Over the break an article appeared in The Economist spotlighting three “schools of macroeconomic thought”:  Scott Sumner’s market monetarism, Austrian free banking, and neo-chartalism (MMT).  In addition to noting the role of the blogosphere in refining and promoting these heterodoxies, the article elects to use Paul Krugman as a stand-in for the “mainstream” opponent.

If you step back, what’s slightly unsatisfactory about this choice is that Krugman is, right now, more in tune with the policy preferences of two-thirds of these “doctrines on the edge of economics” than he is with the reigning fiscal or monetary policy stance of the US government.  Krugman has written extensively about the fact that our current debt and deficit levels present no serious current economic problem.  (The dispute between Krugman and MMTers stems from disagreements about the long-term debt.)  And as The Economist points out, Krugman is fine with nominal GDP targeting.

Figuring out where to draw the boundaries of “the mainstream” in the economics profession is one thing, but when it comes to the range of politically acceptable policy options (a different kind of mainstream, admittedly) Krugman stands shivering in the cold side-by-side with a lot of heterodox thinkers.  With respect to both policy outcomes and policy rhetoric, our institutions seem to pay a great deal more attention to deficits, debt, and inflation than they do to unemployment and the threat of deflation (though one might argue that, at least with respect to fiscal stimulus, this has more to do with the fact that in the US political system the “opposition” party has the ability to see the government fail.  Resistance to fiscal stimulus may all but disappear from Congress in the event of a Romney presidency.  Explaining the preferences of the FOMC is a more complicated affair.)  The mainstream policy space since 2010 excludes neo-chartalism, market monetarism, and Paul Krugman.

A handful of the Levy Institute’s working papers and policy briefs related to the neo-chartalist approach can be read here:  “Money,” “Deficit Hysteria Redux?“, “Money and Taxes,” “Modern Money.”

Courtesy of INET, here is Pavlina Tcherneva explaining her “bottom up” approach to fiscal policy.

Notice the way she uses the term “trickle down” to apply also to conventional pump-priming fiscal policy (targeting growth and hoping for the right employment side-effects).  We need to move beyond the conventional options on fiscal policy, says Tcherneva; beyond a fiscal policy space marked out by aggregate demand management on one end and austerity on the other.  There’s a third approach that’s more in tune with the “original Keynesian spirit,” as she puts it:  directly employing the unemployed.  We should be targeting employment and the unemployed directly rather than trying to achieve this through the kind of bank-shot maneuver represented by conventional pump priming.

You can read some of Tcherneva’s work on this issue here and here.  One-pager here.

These two stories need to get together in a room and talk:

1) Demand for US debt is really high.

2) Government (net) investment is at a 40-year low.

Notice that neither of these facts plays any noticeable role in the policy debates that dominate the US political scene.  There we’re offered a choice of competing visions between radicals who claim that current levels of government spending and investment represent the collapse of free civilization, and conservatives (only, we don’t call them that) who seem to think that we have the share of public investment more or less right (give or take a few dollars for green energy).

In 2009, the Institute released some careful research on the micro-level effects of the recovery act (one example is at this link). That work helps to answer questions about how the benefits of specific stimulus packages will be spread out among different individuals, and households, and demographic groups in the United States.

Increasingly, these and other distributional issues loom large in U.S. debates about economic policy. For example, some influential economists contend that a distribution of income that is increasingly slanted toward “the 1 percent” has been a contributing factor to the dangerous upward trend in U.S. household debt that began decades before the recent financial crisis.  The regressive tax policies called for by many candidates ahead of tomorrow’s big Iowa Republican presidential caucuses also bring to mind these serious problems (see this New York Times link for a description of the Republican candidates’ somewhat varied positions on fiscal issues).

An important school of thought that emphasized distributional issues in macroeconomics was the so-called “Cambridge school,” whose name connotes its association with Cambridge University in England and Cambridge progenitors such as John Maynard Keynes. This year, Piero Garegnani, who was closely linked in many ways with this school of thought, passed away (an interesting professional obituary is here). It was interesting to see this eminent Italian economist speak in a small, uncrowded room, at the big annual economists’ conference in Chicago, about five years ago. Decades earlier, Garegnani was a protagonist in the “capital controversy” between the Cambridge school and a number of well-known orthodox economists, most of them based in Cambridge, Massachusetts, here in the United States.

Geoffrey Harcourt was another important figure in this debate. During the Institute’s holiday break last week, I eagerly read The Structure of Post-Keynesian Economics: The Core Contributions of the Pioneers, Harcourt’s sympathetic 2006 account of the work of the Cambridge school and some of its closest post-Keynesian intellectual relatives. The book moves quickly in its 157+ pages through many of the main ideas developed by these post-Keynesian schools. The points are made with words, simple algebra, and diagrams. The book contains some interesting tidbits and observations that only an insider such as Harcourt could muster.

Among the themes of the book continue reading…

Philip Arestis and Malcolm Sawyer have a guest post at Triple Crisis that critiques the latest proposal for a new fiscal compact in the EU (essentially an SGP with more automatic sanctions for those who surpass the 3 percent of GDP budget deficit limit and the annual structural deficit limit of 0.5 percent of GDP).  Arestis and Malcom note the asymmetrical restrictions of the compact (there are limits on deficits, but not surpluses) and demonstrate that the deficit limits are entirely too stringent:

The ‘fiscal compact’ assumes that an upper limit of 3 per cent of GDP is consistent with a near balanced structural budget despite the swings in economic activity and associated swings in budget deficits as the automatic stabilisers take effect. As a rule of thumb a 1 per cent fall in GDP below trend leads to around a 0.7 per cent rise in the budget deficit – hence a more than 3 per cent drop in GDP before trend with a structural deficit of 0.5 per cent would lead to a country breaching the limit. Note that this is a drop in GDP below trend – and could come from an actual drop of more like 1 per cent (with a 2 per cent trend growth rate).

In our latest Strategic Analysis we estimate that a cut in the general government deficit in the United States would have strong adverse effects on unemployment and a relatively smaller impact on the U.S. public debt-to-GDP ratio, since GDP would slow down with a cut in government expenditures and transfers.

A similar strategy of deficit reduction seems to be on the agenda for many eurozone countries; notably Italy, where a new government was recently put in charge to implement unpopular tax increases that the Berlusconi government was not willing to adopt.

A comparison of our simulation for the U.S. with the European Commission’s for the eurozone may therefore be interesting.

First of all, the United States is now (third quarter of 2011) back to the pre-recession level of output, as measured by real GDP. Using this figure we could say that the recession is behind us, and we can plan for the future (although this is far from true if we look at the unemployment rate!). And in our projections we show that an acceleration in aggregate demand is needed if the unemployment rate is going to be reduced (the green line), while policies to cut the government deficit will lead to stagnation (the red line) and an increase in unemployment.

Let’s look at a similar chart for Europe, taken from a simple synthesis of the new roles for economic governance in the area:

Real GDP in the area is still below its pre-recession level, and stagnating. We would think that European governments would be meeting frequently to discuss how to recover the lost ground in output and employment, but instead they meet with quite a different problem in mind: how to enforce balanced budget rules on national governments. The Italian government, still one of the largest economies in the area, is now passing a bill that will increase taxes substantially, further depressing domestic demand.

What the EU is planning is the wrong policy at the wrong time. And if the multiplier in the EU is similar to what we estimate for the United States, the consequences for the unemployment rate will be substantial.

Speaking of balances, late last week Martin Wolf delivered a helpful column (“Why cutting fiscal deficits is an assault on profits,”  FT Nov. 24).  Wolf writes that if households are cutting back, a government that attempts to reduce deficits while anticipating no substantial changes in net exports must expect corporate surpluses to shrink.  But increased investment is unlikely, so:  “If the government wishes to cut its deficits, other sectors must save less. … What the government has not admitted is that the only actors able to save less now are corporations. The government’s – not surprisingly, unstated – policy is to demolish corporate profits.”

Wolf is consistently worth the read.

In a new policy note Marshall Auerback argues that discussions of how to solve the euro crisis often conflate two distinct issues:  solvency and insufficient demand.  “Policymakers want the ECB to do both,” he writes, “but in fact, the ECB is only required to deal with the solvency issue. When you do that in a credible way, then you get the capital markets reopened and you give countries a better chance to fund themselves again via the capital markets.”

Auerback considers a proposal that would, by addressing national solvency, give member-states the space necessary address the growth problem.  The proposal (developed also by Warren Mosler) calls for the ECB to make annual distributions of euros to national governments on a per capita basis.  By contrast with targeted bailouts, these per capita distributions would avoid problems of moral hazard, says Auerback.  They would also provide the ECB with a more effective policy lever (withholding of payments) to ensure compliance with the Stability and Growth Pact.  Concerns about inflation with respect to this plan are misplaced, he argues:

To anticipate the screams of the hyperinflation hyperventillistas, the revenue sharing proposal would be noninflationary. What is inflationary with regard to monetary and fiscal policy is actual spending. These distributions would not alter the actual annual government spending and taxation levels demanded by the austerity measures and SGP constraints. They would simply address the solvency issue, which has effectively cut the PIIGS off from market funding (because the markets believe they are insolvent).

Read the whole thing here.

If you missed last week’s Reuters-sponsored Keynes vs. Hayek debate at the Asia Society, video of the event is attached below, beginning with James Galbraith’s contribution.

The debate, predictably, ended up being more about the last two-and-a-half years of economic policy.  Note also the way in which this turns into a Democratic Keynesianism vs Republican Keynesianism debate; due in no small part to the Wall Street Journal‘s Steve Moore, who argues that instead of Obama’s wretched ARRA, a mixture of tax cuts and spending increases, what we really need is … a mixture of tax cuts and spending increases.  The key to being a Moore-style Schmeynesian, as near as I can tell, is that when describing Obama’s policies one ignores the tax cuts, and when describing Reagan-era fiscal policy one mumbles something about “defense” rather than spending increases.

(Note also Galbraith’s list of Hayek’s later policy preferences, which would place Hayek somewhere in the progressive wing of today’s Democratic Party).

(cross posted at EconoMonitor)

For more than a decade, I’ve been arguing that the EMU was designed to fail. It was based on the pious hope that markets would not notice that member states had abandoned their currencies when they adopted the euro, thereby surrendering fiscal and monetary policy to the center. The problem was that while the center was quite happy to centralize monetary policy through the august auspices of the Bundesbank (with the ECB playing the role of the hapless dummy whose strings were pulled in Germany), the center never wanted to offer fiscal policy capable of funding essential spending. (See also Nouriel Roubini’s Eurozone Crisis: Here Are the Options, Now Choose and  Marshall Auerback’s piece: The Road to Serfdom.)

Member states became much like US states, but with two key differences. First, while US states can and do rely on fiscal transfers from Washington—which controls a budget equal to more than a fifth of US GDP—EMU member states got an underfunded European Parliament with a total budget of less than 1% of Europe’s GDP. This meant that member states were responsible for dealing not only with the routine expenditures on social welfare (health care, retirement, poverty relief) but also had to rise to the challenge of economic and financial crises.

The second difference is that Maastricht criteria were far too lax—permitting outrageously high budget deficits and government debt ratios.

What? Before readers accuse me of going over to the neoliberal side, let me explain. Most of the critics on the left had always argued that the Maastricht criteria were too tight—prohibiting member states from adding enough aggregate demand to keep their economies humming along at full employment. OK, it is true that government spending was chronically too low across Europe as evidenced by chronically high unemployment and rotten growth in most places. But since these states were essentially spending and borrowing a foreign currency—the euro—the Maastricht criteria permitted deficits and debts that were inappropriate.

Let us take a look at US states. All but two have balanced budget requirements—written into state constitutions—and all of them are disciplined by markets to submit balanced budgets. When a state finishes the year with a deficit, it faces a credit downgrade by our good friends the credit ratings agencies. (Yes, the same folks who thought that bundles of trash mortgages ought to be rated AAA—but that is not the topic today.) That would cause interest rates paid by states on their bonds to rise, raising budget deficits and fueling a vicious cycle of downgrades, rate hikes and burgeoning deficits. So a mixture of austerity, default on debt, and Federal government fiscal transfers keeps US state budget deficits low.

(Yes, I know that right now many states are facing Armageddon—especially California—as the global crisis has crashed revenues and caused deficits to explode. This is not an exception but rather demonstrates my argument.)

The following table shows the debt ratios of a selection of US states. Note that none of them even reaches 20% of GDP, less than a third of the Maastricht criteria. continue reading…