A Sinking Ship

Eight years ago, the world economy was shaken by the worst financial crisis since the depression of 1929. Despite the trillions of dollars spent on bailouts and on governments’ attempts to stimulate the economy through monetary policies, the world has not yet fully recovered, and several developing countries are facing their bitterest share just now. Still, many refrain from acknowledging the necessity of governments to engage in a different – and more effective – policy to boost economic activity and employment: fiscal expansions. Nevertheless, the burden is getting so heavy that even the more skeptical are turning to reason.

A recent text written by three important economists at the IMF, titled Neoliberalism: Oversold? has drawn a lot of attention in the past days. Perhaps the most impressive matter that should be highlighted about the text is in its very title: the use of the word neoliberalism, so far mostly used by critics of this agenda that gained strength in the 1980s and generally associated with a sort of “conspiracy theory”. Besides that, the findings of the text should come as no big surprise to non-mainstream economists: instead of economic growth, neoliberalism has brought financial instability and increasing inequality.

This is due to two main pillars of the neoliberal agenda: capital flows liberalization and government fiscal consolidation. Freedom of the capital accounts was expected to bring about a more efficient allocation of resources at an international level. Both developed and developing countries would reap benefits from it: the former by obtaining higher returns on capital investment and the latter by receiving the necessary savings to finance capital development.

The same is true for austerity policies, which would lead to a more efficient allocation of resources domestically. Two main ideas associated with fiscal consolidation are the famous “crowding-out effect,” in which government expenditure would decrease the availability of resources to the private sector thus not resulting in any real change in the economy (a mechanism adjusted by the interest rate), and the “burden of debt”, in which public indebtedness would necessarily lead to higher taxes in the future, then transferring the “burden” to pay off the debt to the future generations.

By looking into data, the IMF authors reach the conclusion that the beneficial effects of such policies “appear to have been somewhat overplayed”. Indeed, instead of stimulating economic growth, those policies have resulted in decreasing output. Capital account liberalization has been much associated with financial instability (especially in the recipient countries), and fiscal cuts with increasing unemployment. Most importantly, such policies seem to lead to increasing economic inequality, which hurts the sustainability of economic growth in the long-run.

Fiscal consolidation and free capital flows have led to the trap that the world economy is now found: a sinking ship commonly referred to as “secular stagnation”. After almost a decade has passed since the financial crisis and advanced economies still have not engaged in fiscal stimulus despite the failure of the non-orthodox monetary policies on bringing about robust growth. Instead of having that money spent into the economy, banks and other private investors were just sitting on it – apparently, not even negative interest rates managed to encourage lenders, showing the limits of monetary policy to generate growth and sustain employment.

Furthermore, in a world in which capital flows are free, high international liquidity was mostly drained by developing economies due to the high-interest rate differentials. The increase in capital flows has a direct impact both on foreign reserve accumulation and exchange rates, which can have disruptive effects for developing countries hurting foreign trade competitiveness and risking a balance of payment crisis. In a case of increasing country’s indebtedness denominated in foreign currency, a change in the perception of international lenders might lead to either capital flood or capital flight.

This deserves special attention in the current state of the world economy. The US has not yet reached the levels of inflation that it aims (despite the plan to continue the interest rate hikes), China is going through a downturn and a restructuring of its economy towards a consumer-based one, Europe is in the brink of dismantling, and Latin America is struggling both politically and economically (with Brazil as one of the protagonists). The drop in global trade and the reverse in money flows can bring about an obstacle to the ability of developing countries to obtain foreign exchange, and thus to meet their foreign debt commitments.

With decreasing global demand and a lack of willingness to make use of fiscal stimuli, the burden of the adjustment during this sluggish riptide is the employment level. In a report from January, the International Labour Organization (ILO) estimated that world unemployment is likely to reach 200.5 million in 2017, an increase of 3.4 million new jobless people within this and the next year, with the developing and emerging economies in Latin America, Asia and Africa taking the worst impact, plummeting along with commodity prices.

How can we stop the ship from sinking? A coherent global effort to generate demand and employment is needed. Governments, especially in countries with greater economic and political leverage (such as US and Germany), should engage in fiscal expansions targeting investment and employment. With investors’ animal spirits leashed, policymakers should not count on the private sector as a source of aggregate demand, and neither on exporting their way out of the crisis – as in a “beggar-thy-neighbor” type of policy. Instead, direct employment creation should be an objective of a global coordination, which then would provide the necessary aggregate demand to revive global trade, besides being a great mechanism to tackle the neoliberal trend of rising inequality.

Ideally, this should be the first step towards a more substantial change in the international financial architecture: from one that incites financial instability through chronic current account deficits/surpluses and abrupt movements of capital, towards one that nurtures and sustains stability and employment in the long-run. [For an enlightening discussion on the subject, see here].

What we shall remember is that although developing countries are being the first ones to fall into the cold waters of depression, the whole ship will sink eventually unless the proper policies are adopted – and austerity and liberalization have proven not to be useful lifebuoys.

Written by Vitor Mello
Illustration by Heske van Doornen

Why is Austerity Still Being Prescribed?

After years of strict austerity and a worsening crisis, the Greek economy is still in a slump.

However, Eurozone officials continue to prescribe the medicine of austerity.  The diagnosis for the Greek crisis was the fiscal profligacy of its government, and thus to restore the health of its economy, Greece simply had to slash its spending. As with any prescription, some short-term side effects were expected. However, year after year the side effects have gotten worse, with unemployment and poverty at all-time highs and demand at all-time lows. Meanwhile, the economy, in a deepening recession, is far from being cured. To make matters worse, despite the reduced fiscal deficits, the shrinking economy means the debt-to-GDP ratio is nevertheless growing.

In the aftermath of the Global Financial Crisis, Europe embraced austerity as the best medicine to cure its damaged economies. Conservative economists and leading institutions such as the European Central Bank (ECB) and International Monetary Fund (IMF) promoted the concept of austerity. The EU imposed spending cuts on all its members. It is using the dire situation of Greece as a warning against the accumulation of more debt. A  council of Eurozone ministers, spearheaded by Germany, aggressively pushed for more austerity. Meanwhile, despite complying with the prescribed “medicine,” the health of the Greek economy grew increasingly worse…

However, the theoretical justification behind austerity is questionable. The fear of government deficits was backed by studies such as “Growth in a time of debt” by Carmen Reinhart and Kenneth Rogoff. This paper, published in 2010 predicted catastrophic economic consequences for any country surpassing a debt-to-GDP ratio of more than 90%. Backed by this research, high-ranking European officials made their case to abruptly cut government spending.  

While Reinhart and Rogoff’s study created a buzz amongst conservative politicians when it was published. However, it was mostly ignored by the same politicians when it was discredited.  In 2013, it was shown that the spreadsheet used for the calculations in the study was laden with mistakes. Its results were gravely exaggerated. After the errors were fixed, some correlation between government debt and slow growth remained but not one sufficient to establish causation. It is plausible to assume that slow growth is the cause of the increase in government debt. A summary of this controversy can be found.

In the early 2000s, the Greek government began to accumulate massive amounts of debt. By 2009, the government debt had reached almost 135% of GDP. The government quickly enacted extreme spending cuts. So, it is resulting in a  ratio decrease that lasted until 2011. However, the Greek economy, in the midst of a deep recession. It did not respond very well to these cuts which came coupled with the added bonus of tax hikes. Domestic demand collapsed and unemployment soared. Moreover, overall confidence in the economy faded. Greek GDP fell, and the debt-to-GDP ratio exploded. Currently, that ratio is at about 180% of GDP and is projected to reach 200% by 2020. (OECD) The Greek economy is on a downward spiral in which imposed spending cuts reduce incomes, reduce spending, and further contract the economy, and limit its ability to repay its debts.

Despite the academic case for austerity weakening, the Greek parliament is forced to impose even deeper spending cuts to receive more funds from European institutions. Without additional loans, Greece would be unable to make the payments on its previous debt. However, most of the bailout money received by Greece has gone on payments for maturing loans.

The Greek sovereign debt has turned into a ponzi scheme. New loans are obtained to make interest payments on older ones, while the principals rise and the economy shrinks. The IMF, initially a main proponent of austerity, has recently come out in favor of restructuring Greece’s debt and allowing for some economic stimulus. It appears that EU officials are finally willing to listen, at least in respect, to debt restructuring. Last week, the council of Eurozone ministers agreed to discuss some debt relief. However, this comes with the same condition attached: more and even harsher austerity.

For a sick economy such as Greece, it is difficult to see how even aggressive spending cuts could nurse it back to health.  After austerity has failed year after year in reducing Greek debt and revitalizing its economy, it is time to try a different medicine. Under EU agreements, countries are required to be fiscally conservative. Moreover, EU officials, under German direction, have refused to change their stance on weakening the austerity imposed on Greece. Greece’s suffering has become an example of what happens when those rules are broken.

However, if the EU wants Greece to repay its debt and recover, it needs to stop punishing it and give it room for growth. The European officials who continue to force austerity on Greece should take a step back and realize that the best way to reduce the Greek debt-to-GDP ratio and make it sustainable, is to allow for its economy to grow. Clearly, austerity measures have not brought about the desired growth and health. Greece needs a different prescription. One that would indeed stimulate its economy and not keep it locked in an ICU.

Written by Lara Merling
Illustrations by Heske van Doornen

Stability is Destabilizing

In a recent  interview with Andrew Ross Sorkin, published in The New York Times, President Obama argued that the U.S. economy is in fine shape, despite public feelings that it might not be. Then a few days later the same newspaper ran an interview with William C. Dudley, the president of the Federal Reserve Bank of New York, in which he foresaw continued economic growth. And like the president of the Richmond Fed, Mr. Dudley made the case for slowly raising interest rates because the economy is “on track” and global conditions are “dramatically better.”

The rhetoric coming from these top policymakers can seem rather soothing to most people, including many economists. However, we know that Hyman Minsky would have remained highly skeptical. In fact, Minsky famously argued that “stability is destabilizing,” and that is because periods of economic instability and recessionary episodes emerge naturally out of the normal functioning of a prosperous modern capitalist economy.

For  Minsky  the  nature  of  instability  is  linked  to  the  relation  between  finance  and investment in capital assets  during  the  business  cycle. Economic agents often compromise future incomes in order to secure the assets they need to undertake production. The accumulation of capital in the economy is largely financed by borrowing, which is recorded as liabilities on balance sheets. The liabilities represent a group of payment commitments on a future date, while the assets held represent a series of expected cash receipts from operations. The performance of the economy will later either validate or invalidate the structure of those balance sheets. Even though Minsky was talking about the capital development of the economy, his argument can be broadly extended to any economic unit; from a corporation borrowing to build its new headquarters to a person borrowing to buy a car or pay for college.

In his Financial Instability Hypothesis (FIH), Minsky identified the degree of financial fragility in the system by defining three income-debt relations for economic units: hedge, speculative, and Ponzi finance. For hedge financing units, the income flows from operations are enough to fulfill debt commitments outflows in every period. For units involved in speculative finance, the income flows are only enough to meet the interest component of their obligations and they will have to roll over debt because they cannot repay the principal. For Ponzi finance, the income flows from operations are not enough to cover the interest costs of their loans or the repayment of principal. Ponzi units highly depend on the possibility of refinancing their debt, otherwise they have to resort to the liquidation of assets or issuing new liabilities in order to meet their obligations.

The movement to more units engaged in Ponzi finance happens as a natural consequence of periods of stability and prosperity. During economic expansions, borrowers and lenders become confident in the ability of the former to meet cash commitments, which is a rational response based on recent past experiences and on the higher probabilities of success associated with the expansionary environment.

Thus, economic  units  are  not  likely to  have  difficulties  to  meet  their  payment commitments as they come due during economic expansions. However, such optimistic expectations  lead to  relaxing  lending  standards and  reducing margins of safety. They also validate riskier projects, the use of more debt relative to assets, and lower liquidity; all of which increase the fragility of the economic system (for more see here and here).

Borrowers and lenders seem to operate on a hit-or-miss basis; if a behavior is successful, it will be rewarded and it will be repeated. So the behaviors described above will continue, and in fact be encouraged, until the turn of the economic cycle. Thus, while the economy prospers, financial positions are becoming increasingly fragile under the stable surface. Indeed, according to Minsky, during prolonged periods of prosperity the modern capitalist economy tends to move from a robust financial structure dominated by hedge financing units, to what he called a “deviation amplifying system” dominated by abundant speculative and Ponzi financing units.  

The boom gives way to the bust when interest rates suddenly rise or when realized income flows fail to meet what was projected (note that economic units need not incur losses, but just have revenues depart from expectations – so basically any small shock to a fragile economy can potentially trigger a crisis). When the economic environment changes, income flows begin to fall and Ponzi units find it impossible to borrow to sustain their positions. They will then try to make position by selling out position; this means selling assets to meet their payments. The consequence of a generalized sell-off is to put downward pressure on asset prices, which can make the market prices too low as to generate sufficient income to meet the commitments – making this operation self-defeating. These dynamics, plus the excess supply, reinforce the necessity to sell and raise the real debt burden, leading to a potential Fisher-style debt deflation. These processes reset the system, starting again from a robust financial position – because all the fragile positions were washed off by the debt deflation – but will eventually give way to another crisis.

The idea that “stability is destabilizing” is summarized by Minsky’s two theorems of financial fragility in the FIH: (I) the economy has financing regimes under which it is stable (hedge) and financing regimes in which it is unstable (speculative and Ponzi); and (II)  over periods of prolonged prosperity, the economy  transitions from financial relations that make for a stable system to financial relations that make for an unstable system. In other words, the economy tends to move from a financial structure with abundant units engaged in hedge finance to a structure dominated by speculative and Ponzi units. The natural shift from hedge positions to speculative to Ponzi is a required condition for instability to arise, and, as explained above, the move (and the erosion of margins of safety) happens during periods of economic stability and prosperity. One of Minsky’s most important contributions was to point out that the process leading to an unstable system is an inevitable, endogenous, and evolutionary process of the modern capitalist economy.

So, what can we learn from all of this? Well, the next time you hear politicians or big shot economists talking about how stable the economy is and how on track it is, remember Minsky and remain skeptical.

Written by Oscar Valdes-Viera

Bloated Bodies & Starved Economies: Two harmful misconceptions

Over 35% of American adults are considered obese. These numbers are disproportionately higher in communities of color, whose access to healthy food is limited by time, money, and location. American Big Fast Food pushes “healthy” options which are laden with sugar, but advertised as “fat free”. The nutrition science community sold the idea that fat free meant free from creating fat, but the distinction is not quite true. Likewise, “low calorie” diets were sold on a similar idea that all calories are equal. The body in fact has different subsystems for digesting different types of calories. Carbohydrates go one place, proteins another, and fats themselves are digested separately. Carbohydrates are easily stored as glycogen and when present in the system the body prefers the quick use of them. When no carbohydrates are present, gluconeogenesis breaks down fats and proteins for use as energy. Looked at from this system perspective, the high carb low fat diet commonly advocated from the 1980s onward seems rather foolish if one wishes to burn fat stored on the body. In fact, the opposite should be advocated, a low-carbohydrate diet which starves the body of the fast glycogen deposits and forces it to switch into ketosis. The aphorism that “fat makes you fat” was wrongly sold to the public. While an understanding of the body system seems to clearly disprove the old ideas, the fact that the old paradigm pervaded common thought means communities continue to suffer from obesity without access to the new knowledge and healthy diets. 

fatisnotfatAmerica has another problem caused by a common misconception. There is a pervasive view that the government should not have a deficit, and should in fact run a surplus and pay down all of its debt. Of course, any good American pays down their debts. The banking system is gracious enough to give us loans to buy houses, cars, and get educations. We pay them back for the opportunity, never wanting to default on payments and enter bankruptcy. It makes sense that we think that our government, which so well represents us, should similarly pay back its debts. It is not quite that simple. Much like the fat in food being different from the fat in our bodies, the idea that government debt is the same as household debt is a harmful misconception. Like not all calories are the same, not all debts are the same. When the government runs a deficit, and spends more than it collects in taxes, it is engaging in an act of money creation. When it runs a surplus, and spends less than it collects in taxes, it is engaging in an act of money deletion. Like understanding the subsystems of the body helped us understand how different calories are used, understanding the economic subsystem of money helps us understand how different debts are used and created. 

The government determines what is used for money. Today, USD denominated deposits within the banking system are the main thing we use for money. They are widely accepted and we use them to pay taxes. Deposits enter into the system in two ways. The first is through the budget process which determines the amount of fiscal spending, most of it largely mandatory based on existing law. The budget has some discretionary spending which can be increased by Congress, which can go towards things like education, public jobs, and infrastructure. As the Treasury deficit spends deposits in bank accounts are created, and the Treasury issues a bond as the matching liability on its balance sheet (“the debt”). The other way deposits enter the system is through private banks making loans to households and firms. Banks can always extend loans if they think the venture will be profitable. They make the loan, which creates a deposit as a liability in another bank. After loans are created, the banking system needs to meet reserve requirements for the amount of deposits in the system. If they are not holding enough reserves they can sell assets to the Fed to get them. So banks make loans whenever they see profitable business ventures, and the government accommodates with enough reserves for them to do so. money creation3.jpg

After deposits are created, they circulate hopefully a few times within the banking system but ultimately are collected as taxes or used to pay down private debts. When taxes are collected the Treasury extinguishes some bonds as the debt is now paid. So running a surplus means the government is removing deposits from the system (“paying down the debt”). What happens if we rely on only the private sector to add deposits? Bill Clinton tried in the 1990s when he ran an unprecedented surplus for a couple years. It turns out however that Americans are stubborn and still wanted to buy houses, cars, and get educations. So as our real incomes fell rather than reduce our standards of living we graciously racked up debt with the banking sector. The banks saw us as profitable ventures and gave us loans as deposits, causing the central bank to create the reserves to accommodate this lending. This debt that households accumulated is fundamentally different than the debt pinned on the government as this process unfolds. This is because the government can never be forced to default. Looking at the net flows of financial balances yearly sheds some light into this process. Every year, the net amount spent by the government (red line) matches the net amount saved (or dissaved) by the rest of the world (blue is domestic, green is foreign). This exact mirroring is the result of accounting identities within the system. 

sectoral_balances1

In the 1990s and 2000s you see the private sector as a whole taking on debt and dissaving for the first time in recent history, as the government ran a surplus and other countries bought up large amounts of US securities. Today many US households are still holding onto these debts. The misconception that government debt is the same as these private debts has starved our economy. Much like the mistake of the nutritional science community in prescribing low fat diets to reduce fat, it has been the mistake of the economic science community to prescribe low government debts in order to fix our household debts. debtisnotdebt3In order for households to get enough deposits so they can pay back their debts, the government should run deficits that end up in their hands. The reliance on the private sector has taken priority over the public good, and most of the deposits have landed in the hands of the top 1%. They were supposed to “trickle-down” the wealth to the rest of us, but after forty years of trying this has not happened. The private sector only employs as many people as it finds profitable to do so, and if they can deploy their capital in financial casinos to make more profit than employing people to build stuff that enhances society, they will do just that. So how can we get money into the hands of the financially responsible Americans who just want to work and pay back their debts? A answer to this problem is to rely on direct government job creation, much like the New Deal after the Great Depression. This spending will cause the government to accumulate more debt in the short term, but if spent on education, infrastructure, public jobs, worker co-ops, and raising the minimum wage then these new deposits would funnel into the bottom of the income distribution, and American households could pay down their own debts. Maybe then we’ll realize: government debt, like a nice fatty avocado, is good for us.

Written by Bradley Voracek