New Directions in Monetary Economics: An Interview with Marc Lavoie – Part II

Marc Lavoie is a professor in the Department of Economics at the University of Ottawa. He is the author of numerous books on post-Keynesian economics. His latest work ‘Monetary Economics’, written with the late Wynne Godley, is now available in paperback from Amazon.com.

Interview conducted by Philip Pilkington. Part I of this interview can be found here

Philip Pilkington: I think the first part of the interview provides a pretty good sketch of what you and Godley have built in the book – although, obviously, this barely scratches the surface and there is a great deal more than this in the book. Still though, I think readers should be able to grasp the broad aim of the book, at least.

If you don’t mind I’d like to move onto some more practical issues. The models set out in the book lead to some very different conclusions than the mainstream models as far as the effects of macroeconomic policy go. This has enormously important implications for both policymakers and people working in the financial markets. I’ll go into this a little bit more below, but first I’d like to draw attention to the fact that a simple model derived from your’s and Godley’s main work is already in use by both market practitioners and Keynesian-oriented economists, such as the Financial Times’ Martin Wolf. Aficionados of what has come to be known as Modern Monetary Theory (MMT) will also recognise the model which is, of course, called the ‘Sector Financial Balances Model of Aggregate Demand’ model. Could you outline briefly what it is that this model depicts and highlight its importance for economic analysis?

Marc Lavoie: First I should say that I learned all of this from Wynne. Yes, it is true that there is a great amount of interest now devoted to his analysis based on the sectoral financial balances, and which he used extensively for his conditional forecasts since the late 1990s. Even the Giant Squid, Goldman Sachs, provides analyses based on this equation, which says that financial lending by the domestic private sector (saving less investment) and the domestic public sector (overall tax revenue less overall government expenditures) has to equal the current account balance (CAB: net exports plus net foreign income), or with the standard notation: (S-I) + (T-G) = CAB.

This equation can be retrieved from our two-country models in the book. Wynne considered that it was a breakthrough when in the mid-1970s he discovered this accounting macroeconomic identity, an identity that was also put forward by Joseph Steindl (a student of Kalecki) when he was (already then in 1984) complaining about the poor state of macroeconomic theory. Interestingly, this identity, which I call the fundamental accounting identity, can also be found in the first-year textbook of Baumol and Blinder. So it is not as if mainstream authors were unaware of it.

What is the usefulness of this identity? Initially, Wynne saw the identity as a neat way to verify the consistency of the assumptions and forecasts that were imbedded in various parts of a model: forecasts on investment, saving rates, the government deficit, the external balance, and so on. Then he used the identity as a way to assess whether some imbalances were sustainable or not, looking at their implications for stocks. Finally, towards the end of his life, he tried to use it in the way that you defined it, as a ‘sector financial balances model of aggregate demand’. As much as I was comfortable with the first two uses, I was never much convinced by its ability to say much about aggregate demand. The identity is great in pointing out inconsistencies: for instance, when the UK government makes some forecasts about future net exports and government deficits, then, knowing about private saving, it is clear from the identity that the UK government is assuming a huge increase in private investment, something that just cannot happen in the current climate, whatever confidence austerity policies can generate among the business class.

But what about aggregate demand? GDP is made up of the four components of consumption, investment, government expenditures and net exports. It may be that the (S-I) balance is negative, meaning that the domestic private sector is borrowing, thus stimulating the economy, but this does not mean much for aggregate demand if investment is next to zero or if government expenditures are low.

I think there is also quite a controversy about this on the blogosphere. So the identity is useful and relevant, but there is a limit as to what it can tell us. I think that the practical contribution of our book is that we have rehabilitated the use and importance of flow-of-funds analysis and its associated balance sheets in national accounting. This is a point made very clearly by the Dutch economist Bezemer, when he claims that those that saw the crisis coming, and provided analytical reasons for the crisis, were mainly economists concerned with macroeconomic financial flows and balance sheets. Indeed, I have recently seen papers by economists working at the ECB and the Bank of England who refer to our analysis and argue that balance sheet linkages can help in spotting future financial fragility episodes. Despite the long-standing tradition in flow-of-funds analysis, most macroeconomists, especially the mainstream ones, had come to the conclusion that not much worthy of theorizing could be done with it. I was myself skeptical in the 1980s, after having supervised a Masters thesis on Canadian financial flows. But we all realize now that financial flows and stocks of debt are important to understand the evolution of the economy. Of course Minsky readers knew that a long time ago. I would say that Godley’s work, and hence our book, provides a framework to entertain and develop these ideas.

PP: You’re right, there has been a bit of controversy on the blogs about the private sector in the model. Perhaps, seeing that you worked closely with Godley, you could give us a few more thoughts on this. Why is it that you don’t think that private sector borrowing contributes to aggregate demand? I think the proponents of this view would say that net private sector debt that is spent into the economy buys up goods and services and should thus be considered a component of aggregate demand. What would you say to that?

ML: If firms borrow to invest in new machines or new construction, this will certainly contribute to aggregate demand. However, you may also decide to borrow to purchase stock market shares, because you think the value of these shares will go up; the fellow who sells these shares may think instead that the stock market will crash, so this fellow will put the proceeds of the sales in a bank deposit. How will this help aggregate demand? Gross debt has gone up, but aggregate demand has not. Also, you may consider the banana parable provided by Keynes in 1930. Suppose there is a thrift campaign going on, where households are induced to save until they are blue in the face, so that the sales and the price of bananas go down. Firms will then be making losses, and they will need to borrow from the banks to cover their losses. So once again, gross debt, this time of the business sector, has gone up, but the economy is crashing. The balance sheet of banks is growing, the extra money balances of households have as a counterpart the extra advances that businesses need to take, but the economy is stalling.

PP: Good point. But could the same not be said for public sector deficits that are being used to recapitalise zombie banks and/or make interest payments on outstanding government debt?

ML: Quite right on the zombie banks! When governments buy the shares of illiquid or insolvent banks, this adds to gross debt, although not necessarily to net debt. In Canada, the debt of the federal government rose by $75 billion before the Canadian economy ran into a recession and when the government was still running a balanced budget: the government indirectly purchased $75 billion worth of mortgages. But of course the argument here was that the banks needed to be saved so as to avoid a collapse of the financial system, and hence bad consequences for the real economy.

Interest payments on outstanding government debt are a bit more complicated: they are not part of GDP, although they were in the first version of the national accounts, back in 1953. But interest payments are like negative taxes: they add revenue to disposable income. All those who receive interest payments from government securities could spend them on consumption, just like those who borrow could choose to spend the extra money on consumption. So this is why these interest payments are not part of aggregate demand; but on the other hand they can have an indirect effect through the consumption or even the investment component. In fact, taking into account this interest flow from government securities is one of the key differences between stock-flow consistent models and standard models, which often omit this flow in their accounting.

PP: You say that government interest income – which is income, after all – doesn’t translate directly into aggregate demand; would you say the same thing is true for certain types of speculative income in the private sector such as incomes derived from stock market gains, housing booms and other sorts of speculation? And does this tie into your conception of private debt and its effects on the economy more generally? And do you tie this into your models?

ML: Indeed, it is similar. Capital gains, which are different from current income, but which add to income as defined by Hicks, Haig and Simons, add to wealth, and we know that there is an empirical relationship between wealth and consumption, an addition of $100 in wealth bringing in about 4 extra dollars in consumption. So, yes, there is an indirect relationship between these capital gains and aggregate demand. We have this in our theoretical models, and so do the Godley-inspired empirical models used at the Levy Institute. Indeed this is an idea of Wynne that goes back to the 1970s when, with his colleagues Francis Cripps and Ken Coutts, Godley argued that there existed a stock-flow norm between desired wealth and actual income. It is only later that he realized that this norm could be derived from the assumption that households spend a certain proportion of their current income and a (much smaller) proportion of their wealth. Personally, I don’t think that I am considering such a norm when I take consumption decisions, but Wynne claimed that he did!

PP: Let’s move onto some of the more surprising findings your computer simulated models in the book turned up. One of these was that government deficits are basically endogenous variables. That is, they are not really ‘set’ by the government at all, but instead by other variables such as private sector saving or the trade balance. Perhaps you could explain the importance of this finding for a world in which policymakers and financial professionals together with many economists demand balanced government budgets at least in the medium to long term?

ML: Well, we are back to the sectoral balances. We know, as an identity, that the government deficit has to be equal to the current account deficit plus the financial saving of the private sector. So what we now need is a model that will entertain some behavioural equations and some causality. In real time, looking at the data, for instance both in the US and in Canada, there is a tight relationship between the financial saving of the private sector and the government deficit. As Kalecki would ask, which of the two is more likely to influence the other? I would think that the investment and the saving behaviour of the private sector is most likely to influence the budget balance. Similarly, at least when economies reach a semi-stationary state, with no growth, government deficits and budget deficits go hand in hand. In this case, the causality can go both ways. Budget deficits could arise because governments wish to spend more; but they could also arise because, for whatever reason, the trade balance is going into red territory. Everybody is smart enough to realize that all countries cannot run current account surpluses simultaneously; but if there is no growth, this also implies that all countries cannot run budget surpluses simultaneously. And so, if some countries are running budget surpluses, the others will end up with budget deficits.

These relationships are particularly important when we consider what is going on within the euro zone, which is roughly in a current account neutral position vis-à-vis the rest of the world. The Germans don’t seem to realize that if countries in the South of Europe are running current account deficits and budget deficits, this may have to do with the fact that wages and domestic aggregate demand has been restrained in Germany, so that Germany is running a large current account surplus, which causes twin deficits in many of the other countries of the euro zone. Besides what we say in the book about open economies, we developed a three-country model in an article published in the Cambridge Journal of Economics in 2007, two of these countries (say Germany and Italy) being in a euro zone with a single central bank. There, if Germany improves its competitiveness with respect to the third country, say the USA, it will generate a current account deficit and a budget deficit in Italy. So indeed, the budget balance is endogenous, and a deficit may appear through no fault of the deficit country. It has nothing to do with irresponsible behaviour.

PP: But this has enormous consequences for macroeconomic policy, does it not? Almost all macroeconomic policy today – be it fiscal compacts in Europe or debt ceilings in the US – is dictated by arbitrary budgetary restrictions that are founded on the premise that government spending decisions are determined exogenously by the government. But if governments basically have no control over their spending decisions then basically every government in the world is barking up the wrong tree with regards to policy. Perhaps you could spell out some of the possible implications of this?

ML: I would put it like this: In a closed economy, the existing stock-flow consistent models show that public debt to GDP ratios are likely to stabilize endogenously, even though governments are pursuing full employment policies and let government expenditures and government deficits rise to pursue this objective, provided real after-tax interest rates are not too high. So, this would be in accord with what neo-chartalist (MMT) economists are saying: let us take care of the employment problem first, and the deficit problem will eventually take care of itself, either through growth or through the rise in interest payments by the government, which will generate higher consumption and hence more aggregate demand, as was clearly the case in Italy in the 1980s, when the Italian sovereign debt was being held by Italians.

In an open economy, with a flexible exchange rate, where the government borrows in its own currency, Wynne and I would argue that this result still roughly holds. If the government borrows in a foreign currency however, as is the case of most countries, then this in itself is likely to create all sorts of problems. In the case of a fixed exchange rate, or in the case of the euro zone, the expansionary policy of a single country will worsen the deficit of its government. So here, we clearly need cooperation. If a single country goes for austerity policies, while all the others keep expanding, that country will be successful in reducing its budget and trade deficit. However, as you mention, the fiscal compacts in Europe ask all governments to tighten their expenditures, so these concerted austerity policies will have detrimental effects on all; those running large budget and current account deficits will continue to do; and all countries will end up with a lower GDP or at best lower rates of GDP growth.

So, we might as well have stimulus policies in all countries, and mostly so in countries that currently have trade surpluses, so that all countries end up with a higher GDP or higher rates of GDP growth, that is, aim for a high equilibrium rather than a low one, thus convincing the financial markets that everyone is on the right track, and that hopefully the deficit problems will get solved endogenously, as in the closed-economy case. I don’t think there is anything extraordinary about what I am saying: even the IMF has persistently asked countries in good financial and trade positions to go for stimulus programs and delay the so-called medium-term consolidation programs.

PP: The sectoral balances model has been adopted by some fairly mainstream sources – notably, Martin Wolf over at the Financial Times (he calls it his ‘favorite graph’) and analysts over at Goldman Sachs. Is this what you and Godley were aiming for – I mean a serious engagement with those outside of heterodox economic circles?

ML: It’s hard to speak for Wynne, since he is not here anymore, but I will, based on several conversations that we had when we were writing the book. Wynne was fully aware that he was spending quite a bit of time on forecasting and on economic policy, but he felt that his lasting contribution would be on the theory side, and hence he attached great importance to the writing of the book, despite being constantly diverted from it by the news.

It is obvious that all of life Wynne wanted to have an impact on economic policy, as demonstrated by the incredibly large amount of articles and letters to the editor that he published in newspapers during his academic life. So certainly, the fact that Martin Wolf at the Financial Times or Jan Hatzius at Goldman Sachs made use of his fundamental identity approach certainly did please Wynne, because it meant that his ideas would eventually get picked up in the policy sphere. But I think that Wynne knew that he was considered as a maverick within the academic sphere, and that there was little chance that he would be influential outside the heterodox academic circles. This was also my view, and this is why we felt that the real target audience of the book was heterodox economists or perhaps also some practical economists or market participants interested in economic theory.

The other main feature of the book is that it provides a formal approach to post-Keynesian theory, recognizing that stock-flow consistent models that integrate the real and the financial sectors are not the only kind of formal modelling that can be done. There are students of economics out there who look for something else than neoclassical economics, because they feel it lacks realism, but who at the same time do not want to give up on formalism. So for them, the book is a welcome addition, and perhaps it will help to keep some bright students within heterodox or post-Keynesian economics. As Gennaro Zezza and I pointed out in our introduction to the Selected Writings of Wynne Godley (2012), Wynne wanted to make a contribution to economic theory, but only insofar as his method and models helped to provide means to answer key questions of economic policy.

PP: Well, I guess the best way to finish this up would be to ask you a very general question. I don’t think that it would be totally without merit to say that your’s and Godley’s book is one of the most promising in terms of getting the rest of the profession interested in heterodox economics. Many of the complaints raised by the profession – although, I must say: these are not as prevalent from younger members – are based on the fact that alternative theories are not supported by complete models. But with the book I don’t really think they can make this claim anymore. So, do you think that in the wake of the world crisis neoclassical economics can be pushed back within the profession? Although I doubt I have to explain it to you, by that I don’t mean that some sort of new ISLM neoclassical-Keynesian synthesis will take over; I mean, do you see there being any chance that real heterodox perspectives can make serious headway in the coming decades by influencing younger economists etc?

ML: Heterodox economists always had some influence on mainstream economists, for instance the efficiency wage hypothesis, popular among New Keynesian authors, which says that higher wages will induce workers to work harder or will induce them to shirk less on the job, is an idea that was taken from Marxist and Institutionalist authors. But these heterodox ideas are marketed into a standard neoclassical framework, based on utility or profit maximizing. So it is probable, following the subprime financial crisis, that more heterodox concepts will have some impact on mainstream macroeconomics, for instance the idea that personal debt may have some detrimental macroeconomic consequences, as suggested by Minsky, or that credit flows, not the stock of money, are really key. But I don’t really ask these questions myself. I put forward my ideas, as we did in the book, and I hope that some scholars will pick them up and will develop them further, and I hope that some readers will see their potential for economic policy.