Saturday, October 16, 2010

Keynesliness is Next to Godleyness.

I've already blogged about James K. Galbraith's fulsome summary of the economists who got it right on the market failure(s) that led to the Great Recession, and I encourage readers to consume his entire survey of that universe.

But [at least] one particular work is deserving of being re-published herein: the work of Wynne Godley and his team at the Levy Institute.

The work of John Maynard Keynes is linked closely to the accounting framework that we call the National Income and Product Accounts. Total product is the flow of expenditures in the economy; the change in that flow is what we call economic growth.

The flow of expenditures is broken into major components: consumption, investment, government and net exports, each of them subject to somewhat separable theories about what exactly determines their behavior.

Accounting relationships state definite facts about the world in relational terms. In particular, the national income identity (which simply states that total expenditure is the sum of its components) implies, without need for further proof, that there is a reciprocal, offsetting relationship between public deficits and private savings. To be precise, the financial balance of the private sector (the excess of domestic saving over domestic investment) must always just equal the sum of the government budget deficit and the net export surplus.

Thus increasing the public budget deficit increases net private savings (for an unchanged trade balance), and conversely: increasing net private savings increases the budget deficit.

The Cambridge (UK) economist Wynne Godley and a team at the Levy Economics Institute have built a series of strategic analyses of the U.S. economy on this insight, warning repeatedly of unsustainable trends in the current account and (most of all) in the deterioration of the private financial balance. They showed that the budget surpluses of the late 1990s (and relatively small deficits in the late 2000s) corresponded to debt accumulation (investment greater than savings) in the private sector. They argued that the eventual cost of servicing those liabilities would force private households into financial retrenchment, which would in turn drive down activity, collapse the corresponding asset prices, and cut tax revenues. The result would drive the public budget deficits through the roof.

And thus—so far as the economics are concerned—more or less precisely these
events came to pass.

Godley’s method is similar to Baker’s: an unsustainable condition probably exists when an indicative difference (or ratio) deviates far from prior values. The difference is that Godley’s approach is embedded explicitly in a framework of accounts, so that there is a structured approach to figuring out what is and what is not tolerable. This is a definite advance.

For example: public sector surpluses were (not long ago) driven by private-sector debt accumulation. This raises the question, how can such accumulation be sustained and what happens when it stops? Conversely in a downturn: very large public-sector deficits are made inevitable by the private-sector’s return to net saving.

But how long will public policymakers, unaccustomed to thinking about these relationships, tolerate those deficits? The question is important, since if for political reasons they do not, the economy may collapse.

On the international side, the willingness of foreigners to hold US government bonds as reserve assets creates a counterpart in the U.S. public deficit: U.S. budget deficits are inevitable so long as the world wishes to add to its reserves of Treasury bonds.

But this raises another focused question: what drives the reserve asset decisions of foreign central banks? In this way, the Godley framework very usefully concentrates our attention on the critical questions: the things we know about, and things we need to know about.

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