One of the mysterious aspects of public sector debt is what happens to the bondholders when debt is retired. Take the Canadian government`s debt repayment plan as a case in point. The Government intends to pay down as much as 31.5 billion dollars according to its economic plan over the next 6 years.
First of all the bulk of Canadian federal government debt holders (about 80 %)are Canadian residents and taxpayers. So paying off these debt holders will return money in the form of interest and principal payments within the domestic economy. Previously invested savings will now have to seek new outlets for investment.
As less and less new government debt is issued because governments are with the exception of Ontario running surpluses where will these savers turn ? Alberta alone has an 11 billion dollar plus surplus.
In addition the interest payments unless they are sheltered within RRSPs will be subject to taxation thereby returning a portion of the income flow back into the Government`s revenues. This has been true even before the debt was retired as regular interest paid on the debt went in large measure to Canadian taxpayers. But the absence of new issues will likely lead to an increase in the supply of savings seeking investment outlets. Where will the money go ? The stock market ? The corporate bond market ? The foreign bond and stock markets ? These are interesting questions that have implications for the future value of stocks, the behaviour of medium and long term interest rates and the exchange value of the Canadian dollar.
Beyond this paying down the debt will not be stimulative, although reducing the Government`s surplus through tax reductions and new program spending is. Unless you believe that paying down the debt significantly reduces interest rates through increasing the supply of loanable funds there is nothing stimulative about increasing the supply of liquid savings.So long as the overall economy is growing there is no problem. But should it slow down the increase in liquid savings will complicate matters.Of course, if these former bond holders become consumers with their savings thats a different story. But not a likely one.
More about this later.
Saturday, October 9, 2010
On exchange rates and trade balances
A Rising Exchange rate on our dollar complicates the problem of selling our exports.Some politicians apparently believe that a strong dollar is good for Canada and that a rise in the exchange rate is good for our exports. This could only be so if the rise in the price of our exports abroad due to the rise in the value of our currency can be offset by a rise in productivity which cheapens the cost of production despite the rise in price due to the rising exchange rate . But how can that happen?
Theoretically it can happen in two ways. One way is virtuous, perhaps , the other definitely not virtuous. The first possible virtuous way is if new technology which increases output without causing job loss in the industry concerned appears on the scene, paid for by rising profits in the industry. This might happen.
But all too often the incentive of new technology is to displace labour. Workers are replaced by machines and not necessarily absorbed in new industries. Furthermore, there is the danger that industries under pressure from rising exchange rates will seek to raise productivity by forcing workers to work longer hours with less pay or lay off some workers to reduce labour costs while simultaneously trying to increase output. This is the non virtuous way.
It is this latter approach that all too often has been resorted to by manufacturing concerns in the auto industry in the United States . The labour unions in Canada are understandably opposed to these kinds of anti-worker labour practices and have vowed to fight this pressure for reduction in wages, working conditions and benefits. So if the Federal government wants to give itself and manufacturing interests some leeway to plan for virtuous productivity gains it needs to restrain the Bank of Canada`s enthusiasm for higher interest rates. Because higher rates result in a higher exchange rate for the dollar and greater pressure on the manufacturing export industries.
It sounds complicated but its what the new globalized world is all about. Thinking smarter about economic policy makes good sense for everyone.
Theoretically it can happen in two ways. One way is virtuous, perhaps , the other definitely not virtuous. The first possible virtuous way is if new technology which increases output without causing job loss in the industry concerned appears on the scene, paid for by rising profits in the industry. This might happen.
But all too often the incentive of new technology is to displace labour. Workers are replaced by machines and not necessarily absorbed in new industries. Furthermore, there is the danger that industries under pressure from rising exchange rates will seek to raise productivity by forcing workers to work longer hours with less pay or lay off some workers to reduce labour costs while simultaneously trying to increase output. This is the non virtuous way.
It is this latter approach that all too often has been resorted to by manufacturing concerns in the auto industry in the United States . The labour unions in Canada are understandably opposed to these kinds of anti-worker labour practices and have vowed to fight this pressure for reduction in wages, working conditions and benefits. So if the Federal government wants to give itself and manufacturing interests some leeway to plan for virtuous productivity gains it needs to restrain the Bank of Canada`s enthusiasm for higher interest rates. Because higher rates result in a higher exchange rate for the dollar and greater pressure on the manufacturing export industries.
It sounds complicated but its what the new globalized world is all about. Thinking smarter about economic policy makes good sense for everyone.
The Liberals mini budget
The Canadian Federal Government's economic statement or mini budget contains some interesting information. Because it intends to reduce taxes, increase spending and reduce the surplus in the coming year from over 13.6 billion dollars to just 4.6 billion if we include the contigency funds of 3 billion the net effect will be more stimulative or at least less contractionary than would otherwise be the case.
So long as the unemployment rate stays at 6.6% or hopefully drops further and the central bank doesn't raise interest rates the results ought to be positive for growth. What is also revealing about the statement is the enormous size of the surpluses that are going to be available for the forseeable future provided there are no surprises on the revenue front because of a business cycle downturn due to energy shock or central bank shock.
The Government also plans to pay down an additional 31.5 billion dollars in debt reduction in order to reduce the debt to GDP ratio to 25 and then 20 % by far the lowest debt ratio in the G7. Since the debt ratio will drop anyway simply by the growth in the GDP and the ratio is already below 30 % on a national accounts basis there is lots of room for moving some of the funds from debt reduction to program spending investments in health care, education, infrastructure and refurbishing the military over the coming years.
Program spending despite the increase in spending that is announced in the statement of an additional 10 billion dollars is still at the lowest it has been as a share of the GDP since the 1950s. If the Government wanted to lower the unemployment rate further down to below 6 % and repair more of the damage to the health care system and infrastructure the opportunity is definitely there.
So long as the unemployment rate stays at 6.6% or hopefully drops further and the central bank doesn't raise interest rates the results ought to be positive for growth. What is also revealing about the statement is the enormous size of the surpluses that are going to be available for the forseeable future provided there are no surprises on the revenue front because of a business cycle downturn due to energy shock or central bank shock.
The Government also plans to pay down an additional 31.5 billion dollars in debt reduction in order to reduce the debt to GDP ratio to 25 and then 20 % by far the lowest debt ratio in the G7. Since the debt ratio will drop anyway simply by the growth in the GDP and the ratio is already below 30 % on a national accounts basis there is lots of room for moving some of the funds from debt reduction to program spending investments in health care, education, infrastructure and refurbishing the military over the coming years.
Program spending despite the increase in spending that is announced in the statement of an additional 10 billion dollars is still at the lowest it has been as a share of the GDP since the 1950s. If the Government wanted to lower the unemployment rate further down to below 6 % and repair more of the damage to the health care system and infrastructure the opportunity is definitely there.
Wednesday, September 22, 2010
Inflation rate only 1.7 % in Canada
There is further evidence that the Bank of Canada has probably acted unwisely when it raised interest rates recently. the official overall inflation rate has risen only 1.7 % as of August. this is less than expected and below the Bank of Canada's target rate of 2 %.Once we deduct energy and foodstuffs out of the calculation the rate is even less.
Sunday, September 19, 2010
Lets drop the NAIRU
Jan. 29, 2006
The central bank's continuing obsession with interest rate rises is a consequence of their dogmatic attachment to a theory associated with the concept of the NAIRU, the non accelerating inflation rate of unemployment which argues that any attempt to lower inflation below the natural rate or the NAIRU rate will generate expectations of accelerating inflation in the future.
The origins of this theory go back to Milton Friedman's paper presented at the American Economic Association's annual meeting in 1968. Friedman borrowing the concept of the natural rate from the Swedish economist Knut Wicksell who as early as the end of the nineteeenth and the beginning of the twentieth century had argued for the existence of the natural rate of interest below which one would get inflation argued that in the long run any rate of inflation was compatible with the natural rate of unemployment.(See the discussion of Wicksell`s doctrine in David Laidler`s excellent work, Fabricating the Keynesian Revolution:Studies in the inter-war Literature on Money, the Cycle and Unemployment,Cambridge university Press, 1999 pp.27-34)
(For a thorough discussion of the history of the concept and an alternative approach which I call the natural rate of inflation see Harold Chorney, "Restoring Full Employment:The natural rate of inflation versus the natural rate of unemployment", a paper presented to the Adelphi University Conference on Social Policy as if People Matter, Garden City , New York available on line at www.adelphi.edu/peoplematter/schedule2.php or simply google Harold Chorney and click on the Adelphi entry)
Friedman argued that whatever short run trade offs that might exist with the Phillips curve would be eliminated in the long run when workers realised the illusory benefits of wage increases in an inflationary environment. In other words money illusion would disappear. Because workers initially overestimated the value of their wage they sacrificed leisure time for work and ended up working for lower real wages than they would truly accept if there were no money illusion.
Once money illusion disappeared they would refuse to work for these lower real wages and would demand ever accelerating wage increases to compensate for inflation.Hence, in order to keep the unemployment rate below the natural rate the cost would be accelerating inflation.
This doctrine which is based on a number of heroic assumptions also ignores the fact that when the central bank preempts inflation by diagnosing inflationary expectations it almost always guarantees an accelerating rate of unemployment and a serious recession as a consequence.
In fact, what Friedman and his followers at our central banks have done is re-invent Marx's concept of the reserve army of the unemployed whose role it is to keep inflation low at the cost of unnecessary high unemployment, greater poverty and greater homelessness . (See the excellent discussion of the NAIRU in Dean Baker, The Nairu:Is it a real constraint? , in Dean Baker, Gerald Epstein and Robert Pollin, Globalization and Progressive Economic Policy ,Cambridge university press, 1998 pp369-388. See also Robert Eisner's comment on Baker in Baker et al, pp.388-390.)
An actual econometric study of the NAIRU for 17 OECD countries by Baker and one by Eisner for the US shows that there is little evidence for the existence of the NAIRU as a real as opposed to theoretical constraint. What is real of course, however, is the behaviour of the central banks and their attachment to the concept.
Baker's study analyses data from 1950 to 1995 and Eisner from 1956 to 1995. Both of them do so on a quarterly basis.When Eisner analysed the data on an assymetrical basis separating observations above the NAIRU rate from those below the rate he found that the NAIRU hypothesis was not confirmed."The sums of past inflation co-efficients summed to less than unity,and/or for low unemployment the sums of unemployment co-efficients were close to zero; for regressions with the consumer price index they were even slightly positive. This indicated...that at worst, unemployment below the hypothesized NAIRU would generate a slightly higher equilibrium but not accelerating inflation, and that it might even lower inflation."( P.389 in Baker et al) Eisner goes on to suggest that optimal unemployment rates for the US from the point of view of low inflation and low unemployment are in the 4-5 % range. Only below 4 % does inflation appear to be a significant threat. My view of the Canadian case is that we could achieve unemployment as low as 4.5 to 5 % before having any sort of threat of rapidly rising inflation. This a great deal lower unemployment than what David Dodge and the Bank of Canada are working with when they trigger their increased interest rates.
Unemployment bottomed out at 6.4 % and in fact had only dipped below 7 % when Dodge began increasing the rates.
Its time to drop the NAIRU and get up to date on the virtuous circle of low unemployment and low inflation.A single percentage point reduction in the unemployment rate generates over 100,000 additional jobs for the economy and considerably more GDP.
It really is time to bring monetary policy at the central bank up to date and discard old discredited theories that have cost us unnecessary unemployment, poverty and homelessness.
The central bank's continuing obsession with interest rate rises is a consequence of their dogmatic attachment to a theory associated with the concept of the NAIRU, the non accelerating inflation rate of unemployment which argues that any attempt to lower inflation below the natural rate or the NAIRU rate will generate expectations of accelerating inflation in the future.
The origins of this theory go back to Milton Friedman's paper presented at the American Economic Association's annual meeting in 1968. Friedman borrowing the concept of the natural rate from the Swedish economist Knut Wicksell who as early as the end of the nineteeenth and the beginning of the twentieth century had argued for the existence of the natural rate of interest below which one would get inflation argued that in the long run any rate of inflation was compatible with the natural rate of unemployment.(See the discussion of Wicksell`s doctrine in David Laidler`s excellent work, Fabricating the Keynesian Revolution:Studies in the inter-war Literature on Money, the Cycle and Unemployment,Cambridge university Press, 1999 pp.27-34)
(For a thorough discussion of the history of the concept and an alternative approach which I call the natural rate of inflation see Harold Chorney, "Restoring Full Employment:The natural rate of inflation versus the natural rate of unemployment", a paper presented to the Adelphi University Conference on Social Policy as if People Matter, Garden City , New York available on line at www.adelphi.edu/peoplematter/schedule2.php or simply google Harold Chorney and click on the Adelphi entry)
Friedman argued that whatever short run trade offs that might exist with the Phillips curve would be eliminated in the long run when workers realised the illusory benefits of wage increases in an inflationary environment. In other words money illusion would disappear. Because workers initially overestimated the value of their wage they sacrificed leisure time for work and ended up working for lower real wages than they would truly accept if there were no money illusion.
Once money illusion disappeared they would refuse to work for these lower real wages and would demand ever accelerating wage increases to compensate for inflation.Hence, in order to keep the unemployment rate below the natural rate the cost would be accelerating inflation.
This doctrine which is based on a number of heroic assumptions also ignores the fact that when the central bank preempts inflation by diagnosing inflationary expectations it almost always guarantees an accelerating rate of unemployment and a serious recession as a consequence.
In fact, what Friedman and his followers at our central banks have done is re-invent Marx's concept of the reserve army of the unemployed whose role it is to keep inflation low at the cost of unnecessary high unemployment, greater poverty and greater homelessness . (See the excellent discussion of the NAIRU in Dean Baker, The Nairu:Is it a real constraint? , in Dean Baker, Gerald Epstein and Robert Pollin, Globalization and Progressive Economic Policy ,Cambridge university press, 1998 pp369-388. See also Robert Eisner's comment on Baker in Baker et al, pp.388-390.)
An actual econometric study of the NAIRU for 17 OECD countries by Baker and one by Eisner for the US shows that there is little evidence for the existence of the NAIRU as a real as opposed to theoretical constraint. What is real of course, however, is the behaviour of the central banks and their attachment to the concept.
Baker's study analyses data from 1950 to 1995 and Eisner from 1956 to 1995. Both of them do so on a quarterly basis.When Eisner analysed the data on an assymetrical basis separating observations above the NAIRU rate from those below the rate he found that the NAIRU hypothesis was not confirmed."The sums of past inflation co-efficients summed to less than unity,and/or for low unemployment the sums of unemployment co-efficients were close to zero; for regressions with the consumer price index they were even slightly positive. This indicated...that at worst, unemployment below the hypothesized NAIRU would generate a slightly higher equilibrium but not accelerating inflation, and that it might even lower inflation."( P.389 in Baker et al) Eisner goes on to suggest that optimal unemployment rates for the US from the point of view of low inflation and low unemployment are in the 4-5 % range. Only below 4 % does inflation appear to be a significant threat. My view of the Canadian case is that we could achieve unemployment as low as 4.5 to 5 % before having any sort of threat of rapidly rising inflation. This a great deal lower unemployment than what David Dodge and the Bank of Canada are working with when they trigger their increased interest rates.
Unemployment bottomed out at 6.4 % and in fact had only dipped below 7 % when Dodge began increasing the rates.
Its time to drop the NAIRU and get up to date on the virtuous circle of low unemployment and low inflation.A single percentage point reduction in the unemployment rate generates over 100,000 additional jobs for the economy and considerably more GDP.
It really is time to bring monetary policy at the central bank up to date and discard old discredited theories that have cost us unnecessary unemployment, poverty and homelessness.
The British national debt 1690 to 1910
Over the years that I have researched the question of the national debt and its impact upon an economy I have always been astonished at how boldly politicians, journalists and others ignore the lessons of historical experience.
For example, during the great depression of the 1930s one of the principal barriers to the relaunching of the British and North American economies was the obsession in balancing the budget despite the hardship that this act imposed and despite the negative consequences for the economy and the unemployed.In my writings I have drawn upon historical statistics to show that debt to GDP ratios were much higher than the levels reached in recent years and yet despite this the economies recovered and prosperity was restored and the debt ratio eventually dropped.
This was brought about through rapid economic growth and a sharp decline in the rates of unemployment. The notion that economic growth, wealth creation and prosperity are not incompatible with high debt to GDP ratios is crystal clear from the British case. The economic historian James Macdonald in his excellent work A free nation deep in debt makes exactly this point on pages 354-355.
He displays a chart which runs debt as a percentage of the GDP for Great Britain from 1690 to 1910. The ratio begins at 0% in 1690 runs higher and higher in a lurching manner until it peaks at about 300 % of the GDP in the late 1820s and then consistently declines with several brief upticks until it closes at around 20 % in 1910.As Macdonald states the debt was never lower than 100 % of the GDP for the century between 1760 and 1860 and averaged above 150 % from 1780 to 1845. "simplistic notions that national power and national debt are mutually incompatible are disproved by this single historical fact." (p.355)
For it was during this period that Britain became the leading industrial power in the West.Similarly in the twentieth century the British debt to GDP ratio rose to above 200 % and despite this Britain remained an important industrial power with a very high standard of living.
For example, during the great depression of the 1930s one of the principal barriers to the relaunching of the British and North American economies was the obsession in balancing the budget despite the hardship that this act imposed and despite the negative consequences for the economy and the unemployed.In my writings I have drawn upon historical statistics to show that debt to GDP ratios were much higher than the levels reached in recent years and yet despite this the economies recovered and prosperity was restored and the debt ratio eventually dropped.
This was brought about through rapid economic growth and a sharp decline in the rates of unemployment. The notion that economic growth, wealth creation and prosperity are not incompatible with high debt to GDP ratios is crystal clear from the British case. The economic historian James Macdonald in his excellent work A free nation deep in debt makes exactly this point on pages 354-355.
He displays a chart which runs debt as a percentage of the GDP for Great Britain from 1690 to 1910. The ratio begins at 0% in 1690 runs higher and higher in a lurching manner until it peaks at about 300 % of the GDP in the late 1820s and then consistently declines with several brief upticks until it closes at around 20 % in 1910.As Macdonald states the debt was never lower than 100 % of the GDP for the century between 1760 and 1860 and averaged above 150 % from 1780 to 1845. "simplistic notions that national power and national debt are mutually incompatible are disproved by this single historical fact." (p.355)
For it was during this period that Britain became the leading industrial power in the West.Similarly in the twentieth century the British debt to GDP ratio rose to above 200 % and despite this Britain remained an important industrial power with a very high standard of living.
A theory of inflation
Throughout the history of monetary theory the subject of inflation and the role of the money stock has loomed large. One can go back to Copernicus and discover rudiments of the quantity theory of money .
The doctrine that there was a direct relationship between money stock, its speed of circulation and prices at which goods and services sold in the economy is a very old doctrine. The problem with it and the problem that writers and financial market actors had with the doctrine from John Law in the 18th century to Keynes in the twentieth century was that it developed into a dogma that aserted that any increase in money stock automatically led to price rise or inflation. The original classical statement of the theory that MV=PT argued that since both velocity was so stable so as to be a constant and T (transactions a proxy for output) was because of Say's law and Walras's law also a constant at full employment. Hence there was a direct relationship between money and prices.
The problem was, as Keynes and others pointed out, Say's law that supply always created its own demand was false and Walras's invisible auctioneer who cleared temporary gluts through the process of tâtonnement was not always operational and velocity also varied in unpredictable ways. The consequence then of moving from a barter economy to a money economy was therefore that money was not neutral, could be held for its own sake, markets would not always clear and thus the direct relationship between changes in the money stock and inflation did not always hold.
Instead it is more insightful to consider that money is a vector in the economy that operates along side other vectors to influence economic activity. Sometimes its force acts largely upon output other times largely upon prices but often affects both output and prices. Since the economy is measured by P*O increases in the money stock can act largely to increase O but also to affect P somewhat. But as the supply of unemployed factors drops, more of the impulses can affect prices.The neoclassicals argue that when this occurs in an accelerating fashion you have reached the point just beyond the NAIRU rate.But my argument is that they have set this rate far too high.
Hence , it is possible to have simultaneously both some unemployment and some price rise without experiencing accelerating inflation or inflationary expectations.In fact, some of this price rise is a necessary lubricant for the operation of the economy and the forward investment planning of the private sector. It ought not to be misdiagnosed as accelerating inflation.
The real economy,as opposed to the black box economy that the quantity theory operates with, is composed of many industries and sectors. In some, strong trade unions and powerful oligopolies dominate. In others, there are many very small firms and entrepreneurs and little opportunity for price rise until full capacity is reached. In the more oligopolized unionized industries the inflationary process can begin at much lower rates of capacity utilization.
Hence, to get the overall picture we have to aggregate all the industries and sectors with the appropriate weights given to each in order to see whether or not we are likely to experience price rises that can be called inflationary. We can think of the money stock as a wave of water that washes across the variegated economy , in some place simply lubricating investments and activity in other places facilitating inflationary price rise. Supply bottlenecks, wage push, profit push and elasticity of demand as well as the decisions to save and the decisions to invest will affect the overall outcome.
Any modern theory of inflation must also take into account internet technology, just in time production, globalization and free trade all of which act as anti-inflationary forces. The problem with our central banks is that they appear to be taking decisions based on a much more restrictive theory of the inflationary process. One that places excessive weight on inflationary expectations and a narrow conception of the quantity theory.
The doctrine that there was a direct relationship between money stock, its speed of circulation and prices at which goods and services sold in the economy is a very old doctrine. The problem with it and the problem that writers and financial market actors had with the doctrine from John Law in the 18th century to Keynes in the twentieth century was that it developed into a dogma that aserted that any increase in money stock automatically led to price rise or inflation. The original classical statement of the theory that MV=PT argued that since both velocity was so stable so as to be a constant and T (transactions a proxy for output) was because of Say's law and Walras's law also a constant at full employment. Hence there was a direct relationship between money and prices.
The problem was, as Keynes and others pointed out, Say's law that supply always created its own demand was false and Walras's invisible auctioneer who cleared temporary gluts through the process of tâtonnement was not always operational and velocity also varied in unpredictable ways. The consequence then of moving from a barter economy to a money economy was therefore that money was not neutral, could be held for its own sake, markets would not always clear and thus the direct relationship between changes in the money stock and inflation did not always hold.
Instead it is more insightful to consider that money is a vector in the economy that operates along side other vectors to influence economic activity. Sometimes its force acts largely upon output other times largely upon prices but often affects both output and prices. Since the economy is measured by P*O increases in the money stock can act largely to increase O but also to affect P somewhat. But as the supply of unemployed factors drops, more of the impulses can affect prices.The neoclassicals argue that when this occurs in an accelerating fashion you have reached the point just beyond the NAIRU rate.But my argument is that they have set this rate far too high.
Hence , it is possible to have simultaneously both some unemployment and some price rise without experiencing accelerating inflation or inflationary expectations.In fact, some of this price rise is a necessary lubricant for the operation of the economy and the forward investment planning of the private sector. It ought not to be misdiagnosed as accelerating inflation.
The real economy,as opposed to the black box economy that the quantity theory operates with, is composed of many industries and sectors. In some, strong trade unions and powerful oligopolies dominate. In others, there are many very small firms and entrepreneurs and little opportunity for price rise until full capacity is reached. In the more oligopolized unionized industries the inflationary process can begin at much lower rates of capacity utilization.
Hence, to get the overall picture we have to aggregate all the industries and sectors with the appropriate weights given to each in order to see whether or not we are likely to experience price rises that can be called inflationary. We can think of the money stock as a wave of water that washes across the variegated economy , in some place simply lubricating investments and activity in other places facilitating inflationary price rise. Supply bottlenecks, wage push, profit push and elasticity of demand as well as the decisions to save and the decisions to invest will affect the overall outcome.
Any modern theory of inflation must also take into account internet technology, just in time production, globalization and free trade all of which act as anti-inflationary forces. The problem with our central banks is that they appear to be taking decisions based on a much more restrictive theory of the inflationary process. One that places excessive weight on inflationary expectations and a narrow conception of the quantity theory.
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