as many dots as the other scatter plots.) The “Prediction of Debt Based on Past Growth” graph shows that some countries, at some times, have debt above what one would expect based on past growth and some countries have debt below what one would expect based on past growth. If higher debt causes lower growth, then national debt beyond what could be predicted by past economic growth should be bad for future growth.

Our next graph below, labeled “Relationship Between Future Growth and Excess Debt to GDP” shows the relationship between a debt to GDP ratio beyond what would be predicted by past growth and economic growth 5 to 10 years later. Here there is no downward slope at all. In fact there is a small upward slope. This was surprising enough that we asked others we knew to see what they found when trying our basic approach. They bear no responsibility for our interpretation of the analysis here, but Owen Zidar, an economics graduate student at the University of California, Berkeley, and Daniel Weagley, graduate student in finance at the University of Michigan were generous enough to analyze the data from our angle to help alert us if they found we were dramatically off course and to suggest various ways to handle details. (In addition, Yu She, a student in the master’s of applied economics program at the University of Michigan proofread our computer code.) We have no doubt that someone could use a slightly different data set or tweak the analysis enough to make the small upward slope into a small downward slope. But the fact that we got a small upward slope so easily (on our first try with this approach of controlling for past growth more carefully) means that there is no robust evidence in the Reinhart and Rogoff data set for a negative long-run effect of debt on future growth once the effects of past growth on debt are taken into account. (We still get an upward slope when we do things on a year-by-year basis instead of looking at non-overlapping five-year growth periods.)

Daniel Weagley raised a very interesting issue that the very slight upward slope shown for the “Relationship Between Future Growth and Excess Debt to GDP” is composed of two different kinds of evidence. Times when countries in the data set, on average, have higher debt than would be predicted tend to be associated with higher growth in the period from five to 10 years later. But at any time, countries that have debt that is unexpectedly high not only compared to their own past growth, but also compared to the unexpected debt of other countries at that time, do indeed tend to have lower growth five to 10 years later. It is only speculating, but this is what one might expect if the main mechanism for long-run effects of debt on growth is more of the short-run effect we mentioned above: the danger that the “bond market vigilantes” will start demanding high interest rates. It is hard for the bond market vigilantes to take their money out of all government bonds everywhere in the world, so having debt that looks high compared to other countries at any given time might be what matters most.

Our view is that evidence from trends in the average level of debt around the world over time are just as instructive as evidence from the cross-national evidence from debt in one country being higher than in other countries at a given time. Our last graph (just above) shows what the evidence from trends in average levels over time looks like. High debt levels in the late 1940s and the 1950s were followed five to 10 years later with relatively high growth. Low debt levels in the 1960s and 1970s were followed five to 10 years later by relatively low growth. High debt levels in the 1980s and 1990s were followed five to 10 years later by relatively high growth. If anyone can come up with a good argument for why this evidence from trends in the average levels over time should be dismissed, then only the cross-national evidence about debt in one country compared to another would remain, which by itself makes debt look bad for growth. But we argue that there is not enough justification to say that special occurrences each year make the evidence from trends in the average levels over time worthless. (Technically, we don’t think it is appropriate to use “year fixed effects” to soak up and throw away evidence from those trends over time in the average level of debt around the world.)

We don’t want anyone to take away the message that high levels of national debt are a matter of no concern. As discussed in “Why Austerity Budgets Won’t Save Your Economy,” the big problem with debt is that the only ways to avoid paying it back or paying interest on it forever are national bankruptcy or hyper-inflation. And unless the borrowed money is spent in ways that foster economic growth in a big way, paying it back or paying interest on it forever will mean future pain in the form of higher taxes or lower spending.

There is very little evidence that spending borrowed money on conventional Keynesian stimulus—spent in the ways dictated by what has become normal politics in the US, Europe and Japan—(or the kinds of tax cuts typically proposed) can stimulate the economy enough to avoid having to raise taxes or cut spending in the future to pay the debt back. There are three main ways to use debt to increase growth enough to avoid having to raise taxes or cut spending later:

1. Spending on national investments that have a very high return, such as in scientific research, fixing roads or bridges that have been sorely neglected. 

2. Using government support to catalyze private borrowing by firms and households, such as government support for student loans, and temporary investment tax credits or Federal Lines of Credit to households used as a stimulus measure. 

3. Issuing debt to create a sovereign wealth fund—that is, putting the money into the corporate stock and bond markets instead of spending it, as discussed in “Why the US needs its own sovereign wealth fund.” For anyone who thinks government debt is important as a form of collateral for private firms (see “How a US Sovereign Wealth Fund Can Alleviate a Scarcity of Safe Assets”), this is the way to get those benefits of debt, while earning more interest and dividends for tax payers than the extra debt costs. And a sovereign wealth fund (like breaking through the zero lower bound with electronic money) makes the tilt of governments toward short-term financing caused by current quantitative easing policies unnecessary.

But even if debt is used in ways that do require higher taxes or lower spending in the future, it may sometimes be worth it. If a country has its own currency, and borrows using appropriate long-term debt (so it only has to refinance a small fraction of the debt each year) the danger from bond market vigilantes can be kept to a minimum. And other than the danger from bond market vigilantes, we find no persuasive evidence from Reinhart and Rogoff’s data set to worry about anything but the higher future taxes or lower future spending needed to pay for that long-term debt. We look forward to further evidence and further thinking on the effects of debt. But our bottom line from this analysis, and the thinking we have been able to articulate above, is this: Done carefully, debt is not damning. Debt is just debt.

Debt and Growth: The Chicken or the Egg?

..., and what to put in the European omelet?


How does debt affect growth?  The well-known correlation found by Rheinhart and Rogoff in their analyses of financial crises found that growth tends to substantially slow down as the debt to GDP ratio approaches 90%.  Based on this correlation, policy makers began to advocate austerity as a way to reduce debt, and thereby restore growth.

Of course, correlation does not prove causation, and Paul Krugman jumped at that, pointing out that it was quite likely that causation ran the other way.  As a result of anemic growth, countries would pursue countercyclical fiscal policy.  This would create the appearance that only low growth countries pursue higher levels of debt.  However, the association between the two variables actually arises from textbook countercyclical fiscal policy.  Had the government decided to retrench, the economy would have suffered even more, compounding the growth problem.

So how to resolve these issues?  A recent VoxEU article on the relationship between debt and growth caught my eye, as it proposed a novel mechanism to estimate the effect of debt on growth.  While I don't understand the full mechanics, the working paper seems to use the stock of foreign debt as a variable to instrument the stock of debt.  At the end of the analysis, the authors conclude that, while R+R find a strong correlation, the new data instrumented for endogenity cannot reject the null hypothesis that debt has no effect on growth.  This then has a critical role in determining policy because it suggests that countries, when in dire output straits, should not ignore the role of fiscal policy.  The debt effects are unlikely to be strong enough to overwhelm any first order effects from fiscal stimulus.  Especially given the recent interest in hysteresis and reductions in potential output, it seems almost certain that fiscal retrenchment is not the answer.  Along these lines, I also found some older articles, one an old study looking at old U.S. time series data, and another on Latin American growth, that both suggest we should be worry about the output gap.  Long run growth can be seriously affected by temporary deviations, and therefore we need to fill the gap, whether by fiscal or monetary policy.

Another note in the paper that was particularly interesting was that the authors traced much of the negative correlation between debt and growth to the destructive policies governments would pursue when at high levels of debt.  In the words of the authors:

We believe that there is a subtle channel through which high levels of public debt can have a negative effect on growth. In the presence of multiple equilibria, a fully solvent government with a high level of debt may decide to put in place restrictive fiscal policies aimed at reducing the probability that a change in investors’ sentiments would push the country towards the bad equilibrium. These policies, in turn, may reduce growth (Perotti 2012), especially if implemented during a recession (such policies may even be self-defeating and increase the debt-to-GDP ratio, DeLong and Summers 2012, UNCTAD 2011).3 In this case, it would be true that debt reduces growth, but only because high debt leads to panic and contractionary policies.

This argument piqued my interest for two key reasons.  The first is that it echoes a paper by Bernanke on the effect of supply shocks on the economy.  In the paper, Bernanke argued that a lot of the damage from a supply shock wasn't actually from the shock itself, but rather from the monetary policy response.  In the case of debt, much of the harm from high levels of debt isn't from the debt, but rather from the fiscal policy response.

The second is that this advice on debt and growth seems particularly pertinent for the Eurozone.  This paper provides strong evidence that the austerity cure is anything but.  Even if growth is needed, but fiscal retrenchment is not the answer.  Netherland's recent rejection of harsh cuts, and France's electoral shift both show that democracy is having its say and is refusing this cup of self-defeating suffering.  They recognize that cutting budgets cannot be the only way forward, and that policy needs to be fundamentally changed to recognize the elaborate chicken and egg relationship between debt and fiscal policy.  I only hope that they figure out that omelet before the bond markets take away the chance.

Fiscal Policy in a Monetary Union

Recently, I read a post about the desirability of the various UK austerity programs within the UK monetary union.  What is special about the countries in the UK monetary union is that they are, to a certain extent, a fiscal union as well.  Scotland, Northern Ireland, Wales all have voting power within the English parliament at Westminster.  However, England does not have voting power in the parliaments of the other states, and therefore they still have some degrees of freedom to pursue their own fiscal policy, including the power to finance the policy through bond markets.  What this means is that fiscal policy, in a sense, can be devolved from the “federal” government to the individual countries.  Such a possibility is discussed by Brian Ashcroft when he calls upon the Scottish government to pursue policy to counteract the effects of fiscal austerity.

Well, first, it suggests that an independent Scotland as an accepted part of the UK sterling monetary union should be able to adopt a different fiscal policy stance to stabilise GDP than rUK. However, it also suggests that providing the degree of fiscal devolution is sufficient to allow changes in tax and spend that can influence aggregate demand then this option is also available within the UK political union. Further academic research is required on the appropriate form and degree of fiscal devolution for effective stabilisation but there is little doubt that stabilisation at the level of nations and regions within the UK is feasible. 

Moreover, if an independent Scotland is part of the sterling monetary union the Bank of England and rUK government will almost certainly require that the Scottish government abide by a set of fiscal rules - see this earlier post. The fiscal framework could be little different under devolution from that under independence. Under devolution, Scotland could have a separate stabilisation policy as well as the benefits from the risk pooling arrangements e.g. social security, bank bailouts etc. that are available as part of the UK. It is true that the high levels of trade with the UK would make it difficult for fiscal policy to chart a radically different stabilisation path from rUK but that would apply to an independent Scotland too.

Based on this concept, what if fiscal policy were devolved in the United States?  This concept of devolution would allow each state to design a fiscal policy appropriate for the macroeconomic conditions in each state.  Such a policy would be somewhat consistent with the concept of Market Preserving Federalism (MPF).  MPF was originally used by Weingast in the context of public choice; how do subnational units efficiently provide public goods to their citizens?  Samuelson argued that it was impossible, and that due to cross-border externalities, the central government had to intervene.  However, Weingast, building on Tiebout, argued that the subfederal units could be thought of as firms, and that they could compete against each other to reach optimal public good bundles.  For this to occur, five conditions must be met:

1. 1.    There exists a hierarchy of governments with a delineated scope of authority (for example, between the national and subnational governments) so that each government is autonomous in its own sphere of authority.
2. 2.    The subnational governments have primary authority over the economy within their jurisdictions.
3. 3.    The national government has the authority to police the common market and to ensure the mobility of goods and factors across subgovernment jurisdictions.
4. 4.    Revenue sharing among governments is limited and borrowing by governments is constrained so that all governments face hard budget constraints.
5. 5.    The allocation of authority and responsibility has an institutionalized degree of durability so that it cannot be altered by the national government either unilaterally or under the pressures from subnational governments.

Each of these five conditions are important to supporting MPF.  Without a hierarchy of governments (1), there is no federalism; the unitary state cannot be differentiated from the federal unit.  If subnational governments don’t have primary control (2), then they can’t properly compete against each other.  Without factor mobility (3), there is no competition.  As MPF was originally formulated in the context of public choice, the factors of production must have choice in where they are located.  Subnational control over factor mobility in the common market would prevent this.  Without (4), transfer payments can be used to smooth over competitive differences, limiting efficiency.  Finally, without (5), there is too much policy uncertainty, and the MPF regime may fall apart.

In devolved fiscal policy, the public good is no longer something concrete like transportation infrastructure or police protection; it’s aggregate demand management.  AD policy truly is a public good, as when the macroeconomy is doing well in an area, nobody can opt out of it (nonrival), and the government cannot effectively exclude, outside of arbitrary jailing, any citizen from the benefits.  Yet in the provision of this public good, the fourth condition, the hard budget constraint, becomes very problematic.  A hard budget constraint substantially limits the ability of the sub-federal units to pursue counter-cyclical fiscal policy such that, in recessions, the sub-federal units are forced to cut spending.  As a result, the economy suffers due to the shortfall in aggregate demand.  This is confirmed by data from the 2008 recession: over the course of the downturn, state and local spending collapsed, effectively counteracting the effect of the federal stimulus.

So what happens if the fourth condition is loosened; what if state and local governments were allowed to borrow?  In effect, there then would be fifty states with sovereign fiscal policies in a common monetary union; a situation quite similar to that in Europe.  During the construction of the European monetary union, the United States was often used as a model in the literature to help describe how Europe would work.  In this case, Europe can be used to help evaluate a hypothetical United States, in which sub-federal, and not the federal, units have borrowing power.

In Europe, the concern was that, in the absence of borrowing rules, the fiscal policies of the individual European states would err towards fiscal irresponsibility.  Since prices for most goods would not be affected by an individual country’s fiscal policy, aggregate supply would be much more elastic, heightening the effect of expansionary fiscal policy.  As a result, each state would have an incentive to boost its output through government spending and push the debt to the future.  However, once every state decides to pursue fiscal expansion, the aggregate supply relation puts the brakes on output growth, resulting in higher inflation instead.

Would the same thing happen for devolved fiscal policy in the United States?  According to analysis by McKinnon, the answer is “not necessarily.”  Because of Ricardian equivalence, a state’s decision to take up higher levels of debt can be interpreted as an obligation to raise taxes or cut spending on other programs in the future.  Assuming sufficient factor mobility to cause horizontal competition between states, the taxes to finance the debt spur firms to move away from indebted states to move towards lower debt states.  Consequently, debt financed expansions would be limited to public goods that have a positive return in the state, as those would be the only programs for which firms would be willing to pay taxes.  Note that these public goods can include education and health care systems as well.  If workers are drawn to the state by the productive investments in human capital, firms will have more opportunities to find talented workers in that state.  These local public goods would also be the answer to the spillover effect of fiscal stimulus.  As per open economy models of fiscal stimulus, simple increases in consumption have a high probability of being spent in other states.  On the other hand, local investments contain more of the stimulatory effect within the state.  As a result of competition between states, there is more likely to be efficiency within states.

What is particularly attractive about this arrangement is that it forces aggregate demand management in recessions to function as quasi-aggregate supply management.  As “easy” stimulus would diffuse across borders, so the more onerous task of improving the capital stock, both human and traditional, becomes the key mechanism through which to achieve macroeconomic stability.  This also creates exciting possibilities with regards to the interaction between each subnational unit’s fiscal policy and national monetary policy.  If the price level is pushed down as a result of an increase in aggregate supply, it may force the hand of an inflation targeting central bank that is otherwise unwilling to fill the output gap.

Some may point to Europe as an example of why this system would not work; devolved fiscal policy under a monetary union has only led to severe debt crises there.  However, one key difference is the extent of factor mobility in Europe as compared to the United States.  Much of the empirical literature on the Eurozone has pointed out the limited mobility of labor within the Eurozone.  Although many of the de jure barriers to immigration have been removed, the de jure barriers are still very problematic.  Moving from Germany to Portugal is not quite as simple as moving from Maine to California.  One has to learn a new language, use it effectively in a job, and then be aware of new cultural mores to truly fit in.  Consequently, labor mobility in the Eurozone has been estimated at about one third of that in the United States.  After adding high levels of transfer payments between countries, there is very little competition between the European countries for labor; there is no “factor-price equalization.”  As a result, firms cannot easily relocate, giving individual countries more space to pursue inefficient levels of government spending.  The threat of future taxes embodied by present debt is not strong enough to spur firms to move.

With Scott Sumner proudly proclaiming a market monetarist end to macro, it is time to turn our attention to what we can do afterwards.  In a world in which knowledge is increasingly dispersed, and centralization is unequipped to deal with the complex nature of economic policy, devolving policy domains, such as fiscal policy, may be the answer.