Macroeconomics, Finance and Money: Essays in Honour of Philip Arestis

Macroeconomics, Finance and Money Sawyer Previous books Giuseppe Fontana (Edited with Mark Setterfield) Macroeconomi...

Author: Philip Arestis | Giuseppe Fontana | J. S. L. McCombie | Malcolm C. Sawyer

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Macroeconomics, Finance and Money

Sawyer

Previous books Giuseppe Fontana (Edited with Mark Setterfield) Macroeconomic Theory and Macroeconomic Pedagogy, Basingstoke, Palgrave Macmillan, 2009. Money, Uncertainty and Time, Abingdon (UK), Routledge, 2009. (Edited with Jesus Ferreiro and Felipe Serrano) Fiscal Policy in the EU, Basingstoke, Palgrave Macmillan, 2008. (Edited with Riccardo Realfonzo) The Monetary Theory of Production: Tradition and Perspectives, Basingstoke, Palgrave Macmillan, 2005. John McCombie (Edited with C. Rodriguez Gonzalez) Issues in Finance and Monetary Policy, Basingstoke, Palgrave Macmillan, 2007. (Edited with C. Rodriguez Gonzalez) The European Union: Current Problems and Prospects, Basingstoke, Palgrave Macmillan, 2007. (Edited with P. Arestis and M.C. Baddeley) Economic Growth. New Directions in Theory and Policy, Cheltenham: Edward Elgar, 2007. (Edited with P. Arestis) Unemployment: Past and Present, Basingstoke, Palgrave Macmillan, 2008. (Edited with P. Arestis) Missing Links in the Unemployment Relationship, Basingstoke, Palgrave Macmillan, 2009. Malcolm Sawyer (Edited with P. Arestis) Path Dependency and Macroeconomics, Basingstoke, Palgrave Macmillan, 2009. (Edited with J. Creel) Current Thinking on Fiscal Policy, Basingstoke, Palgrave Macmillan, 2009. (Edited with P. Arestis) Critical Essays on the Privatisation Experience, Basingstoke, Palgrave Macmillan, 2008. (Edited with P. Arestis) Political Economy of Latin America: Recent Economic Performance, Basingstoke, Palgrave Macmillan, 2007. (Edited with P. Arestis) Alternative Perspectives on Economic Policies in the European Union, Basingstoke, Palgrave Macmillan, 2006.

Sawyer

Macroeconomics, Finance and Money Essays in Honour of Philip Arestis Edited by

Giuseppe Fontana John McCombie and

Malcolm Sawyer

Sawyer

Selection and editorial content © Giuseppe Fontana, John McCombie and Malcolm Sawyer 2010 Individual chapters © Contributors 2010 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2010 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN 978–0–230–22906–8

hardback

This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Macroeconomics, finance and money : essays in honour of Philip Arestis / edited by Giuseppe Fontana, John McCombie and Malcolm Sawyer. p. cm. Summary: “This volume focuses on current issues of debate in the area of modern macroeconomics and money, written from (a broadly interpreted) post Keynesian perspective. The papers connect with Philip Arestis’ contributions to macroeconomics and money, and pay tribute to his distinguished career”—Provided by publisher. Includes bibliographical references and index. ISBN 978–0–230–22906–8 (hardback) 1. Macroeconomics. 2. Capital market. 3. Monetary policy. I. Arestis, Philip, 1941– II. Fontana, Giuseppe, 1968– III. McCombie, J. S. L. IV. Sawyer, Malcolm C. HB172.5.M33556 339—dc22 10 19

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Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne

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1 10

Contents List of Figures

viii

List of Tables

x

Contributors

xii

Philip Arestis: An Appreciation

xiii

Part 1 Monetary Policy, Central Banks and the ‘New Consensus in Macroeconomics’ 1. Are the Macro Econometrics Models of the Federal Reserve Board, the Bank of Canada, and the Sveriges Riksbank consistent with the New Consensus Macroeconomics Model? Jérôme Creel and Giuseppe Fontana 2. Arestis and Sawyer’s Criticism on the New Consensus Macroeconomics: Some Issues Related to Emerging Countries Luiz Fernando de Paula and Fernando Ferrari-Filho 3. Inflation Targeting in Canada: Myth versus Reality Mario Seccareccia and Marc Lavoie

3

19 35

4. Monetary Policy Challenges of the ECB Facing a Divergent Inflationary Process in the EMU Area Georg Erber and Harald Hagemann

54

5. Macroeconomic Consensus and Political Economy Aspects of Monetary Policy Design Georgios Chortareas

75

6. Central Bank Communication, Transparency and Interest Rate Volatility: Evidence from the USA Iris Biefang-Frisancho Mariscal and Peter Howells

91

Part 2 Inflation and Economic Policy 7. The Thatcher Monetarist Experiment, 1979–85: An Assessment John McCombie

v

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111

vi Contents

8. Phillips’ Curve, Independence of Central Banks and Inflation Targeting Malcolm Sawyer

126

9. Monetary Policy Rules and Phillips’ Curve Tradeoffs in a Kaleckian Framework Tracy Mott

139

10. The Banking Crisis, Nationalization of Banking and the Mixed Economy Yiannis Kitromilides 11. How Does a Capitalist Economy Work in the Real World? Paul Davidson

150 163

Part 3 Finance, Crisis and Bubbles 12. Bubbles Lead to Long-term Instability Elias Karakitsos

179

13. The Subprime Crisis: A Minskyan Phenomenon? Elisabetta De Antoni

196

14. A Minsky Moment, or Not? Korkut Ertürk and Gökcer Özgür

209

15. Does Financial Liberalization Help the Poor? Asena Caner

224

16. Finance, Speculation and Stability: Post-Keynesian Policies for Modern Capitalism Geoff Harcourt

237

17. ‘Financialization’, Capital Accumulation and Productivity Growth: a Post-Keynesian Approach Eckhard Hein

250

Part 4 Financial Markets and Governance in Developing Economies 18. Instantiating Neo-Liberal Reform via Economic Theory and Small Group Agreements Ilene Grabel 19. Financial Liberalization, Growth and Financial Crisis Marisol Esteban, Jesús Ferreiro and Felipe Serrano 20. Institutions and Finance in Developing Countries: Challenges to Orthodoxy Howard Stein

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269 282

295

Contents vii

21. Are the Institutions of the Stock Market and the Market for Corporate Control Evolutionary Advances for Developing Countries? Ajit Singh

311

22. Financial Globalization and Innovation: Lessons of a Lost Decade for the OECD Economies Pascal Petit

327

Index

344

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List of Figures 1.1 1.2 1.3

The Aggregate Demand (AD) Channel of the transmission mechanism of monetary policy in the NCM model

6

The inflation expectations channel of the transmission mechanism of monetary policy in the NCM model

6

Partial equilibrium effect on inflation of a reduction of 1 percentage point in the unemployment rate

9

1.4

The monetary transmission mechanism in Canada (two-year long positive shock on the nominal interest rate)

13

1.5

The impact of a financial shock in Canada (exogenous increase to the country-specific risk premium)

14

The monetary transmission mechanism in Sweden (one temporary standard deviation of the policy rate)

16

Evolution of Canadian CPI and inflation gap between Canada and the United States, 1967–2008

41

Canadian Overnight Rate and the US Federal Fund Rate Gap in Real Terms, 1967–2008

45

European Monetary Union Index of Consumer Prices Item Weights in HICP in 2000

56

1.6 3.1 3.2 4.1

4.1a Italian Index of Consumer Prices Item Weights in HICP in 2000

57

4.1b Spanish Index of Consumer Prices Item Weights in HICP in 2000

57

4.1c German Index of Consumer Prices Item Weights in HICP in 2000

57

4.1d French Index of Consumer Prices Item Weights in HICP in 2000

58

4.2 4.3 4.4

HICP indices (1996 = 100) for Eurozone member and some other EU-member countries, monthly values, 1995–2009

59

Annualized monthly inflation rates for Eurozone member and some other EU-member countries, 1995–2009

60

Country weights in the EMU harmonized consumer price index in 2001

62

viii

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List of Figures ix

4.5 ␤-Convergence of selected EU-member countries towards the Eurozone national annualized monthly inflation rates

63

4.6 ␴-Convergence of EU-member countries towards the Eurozone HICP-inflation rate, January 1996 until January 2009

71

6.1 Forward rate movement prior to increase in March 1997

99

6.2 Forward rate movement prior to increase in June 2004

99

6.3 Volatility of the forward rate measured as the squared change

100

9.1 Cycles with a stabilizing policy rule

142

9.2 Phillips’ curve tradeoffs

145

12.1a Gross, net real estate of households and mortgage debt

183

12.1b Household net wealth

184

12.1c Liquidity and credit risk vs credit risk (Libor OIS vs Libor Repo)

185

12.2a Output gap and potential output

188

12.2b Interest rate, inflation and natural interest rate

188

12.3 High response of net wealth to interest rates

190

12.4 High net wealth response to profitability

191

13.1 Subprime crisis: the antecedent facts

202

17.1 Growth equilibrium with endogenous productivity growth

259

17.2 Increasing shareholder power and ‘expansive’ demand regime

259

17.3 Increasing shareholder power and ‘contractive’ demand regime

260

22.1 Barriers to entry and state controlled companies

330

22.2 Regulation in 1998 and 2003

330

22.3 Diffusion of the multidivisional structure in some European countries and in Japan

332

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List of Tables 1.1 1.2

2.1 3.1

Partial equilibrium response of capital stocks and private spending to changes in financial conditions

8

The monetary transmission mechanism in the FRB/US model in a full-model simulated effect of 1 percentage point fall in the federal funds rate

11

Exchange rate regime and monetary policy framework of BRIC countries from 1999 to 2008

30

Inflation regressions, Canada and United States 1977–2008

43

3.2a Taylor Rule reaction functions, Canada 1967–2008 and sub-periods 1967–90 and 1991–2008

47

3.2b Taylor Rule reaction functions, United States 1967–2008 and sub-periods 1967–90 and 1991–2008

48

3.2c Modified Taylor Rule reaction functions, Canada 1967–2008 and sub-period 1991–2008, with lagged dependent variable and US interest rate effect

49

3.3 4.1

4.2

6.1

Regression analysis of growth in labour income, Canada and United States, 1967–2008

51

OLS-estimation results for persistent differences between selected Eurozone member countries plus the UK, Denmark and Sweden

66

SUR-estimation results for persistent differences between selected Eurozone member countries plus the UK, Denmark and Sweden

68

FOMC statements and subsequent policy action in the period January 2000 until June 2003

95

6.2

FOMC statements and subsequent policy actions, since 2003

6.3

The estimation results of the mean equation (1)

102

6.4

Estimation results of the effect of communication in the conditional volatility equation

103

Test results on the equality of coefficients in the three regimes

105

6.5

x

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97

List of Tables xi

17.1 Overall effects of a change in shareholder power

261

20.1 Bank models

303

21.1 Financing of corporate growth in 19 developing countries and 22 advanced countries for 1995–2000

319

22.1 The widening range of innovation strategies in the 1990s

335

22.2 Growth and productivity in Europe 15

337

22.3 Growth and productivity in the US

338

22.4 Venture capital deals less prone to support seed and early stage projects after 2001

340

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Contributors Iris Biefang-Frisancho Mariscal, University of the West of England, UK Asena Caner, TOBB University of Economics and Technology, Turkey Georgios Chortareas, University of Athens, Greece Jérôme Creel, ESCP–EAP European School of Management Paul Davidson, New School University New York, USA Elisabetta DeAntoni, University of Trento, Italy Luiz de Paula, University of the State of Rio de Janeiro, Brazil Georg Erber, University of Hohenheim, Germany Korkut Ertürk, University of Utah, USA Marisol Esteban, University of the Basque Country, Bilbao, Spain Fernando Ferrari, University of the State of Rio de Janeiro, Brazil Jesus Ferreiro, University of the Basque Country, Bilbao, Spain Giuseppe Fontana, University of Leeds, UK and University of Sannio, Italy Ilene Grabel, Denver University, USA Harald Hagemann, University of Hohenheim, Germany Geoff Harcourt, University of Cambridge, UK Eckhard Hein, Berlin School of Economics and Law, Germany Peter Howells, University of the West of England, UK Elias Karakitsos, Global Economic Research London, UK Yiannis Kitromilides, University of Westminster, UK John McCombie, University of Cambridge Tracy Mott, Denver University, USA Gökcer Özgür, University of Utah, USA Pascal Petit, CEPREMAP, Paris, France Malcolm Sawyer, University of Leeds, UK Mario Seccareccia, University of Ottawa, Canada Felipe Serrano, University of the Basque Country, Bilbao, Spain Ajit Singh, University of Cambridge, UK Howard Stein, University of Michigan, USA xii

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Philip Arestis: An Appreciation The essays in this book have been presented to celebrate the work of Philip Arestis. In putting together this collection we have sought contributions that relate to many of the main areas in which Philip has made important and major contributions: the general headings would be macroeconomics, money and finance within a Post Keynesian perspective. Philip was born in Cyprus in October 1941 and grew up in Famagusta in the south east of the island, now occupied by Turkish troops. His study of economics began at the University of Athens and then the London School of Economics during periods of much political protest at both universities. He graduated from Athens Graduate School of Economics and Business Studies in 1965 and with an MSc (Economics) from London School of Economics in July, l969. He was awarded a PhD (Economics) from the University of Surrey in June, l976. Philip started teaching at Thames Polytechnic in 1969 as a lecturer, and stayed there until 1988 being promoted first to senior then principal lecturer and becoming Head of Economics. At the same time he also taught at other institutions of higher education. He moved to North East London Polytechnic (later University of East London) in 1988 as Professor of Economics and Head of Department of Applied Economics (which became the Department of Economics in August, 1992). There he initiated major changes in the economics degree, the development of Masters programmes and a PhD programme, and became Research Professor in 1997. A brief sojourn at South Bank University as Professor and Director of Research was followed by a stay as Research Professor at the Levy Institute of Bard College, USA. He was appointed Director of Research, Cambridge Centre of Economic and Public Policy, Department of Land Economy, University of Cambridge in January 2004. This listing of posts cannot begin to indicate the range of Philip’s activities associated with economics and higher education. He has been an energetic and enthusiastic organizer of conferences on important themes, generally followed by editing books based on the conference papers. He has played major roles in the design of new degree programmes, in engaging with validation of the programmes of other institutions of higher education (in the context of the CNAA and other bodies), advising universities on appointments and promotions and xiii

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xiv Philip Arestis: An Appreciation

in the tasks of external examining at all levels. He has been heavily involved in the apparatus for raising standards of research and teaching as an assessor for the Quality Assurance Agency and was a member of the Economics Panel in two Research Assessment Exercises. He was an elected Council Member of the Royal Economic Society. His research activities are epitomized by his membership of the Co-ordinating Committee of the ESRC-funded ‘Money Study Research Group’, which in 1990 became the ‘Money, Macro and Finance Research Group’, where he served as Vice Chair. He was co-founder of the Post-Keynesian Economics Research and Study Group, which has been a major stimulus for research in post Keynesian economics. As editor of British Review of Economic Issues, he helped to push forward research particularly in what was then the polytechnic sector in the UK. He has continued as member of editorial boards of too many journals to list here. More recently, Philip was appointed to the prestigious post of Chief Academic Adviser to the Government Economic Service on Professional Development in Economics. Throughout, Philip has been concerned to foster economics research and particularly to encourage the research of others through participation in conferences and workshops, through being an active reader and commenter on the work of others, an energetic and reliable referee for academic journals, editorial adviser to academic publishers, editing a vast range of books and journals and being a co-researcher. It is also appropriate here to note the Festschrifts to others which he has organized and edited (some 12 volumes honouring seven economists). His contributions to the development of post Keynesian and heterodox economics can also be seen in the books he has edited, and handbooks and dictionaries, that provide a systematic coverage of heterodox economics and economists and seek to bring them to a wider audience (55, 56, 60: numbers refer to entries in the selected bibliography below). Philip has contributed to a wide range of areas within macroeconomics. He has moved between theoretical work, the application of econometrics to macroeconomic issues and macroeconomic policy. He has always been insistent that the theoretical framework behind any applied work or policy discussion should be firmly based and articulated. But, equally, the theoretical work should be of direct relevance to the understanding of the functioning of the economy, or, put rather more colloquially, the real world. Philip’s initial research focused on money and monetary policy. His PhD topic was ‘Optimal Choice of Monetary Policy Instruments in the UK’, and other work included estimating the demand for money (to which he has returned on a number of occasions (14)). This was

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Philip Arestis: An Appreciation xv

complemented by bringing the supply of money into the analysis and exploring issues of causality between money, prices and income (1, 12, 16). This was closely related to the debates of the time over monetarism to which Philip made important contributions (8). The debates over monetarism with its insistence on the controllability of the money supply for purposes of controlling inflation helped to revive interest in the nature of credit money and the endogeneity of money. Philip contributed to the analysis of endogenous money both in theoretical terms and in empirical investigations of the credit money system (12). The era of monetarism in the 1980s was also an era of the decay of fiscal policy and the associated arguments that fiscal policy was impotent and/or counterproductive. At that time Philip undertook crucial empirical work that helped to defend the effectiveness of fiscal policy (3, 5, 6). The importance of fiscal policy and the ways in which it can be used as an effective anti-dote to recession was a theme to which Philip returned in the early 2000s in a series of articles, written at a time when fiscal policy was still out of favour, but vindicated by the ways in which a number of governments have used fiscal policy in the financial crisis of 2007–09 (39, 59). Econometric work applied to macroeconomics modelling has been a central feature of Philip’s work (starting with 52). He developed and estimated a specifically post Keynesian approach to macroeconomics and the estimation of the major building blocks of a full analysis was a major feature of Philip’s work in the 1980s (9, 10, 12, 13). This was later followed by major works setting out the post Keynesian approach as a coherent and relevant one for macroeconomic analysis (53, 54, 17, 22). This body of work illustrated the three basic strands of Philip’s approach – clear theoretical ideas, application of econometrics and concern over policy implications. Inflation became the central macroeconomic policy concern in the 1970s and in many respects has remained so, and the rise of monetarism can be seen as closely associated with that concern over inflation, and the ‘magic solution’ which monetarism putatively offered in the form of control of the money supply. The difficulties of controlling the money supply were highlighted by Philip (16). His work relating to inflation has had two very distinct strands. The first has been the pursuit of a post Keynesian approach to the modelling of inflation, involving the interaction of wage and price determination with a recognition of the role of real wage targets on the wage-bargaining process. He developed important empirical work on this during the 1980s, returned to the theme with a focus on wage determination in the late 1990s,

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xvi Philip Arestis: An Appreciation

and developed the theory on wage and price determination further in a ‘structuralist’ approach to inflation in the past few years (10, 14, 19, 26, 38, 44). The second, which has linked monetary policy and inflation, has been the critique of the policy known as inflation targeting, which was widely adopted around the globe from the early 1990s onwards. It is again the case that this critique has been pursued along both empirical and theoretical lines with empirical work on the (lack of) cross-country relationship between the adoption of inflation targeting and the decline of inflation, and theoretical work which has argued that there are weak, if any, links between the policy instrument of interest rate and the pace of inflation (41, 49). Philip has also examined in detail from an empirical perspective some of the presumed links underpinning inflation targeting (24, 33, 35). Besides inflation targeting, another policy that has rather taken over has been that of financial liberalization. As some of the essays in this book witness, Philip has become a major and influential critic of that policy approach. He has adhered to a broadly Minskian approach emphasizing that the act of financial liberalization with the removal of interest rate ceilings and controls over the volume of credit provides a stimulus to rapid credit expansion, risky lending and a fragile banking and financial system (29, 58). In turn, the rapid credit creation often spills over into asset price bubbles. The financial crash becomes inevitable! He has again empirically investigated the relationship between financial liberalization and economic performance and has found that the former does not necessarily lead to an improvement in the latter (30, 36, 37, 39, 42). These are all topics of great public policy interest. In the past 15 years or so, Philip has been particularly concerned with four areas relating to economic policy. The first was the analysis of the nature of ‘New Labour’ and its economic policies, which were identified as strongly influenced by new Keynesian economics (25). The second has been the nature of macroeconomic policy within the European Union and particularly with the eurozone and the adoption of the Stability and Growth Pact, where he has been a persistent critic of the deflationary nature of this policy and of the role of the European Central Bank, and the advocate of alternative policies that address issues of unemployment (27, 57). The third has encompassed a critical exploration of the emergent dominant mainstream ‘new consensus in macroeconomics’ and the manner in which it has influenced monetary policy (43, 47, 61). The fourth has been seeking to develop alternative macroeconomic policies that would serve us better than the neo-liberal policies of recent years (24, 51).

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Philip Arestis: An Appreciation xvii

At the time of writing, Philip has formally retired. We say ‘formally’ because Philip’s enthusiasm for his research and teaching remains unabated. He has been made ‘Honorary Senior Departmental Fellow’ of the University of Cambridge and Emeritus Fellow of Wolfson College. He continues to work in his office in Cambridge, where the numbers of journals and books stacked on every conceivable surface slowly increase, and the columns are now in danger of imminent collapse. He is still bringing his customary care and enthusiasm to supervising and inspiring a new generation of MPhil and PhD candidates and lectures widely on various aspects of monetary policy. He still seems to be forever jetting around the world presenting papers to sundry universities and central banks, acting as external examiner for degrees at both UK and overseas universities and examining numerous PhDs. There is no sign of any let up in Philip’s prolific output of articles, both in the prestigious academic journals and in books and policy journals. This book and the articles it contains are offered as a small tribute to Philip’s outstanding scholarship and the major contribution he has made to the economics profession and the academic world.

Selected bibliography Articles 1. ‘Some Investigations of Demand and Supply Functions for Money in the Federal Republic of Germany, 1965–1974’ (with S.F. Frowen), Weltwirschaftliches Archiv (March, 1976). 2. ‘The Dynamic Impacts of Government Expenditure and the Monetary Base on Aggregate Income: The Case of Four O.E.C.D. Countries, 1965–1974’, (with S.F. Frowen and E. Karakitsos), Public Finance (No 1, 1978). 3. ‘The ‘Crowding Out’ of Private Expenditure by Fiscal Actions: An Empirical Investigation’, Public Finance (No 1, 1979). 4. ‘Consumption Out of Different Types of Income’ (with C. Driver), Bulletin of Economic Research (November, 1980). 5. ‘Fiscal Actions and ‘Crowding Out’ in the UK’, Metroeconomica (February/ October, 1981). 6. ‘Crowding Out in the UK within an Optimal Control Framework’ (with E. Karakitsos), Journal of Public Policy (Vol. 2, No 1, 1982). 7. ‘UK Unemployment and Post-Keynesian Remedies’ (with C. Driver), Metroeconomica (October, 1983). 8. ‘On the UK Monetarist Experiment’, Journal of Public Policy (April, 1984). 9. ‘The Real Segment of a Post Keynesian Model’ (with C. Driver and J. Rooney), Journal of Post Keynesian Economics (Winter, 1985–86). 10. ‘Wages and Prices in the UK: The Post Keynesian View’, Journal of Post Keynesian Economics (Spring, l986); reprinted in M.C. Sawyer (ed.), PostKeynesian Economics (Edward Elgar Publishing Limited, 1989).

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xviii Philip Arestis: An Appreciation 11. ‘The Effect of Income Distribution on Consumer Imports’ (with C. Driver), Journal of Macroeconomics (Winter 1987). 12. ‘The Credit Segment of a UK Post Keynesian Model’, Journal of Post Keynesian Economics (Winter, 1987–88). 13. ‘On the Post Keynesian Challenge to Neo-Classical Economics: A Complete Quantitative Macro-Model for the UK Economy’, Journal of Post Keynesian Economics (Summer, 1989). 14. ‘Conflict, Wage Relativities and Hysteresis in UK Wage Determination’ (with Peter Skott), Journal of Post Keynesian Economics (Spring, 1993). 15. ‘Financial Innovations and the Demand for Money in the UK and in Germany: A Comparative Application of Cointegration and Error-Correction Modelling’ (with Harald Hagemann, Hans-Michael Trautwein, Iris BiefangFrisancho Mariscal and Peter G.A. Howells), Weltwirschaftliches Archiv (June, 1995). 16. ‘The Endogenous Money Stock: Empirical Observations from the UK’ (with Iris Biefang-Frisancho Mariscal), Journal of Post Keynesian Economics (Summer, 1995). 17. ‘Post-Keynesian Economics: Towards Coherence’, Cambridge Journal of Economics, Vol. 20, No 1 (January, 1996). 18. ‘Financial Development and Economic Growth: Assessing the Evidence’ (with Panicos O. Demetriades), Economic Journal, Vol. 107, No 442, (May, 1997). 19. ‘Conflict, Effort and Capital Stock in UK Wage determination’ (with Iris Biefang-Frisancho Mariscal), Empirica (Autumn, 1997). 20. ‘How Many Cheers for the Tobin Financial Transactions Tax?’ (with M.C. Sawyer), Cambridge Journal of Economics, Vol. 21, No 6, (November, 1997). 21. ‘Keynesian Economic Policies for the New Millennium’ (with M.C. Sawyer), Economic Journal, Vol. 108, No 446 (January, 1998). 22. ‘Post Keynesian Economics and Its Critics’ (with Stephen P. Dunn and Malcolm C. Sawyer), Journal of Post Keynesian Economics, Vol. 21, No 4, (Summer, 1999). 23. ‘Unit Roots and Structural Breaks in OECD Unemployment’ (with Iris Biefang-Frisancho Mariscal), Economics Letters, Vol. 65, No 2 (November, 1999). 24. ‘Is There a Trade-off Between Inflation and Output Gap?’ (with G.M. Caporale and A.Cipollini), The Manchester School of Economic and Social Research, Vol. 70, No 4, (Special Issue, 2002). 25. ‘Financial Liberalisation in Developing Countries’ (with Panicos O. Demetriades), Eastern Economic Journal, Vol. 25, No 4 (Fall, 1999). 26. ‘Capital Stock, Unemployment and Wages in the UK and Germany’ (with Iris Biefang-Frisancho Mariscal), Scottish Journal of Political Economy, Vol. 47, No 5 (November, 2000). 27. ‘An Alternative Stability and Growth Pact for the European Union’ (with K. McCauley and M.C. Sawyer), Cambridge Journal of Economics, Vol. 25, No 1 (January, 2001). 28. ‘Financial Development and Economic Growth: The Role of Stock Markets’ (with P.O. Demetriades and K. Luintel), Journal of Money, Credit and Banking, Vol. 33, No 1, (February, 2001).

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Philip Arestis: An Appreciation xix 29. ‘The Economic Analysis Underlying the ‘Third Way’ (with M.C. Sawyer), New Political Economy, Vol. 6, No 2 (July, 2001). 30. ‘Financial Crisis in South East Asia: Dispelling Illusion the Minskyan Way’ (with Murray Glickman), Cambridge Journal of Economics, Vol. 26, No 2 (March, 2002). 31. ‘The Impact of Financial Liberalisation Policies on Financial Development: Evidence from Developing Economies’ (with P. Demetriades, B. Fattouh and K. Mouratidis), International Journal of Finance and Economics, Vol. 7, No 2 (April, 2002). 32. ‘Credibility of EMS Interest Rate Policies: A Markov Regime-Switching Approach’ (with Kostas Mouratidis), The Manchester School of Economic and Social Research, Vol. 72, No 1 (January, 2004). 33. ‘Threshold Effects in the U.S. Budget Deficit’ (with A. Cipollini and B. Fattouh), Economic Inquiry, Vol. 42, No 2 (April, 2004). 34. ‘Is There a Trade-Off between Inflation Variability and Output-Gap Variability in the EMU Countries?’ (with K. Mouratides), Scottish Journal of Political Economy, Vol. 51, No 5 (November, 2004). 35. ‘Credibility of Monetary Policy in Four Accession Countries: A Markov Regime-Switching Approach’ (with K. Mouratides), International Journal of Finance and Economics, Vol. 10, No 1 (January, 2005). 36. ‘Finance and Development: Institutional and Policy Alternatives to Financial Liberalisation Theory’ (with M. Nissanke and H. Stein), Eastern Economic Journal, Vol. 31, No 2 (Spring, 2005). 37. ‘An Institutional Perspective to Finance and Development as an Alternative to Financial liberalisation’ (with H. Stein), International Review of Applied Economics, Vol. 19, No 4 (October 2005). 38. ‘Aggregate Demand, Conflict, and Capacity in the Inflationary Process’ (with M.C. Sawyer), Cambridge Journal of Economics, Vol. 29, No 6 (October, 2005). 39. ‘Fiscal Policy Matters’ (with M.C. Sawyer), Public Finance, Vol. 54, No 3–4 (1999), (October, 2006). 40. ‘Financial Development and Productive Efficiency in OECD Countries: An Exploratory Analysis’ (with G. Chortareas and E. Desli), The Manchester School of Economic and Social Research, Vol. 74, No 4 (July, 2006). 41. ‘Has Inflation Targeting Had Any Impact on Inflation?’ (with Alvaro Angeriz), Journal of Post Keynesian Economics, Vol. 28, No 4 (Summer, 2006). 42. ‘Technical Efficiency and Financial Deepening in the Non-OECD Economies’, (with G. Chortareas and E. Desli), International Review of Applied Economics, Vol. 20, No 3 (July 2006). 43. ‘Fiscal Policy Matters’ (with M.C. Sawyer), Public Finance, Vol. 54, No 3–4 (1999), (October, 2006). 44. ‘The Role and Nature of Monetary Policy When Money is Endogenous’ (with M.C. Sawyer), Cambridge Journal of Economics, Vol. 30, No 6 (November, 2006). 45. ‘The Relationship Between Capital Stock, Unemployment and Wages in Nine EMU Countries’ (with M. Baddeley and M.C. Sawyer), Bulletin of Economic Research, Vol. 59, No 2 (May, 2007). 46. ‘Assessing the Performance of ‘Inflation Targeting Lite’ Countries’ (with A. Angeriz), The World Economy, Vol. 30, No 11 (November, 2007).

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xx Philip Arestis: An Appreciation 47. ‘Monetary Policy in the UK’ (with A. Angeriz), Cambridge Journal of Economics, Vol. 31, No 6 (November, 2007). 48. ‘A Critical Reconsideration of the Foundations of Monetary Policy in the New Consensus Macroeconomics Framework’ (with M.C. Sawyer), Cambridge Journal of Economics, (2008, Vol. 32, No 5, 761–79). 49. ‘Assessing Inflation Targeting Through Intervention Analysis’ (with A. Angeriz), Oxford Economic Papers, Vol. 60, No 2 (April, 2008). 50. ‘Financial Structure and Economic Growth’ (with K.L Luintel, M. Khan and K. Theodoridis), Journal of Development Economics, Vol. 86, No 1 (April, 2008). 51. ‘21st Century Keynesian Economic Policies’ (with M.C. Sawyer) in 62 below.

Books 52. Introducing Macroeconomic Modelling: An Econometric Study of the United Kingdom, (with G. Hadjimatheou) (Macmillan, 1982). 53. Post-Keynesian Monetary Economics: New Approaches to Financial Modelling (Edward Elgar Publishing Limited, 1988). 54. The Post-Keynesian Approach to Economics: An Alternative Analysis of Economic Theory and Policy (Edward Elgar Publishing Limited, 1992). 55. Biographical Dictionary of Dissenting Economists (with M.C. Sawyer) (Edward Elgar Publishing Limited, 1992. Second edition 2000). 56. The Elgar Companion of Radical Political Economy (with M.C. Sawyer) (Edward Elgar Publishing 1994). 57. The Euro: Evolution and Prospects (with A. Brown and M.C. Sawyer) (Edward Elgar Publishing Limited, 2001). 58. The Post-Bubble US Economy: Implications for Financial Markets and the Economy, (with E. Karakitsos) (Palgrave Macmillan, 2004). 50. Re-examining Monetary and Fiscal Policies in the Twenty First Century (with M.C. Sawyer) (Edward Elgar Publishing Limited, 2004). 60. A Handbook of Alternative Monetary Economics (ed. with M.C. Sawyer) (Edward Elgar Publishing Limited, 2006). 61. Is There a New Consensus in Macroeconomics? (Palgrave Macmillan, 2007). 62. 21st Century Keynesian Economics (edited with M.C. Sawyer) (Palgrave Macmillan 2010, forthcoming).

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Part 1 Monetary Policy, Central Banks and the ‘New Consensus in Macroeconomics’

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1 Are the Macro Econometrics Models of the Federal Reserve Board, the Bank of Canada, and the Sveriges Riksbank consistent with the New Consensus Macroeconomics Model? Jérôme Creel and Giuseppe Fontana

1. Introduction On the 131st anniversary of the birth of Winston Churchill in November 2005, a conference was held in the Cabinet War Rooms of the Churchill Museum, next to HM Treasury in London. The conference was sponsored by the Government Economic Service (GES) and HM Treasury, and it had the captivating title ‘Is There a New Consensus in Macroeconomics’. Philip Arestis (with the help of Andrew Ross of the GES) was the main organizer of the conference. In his typical working style, he then collected the conference contributions in a Palgrave Macmillan book with the same title published early in 2007. Philip, Andrew Ross, and the contributors to the conference, which included among others Charles Bean, current deputy governor at the Bank of England, and William Poole, former chief executive of the Federal Reserve Bank of St Louis, had no doubts that ‘there is now a new macroeconomic consensus in the sense that there is today a level of agreement among economists on macro issues not seen since the late 1960s/early 1970s’ (Arestis, 2007, p. 3). The purpose of this chapter is to briefly discuss this New Consensus Macroeconomics (NCM) and to assess in which measure it is consistent with or embedded in the macro econometrics models used at some of the major central banks around the world. Arestis and Sawyer (2009) have argued that the macro econometrics models used at the Bank of England and at the European Central Bank (ECB) do reflect the NCM. Drawing on that work, the chapter looks at the case of the models of the 3

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Bank of Canada, the Federal Reserve Board (FRB) in USA, and the Sveriges Riksbank in Sweden. Are the macro econometrics models of these central banks consistent with the NCM? Similarly, how do the policy decisions of these central banks follow the policy recommendations of the NCM? There are two main roles for macro econometrics models at modern central banks. First, these models are used for forecasting purposes, i.e. they are designed to provide a framework for organizing the discussion of policy committees around the key structural features of the economy and the likely effects of monetary policy. Secondly, these models are used for simulation purposes, i.e. they are designed to assess the relative merits of alternative monetary policy strategies or to simulate the effects of changing key assumptions of the theoretical model. Therefore, in their forecasting and policy simulation roles, macro econometrics models play a significant role in the determination of the policy rate and the general outlook of the economy by central bankers. The chapter is organized as follows. Section 2 discusses the main features of the NCM. Then, Section 3 looks at the models used at the FRB, the Bank of Canada, and the Sveriges Riksbank and their consistency with the NCM. Finally, Section 4 provides a short summary and conclusions of the chapter.

2. The New Consensus Macroeconomics model The NCM marks a significant stage in the evolution of macroeconomics ideas. It represents a dramatic shift from the quantity-theoretic framework defended by monetarists and neo-classical synthesis Keynesians alike, towards a non-quantity theoretic framework in the spirit of the monetary contributions of Wicksell and Keynes (Fontana, 2007). According to the NCM, the variable under the control of the central bank is not a monetary aggregate, but rather the short-run nominal interest rate. Furthermore, over the last two decades the non-quantity theoretic framework of the NCM has also shown remarkable flexibility, being able to encompass modern theoretical notions, including the natural rate hypothesis, and the expectations-augmented or inertia Phillips curve. It has also absorbed the rational expectation hypothesis, and built on the insights and methodology of the real business cycle theory. Several authors have explored in details the building blocks of the New Consensus model and its assumptions (e.g. Carlin and Soskice, 2009; and Clarida et al., 1999).1 For the purpose of this chapter, it will suffice to recall the main features of the model. The core of the NCM is grounded around a 3-equation model, namely an IS-type equation, a

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Jérôme Creel and Giuseppe Fontana 5

Phillips curve equation, and a monetary policy equation. These equations are all derived from explicit optimizing inter-temporal behaviour of individual agents in presence of market failures, including imperfect competition, incomplete markets, and asymmetric information. The expectations-augmented Phillips curve represents the short-run aggregate supply side of the model, where the IS-type curve and the monetary policy rule provide a reduced form account of the short-run aggregate demand side of the model. The 3-equation model describes a closed economy, though the model can be easily extended to the open economy with a real exchange rate equation, a current account balance equation, and a nominal exchange identity (see, for instance, Arestis and Ross, 2007). A simple version of the 3-equation model is represented below:

( y y )t a0 a1 ( y y )t1 a2 Et ( y y )t1 a3 (it Et (p )t1 ) s1

(1)

pt b1pt 1 b2 Et (pt 1 ) b3 ( y y ) t s2

(2)

(

)

(

it r * c1 p p T c2 y y

)

(3)

where a3 0, and a0 is a constant that indicates, among others things, the effects of fiscal variables on the output gap ( y y−); b1 b2 1, and b3 0; c1 1, and c2 0; Et is the expectations operator; it is the nominal interest rate controlled by the central bank; p is the rate of inflation; pT is the target for the inflation rate; r* is the equilibrium real interest, namely the interest rate that prevails in the long run when current output y is at potential level y−; finally s1 and s2 represent stochastic shocks. Equation (1) describes an IS-type curve: the current output gap is determined by past and expected future output gaps, as well the real interest rate. Equation (2) is a Phillips curve, with inflation determined by the current output gap, past and expected future inflation rates. The latter term is an indirect measure of the degree of commitment and credibility of the central bank to the long run goal of price stability. Finally, Equation (3) is a simple monetary policy rule, namely a standard Taylor rule, with the nominal interest rate explained by the current output gap, the deviation of current inflation from its target, and the equilibrium real interest rate. The set of equations (1)–(3) summarizes the core propositions of the NCM and its policy implication, namely that the central bank has a key role in achieving and maintaining price stability in the long run, at the same time providing as much output stabilization as possible in the short run. These short and long-run goals are achieved through an

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aggregate demand channel and an inflation expectations channel of the transmission mechanism of monetary policy. Figure 1.1 presents the aggregate demand channel. i ⇒ r ⇒ C & I ⇒ AD ⇒ Y & UN ⇒ ( y y ) ⇒ p Figure 1.1 The Aggregate Demand (AD) Channel of the transmission mechanism of monetary policy in the NCM model

The aggregate demand channel of the transmission mechanism of monetary policy in the NCM model strongly relies on the short-run price and wage rigidities, which allow the central bank to influence the short-run real interest rate, namely (it Et (p)t1), by simply changing the short-run nominal interest rate it . This means that ceteris paribus the central bank can alter real interest rate-sensitive components of the IS-type curve in equation (1), and hence the aggregate demand function AD, which in turn affects the level of current output y in the output gap ( y y−). In addition, equation (2) shows that the current inflation rate is a function of the output gap ( y y− ). Therefore, by appropriate changes in the level of current output and hence of the output gap, the central bank is able to bring, and then maintain, the current inflation rate to its desired target level pT.

(

)

i ⇒ p p T ⇒ Et (pt 1 ) Figure 1.2 The inflation expectations channel of the transmission mechanism of monetary policy in the NCM model

Figure 1.2 presents the inflation expectations channel of the transmission mechanism of monetary policy in the NCM model. Once established the inflation expectations channel is less laborious, though not less important, than the aggregate demand channel. Equation (2) shows that the current inflation rate is a function of the expected value of the future rate of inflation Et (pt1). This means that as long as the central bank is seen to be committed through its interest rate policy strategy to achieving and maintaining price stability in the long run, namely p pT, then Et (pt1) is anchored to the actual level of inflation p. In other words, in this case the expected value of the future rate of inflation becomes less important in determining the current rate of inflation. Over the past few years, and especially in the face of the current financial crisis and serious recession, the NCM model has been the object of several criticisms (see, e.g., Arestis 2009). For the purpose of this chapter,

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it is important to highlight only one of the most controversial features of the NCM model, namely the neutrality of monetary policy in the long run. Changes in the short-run nominal interest rate by the central bank via adjustments in components of the aggregate demand function are able to affect current output; but interest policy changes never affect potential output. In fact, in the long run, when price and wages are flexible, the central bank is unable to affect the short-run real interest rate, and hence unable to have any real effects in the economy. The long-run neutrality of money in the NCM framework has been highlighted in recent talks by Ballard (2009a, 2009b), president of the Federal Reserve of St Louis. He showed that the quantitative easing pursued by the Fed since fall 2008 is fully consistent with the usual NCM framework provided the interest-rate rule is substituted with a monetary feedback rule. The latter rule would make the monetary aggregate evolve according to the gap between the actual inflation rate and its target, on the one hand, and the output gap, on the other hand. At the steady state, i.e. in the long run, money would be neutral.

3. Some modern macro econometrics models and the NCM model Arestis and Sawyer (2009) have argued that the macro econometrics models used at the Bank of England and at the ECB reflect the NCM model. Drawing on that work and the previous analysis of the NCM, this section looks at the macro econometrics models used at the FRB, the Bank of Canada, and the Sveriges Riksbank. Are the macro econometrics models of these central banks consistent with the NCM? Similarly, how do the policy decisions of these central banks follow the policy recommendations of the NCM? (a) The Federal Reserve Board (FRB) and the NCM model Structural models have been used at the FRB for over four decades. The first model, the so-called MPS model, was a joint project between policy makers and academic economists.2 It was a great success and set the standard for macro econometrics modelling for a long time. The MPS model and its open economy extension, the MCM, were replaced in the mid-1990s with the FRB/US and FRB/Global. These new models rely on advanced econometric techniques like a-theoretic VARs for the estimation and testing of long-run relationships. More importantly, they embed a key feature of the NCM, namely an explicit role for expectations in the monetary policy process.

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Table 1.1 and Figure 1.3 represent the main stages of the aggregate demand and the inflation expectation channels of monetary policy as they are formalized in the FRB/US model. In both tables interest rates in the economy are related to the federal funds rate by the expectations theory of the term structure of interest rates. This means that the Federal Reserve (Fed) can alter financial conditions in the economy by modifying the current and expected value of the funds rate. Table 1.1 shows the partial equilibrium response, i.e. feedback effects excluded, of capital stocks and private spending to a 1 percentage point decrease in interest rates: a change in financial conditions has mainly three types of effects, namely credit effects (top part of Table 1.1), wealth effects (middle part), and exchange rate effects (lower part). More precisely, a decrease in interest rates: (a) reduces the borrowing cost for buying goods; (b) raises the price of equities, which has positive household wealth effects on consumer spending; and finally (c) depreciates the exchange value of the dollar with respect to foreign currencies, improving in this way the US current account. Table 1.1 Partial equilibrium response of capital stocks and private spending to changes in financial conditions Category of stock and spending

Response in level at end of year 1 2 3 15 1 percentage point decrease in interest rates

Capital stocks Consumer durable goods Housing Producers’ durable equipment

0.3 0.1 0.1

0.7 0.3 0.5

0.8 0.5 1.0

0.8 1.3 4.0

Private investment spending Consumer durable goods Housing Producers’ durable equipment1

1.7 4.8 1.3

1.7 6.8 3.1

1.3 5.7 3.8

0.8 1.3 4.0

20 percent increase in stock market wealth Private sending Consumer durable goods Housing Consumer spending on nondurable goods and services Exports Imports

0.9 2.4

1.3 3.5

1.1 2.9

0.2 0.4 0.5 6 percent depreciation of the dollar 1.7 1.1

4.8 3.5

5.5 3.8

Note: 1. Include effect of a 1 percentage point fall in the rate of return on equity. Source: Reifschneider et al., 1999, p. 5.

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0.6 0.6 0.6 5.7 3.7

Jérôme Creel and Giuseppe Fontana 9 Percentage point change 3.0

Sustained reduction

2.5 2.0 1.5 1.0 0.5 0

Two-year reduction

1

2

3

4

5

6

7

8

Figure 1.3 Partial equilibrium effect on inflation of a reduction of 1 percentage point in the unemployment rate Source: Reifschneider et al., 1999, p. 7.

Credit effects, i.e. the reduction in the borrowing cost for buying goods, are split into stock and flow effects. Stock effects on consumer durable goods, residential structures, and business equipment due to a 1 percentage point decrease in interest rates are positive, although, because of frictions, the adjustment of stocks to the new long-run desired level is slow but gradual. By contrast flow effects, which have the same signs of stock effects, follow a hump-shaped pattern due to the accelerator effect: there is a sustained increase in spending in years two and three, before it declines over time to the long-run desired level. Regarding the wealth effects, a 1 percentage point decrease in the yield of bonds increases equity prices, which boost household wealth, and hence affect positively the desired level of consumer spending on durable goods, residential structures, and non-durable goods and services. Finally, according to the FRB/US uncovered interest rate parity condition a 1 percentage point decrease in long-run interest rates causes a 6 percentage point depreciation of the exchange value of the dollar with respect to foreign currencies, which influences positively exports of US goods and negatively imports of foreign goods. In sum, a 1 percentage point reduction of interest rates via positive credit effects, wealth effects, and exchange rate effects increases output and decreases unemployment. Figure 1.3 shows the effects on inflation of a 1 percentage point decrease in unemployment. There are several factors that affect the

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aggregate price level in the FRB/US model, but for the discussion what matters is the unemployment rate. In one case, it is assumed that the unemployment rate drops permanently 1 percentage point below its long-run equilibrium rate. As a result, households modify their price expectations and inflation becomes persistent, climbing steadily at an annual rate of 0.4 percentage points over a period of eight years. In the other case, it is assumed that the unemployment rate drops 1 percentage point below its long-run equilibrium rate only for a two-year period. The two-year reduction line shows that inflation picks at 0.8 percentage points after three years and stays at that level for the remaining years. Table 1.2 shows the full-model simulated effects of 1 percentage point fall in the federal funds rate compared to the baseline policy strategy, namely a constant federal funds rate. For a 1 percentage point drop in the federal funds rate there is a reduction in the yield on 10-year Treasury bonds (r10) of 0.3 percentage point at the end of year one, and 0.5 percentage point at the end of year two, where the different annual values are explained by the evolving nature of expectations. The reduction in (r10) causes an increase in stock market prices, and a depreciation of the dollar compared to foreign currencies. The effects on the US economy of the improved financial conditions are shown in rows 3–6 of Table 1.2: consistently with the NCM model the unemployment rate decreases, current output increases, and consumer price inflation rises. Interestingly, in the lower part of Table 1.2 the last two effects are decomposed into various components. In particular, the output response to improved financial conditions is decomposed into expenditure categories and transmission channels. Regarding the former, it is worthy to note that a disproportionate share of the increase in output is explained by investment spending. The lower part of Table 1.2 also shows the decomposition of the output response in terms of transmission channels, namely credit effects, wealth effects, and exchange rate effects. In this case, it is worthy to highlight the prominent role of credit effects, which account for more than one-third of the change in output. Table 1.2 shows also the effects of a fourth transmission channel, i.e. anticipated non-financial responses. The underlying hypothesis is that changes in the federal funds rate have direct influence on the expected values of future output and inflation, which feed back on the value of current GDP. This anticipation channel is extremely powerful in the short run, and it highlights once more the role of the inflation expectation channel in the FRB/US model. Finally, the lower part of Table 1.2 shows the decomposition of the inflation response into three transmission channels, namely resource utilization, exchange rate effects, and anticipated non-financial responses.

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Jérôme Creel and Giuseppe Fontana 11 Table 1.2 The monetary transmission mechanism in the FRB/US model in a full-model simulated effect of 1 percentage point fall in the federal funds rate Item

Response at end of year 1

2

Change from baseline Financial markets Yield on 10-year Treasury bonds Stock market prices Exchange rate value of the dollar

0.3 8.8 2.2

0.5 12.7 4.9

Aggregate activity GDP (chain-weighted 1992 dollars) Unemployment rate Consumer price inflation rate

0.6 0.2 0.2

1.7 0.7 0.6

Portion of total response Decomposition of GDP response into expenditure categories1 Consumer spending, durable goods (8.3) Consumer spending, others (59.4) Business fixed investment (10.6) Residential investment (4.0) Inventory investment (0.8) Exports (11.9) Imports (13.1) Government (17.9)

24.0 28.0 13.0 26.2 16.4 7.1 17.5 2.4

18.6 26.2 18.5 24.0 10.7 13.0 14.8 3.4

Decomposition of GDP response into transmission channels Cost of borrowing Stock market Exchange rate value of the dollar Anticipated nonfinancial responses

26.9 16.0 6.9 50.2

36.4 20.7 17.3 25.7

Decomposition of inflation response into transmission channels Resource utilization Exchange rate value of the dollar Anticipated nonfinancial responses

10.6 24.8 64.6

33.1 22.4 44.5

Note: 1. 1997 nominal shares of GDP in parentheses. Source: Reifschneider et al., 1999, p. 8.

The latter plays a lion’s share in explaining the movements of the inflation rate in the short run. Again, this highlights the role of the inflation expectation channel in the FRB/US model. This channel is extremely powerful in the first two years, but its effects disappear in the third year (not shown in the table). This is in contrast with the resource utilization

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channel, which plays the dominant role over time, confirming that the deflationary role of unemployment in the NCM model is embedded into the FRB/US model. The exchange channel plays an important stable role through its effects on imported inflation in the US economy. (b) The Bank of Canada and the NCM model The purpose of this section is to shed light on the instruments used by the Bank of Canada to forecast Canada’s economy and implement simulations for different kinds of monetary policies. As recalled by Macklem (2002), the Bank of Canada has long made use of macro models to perform economic forecast and simulations. In his words, ‘the projection combines a structural macro model of the Canadian economy with the latest intelligence on the near-term prospects for economic activity, as well as the staff’s judgment on various issues. The model is used to trace the link from the policy instruments (the target overnight interest rate) through to inflation. (…) The third and final step is from the output gap and expected inflation to actual inflation’ (p. 12). It is noteworthy to highlight from this quote that in Macklem’s view, ‘latest intelligence’ and the NCM model, as described by Figures 1.1 and 1.2, are synonyms. The structural model referred to by Macklem (2002) is the Quarterly Projection Model (QPM), which has recently been upgraded, though the new model has not lost its NCM properties. In fact, since December 2005, the QPM has been replaced with the Terms-of-Trade Economic Model (ToTEM) (Murchison and Rennisson, 2006). The ToTEM is a closedeconomy model, and the open-economy extension is the Bank of Canada Global Economy Model (BoC-GEM) (Lalonde and Muir, 2007). The ToTEM and the BoC-GEM are dynamic stochastic general equilibrium (DSGE) models with differentiated goods, and incorporating an endogenous monetary policy rule, which is derived from the optimizing behaviour of the Bank of Canada: quadratic preferences depend on inflation and output gaps, as well as a cost for modifying the policy instrument. The ensuing monetary reaction function is a Taylor-rule with an inertial component. As such, it is fully consistent with the NCM ‘common wisdom’ embodied in the 3-equation model presented in Section 2. Figure 1.4 reproduces the impact, quarter after quarter, of a 1-point increase in the nominal interest rate. It is worth noting that the features of the model seem to be consistent with that of a VAR empirical model. However, during the first year, monetary policy is more effective in reducing GDP than in the empirical model, whereas in the long run it is more efficient in stabilizing the output. The conclusion seems to be that, due to effective calibration, the theoretical model performs better

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Jérôme Creel and Giuseppe Fontana 13 0.2 0.1 0.0 –0.1 –0.2 –0.3 –0.4 –0.5 –0.6 –0.7 5

10

15

20

Estimated VAR

25

30

35

40

To TEM

Figure 1.4 The monetary transmission mechanism in Canada (two-year long positive shock on the nominal interest rate) (x-axis: quarters) Source: Murchison and Rennisson, 2006, p. 67

than a VAR model. In comparison with FRB model (see Table 1.2), the monetary transmission mechanism in Canada is much less pronounced after two years: the impact of a 1-point increase in the short-term interest rate is almost three times lower in absolute terms than in the US. The incidence of a 7-percent depreciation of the Canadian dollar depends on the assumption regarding the mark-up level. If competition is strong, exporters are reluctant to pass on the higher costs of their intermediate imported products in their final prices. In the end, exports grow more after depreciation if competition is intense. With a high level of competition, exports grow by 4 percent after two years, i.e. relatively less than in the FRB model. A main difference between Bank of Canada and FRB forecast models is in the incidence of the currency depreciation on imports. Whereas imports are supposed to decrease in the US, they are expected to increase in Canada. There are two reasons for this result: the price effect is assumed to be slow to materialize, i.e. the pass-through from currency depreciation to higher price for imported goods is weak, and the substitution effect is assumed to be low, i.e. consumers do not modify their consumption portfolio between domestic and imported goods because both are assumed not to be close substitutes. Both reasons echo the view that supporters of the NCM model aim at adapting theory to ‘practical circumstances’ (Fontana,

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14 0.32 0.28 0.24 0.20 0.16 0.12 0.08 0.04 0.00 –0.04

1.0 0.8 0.6 0.4 0.2 0.0 –0.2 5 10 15 20 25 30 35 40 45 50 55 60

5 10 15 20 25 30 35 40 45 50 55 60 Core CPI inflation

Real marginal cost (consumption sector)

0.5

1.0

0.4

0.8

0.3

0.6

0.2

0.4

0.1

0.2

0.0

0.0

–0.1

–0.2 5 10 15 20 25 30 35 40 45 50 55 60

5 10 15 20 25 30 35 40 45 50 55 60

90-day interest rate

Output (real GDP)

0.1

10

0.0

8 6

–0.1

4 –0.2

2

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–2 5 10 15 20 25 30 35 40 45 50 55 60

5 10 15 20 25 30 35 40 45 50 55 60 Real exchange rate ( is a depreciation)

Real consumption 5

1.6

4

1.2

3

0.8

2 0.4

1

0.0

0 –1

–0.4 5 10 15 20 25 30 35 40 45 50 55 60 Real exports

5 10 15 20 25 30 35 40 45 50 55 60 Real imports

Figure 1.5 The impact of a financial shock in Canada (exogenous increase to the country-specific risk premium) (x-axis: quarters) Source: Murchison and Rennisson, 2006, p. 73.

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2009), and trying to have their models reproduce stylized facts such as, e.g., a J-curve effect after a currency depreciation (see Figure 1.5). (c) The Sveriges Riksbank and the NCM model This section highlights the instruments used by the Bank of Sweden – the Sveriges Riksbank, which is the oldest central bank in the world with a 350-year history3 – to forecast Sweden’s economy and implement simulations for different kinds of monetary policies. Since the end of 2005, economic staff at the Riksbank uses a DSGE model for the Swedish economy. The Riksbank Aggregate Macromodel for Studies of the Economy of Sweden (RAMSES) is an extension to the open economy of the NCM model discussed in Section 2: rational expectations, optimization, monopolistic competition, price rigidity in the short run, neo-classical features in the long run, and policy rules are the main features of the model. The originality of RAMSES rests on the modification of the uncovered interest parity (UIP) thanks to the ad hoc inclusion of a lagged dependence between the exchange rate and the domestic interest rate. The latter inclusion replicates in the short run the stylized fact that a higher domestic interest rate produces a gradual exchange rate appreciation, in opposition with UIP’s prediction. The monetary policy rule is an interest rate smoothing in the vein of equation (3) (see section 2; also Woodford, 1999). The economists in charge of RAMSES (Adolfson et al., 2007a) provide a very interesting rationale for constructing a DSGE model for the aggregate economy. They claim that Keynesian models until the early 1980s assumed ‘that players in the economy are governed by various rules of thumb’ (p. 7), to be understood as rules without microfoundations under rational expectations. Moreover, they claim that the reliance on such rules of thumb in a Keynesian framework had two reasons: first, there was a ‘lack of technical tools (…) for solving complex systems’ and, second, the first generation of general equilibrium models was ‘at odds with the data’ (p. 7). According to Adolfson et al. the improvement in technical skills and the introduction of some kinds of rigidities to better replicate the data are the main reasons for the use of RAMSES, and more generally of general equilibrium models, for the purpose of forecasting. These authors do not even question the methods by which their model better handles ‘stylized facts’; indeed, there is a contradiction between their claimed appeal to technical and scientific tools, and the necessity to recourse to ad hoc assumptions such as, e.g., a generalization of monopolistic competition to all countries. Adolfson et al. (2007a) also at least implicitly imply that had Keynesian scholars benefited from recent

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technical advances, they would have been using general equilibrium models in earlier periods, although this point is questionable. What is less so at this stage is the sense these authors have of the superiority of their model for the purpose of forecasting. This superiority is observable in the types of simulations exercises Adolfson et al. (2007a) present in their paper. They show what their model would have predicted between 2003 and 2006, provided that no new productivity shocks had occurred. Then they compare predictions with actual data and interpret the total difference ‘as a consequence of technological innovations that improved productivity in 2003–06 and led to high GDP growth’ (p.24). Uncertainty about the predictive power of the macro model is left aside, given that the authors show that the accuracy of RAMSES’ forecast is at least as good as alternative models’ forecasts (pp. 28–33). This high degree of predictive power is very important in a country like Sweden, which is officially targeting inflation and, at the same time, makes its forecasts available to the public.4 The RAMSES monetary transmission mechanism is consistent with the analysis in Figures 1.1 and 1.2. A temporary rise in the policy interest rate Domestic inflation

Real wage

Consumption 0

0.02

0

–0.1

0 –0.05

–0.02

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Export

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Invest. defl. inflation

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10 Output

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5

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Hours worked

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Investment 0.4 0.2 0 –0.2 –0.4 –0.6

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–0.2 5

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Figure 1.6 The monetary transmission mechanism in Sweden (one temporary standard deviation of the policy rate) (x-axis: quarters) Source: Adolfson et al., 2007b, p.27.

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produces a gradual output reduction. Domestic and CPI inflations show a relatively similar evolution. The introduction of a modified UIP produces a more gradual appreciation of the Swedish currency than that required by UIP with rational expectations and price rigidity. In the long run, however, the currency appreciation is higher than that predicted by UIP, therefore showing a hump-shaped response to the policy shock (see Figure 1.6).

4. Concluding remarks This chapter has briefly discussed the New Consensus Macroeconomics (NCM) model, before assessing, in the vein of Arestis and Sawyer (2009), in which measure it is consistent with or embedded in the macro econometrics models used at the Bank of Canada, the Federal Reserve Board (FRB) in USA, and the Sveriges Riksbank in Sweden. The main conclusion is that there are important differences between the ToTEM at the Bank of Canada, the RAMSES at the Sveriges Riksbank, and the FRB/US at the Federal Reserve Board. However, all these macro econometrics models embed the most prominent features of the NCM model, including interest rate policy rules, rational expectations, optimization, monopolistic competition, price rigidity in the short run, and neutrality of money and monetary policy in the long run. They are thus important instruments in spreading the NCM doxa.

Notes 1. See for a critical assessment of the 3-equation model and its methodology, Arestis (2009) and Fontana (2009), respectively. 2. The name MPS is the acronym of MIT, University of Pennsylvania and Social Science Research Council, which supported the project. 3. Indeed, the Riksbank became a central bank in the modern sense in 1897 after it was granted the monopoly of notes issuance. 4. Creel and Hubert (2008) show that the effectiveness of the inflation targeting policy strategy in Sweden in comparison with the experience in Canada could be attributed to its high transparency about forecasts.

References Adolfson M., Lasen S., Linde J. and Villani M. (2007a), ‘RAMSES – a New General Equilibrium Model for Monetary Policy Analysis’, Sveriges Riksbank Economic Review, n°2, 5–38. Adolfson M., Lasen S., Linde J. and Villani M. (2007b), ‘Evaluating an Estimated New Keynesian Small Open Economy Model’, Sveriges Riksbank Working Paper n°203, February, 1–59.

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Arestis, P. (2007), ‘What is the New Consensus in Macroeconomics?’, pp. 22–42, in P. Arestis (ed.), Is There a New Consensus in Macroeconomics?, Basingstoke (UK): Palgrave Macmillan. Arestis, P. (2009), ‘The New Consensus in Macroeconomics: A Critical Appraisal’, in G. Fontana and M. Setterfield (eds), Macroeconomic Theory and Macroeconomic Pedagogy, Basingstoke (UK): Palgrave Macmillan, forthcoming. Arestis, P. and Ross, A. (2007), ‘Introduction’, pp. 1–21, in P. Arestis, Is There a New Consensus in Macroeconomics?, Basingstoke (UK): Palgrave Macmillan. Arestis, P. and Sawyer, M. (2009), ‘Are the European Central Bank and Bank of England Macroeconomic Models Consistent with the New Consensus Macroeconomics?’, Ekonomia, forthcoming. Ballard, J. (2009a), ‘Monetary policy in a Global Recession’, Presentation at the Banque de France – Aix-Marseille University – Toulouse School of Economics International Workshop, Paris, 20 March 2009. Ballard, J. (2009b), ‘Effective Monetary Policy in a Low Interest Rate Environment’, The Henry Thornton Lecture, Cass Business School, London. Carlin, W. and Soskice, D. (2009), ‘Teaching Intermediate Macroeconomics using the 3-Equation Model’, in G. Fontana and M. Setterfield (eds), Macroeconomic Theory and Macroeconomic Pedagogy, Basingstoke (UK): Palgrave Macmillan, forthcoming. Clarida, R., Galí, J. and Gertler, M. (1999), ‘The Science of Monetary Policy’, Journal of Economic Literature, 37(4), 1661–707. Creel J. and Hubert P. (2008), ‘Has the Adoption of Inflation Targeting Represented a Regime Switch? Empirical Evidence from Canada, Sweden and the UK’, OFCE Working Paper, n°2008–23, July, 1–40. Fontana, G. (2007), ‘Why Money Matters: Wicksell, Keynes, and the New Consensus View on Monetary Policy’, Journal of Post Keynesian Economics, 30(1), 43–60. Fontana, G. (2009), Money, Uncertainty and Time, Abingdon (UK): Routledge. Lalonde R. and Muir D. (2007), ‘The Bank of Canada’s Version of the Global Economy Model (BoC-GEM)’, Technical Report n°98, Bank of Canada, September, 1–121. Macklem T. (2002), ‘Information and Analysis for Monetary Policy: Coming to a Decision’, Bank of Canada Review, Summer, 11–18. Murchison S. and Rennisson A. (2006), ‘ToTEM: the Bank of Canada’s New Quarterly Projection Model’, Technical Report n°97, Bank of Canada, December, 1–121. Reifschneider, D.L., Tetlow, R. and Williams, J.C. (1999), ‘Aggregate Disturbances, Monetary Policy, and the Macroeconomy: The FRB/US Perspective,’ Federal Reserve Bulletin, 85 (January), 1–19. Woodford, M. (1999), ‘Optimal Monetary Policy Inertia’, Manchester School, vol. 67, Supplement, 1–35.

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2 Arestis and Sawyer’s Criticism on the New Consensus Macroeconomics: Some Issues Related to Emerging Countries Luiz Fernando de Paula and Fernando Ferrari-Filho

1. Introduction As is well known, the New Consensus Macroeconomic (NCM) can be characterized as an extension of the New Keynesian Theory. The New Keynesian Theory was developed in the 1980s and aimed at presenting a theoretical framework to explain what the New Keynesians believe to be the essential aspect of Keynes’s General Theory: the existence of price and wage rigidities. For instance, according to Mankiw and Romer (1991, p.1), ‘[b]ecause wage and price rigidities are often viewed as central to Keynesian economics, much effort was aimed at showing how these rigidities arise from the microeconomics of wage and price setting’.1 An inflation targeting regime (ITR) has been adopted by a significant number of countries since the beginning of the 1990s. ITR is a framework for monetary policy characterized by the public announcement of target ranges for the inflation rate (Bernanke et al., 1999). According to the ITR, central banks and policy makers, based on Taylor’s recommendation (1993), have to conduct monetary policy to aim at keeping inflation under control. The purpose of this chapter is to analyze Arestis and Sawyer’s criticism on the NCM framework, and its monetary regime proposal, i.e. ITR, and to discuss some special features of the emerging economies that should be considered in any analysis related to economic policies. In particular we seek to address the following questions: What are Arestis and Sawyer’s criticism (and other Post Keynesian economists) on NCM? What are the specificities of the emerging economies that should be considered in any discussion related to macroeconomic policies alternatives? Is NCM style of economic policy suitable for emerging economies? 19

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The chapter begins by addressing the NCM framework and the theoretical foundations of ITR. In doing so it focuses on the critical view of NCM and ITR in the light of Post Keynesian theory, such as Arestis and Sawyer (1998; 2004; 2005; 2006; 2008) and Davidson (1994; 2002). This is followed by an analysis of some special features of emerging economies that should be considered in the discussion related to adoption of ITR and other economic policy arrangement. A final section presents the main conclusions of the chapter.

2. The NCM and ITR: theoretical foundations and a critical view by Post Keynesians 2.1

The NCM model

The NCM is based on three main equations, namely: (i) IS curve – this represents the demand of the economy, in which the current output is determined by the gap between past and future output and the real interest rate; (ii) Phillips curve – this expresses the relation between current output and inflation rate; and (iii) monetary equation according to Taylor’s rule (see Taylor, 1993). Clarida et al. (1999, pp. 1665 and 1695) describes the NCM model as follows: Xt [it tt 1] tXt 1 gt

(1)

t Xt tt 1 t

(2)

i*t (t *) XXt

(3)

where Xt is the output gap, it is the nominal interest rate, t 1 is the period t 1 inflation rate, t is the inflation rate in period t, i*t is target interest rate, * is the target inflation rate and gt and t are disturbances terms. Equation (1) describes the IS curve (it relates the output gap inversely to the real interest rate), equation (2) is the Phillips curve that relates inflation positively to the output gap, and equation (3) is the interest rate rule for inflation targeting and nominal GDP targeting. According to Arestis and Sawyer (2008), this model has a number of important characteristics: (i) Equation (1), in a context of rigorous microeconomic foundations, such as rational expectations hypothesis and inter-temporal

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optimization, has two implications: first, implicitly, there is a full employment assumption; second, there is no consideration about uncertainty. (ii) Equation (2) reflects the idea of central bank credibility, i.e. central bank independence. The authors argue that ‘the notion of the trade-off between inflation and unemployment has been used to argue the case for independence of central banks on the grounds that politicians are tempted to stimulate the economy to reduce unemployment without regard for the long-term inflationary consequences’ (Arestis and Sawyer, 2008, p.278). (iii) Equation (3) ‘endogenises the setting of interest rate by Central Bank’ (Arestis and Sawyer, 2008, p.279). As a result, the interest rate is adjusted with the gap between inflation rate and the target inflation rate and in response to the output gap. The approach briefly described above has a number of assumptions, the most important of which are: (i) The level of unemployment fluctuates around a supply-side determined equilibrium rate of employment, namely the NAIRU (nonaccelerating inflation rate of employment). (ii) Effective demand does not affect the economic activity. Further, the level of employment and of economic activity is viewed as a supplyside phenomenon. (iii) Fiscal policy is impotent in stimulating the economic activity, as well as subordinate to monetary policy. (iv) Monetary policy matters, especially because it controls the inflation rate.

2.2 Main aspects of ITR Having presented the NCM model, we can now focus on the main theoretical and operational aspects of ITR. The theoretical aspects can be summarized as follows: (i) ITR is a monetary policy framework whereby public announcement of inflation targets is undertaken along with explicit acknowledgement that price stability is monetary policy’s primary long-term objective. The price stability goal may be accompanied by output stabilization so long as price stability is not violated. Such a monetary policy framework improves communication between the public, business and

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markets, and provides discipline, accountability, transparency and flexibility in monetary policy. The focus is on price stability, along with three objectives: credibility, flexibility, and legitimacy. (ii) Monetary policy is taken as the main instrument of macroeconomic policy. Indeed, monetary policy is viewed as the most direct determinant of inflation, such that in the long run the inflation rate is the only macroeconomic variable that monetary policy can affect. Monetary policy cannot affect economic activity in the long run. (iii) The objectives of the ITR framework are achieved through the principle of ‘constrained discretion’. In other words, policy makers adjust the monetary policy in responding to economic shocks, financial disturbances, and other unforeseen developments. In this way, ITR serves as a nominal anchor for monetary policy. (iv) Fiscal policy is no longer viewed as a powerful macroeconomic instrument. In addition, ‘monetary policy moves first and dominates, forcing fiscal policy to align with monetary policy’ (Mishkin, 2000, p.4). (v) Monetary policy cannot be operated by politicians, but by monetary authorities in the form of an independent central bank. In general, politicians have to face a monetary policy trade-off: a counter-cyclical monetary policy can expand the economic activity in the short run at the expense of increasing the inflation rate in the long run. In other words, there is a time-inconsistency problem. (vi) The central bank must be independent. It implies that the policy objective of central bank is only price stability. In this way, a mechanism for openness, transparency, and accountability should be in place with respect to monetary policy formulation. (vii) In the case of emerging countries, in which there is a transmission channel from exchange rate to inflation, exchange rate considerations are of crucial importance for ITR.2 In terms of operational aspects, at least three can be addressed: (i) ITR requires that the point target be specified and the period over which the target is expected should be achieved. (ii) It is necessary to adopt a methodology that can provide information on future inflation, and to choose an adequate index price that reflects the prices of goods and services for current and future consumption. (iii) Monetary authorities have to face a trade-off between reducing deviations of inflation from the target and preventing a high degree of output volatility.

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To sum up, the NCM has become associated with the following main features: (i) Effective demand does not play an independent role in the longrun level of economic activity. Further, Say’s Law holds. (ii) There is a temporary nominal price and wage rigidities. In this way, in the short run money is not neutral (i.e. monetary policy affects the real variables). (iii) Economic agents are rational. In other words, agents are continuous optimizers subject to their constraints. (iv) Inflation is a monetary phenomenon. For this reason, monetary policy has a specific goal: to keep inflation under control. (v) Fiscal policy approximates to so-called ‘Ricardian equivalence’.3 (vi) Independence of central bank. (vii) The monetary policy is guided by ITR. 2.3 Arestis and Sawyer and the Post Keynesian criticism on the NCM and an ‘alternative’ economic policy This section presents Post Keynesian criticism on the NCM framework presented in the previous section, and an alternative (Post) Keynesian economic policy to NCM.4 The idea is to discuss some criticism related to the main issues of the NCM, such as: (i) the neutrality of money, at least in the long run; (ii) the use of monetary policy only to target inflation; (iii) rational expectations hypothesis; (iv) unemployment as a result of wage and price rigidities; and (v) economic activity determined by supply-side. NCM states the ITR is the more appropriate institutional framework to assure price stability and to minimize output fluctuations as it can constrain the inflationary bias of monetary authorities (timeinconsistency problem), reducing the degree of freedom of the central bank to produce inflation surprises, and at the same time gives some flexibility so that the central bank can minimize output fluctuations around the long-run trend of output (Bernanke et al., 1999). The monetary theory of the NCM is essentially different from Keynes’s monetary theory in the sense that, contrary to the NCM, money is never neutral. Why? Based on the axiom of money neutrality NCM assumes the existence of a natural rate of employment determined by real forces and is largely independent of monetary policy. For Keynes and (Post) Keynesians, due to the essential properties of money,5 fluctuations in effective demand occur because, when the future is uncertain, people decide to hold money – money is liquid par excellence – as a

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store of value at the expense of purchasing goods or taking decision of investment. In this way, Keynes’s theory is, implicitly, a monetary theory in which money affects the production process of an economy moving through time. So, money is non-neutral in the short- and in the longrun, which means that there is no long-run equilibrium for the economy that is independent of monetary policy (Carvalho, 1992, p.38). According to the NCM, monetary policy has a specific goal: to keep inflation under control. Inflation is largely the result of excess demand, that is, a situation where aggregate demand is higher than long-run equilibrium output determined by the supply side of the economy. In a (Post) Keynesian perspective, monetary policy cannot be neglected. For instance, as Carvalho (1992, p.212) argues, ‘[m]onetary policy … [has] … the role of accommodating transactional demands for money and of preventing changes in the state of liquidity preference from having an impact upon the prices of non-liquid assets’. Monetary policy, once it can prevent changes in expectations and in the liquidity preference of the economic agents, affects consumption and firms’ decisions of investment. Monetary policy operated by the management of the interest rates can have significant impact on the level of economic activity. The management of interest rates can be used in order to influence the private agents’ portfolio in favor of increases of production (using current productive capacity) and the acquisition of capital goods, as it can provoke a shift in the relative prices of different assets, from the more liquid to the more illiquid assets, that is, leading changes in the portfolio decisions that can affect real variables of the economy (output and employment). Further, for Keynes and Post Keynesians, inflation is not a monetary phenomenon. On the contrary, inflation (or deflation) occurs to due changes in flow-supply prices or forward prices of producible goods. In the Post Keynesian view, there are different causes of inflation, and consequently there as various types of inflation. More specifically, according to Davidson (1994, p.143), ‘[a]ny rise in the short-run flow-supply price of output is due to three possible causes: (1) diminishing returns, (2) increasing profit margins, and (3) increasing money wages (relative to productivity increments)’. Inflation is mostly a symptom of a fight over the distribution of current income, among economic agents (workers and capitalists) of the same region, and/or interregionally and/or internationally, and also is the result of cost factors, such as prices of raw materials, especially oil (Arestis and Sawyer, 2005). Thus, price stabilization needs income policies that require some degree of centralization and coordination. In the real world, do economic agents form their expectations based on an ergodic stochastic process?6 Davidson (2002) argues that the

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rational expectation hypothesis denies the risk-uncertainty developed by Keynes. Thus, the NCM reduces uncertainty to a situation of risk, i.e. a certain future is postulated. Contrary to rational expectation hypothesis, Keynes argued that people form their expectation based on an ‘uncertain knowledge’. In his words, ‘human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist’ (Keynes, 1964, pp.162–3). The NCM argues that due to temporary nominal wage and price rigidities, money is not neutral, and, consequently, unemployment occurs. The NCM model provides only an explanation of the lack of variability in price and wages, but do not explain unemployment equilibrium.7 On the other hand, despite the fact, in Chapter 3 of The General Theory of Employment, Interest and Money, Keynes supposed, only to simplify his analysis related to the effective demand, that wages and prices are inflexible in the short run, this is neither a necessary nor a sufficient condition to explain Keynesian involuntary unemployment. The following passage shows that unemployment, in a Keynesian perspective, occurs even when wages and prices are flexible: ‘There is … no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment … The economic system cannot be made self-adjusting along [this line]’ (Keynes, 1964, p.267). Finally, Keynesian analysis recognizes that effective demand assumes a central position in the economic system. Employment levels and the utilization of productive capacity depend crucially on the determinants of aggregate demand, particularly entrepreneurs’ investment decisions. The basic idea of Keynes’s principle of effective demand is that the unemployment problem is always a liquidity problem. In this way, fiscal policy, for instance, instead of being considered an impotent instrument (as in NCM), is indispensable to obtain long-term employment stability. It is a powerful tool to stimulate aggregate demand, triggering a multiplier effect on private income. Keynes recommended public expenditure or investment rather than increasing consumption, because of its stronger multiplier effect (see also Arestis and Sawyer, 2004, Chapter 8). Moreover, the NCM supposes that there is no obstacle to prevent the economy from achieving full employment in the long run. Arestis and Sawyer (2008, p.278), after analyzing the NCM model, argue ‘that at the aggregate level there is the equivalent of Say’s Law: potential supply (of labor) leads to actual supply of labor, and the resulting income is fully spent’. Alternatively, for Post Keynesians the economy cannot be understood without reference to the level of aggregate demand; this is

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important not only in the determination of the level of economic activity but also through its influence on the rate of investment (Arestis and Sawyer, 2005, p.956). Changes in the level of investment expenditures affect not only the level of aggregate demand through the investment multiplier, and hence the current level of employment, but also the equilibrium rate of unemployment, that is, the level of unemployment at which inflation is constant over time. Empirical evidences suggest that interest rate variations can have long-lasting effects over investment and the stock of capital, showing the long-run non-neutrality of monetary policy (Arestis and Sawyer, 2006, p.16). So, monetary authorities should be careful in using interest rate policy to face inflation pressures.

3. Some special features of emerging economies In global financial markets, financial market prices – including exchange rate – have been excessively volatile. Capital markets in emerging countries are thinner and more segmented than in developed countries, subject to shocks unrelated to domestic macroeconomic conditions and contagion. Emerging economies tend to be relatively more vulnerable to the consequences of exchange rate fluctuations than are developed economies. Exchange rate volatility is higher in emerging countries than in developed ones as the former have small and less liquid foreign exchange markets that make such economies more vulnerable to one-way expectations and herd behavior. Indeed they face problems related to the ‘asymmetric financial integration’ as emerging market economies have much larger and volatile capital flows compared to the size of their capital market and economies more generally (Grenville, 2000; Studart, 2002). In particular, exchange rates can influence inflation (‘exchange rate pass-through’) through the prices of traded final goods and imported intermediate goods, and their impact on agents’ inflation expectations. Ho and McCauley (2003, p.6) provide evidence that: (i) income is negatively and significantly correlated with pass-through as lower-income economies have a larger portion of traded goods in the consumption basket; (ii) ‘exchange rate pass-through has tended to be stronger in Latin America than in Asia even though Latin American [countries] are not necessarily more open than their Asian counterparts’. The explanation for such difference is that countries with histories of high inflation – as is the case in many Latin American countries – are more sensitive to exchange rate fluctuations, probably due to the existence of an inflationary memory (Eichengreen, 2002).

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Many emerging economies had experiences with high inflation and consequent price stabilization plans, in general, in countries that were impacted by 1980s external debt, as in the case of Latin American economies (Argentina, Brazil, Chile, Colombia, Mexico and Peru), or suffered problems related to transition to a market economy (Poland and Russia), while other economies did not have such intensive inflationary episodes, as typically was the case of the Asian emerging economies (Malaysia, South Korea, Thailand, etc.). In both groups countries that adopted ITR in most cases implemented it after currency crises. The implications of these findings on emerging countries’ ITR are clear and evident because of the risk that exchange rate volatility poses to emerging countries in pursuing their inflation targets. Indeed, Ho and McCauley (2003, p.22) report that of the 22 target misses by emerging countries in 1998–2002, 10 (45%) were associated with exchange rate moves of over 10% in the aggravating direction, i.e. six cases of overshooting related to large depreciations and four cases of undershooting to large appreciations. Alternatively, developed countries had only two of out nine target misses related to large exchange rate moves. After the liberalization of capital accounts, a general trend in the emerging countries since the end of the 1980s, the capacity of monetary policy to influence short-term interest rates for domestic purposes and resist exchange rate movements simultaneously was somehow eroded. In this connection, Tobin (1978) stated that the main macroeconomic problem related to integrated financial markets is not the choice of the appropriate exchange rate regime but the excessive short-run capital mobility that reduces the autonomy of national governments to pursue domestic objectives with respect to employment, output and inflation: ‘the mobility of financial capital limits viable differences among national interest rates and thus severely restricts the ability of central banks and governments to pursue monetary and fiscal policies appropriate to their internal economies’ (p.154). Under these conditions, economic authorities face some policy dilemmas. One potential dilemma is that inflation and exchange rate developments can be such that they call for opposite monetary policy action – for instance, using monetary policy to counter adverse exchange rate movements may jeopardize the inflation target, although frequently emerging market inflation target have in practice responded with some flexibility to the various challenges posed by exchange rate fluctuations, using not only monetary policy (Ho and McCauley, 2003). Mohanty and Scatigna (2005) report that a number of emerging countries relied

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on interest rate interventions to stem exchange rate volatility. The solution of some dilemmas of economic policy in emerging economies could be ‘solved’ by the use of non-traditional tools of economic policy, such as credit controls and capital controls. In general, interest rate policy when used for controlling aggregate demand for price stabilization purposes is less effective in emerging countries than in developed countries. There are two reasons for such a difference. First, the credit channel transmission mechanism of monetary policy is less effective in emerging countries than in developed ones. The main reason is that the ratio of credit to private sector over GDP is higher in developed countries, what means that in the latter monetary policy is more effective in affecting aggregate demand. Indeed, the ratio of credit to private sector over GDP during the 1990s (on average) was 84% in developed countries, while it was only 28% in Latin America, 26% in Eastern Europe and Central Asia, 12% in Middle East and North Africa – the only high standard in emerging countries was in East Asia and the Pacific, 72% (IADB, 2005, p.5). Secondly, due to the low development of stock market in most emerging countries, consumption expenditure is not sensitive to the wealth effect, as it is in the US, so that interest rate also has low impact on consumption through this channel.8 Consequently, monetary policy in some emerging countries should be tighter (interest rate should be higher) than in developed economies in order to affect aggregate demand; as a result, the sacrifice ratio of a deflation policy is frequently higher in emerging economies than in developed countries. Some empirical studies, for instance, Sarel (1996), show the existence of a minimum inflation rate below which growth rate is reduced. The reason for that is the nominal wage rigidity that prevails in labor markets. According to Tobin (1972) when there is downward nominal wage rigidity, inflation can help grease the wheels of labor market adjustment by facilitating relative wage and price adjustment in sectors with unemployment of labor force. So, a positive, although not so high rate of inflation, is necessary for robust economic growth. Padilha (2007), using a sample of 55 developed and under-developed countries in the period 1990–2004, replicated the methodology used by Sarel (1996) for a larger time span and showed that for emerging countries the minimum rate of inflation is 5.1% per year and for the developed countries is about 2.1% per year. The difference between the minimum level of inflation in emerging and developed countries is due to the fact that a higher rate of output growth in the former generates a higher rate of increase of prices of non-tradable goods relative to the observed in

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developed countries. This means that for emerging countries to have the same rate of inflation as developed countries, the rate of increase of prices of tradable goods must be higher in the latter. This requires a nominal exchange rate appreciation of emerging countries’ currency relative to developed countries’ currency, which can be done only by means of a tight monetary policy with harmful effects over investment and growth. Based on this reasoning we can state that the catching-up of emerging countries to developed countries demands, among other reasons, different target levels of inflation (Oreiro et al., 2009). Finally, we should note that emerging economies in general are more vulnerable to external shocks than developed economies. The empirical studies show that the impact of external shocks on domestic inflation is more intensive in emerging economies than in developed ones. Mohanty and Klau (2001), analyzing the experience of 14 emerging countries during the 1980s and 1990s, found that external supply shocks, in special food and energy prices, are important determinants of domestic inflation. Primary products have an important participation in the household’s consumption in emerging countries due to the patterns of consumption associated with relatively low incomes. Such prices are particularly volatile to climate and eventually geopolitics factors. We can extract three lessons from our discussion. The first one is related to the fact that emerging countries in general are more vulnerable to external shocks than developed countries. As a result, such economies are more prone to face issues related to cost-push inflation, such as due to exchange rate devaluation. The second lesson is that exchange rate considerations can be expected to play a more prominent role in emerging countries, considering the important influence of the exchange rate on domestic inflation in these countries. Consequently, exchange rate movements pose some essential challenges to emerging economies’ monetary authorities. On this, Goldstein (2002) suggests the adoption of a mixing of economic policies in what he denominated ‘managed floating plus’, in which the exchange rate variation would be managed in order to be compatible with the inflation targets. FerrrariFilho and Paula (2008), on the other hand, suggest that a managed floating exchange rate regime and imperfect capital mobility (capital controls) are more appropriate to emerging countries because they make possible the adoption of counter-cyclical economic policies, fiscal and monetary, necessary to permit macroeconomic stabilization. Some sort of managed floating exchange rates regime can be useful if the objective of the central bank is to reduce the exchange rate volatility and also influence somehow the real exchange rate for international

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trade purposes. A central bank intervenes in foreign exchange markets to achieve a variety of macroeconomic objectives, such as controlling inflation, maintaining external competitiveness and/or maintaining financial stability. Thirdly, as we have seen, a positive yet low inflation can help economic growth and reduce unemployment as it works as a mechanism of accommodation of the real disequilibria in the economy, due to supply shocks, negotiation of labor contracts, etc. This can ask for a more flexible arrangement of macroeconomic policy in case of emerging economies, if the objective is not to have low inflation and price stabilization at any cost – that is, at costs of having a lower economic growth. ITR is not the only economic policy framework for price stabilization purposes, as some emerging economies experiences show, for instance, China and India, in which economic policy have other purposes, such as exchange rate stability. Paula (2008), comparing economic policies in the BRIC countries (Brazil, Russia, India and China), shows that China, India and Russia, managing their exchange rate regimes with a restrictive capital account convertibility and making use of a more discretionary economic policy, have been successful, to greater or lesser degree, in cases of management of macroeconomic policy – in which the stability of exchange rate has a crucial role – that seek to create a stable environment for economic Table 2.1 Exchange rate regime and monetary policy framework of BRIC countries from 1999 to 2008 Country Exchange Monetary rate policy regime framework

Indicator of exchange rate

Capital Exchange account rate convertibility volatility

Brazil

Floating, with dirty floating

Inflation targeting

Nominal bilateral

High

High

China

Semifixed

Pegged exchange rate

Real effective

Partial, with many restrictions

Very low

India

Managed floating

Multiple indicators

Nominal bilateral and real effective

Partial, with many restrictions

Very low

Russia

Managed floating

Multiple indicators

Nominal bilateral

Partial, with some restrictions

Low

Source: Authors’ elaboration based on Mohanty and Scatigna (2005) and Paula (2008).

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growth. Economic policies in such countries aim at the preservation of a competitive and stable real exchange rate used as an intermediate target of macroeconomic policies oriented to employment and growth objectives. In particular China’s and India’s cases show how it is correct to implement a gradual and careful management of capital account and policies oriented towards the reduction of external vulnerability. Russia is an interesting case as the economy, until 1998, performed very badly as a result of a chaotic transition process of liberalization to a market economy; since the 1998 crisis the economy has performed very well, due to both the increase in the exports (as a result of the rise of oil prices) and the better management of macroeconomic policy, that has combined a more stable exchange rate with decreasing interest rates. However, due to the country’s dependence on oil and gas exports, Russia has suffered greatly with the world recession that followed the 2008 financial crisis. Brazil, on the other hand, has adopted a more liberal and orthodox economic policy, more in accordance with NCM, that includes a less interventionist approach related to exchange rate policy, a very open capital account and, since 1999, the operation of an inflation targeting regime that has resulted in higher exchange rate volatility, higher interest rates, and a poorer economic performance compared with other BRIC countries, mainly China and India.9 Table 2.1 shows a comparative synthesis of the analysis of the macroeconomic policy of each BRIC country.

4. Conclusion This chapter presented some critical issues related to NCM and ITR based on the Post Keynesian theory. Further, it compared the experience of emerging countries that have adopted this economic policy framework (NCM and ITR) with other emerging countries that have implemented an alternative economic policy. The implications that emerge from this analysis are clear. One should be careful in the adoption of NCM style of economic policy in emerging economies, as it can inhibit some necessary flexibility in the economic policy and at the same can constrain economic growth. Experiences of the ‘big’ emerging economies – the so-called BRICs – show that countries with better economic performance (China and India) have not followed economic policies related to the NCM. Such countries have adopted a gradual path of economic liberalization and have sought to implement a more autonomous economic policy. More importantly, they have defined economic policies as part of their own project of national development.

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Notes 1. For more information on New Keynesian Theory, see Snowdon and Vane (2005, Chapter 7). 2. An analysis on the transmission channel from exchange rate to inflation in Brazil can be observed in Arestis et al. (2009). 3. For more information on ‘Ricardian equivalence’ see, for instance, Barro (1974). 4. According to Arestis and Sawyer (1998, p.181), Keynesian policies can be defined as follows: ‘policy implications arise from the perception of the role of aggregate demand in setting the level of economic activity and the lack of automatic forces leading a market economy to full employment’. So, a laissez-faire market economy exhibits normally elements of instability and, importantly, does not create a level of aggregate demand consistent with full employment. 5. For the essential properties of money in Keynes’s (1964) theory, see Chapter 17 of The General Theory of Employment, Interest and Money. 6. In an ergodic stochastic process the expected value of a probability distribution can be always estimated from past observation. See, for instance, Davidson (2002, Chapter 3). 7. For unemployment models in a New Keynesian view, see, for instance, Mankiw and Romer (1991). 8. According to IADB (2005, p.5), the ratio ‘credit and market capitalization over GDP’ during the 1990s was 149% in developed countries, 48% in Latin America, 38% in Eastern Europe and Central Asia, 80% in Middle East and North Africa – and again the only exception in emerging countries was East Asia and the Pacific, 150%. 9. Looking at the GDP growth performance of the BRIC countries, since 1990, one can see that GDP growth has differed among the countries: average GDP growth on average in China in 1990–2007 was 10%, in India 6.4%, Brazil 2.5% and Russia 2%. If we compare the BRIC countries only in the recent period (1999–2007), that is, after the Russian crisis and after Brazil’s implementation of ITR, the economic performance changes: 9.7% in China, 7.1% in India, 7% in Russia and 3.1% in Brazil. The average inflation (consumption price index) in 1999–2007 was 7.3% in Brazil, 22.2% in Russia, 4.5% in India, and 1.3% in China (IMF, 2009).

References Arestis, P. and Sawyer, M. (1998). ‘Keynesian economic policies for the new millennium’. Economic Journal, 108, pp. 181–95. Arestis, P. and Sawyer, M. (2004). Re-examining Monetary and Fiscal Policy for the 21st Century. Cheltenham: Edward Elgar. Arestis, P. and Sawyer, M. (2005). ‘Aggregate demand, conflict and capacity in the inflationary process’. Cambridge Journal of Economics, 29: 959–74. Arestis, P. and Sawyer, M. (2006). ‘Interest rates and the real economy’. In: C. Gnos, and L.P. Rochon (eds). Post Keynesian Principles of Economic Policy. Cheltenham: Edward Elgar.

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Luiz Fernando de Paula and Fernando Ferrari 33 Arestis, P. and Sawyer, M. (2008). ‘The New Consensus Macroeconomics: an unreliable guide for policy’. Revista Análise Econômica, 26(50): 275–95. Arestis, P., Ferrari Filho, F. and Paula, L.F. (2009). ‘A nova política monetária: uma análise do regime de metas de inflação no Brasil’. Economia e Sociedade, 18(1):1–30. Barro, R.J. (1974). ‘Are governments’ bonds net wealth?’. Journal of Political Economy, 81: 1095–117. Bernenke, B., Laubach, T., Mishkin, F. and Posen, A. (1999). Inflation Targeting: Lessons from the International Experience. Princeton: Princeton University Press. Carvalho, F.C. (1992). Mr. Keynes and the Post Keynesians: Principles of Macroeconomics for a Monetary Production Theory. Cheltenham: Edward Elgar. Clarida, R., Galí, J. and Gertler, M. (1999). ‘The science of monetary policy: a new Keynesian perspective’. Journal of Economic Literature, XXXVII:1661–707. Davidson, P. (1994). Post Keynesian Macroeconomic Theory: A Foundation for Successful Economic Policies for the Twenty-first Century. Cheltenham: Edward Elgar. Davidson, P. (2002). Financial Markets, Money and the Real World. Cheltenham: Edward Elgar. Eichengreen, B. (2002). ‘Can emerging markets float? Should they inflation target?’ Central Bank of Brazil Working Papers Series, No 36. Ferrari-Filho, F. and Paula, L.F. (2008). ‘Exchange rate regime proposal for emerging countries: A Keynesian perspective’. Journal of Post Keynesian Economics, 31: 227–48. Goldstein, M. (2002). ‘Managed floating plus’. Policy Analysis in International Economics, No 66. Washington: Institute for International Economics. Grenville, S. (2000). ‘Exchange rate regime for emerging countries’. Reserve Bank of Australia Bulletin. Sydney: Reserve Bank of Australia, November. Ho, C. and McCauley, R. (2003). ‘Living with flexible exchange rates: issues and recent experience in inflation targeting emerging market economies’. BIS Working Paper, No 130. IADB – Inter-American Development Bank (2005). Unlocking Credit: The Quest for Deep and Stable Bank Lending. Washington: Inter-American Development Bank. IMF – International Monetary Fund (2009). International Financial Statistics. Washington: IMF. Keynes, J.M. (1964). The General Theory of Employment, Interest and Money. New York: HBJ Book. Mankiw, N.G. and Romer, D. (1991) (eds). New Keynesian Economics. Cambridge: MIT. Mishkin, F.S. (2000). ‘What should central banks do?’. Federal Reserve Bank of St Louis Review, 82(6): 1–13. Mohanty, M. and Klau, M. (2001). ‘What determines inflation in emerging market economies?’. BIS Papers, No 8. Mohanty, M. and Scatigna, M. (2005). ‘Has globalization reduced monetary policy independence?’. BIS Papers, No 23. Oreiro, J.L., Paula, L.F. and Squeff, G. (2009). ‘Flexibilização do regime de metas de inflação em países emergentes: uma abordagem pós-keynesiana’. In: J.L. Oreiro, L.F. Paula and R. Sobreira (eds). Política Monetária, Bancos Centrais e Metas de Inflação. Rio de Janeiro: Editora FGV. Padilha, R. (2007). Metas de Inflação: experiência e questões para os países em desenvolvimento. Masters Dissertation. Curitiba: Federal University of Paraná.

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Paula, L.F. (2008). ‘Financial liberalization, exchange rate regime and economic performance in the BRICs countries’. In P. Arestis, and L.F. Paula (eds). Financial Liberalization and Economic Performance in Emerging Countries. Basingstoke: Palgrave Macmillan. Sarel, M. (1996). ‘Nonlinear effects of inflation on economic growth’. IMF Staff Papers 43: 199–215. Snowdon, B. and Vane, H.R. (2005). Modern Macroeconomics: Its Origins, Development and Current State. Cheltenham: Edward Elgar. Studart, R. (2002). ‘Financial integration, instability and macroeconomic performance in the 1990s’. In R. Fendt, and M.A.T. Lins (eds). Uneven Architecture. Rio de Janeiro: Konrad Adenauer Foundation. Taylor, J. (1993). ‘Discretion versus policy rules in practice’. Carnegie-Rochester Conference Series on Public Policy, 39:195–214. Tobin, J. (1972). ‘Inflation and unemployment’. American Economic Review, 62: 1–18. Tobin, J. (1978). ‘A proposal for international monetary reform’. Eastern Economic Journal, 4: 153–9.

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3 Inflation Targeting in Canada: Myth versus Reality Mario Seccareccia and Marc Lavoie

Introduction We have known Philip Arestis for over two decades since we first met in the mid-to-late 1980s just at the time when his research contributions in Post-Keynesian economics had taken off to achieve significant international recognition and success, notably his early collaborative work with Alfred Eichner and Malcolm Sawyer. Over this quarter century, since the early years at the Thames Polytechnic (now the University of Greenwich), we have seen his work proliferate and achieve prominence in many areas of economic analysis. Like that of many other PostKeynesian writers, Philip’s research has been highly versatile, albeit with a strong penchant for macroeconomic policy issues. However, unlike many Post-Keynesians of his generation, his research also shows a strong empirical bent. Indeed, because of his important applied work, he is the only Post-Keynesian, to our knowledge, from whom our own Bank of Canada has actually sought advice and invited him to Ottawa for consultation. It is, therefore, because of this strong research interest in central banking that we have chosen to delve into the issue of monetary policy both on the theoretical and empirical fronts, namely the policy of inflation targeting as implemented in Canada since February 1991. Ever since it was officially pioneered in New Zealand, during the 1990s, inflation targeting seems to have achieved unprecedented popularity among central bankers. Some analysts have even described this phenomenon as giving rise to a new unplanned/spontaneous international order in opposition to the Bretton Woods system in providing a stable international monetary system under floating exchange rates, without a centre country, the IMF or gold (Rose, 2006). In contrast to older systems that relied on gold exchange systems or, more broadly, 35

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fixed exchange rates that would pressure countries to adopt in the long run the inflation rate of the hegemonic centre country, approximately two dozen countries from both the industrialized and developing world now have central banks that are officially committed to achieving inflation targets. While virtually all central bankers subscribe officially to some wide notion of price stability, over the last two decades the new ‘inflation targeters’ pushed their broad mandate one notch further by setting a precise numerical value (usually a 2 percent target) accompanied by a narrow target range (of plus or minus 1 percentage points). The Bank of Canada joined the inflation targeters very early in 1991. At the time, Canada’s inflation rate did see a significant fall from 5.6 percent in 1991 to 1.5 percent in 1992 and, since then, has been gravitating around a 2 percent rate. However, as it will be analysed below, the causality is somewhat debatable. The object of this chapter is to assess the effects of almost two decades of inflation targeting by looking primarily at the Canadian experience. What does inflation targeting at the Bank of Canada do that other central banks still committed officially to the more traditional goals of high employment and price stability do not, as exemplified by the mandate of the US Federal Reserve System that is still guided, say, by the goals established under the Humphrey-Hawkins Full Employment and Balanced Growth Act? We shall see that, while there is clear evidence that inflation rates have fallen in most countries internationally since the early 1990s, there is no strong evidence to support the view that inflation targeters have performed any better than non-inflation targeting countries. It would appear that inflation targeters, such as Canada, merely rode the coat-tail of an international economy that experienced disinflation after the inflationary shocks of the 1970s and early 1980s. The evidence suggests that inflation targeting played no significant explanatory role in the disinflation with the exception of its effect in possibly slowing down wage growth to a rate below what the level of capacity utilization and inflation would have predicted.

The nature of inflation targeting Inflation targeting (IT) is the lineal descendant of a monetary policy framework going back to the views of Knut Wicksell over a century ago in which the central bank is assumed to set interest rates in such a way as to achieve a desired rate of inflation (Seccareccia, 2008). As pointed out by Svensson (2008), this normally entails (1) an announced numerical

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Mario Seccareccia and Marc Lavoie 37

inflation target; (2) an inflation forecast; and (3) a highly transparent mechanism through which the inflation target can be achieved, usually in the form of a precisely defined transmission mechanism of monetary policy, going from the operational target to the inflation outcome, of the type specified at the web site of the Bank of Canada (http://www. bankofcanada.ca/en/monetary_mod/index.html). This framework can be easily presented in the simplest ‘New Consensus’ three-equation framework (as discussed in Arestis and Sawyer, 2004, 2008), which includes an aggregate demand relationship (with a real interest rate as argument), an augmented Phillips curve relationship that incorporates potential output as well as inflation expectations (including a change of cost variable in some specifications), and finally a central bank reaction function that sets the real rate of interest, based on a target inflation rate and the gap to potential output. All central banks have inflation as principal argument in their reaction function nowadays – that is, they react to inflation by raising interest rates in times when inflation is accelerating or high relative to the target and they pursue lower interest rate policy in times of low and decelerating inflation. Inflation targeters have gone a step further than the neo-Wicksellian approach by arguing that the official targeting ‘locks in’ inflation expectations to the target rate (see Arestis and Sawyer, 2008). Hence, the added feature is that, whenever there is a shock to the inflation rate, not only does the central bank stand ready to combat inflation through higher doses of interest rates, but inflation expectations are assumed to revert automatically back to the fixed inflation anchor. For instance, in Canada, it is almost an article of faith in every central bank quarterly monetary policy report that inflation expectations are assumed to remain well anchored at their 2 percent inflation target because of the Bank of Canada’s official commitment (Bank of Canada, 2009: p. 14). This is a litany well recited internationally from the proponents of IT, who repeatedly refer to the ‘lock in’ effect of the preannounced inflation target. For instance, referring to the anchoring of expectations in the face of inflationary shocks, Bernanke et al. (1999) point to various instances internationally: We saw this (‘lock in’) effect, for example, following the exits of the United Kingdom and Sweden from the European Exchange Rate Mechanism and after Canada’s 1991 imposition of the Goods and Services Tax. In each case, the re-igniting of inflation seems to have been avoided by the announcement of inflation targets that helped

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to anchor the public’s inflation expectations and to give an explicit plan for and direction to monetary policy. (Bernanke et al. 1999: p. 288) Hence, despite the exchange rate and tax shocks to the British, Canadian and Swedish economies in the early 1990s, in the above quote, central banks were able to keep a tight lid on the rate of inflation by means of a hard dose of IT policy that anchored inflation expectations to the target level. In terms of the three-equation framework previously mentioned, the implementation of IT policy could impact on either the Phillips curve equation, by modifying the expected inflation term, or the reaction function equation of the central bank, by modifying the weights attached to the inflation gap and the output gap or by affecting its general structure. However, in either case, the effect would be some downward shift in the rate of inflation. Indeed, given its significance in modifying a key parameter in the inflation equation, namely inflation expectations, the emphasis is on a communication strategy that emphasizes transparency and credibility. Hence, an official target adopted by parliament is helpful in instilling public confidence that the central bank is serious and committed to its inflation target and therefore anchors expectations. As former Governor David Dodge (2005) put it so succinctly: ‘With inflation targeting, our policy is more focused, our communications are clearer, and Canada’s inflation expectations are more solidly anchored.’ (Dodge, 2005: p. 5). In much the same way, in order to make its reaction function more predictable and transparent, in 2000 the Bank of Canada adopted a procedure of eight pre-announced dates per year when it meets in order to discuss changes in its target overnight rate to achieve the inflation target whose effect on the rate inflation rate is supposed to work itself out over a period of 18 to 24 months. Hence, we have here a two-pronged approach, with the communications strategy playing an essential role in modifying the expected inflation term of the Phillips Curve equation, and with a possible change in the nature of the reaction function that, for instance, places more weight on combating inflation.

Inflation guideposts versus inflation targets: is there a difference? Those who are familiar with early postwar incomes policies to deal with the problem of inflation would find a great deal of the discussion

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Mario Seccareccia and Marc Lavoie 39

about influencing inflation expectations in the context of IT policy quite familiar. This is because much of the literature in controlling inflation through voluntary guidelines or ‘guideposts’, that goes back to the 1960s, dealt with a similar problem of setting a norm for micro wage and price determination that would then serve as an anchor for aggregate price formation. The most well known of these were the Kennedy–Johnson Guideposts from 1962 to 1966, the British Prices and Incomes Board from 1965 to 1970 and, in Canada we had the Prices and Incomes Commission that lasted from the end of 1968 to 1972. These 1960s and early 1970s brand of incomes policies prior to the first oil price shock were quite similar – all communicated a target for prices and incomes growth, with the latter often tied to some long-term productivity growth norm. Unlike the current IT policies that justify their norm on the basis of the possible positive effects that IT can have in raising economic efficiency and general living standards, the earlier policy concern was to set an anchor that could be justified primarily on income distribution grounds and equity considerations resulting from the uneven effects of high inflation on income distribution. Given their popularity and long history of governments tinkering with incomes policies, one ought not to be at all surprised that the first attempt to implement inflation targeting came not as a result of careful analysis steeped in neoclassical monetary theory by the Reserve Bank of New Zealand. Few economists were immersed in Wicksellian theory at the time. As pointed out by Rowe (2010), it would appear that in 1990, after years of trying to deal with the fallout of a crippling currency crisis during the 1980s, the government of New Zealand was simply trying to implement a public sector incomes policy by seeking to set numerical targets on the various departments of government, including the central bank (see also Fischer, 1995: p. 36). In the process, there came the idea that the central bank could serve as a strategic instrument to extend the numerical targets that were being imposed on the public sector agencies to the entire economy via an inflation target. In that sense, it may be said that, from its origin, IT was conceived by policy makers as just another type of incomes policy in the traditional sense of a guidepost that could modify expectations of inflation, or as stated by Bernanke et al. (1999) inflation targeting in New Zealand in 1990 ‘was timed less to promote disinflation than to forestall a rise in inflationary expectations once monetary policy began to ease.’ (Bernanke et al. 1999, p. 91) The connection with Wicksellian analysis followed later, especially as other central banks, such as the Bank of Canada (1991)

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and the Bank of England (1992), sought to emulate by supplying a more explicit theoretical justification consistent with the emerging New Consensus framework. However, there was one fundamental difference between the original guideposts and IT. Unlike voluntary guidelines, through its reaction function the central bank could always slow down the economy in order to try to get the actual rate of inflation in line with the inflation target. Some would say that this could be achieved through a compulsory type of incomes policy, one based on fear (Cornwall, 1990), by slowing down the economy through doses of higher real interest rates and greater unemployment – that is to say, a perverse incomes policy that raises the income of one group, the rentiers, while slowing the income growth especially of wages earners. Unlike voluntary guidelines, the central bank can also supposedly achieve the inflation target by means of interest rate policy. Hence, through its enforcement capacity, it was assumed that IT would be more efficient in achieving its goal than traditional income policies of the guidepost variety. At the same time, it could achieve its target inflation rate with the political approval of parliament but without the legal restrictions and enforcement provisions required by compulsory incomes policies, which invariably are faced with political and legal challenges from trade unions. This is why IT has had such appeal in societies where fear of inflation had driven policy makers to experiment with new institutional policy structures that would be politically more palatable than the older forms of incomes policy. IT was certainly old wine but mixed seemingly with a more potent new beverage in a flashy new bottle. The IT policy contained the anti-inflation ‘carrot’ – with its voluntary guidelines – as well as the ‘stick’ –with the looming central bank threat to slow down the economy through Wicksellian policy if the well-publicized inflation target became ineffective in modifying inflation expectations. It was this political appeal that assured its quick adoption in numerous countries regardless of whether central banks were constitutionally independent or not. But, did this new IT policy actually work?

Assessing the effectiveness of IT policy: The case of Canada If one examines IT countries individually, especially the pioneering IT countries during the early 1990s, such as New Zealand, Canada, the UK, Sweden and Australia, IT countries fared better on the inflation front when comparing their performance during the pre-IT and the post-IT

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Mario Seccareccia and Marc Lavoie 41 16

Percent

12

8

4

0

−4 1970

1975

1980

1985

1990

1995

2000

2005

Canada inflation rate Canada inflation - U.S. inflation Figure 3.1 Evolution of Canadian CPI and inflation gap between Canada and the United States, 1967–2008 Source: Statistics Canada, CANSIM; and St. Louis Fed, FRED.

periods. For instance, if one looks at Figure 3.1, which traces Canada’s inflation rate, the post-1991 shaded area depicts a dramatically different behaviour for the rate of change in the Canadian CPI. The pre-1991 era is characterized by greater volatility and higher rates of inflation than the post-1991 IT period, although Figure 3.1 also shows that inflation rates between 1983 and 1991 had already stabilized around 4 to 5 percent. In addition, it is not at all obvious that the adoption of IT in 1991 led to the sharp fall in the inflation rate. The two major recessions of 1981–82 and 1990–91 in Canada undoubtedly played a major role in the process of disinflation from peak inflation following the second oil price shock in the early 1980s. Unless one controls for other factors that could have contributed to the decline, one could hardly conclude that IT was the causal factor behind the post-1991 low inflation environment. Our doubt as to the importance of IT is further strengthened when doing cross-country comparisons of IT and non-IT countries. The nonIT countries generally also improved their performance during the same period, thereby suggesting that there may have been other forces at work in the international economy that were slowing down the pace

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of inflation. There is, for instance, the well-known, yet controversial, study by Ball and Sheridan (2005) that compared 20 OECD countries and affirmed that there was no strong evidence that inflation targeting improved performance when measured by the behaviour of inflation, output and interest rates. Their conclusion was that most of the IT countries simply had higher inflation rates than the non-IT countries, thereby resulting in a regression to the mean during the IT era. Other studies, such as Dotsey (2006), have given stronger support for the IT effect when comparing 11 countries from 1982 to 2004; but even there, the latter was somewhat cautious in his conclusions since inflation (and output) volatility declined for both sets of countries. To some extent, this can be seen when observing the Canada–US inflation rate gap in Figure 3.1 for the pre- and post-IT periods. At the superficial level it would appear that IT did make a substantial difference with the persistence of a negative inflation gap between Canada and the United States during much of the period following its policy adoption in February 1991. However, most of the decline in the gap took place during the 1980s and the fall in the gap in the 1990s could just as easily be attributed to the much lower growth performance in Canada vis-à-vis the US for most of the post-IT period. Hence, survey articles, such as that of Dueker and Fischer (2006), have concluded that it is hard to infer that ‘formal inflation targets have led to any divergence between targeters and non-targeters in terms of inflation performance’ (Dueker and Fischer, 2006: p. 448). To evaluate the effect of IT policy on inflation performance, we have conducted some fairly simple regression analysis that was fashionable during the 1970s in evaluating the impact of incomes policies using empirical observations from two countries, Canada and the US, by testing the ‘policy on’ versus the ‘policy off’ periods using standard dummy variables. While both central banks have multi-goal mandates of achieving low inflation and high growth and employment, the Bank of Canada has an additional renewable mandate from parliament to pursue inflation targeting since February 1991. To assess the impact of IT policy, we have estimated a standard price adjustment equation whereby the rate of change of the CPI depends on the usual variables pertaining to the demand and supply sides, namely the rate of capacity utilization in the business sector, the rate of change of unit labour costs, and the rate of change of raw materials or producers’ price index. These equations were estimated using Canadian and the US annual observations both separately, and as ratios, so as to see if the relative changes between the two countries mattered empirically (with all regressions necessitating correction for first and/or second-order autocorrelation).

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Table 3.1 Inflation regressions, Canada and United States 1977–2008 CANADA

Constant Term

Dummy

Lagged Dependent Variable

Inflation

⫺4.246 (⫺0.50)

⫺0.339 (⫺0.49)

0.605 (4.0)

Inflation

⫺5.965 (⫺0.68)

⫺0.120 (⫺0.19)

0.669 (4.28)

UNITED STATES

Constant Term

Dummy


Capacity Utilization

Unit Labour Cost

Raw Material Input Prices

Adjusted R2

D.W.

0.056 (0.59)

0.390 (4.19)

0.017* (1.00)

0.872

2.32

0.072 (0.73)

0.377 (4.06)

0.016* (0.41)

0.855

1.98

-0.212 (-0.94)


Unit Labour Cost


Adjusted R2

D.W.

AR(1)

AR(1)

AR(2)

AR(2)

1.741 (2.28)

⫺1.131 (⫺1.85)

0.324 (2.95)

⫺0.065* (0.85)

0.216 (2.01)

0.308 (5.51)

0.930

1.67

0.392 (1.56)

Inflation

1.643 (2.56)

⫺0.923 (⫺1.96)

0.379 (3.71)

⫺0.060* (⫺0.96)

0.185 (2.13)

0.244 (4.84)

0.931

2.23

0.517 (2.38)

⫺0.390 (⫺2.04)



Unit Labour Cost


Adjusted R2

D.W.

AR(1)

AR(2)

0.080

2.15

⫺0.484 ⫺0.320 (⫺2.21) (⫺1.49)

0.057

2.18

⫺0.497 ⫺0.336 (⫺2.24) (⫺1.53)

RATIOS CANADA/ US

Constant Term

Dummy

Inflation Ratio*

⫺0.244 (⫺0.19)

⫺0.041 (⫺0.40)

0.253 (0.20)

0.042* (1.53)

0.012* (0.50)

Inflation Ratio*

0.671 (0.37)

⫺0.057 (⫺0.54)

⫺0.215 (⫺0.15)

0.041* (1.46)

0.011* (0.46)

Can./US Exchange Rate

⫺0.549 (⫺0.70)

Note: * I(1) series specified in first difference; all other variables were I(0) series according to the standard ADF test in EViews. Sources: Statistics Canada, CANSIM V142812, V1576432, V29509282, V41693271, V4331081, V720956, V735319 and US Bureau of Labor Statistics, on consumers’ and producers’ prices indexes and unit labor costs and the Federal Reserve Bank of St. Louis, FRED on capacity utilization.

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43

Inflation

44


The Canadian inflation rate can be explained by two key variables, the rate of change of unit labour costs and the lagged value of the dependent variable – that is, labour costs and inertia effects (the latter capturing what is sometimes referred to as ‘inertial inflation’ (BressererPereira, 2002–03)) – with none of the other variables being empirically significant, including the dummy variable. In the US, on the other hand, with the exception of the capacity utilization variable, all variables were statistically significant, including (surprisingly) the dummy variable (see the t-ratios in parentheses below the estimated coefficient). Undeniably, this cannot be the outcome of any competitive spillover effect from Canadian enterprises, since business pricing behaviour in Canada did not appear to change as a result of the adoption of IT. The evidence may actually imply that there was perhaps a common third factor impacting on prices and labour cost growth in both Canada and the US, perhaps via globalization, particularly in the context of the North American Free Trade Accord (NAFTA), but with a greater depressing effect on the rate of inflation in the US since the early 1990s. Moreover, the fact that the dummy variable was significant for US data but not for Canadian observations would suggest that IT played no significant role in the evolution of prices in Canada outside of its possible effects on labour costs (to be discussed below). Finally, when specified in ratios with Canada–US inflation ratios being the dependent variable, the regression results are much poorer, with only the ratio of unit labour costs being just below the borderline of statistical significance. Also, consistent with evidence of limited pass-through effect, Canada/ US exchange-rate variation was not statistically significant in the latter relative inflation equation. If implementation of IT policy in Canada had little impact on the price adjustment relation, could it be instead that the adoption of IT affected the nature of the reaction functions between the two countries? For instance, as shown in Figure 3.2, the gap between the real rates set by the Bank of Canada and the US Federal Reserve was positive on average during the IT period despite the sharp fall following the 1990–91 recession in Canada. Indeed, could it be that its gentle rise since the late 1990s reflects a general tightening of Canada’s monetary policy as it sought to keep the inflation rate steady within the official target range? To test whether there was a change in the reaction function, we have estimated a standard Taylor rule regression equation, with the overnight rate and the Federal Funds rate as dependent variables for Canada and the US respectively in Tables 3.2(a) and 3.2(b). Moreover, we have

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Mario Seccareccia and Marc Lavoie 45 6

4

Percent

2

0 −2 −4 −6 1970

1975

1980

1985

1990

1995

2000

2005

Real Central Bank rates gap Figure 3.2 Canadian Overnight Rate and the US Federal Fund Rate Gap in Real Terms, 1967–2008 Source: Statistics Canada, CANSIM: St Louis Fed, FRED.

the inflation rate as argument in the reaction function, with the use of ‘core’ inflation for the post-1991 period, which excludes the most volatile components of the CPI (mainly food and energy prices) so as to take account of the fact that they began targeting the latter and not the general CPI rate of growth, with the usual interpretation of the coefficient of inflation (of the estimated value of the coefficient plus unity). We also have some measure of the output gap as explanatory variable. However, for the measure of the output gap, there is no official estimate publicly available from the Bank of Canada before 1985. Therefore, we have considered two related series that could serve as proxies. We have estimated the reaction function using the capacity utilization of the business sector (measured by Statistics Canada and identical to the series used in our inflation regressions of Table 3.1) and we have also used a modified ‘output gap’ series measured as the difference between the actual and the trend capacity utilization rates (the latter was calculated by using the standard Hodrick-Prescott filtering process). For the post-1991 period, we have replaced our calculated output gap with the actual estimate from the Bank of Canada, which does not exist for most of the pre-1991 period. Moreover, different tests were done for Canada

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46


and the US for both the pre- and post-1991 periods, as well as introducing a dummy variable (during the ‘policy on’) for the regressions for the entire period of the series. Empirical evidence presented in Tables 3.2(a) and 3.2(b) suggests that, while the Taylor specification fits reasonably well the US data, the evidence for Canada is rather weak. Indeed, in Table 3.2(a), neither the dummy nor the two indicators of the output gap are significant. By contrast, the inflation rate is generally significant, and the actual Bank of Canada output gap, measured ex post however, was also statistically significant for the post-1991 period of IT. In the case of the US (in Table 3.2(b)), we have fairly solid empirical evidence of the appropriateness of the Taylor rule in approximating the reaction function of the Federal Reserve. The statistical weakness of the dummy variable indicates that the US Fed did not much change its policy since the early 1990s. Given the weakness of the Taylor rule specification for Canada, an attempt was made to see if an alternative specification would better capture the behaviour of Canada’s central bank in setting its overnight rate. In addition to adding the lagged dependent variable, we also introduced the US Federal Funds rate to explain Canada’s overnight rate. Once the US rate was added, the results presented in Table 3.2(c) were quite devastating for the IT supporters in Canada. None of the traditional variables found in a standard Taylor rule equation were statistically significant in Canada. On the other hand, the past value of interest rates (the inertia effect) and the changes in the US Federal Funds rate dominate. These statistical findings are particularly problematic for IT supporters in Canada who have often emphasized the virtues of IT policy cum floating exchange rate. It would appear that, although with a freely floating exchange rate the monetary authorities can pursue an independent interest rate policy, in practice they continue to eye US rates when setting Canadian interest rates! Although the evidence seems to be quite overwhelming that IT policy did not have a significant effect on either the pricing behaviour of business enterprises or the reaction function of the central bank, it may still be true, like most incomes policies, whether voluntary or enforced by law, that the consequence is primarily on labour income. By impacting on labour costs, the effect is then indirectly transmitted to the rate of inflation. Did IT policy in Canada slow down wage inflation separately from the other factors that would normally impact on wage growth, namely demand factors (captured by the rate of capacity utilization) and inflation (current or past)? To estimate this possible indirect effect through the channel of wage costs, we ran a few regressions for both

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Table 3.2a Taylor Rule reaction functions, Canada 1967–2008 and sub-periods 1967–90 and 1991–2008 Dependent Variable Overnight Rate 1967–2008 Overnight Rate 1967–2008 Overnight Rate 1967–2008 Overnight Rate 1967–2008 Overnight Rate 1967–1990 Overnight Rate 1991–2008 Overnight Rate 1967–1990 Overnight Rate 1991–2008

Constant Term ⫺4.158 (⫺0.49) 3.416 (2.24) ⫺0.422 (⫺0.05) 5.258 (2.76) ⫺0.556 (⫺0.05) ⫺3.63 (⫺0.24) 6.869 (2.29) 2.399 (1.70)

Dummy Variable

⫺2.523 (⫺1.59) ⫺2.346 (⫺1.41)

Inflation Rate 0.740* (3.91) 0.807* (3.92) 0.610* (2.97) 0.671* (2.96) 0.596 (2.30) ⫺0.070* (⫺0.08) 0.594 (2.30) 0.375* (1.56)


Output Gap

0.097 (0.97) 0.087** (1.10) 0.075 (0.74) 0.065** (0.81) 0.091 (0.71) 0.092 (0.52) 0.095 (0.73) 0.638* (3.29)

Adjusted R2

D.W.

AR(1)

0.783

1.69

0.787

1.69

0.792

1.70

0.793

1.72

0.635

1.66

0.257

1.98

0.635

1.66

0.569

2.40

0.784 (7.29) 0.784 (7.03) 0.760 (6.40) 0.774 (6.29) 0.822 (5.00) 0.507 (3.07) 0.825 (4.97) 0.763 (6.51)

AR(2)

Notes: * For period between 1991 and 2008, the rate of change of CPI was replaced by the Bank of Canada Core CPI. The actual Bank of Canada measure of the output gap was used for the post-1991 period. ** I(1) series, variable specified in first difference; all other variables were I(0) series according to the standard ADF test in EViews. Source: Statistics Canada, CANSIM V39050, V41693242, V735319, V41693271, and V4331081.

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Table 3.2b Taylor Rule reaction functions United States 1967–2008 and sub-periods 1967–90 and 1991–2008 Dependent Variable Federal Funds 1967–2008 Federal Funds 1967–2008 Federal Funds 1967–2008 Federal Funds 1967–2008 Federal Funds 1967–1990 Federal Funds 1991–2008 Federal Funds 1967–1990 Federal Funds 1991–2008

Constant Term Rate Rate Rate Rate Rate Rate Rate Rate

2.556 (2.53) 2.531 (2.47) 3.318 (2.47) 3.291 (2.43) ⫺21.903 (⫺2.20) ⫺45.090 (⫺4.82) 5.537 (3.51) ⫺0.943 (⫺0.67)

Dummy Variable

⫺1.035 (⫺0.89) ⫺1.040 (⫺0.88)

Inflation Rate


0.821* (5.12) 0.818* (5.08) 0.765 (4.23) 0.764* (4.21) 0.503 (2.64) 2.160* (3.76) 0.471 (2.46) 2.031* (3.46)

0.197** (2.92)

Output Gap

0.195** (2.89) 0.185** (2.59) 0.184** (2.56) 0.335 (2.79) 0.554 (4.57) 0.365 (3.10) 0.600 (4.73)

Adjusted R2

D.W.

0.814

1.71

0.813

1.71

0.813

1.75

0.812

1.75

0.712

1.82

0.783

1.78

0.731

1.80

0.788

1.62

AR(1) 1.068 (6.14) 1.070 (6.12) 1.028 (5.62) 1.028 (5.58) 1.200 (4.59) 0.823 (6.11) 1.184 (4.86) 0.769 (4.18)

Notes: * For period between 1991 and 2008, the rate of change of CPI was replaced by the CPI less food and energy in the US. ** I(1) series, variable specified in first difference; all other variables were I(0) series according to the standard ADF test in EViews. Source: Federal Reserve Bank of St. Louis, FRED.

Sawyer

AR(2) ⫺0.402 (⫺2.23) ⫺0.396 (⫺2.20) ⫺0.390 (⫺2.06) ⫺0.383 (⫺2.02) ⫺0.443 (⫺1.79)

⫺0.497 (⫺2.07)

Table 3.2c Modified Taylor Rule reaction functions, Canada 1967–2008 and sub-period 1991–2008, with lagged dependent variable and US interest rate effect Dependent Variable

Constant Term

Overnight Rate 1967–2008 Overnight Rate 1967–2008 Overnight Rate 1967–2008 Overnight Rate 1991–2008 Overnight Rate 1991–2008 Overnight Rate 1991–2008

⫺21.818 (⫺2.61) 14.672 (2.11) ⫺9.294 (⫺1.31) ⫺1.334 (⫺0.10) 9.942 (0.91) 4.225 (0.41)

Dummy Variable ⫺0.600 (⫺0.81) ⫺1.935 (⫺1.69) ⫺0.410 (⫺0.70)

Lagged Dependent variable 0.773 (7.77)

0.518 (5.43) 0.522 (2.71)

0.359 (2.27)

Core Inflation Rate 0.326 (2.88) 0.004 (0.02) 0.051 (0.47) ⫺0.438 (⫺0.47) ⫺0.098 (⫺0.16) 0.152 (0.20)

Capacity Utilization 0.270 (2.84) ⫺0.14 (⫺1.64) 0.113 (1.37) 0.048 (0.33) ⫺0.099 (⫺0.75) ⫺0.046 (⫺0.40)

US Federal Funds Rate

0.754 (5.42) 0.530 (4.74)

0.618 (3.59) 0.477 (3.10)

Adjusted R2

D.W.

0.821

1.85

0.882

1.71

0.888

1.77

0.265

1.99

0.619

2.04

0.557

1.91

AR(1)

0.675 (4.81)

0.515 (2.95)

Source: Statistics Canada, CANSIM V39050, V41693242, V735319, V41693271, and V4331081.

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50


Canada and the US to detect if IT policy influenced labour income growth. We used as measure the rate of growth of total labour compensation (obtained from Statistics Canada) and the growth rate of average weekly earnings (taken from the US Bureau of Labor Statistics). These were then regressed on the IT dummy variable, the lagged value of the dependent variable, capacity utilization, and the current (or previous) year inflation rate. The results are shown in Table 3.3. The empirical evidence does show that IT policy may have slowed down wage growth in Canada but not in the United States, at least for the post-1991 period. However, the evidence is weak since, as shown when replacing current with the past value of inflation, the IT dummy variable loses its significance. This was not the case for the United States where the dummy variable remained statistically insignificant regardless of specification. However, in both countries it is the demand side variable (that is, the rate of capacity utilization) which seems to have the most powerful influence on the growth of labour compensation. Although the results are quite sensitive to specification, they are consistent with our general view of incomes policies. In publicizing a voluntary guidepost, IT policy may have affected labour income growth and, via the latter, the rate of inflation. However, its direct effect on price setting was not statistically significant.

Concluding remarks The conventional wisdom among central bankers, regardless of whether they are committed to IT policy or not, is that IT has a beneficial effect on long-term growth by maintaining low inflation rate while containing it within a narrow range. However, the evidence of its effectiveness is highly controversial and not particularly convincing, as also pointed out compellingly by Arestis and Sawyer (2008). Indeed, when comparing the experience of Canada and the US, our simple regression analysis questions the view that IT policy has had any significant impact on the rate of inflation in Canada, with the exception of a possible weak effect on wage inflation. This distributional bias against labour income has also been recognized by other Post-Keynesian economists (see Rochon 2010) and raises questions about its appropriateness as a peculiar type of incomes policy. However, if the question is to achieve growth without inflation, as Epstein and Yeldan (2008) underscore, there are alternatives to IT. The recent experience with monetary policy during the financial crisis of 2008–09 has shown that IT is ineffective when the economy has hit

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Table 3.3 Regression analysis of growth in labour income, Canada and United States 1967–2008 Dependent Variable

CANADA Canada Wage Growth Canada Wage Growth UNITED STATES US Wage Growth US Wage Growth

Constant Dummy Term


Capacity Utilization Rate

Inflation Rate

⫺41.667 (⫺3.90) ⫺51.916 (⫺3.82)

⫺3.113 (⫺1.91) ⫺2.606 (⫺1.38)

⫺0.143 (⫺0.83) ⫺0.011 (⫺0.07)

0.596 (4.77) 0.715 (4.70)

0.614 (2.71)

5.00 (3.57) 2.593 (2.91)

⫺0.770 (⫺0.83) ⫺0.595 (⫺0.90)

⫺0.242 (⫺1.51) ⫺0.020 (⫺0.21)

0.171* (4.28) 0.253* (7.05)

0.084 (0.83)

One-Period Lagged Inflation Rate

0.459 (1.73)

0.405 (4.98)

Adjusted R2

D.W.

0.740

1.68

0.711

1.85

0.742

1.93

0.851

1.80

AR(1)

AR(2)

0.639 (3.70) 0.664 (3.50) 1.116 ⫺0.269 (5.16) (⫺1.30) 0.811 (7.67)

Note: * I(1) series specified in first difference; all other variables were I(0) series according to the standard ADF test in EViews. Source: Statistics Canada, CANSIM V1409158, V41693271, V735319; US Bureau of Labor Statistics, and Federal Reserve of St. Louis, FRED.

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its lower bound for nominal interest rates and policy makers must rely on active fiscal policy to reflate the economy and prevent a deflationary spiral. However, our analysis advises that, even in better and more prosperous times during which discretionary interest rate policy is feasible, IT has been a weak if not essentially ineffective policy measure.

References Arestis, Philip and Malcolm Sawyer (2004), ‘On the Effectiveness of Monetary Policy and Fiscal Policy’, Review of Social Economy, Vol. 62, no 4 (December), pp. 441–63. Arestis, Philip and Malcolm Sawyer (2008), ‘New Consensus Macroeconomics and Inflation Targeting: Keynesian Critique’, Economia e Sociedade, Vol. 17, (Special Issue), pp. 631–56. Ball, Laurence and Niamh Sheridan (2005), ‘Does Inflation Targeting Matter?’, in Ben S. Bernanke and Michael Woodford (eds), The Inflation-Targeting Debate, Chicago: University of Chicago Press, pp. 249–82. Bank of Canada (2009), Monetary Policy Report, Ottawa: Bank of Canada (April). Bernanke, Ben S., Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen (1999), Inflation Targeting: Lessons from the International Experience, Princeton, N.J.: Princeton University Press. Bresserer-Pereira, Luiz Carlos (2002–03), ‘Brazil Quasi-Stagnation and the Growth cum Foreign Saving Constraint’, International Journal of Political Economy, Vol. 32, no 4 (Winter), pp. 76–102. Cornwall, John (1990) The Theory of Economic Breakdown: An InstitutionalAnalytical Approach, Oxford: Basil Blackwell. Dodge, David (2005), ‘Inflation Targeting – A Canadian Perspective’, BIS Review, 20, pp. 1–5; online at: www.bis.org/review/r050323i.pdf. Dotsey, Michael (2006), ‘A Review of Inflation Targeting in Developed Countries’, Federal Reserve Bank of Philadelphia Business Review (Quarter 3), pp. 10–20. Dueker, Michael J. and Andreas M. Fischer (2006), ‘Do Inflation Targeters Outperform Non-Targeters?’, Federal Reserve Bank of St. Louis Review, Vol. 88, no 5 (September/October), pp. 431–50. Epstein, Gerald, and Erinc Yeldan (2008), ‘Inflation Targeting, Employment Creation and Economic Development: Assessing the Impacts and Policy Alternatives’, International Review of Applied Economics, Vol. 22, no 2 (March), pp. 131–44. Fischer, Andreas (1995), ‘New Zealand’s Experience with Inflation Targets’, in Leonardo Leiderman and Lars E.O. Svensson (eds), Inflation Targets, London: Centre for Economic Policy Research, pp. 32–52. Rochon, Louis-Philippe (2010), ‘Inflation Targeting: From Misconception to Misguided Policies’, in Hassan Bougrine and Mario Seccareccia (eds), Introducing Macroeconomic Analysis: Issues, Questions, and Competing Views, Toronto: Emond Montgomery Publications Ltd., pp. 188–96. Rose, Andrew K. (2006), ‘A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed’, NBER Working Paper No. 12711 (November).

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Mario Seccareccia and Marc Lavoie 53 Rowe, Nicholas (2010), ‘Money, Central Banks, and Monetary Policy: The Path to Inflation Targeting.’ In Hassan Bougrine and Mario Seccareccia (eds), Introducing Macroeconomic Analysis: Issues, Questions, and Competing Views, Toronto: Emond Montgomery Publications Ltd., pp. 179–87. Seccareccia, Mario (2008), ‘In Search of the Will-o’-the-Wisp: Central Banking and the Natural Rate of Interest’, Paper presented at the 10th International Post Keynesian Conference in Kansas City, Missouri, USA, June 29–2 July, 2008. Svensson, Lars E.O. (2008), ‘Inflation Targeting’, in The New Palgrave Dictionary of Economics. Second Edition. Eds. Steven N. Durlauf and Lawrence E. Blume. Palgrave Macmillan. The New Palgrave Dictionary of Economics Online. Palgrave Macmillan.

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4 Monetary Policy Challenges of the ECB Facing a Divergent Inflationary Process in the EMU Area Georg Erber and Harald Hagemann 1. Historical development towards the Eurozone Before the process of the European Monetary Union began, the turbulence caused in the internal exchange rate system after the end of the Bretton Woods fixed exchange rate system led to the European Currency Unit (ECU), which was established in 1979, as the forerunner of the euro.1 Derived from a basket of varying amounts of currencies of the EU nations, the ECU was a unit of accounting used to determine exchange rates among the national currencies. The European Central Bank (ECB) was established in 1998. It has been responsible since then for setting a single monetary policy and interest rate for the participating nations, in conjunction with their national central banks. Late in 1998, Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain cut their interest rates to an almost uniformly low level in an effort to promote growth and to prepare the way for a unified currency. At the beginning of 1999 the same EU members adopted a single currency, the euro, for foreign exchange and electronic payments. Greece, however, did not meet the economic conditions required until 2000 but adopted the euro afterwards. Euro coins and notes began circulating in January 2002, and local currencies were no longer accepted as legal tender two months later. The current HICP (Harmonized Index of Consumer Prices), the most crucial indicator for price inflation in the European Economic and Monetary Union (EMU) is based on highly heterogeneous country weights for commodity items for the different member countries to calculate the aggregate HICP inflation rate of the EMU area. This distorts, however, the correct measurement of the inflation rate significantly2 because it takes too much account of the differences in the expenditure 54

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Georg Erber and Harald Hagemann 55

structure of the different countries. One way to get an impression of how much the structural heterogeneity matters in biasing the general inflation rate in the EMU area would be to calculate PPPs (Purchasing Power Parities) for the different countries with respect to the whole EMU area. PPPs would be based on a common fixed weights commodity basket for all households in the EMU across all member countries. Instead the HICP weights for the commodity basket vary significantly from country to country. Therefore country-specific consumption preferences are incorporated in the calculation of the overall Eurozone HICP by using the country-specific commodity weights. Under the current practice two types of change are mixed-up in the analysis: changes and possible convergence in the commodity basket of each country and price changes and possible convergence in prices. Afterwards the contribution of each development to the overall result is ignored and one tends to interpret the development as that of price changes alone. Why are PPPs better than HICPs? The reason is that they give a pure price comparison between different entities like EMU member countries. A PPP comparison between EMU member countries would give the information of how much a standard commodity bundle would cost in different member countries. Its standard is a representative Euroland consumer. The HICPs of the different member countries do not compare the purchasing power of a fixed commodity bundle across different EMU countries but incorporate the national differences in the commodity baskets of each country. The argument presented here is that for the European Central Bank (ECB), the average purchasing power of an average Euroland citizen is what matters to guarantee general price stability of the chosen level of 2% per annum. If one compares the inflationary differences across the different Euroland member countries, it would be myopic to take the different expenditure shares into account to measure the general inflation level of Euroland and the respective differences across member countries by the national HICPs. This is, however, done by the Federal Statistical Office in Germany (see FSO, 2001, pp. 103–7) and Eurostat (see Eurostat, 2002, pp. 135–41). For the comparison of an individual living in one member country the orientation at a national HICP would be more appropriate since it takes into account the national specifics of the expenditures of a single country, but for the ECB which should guarantee price stability of the whole Euroland region a comparison should be based on Euroland and national PPPs to measure the convergence or divergence of inflation rates. In an ideal homogeneous Euroland where all differences between the single member countries have vanished, the difference between national

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HICP with the HICP and the Euroland PPP and the national PPPs would vanish because the weights would be equal everywhere. The current HICP was defined by an EU Council Regulation as follows: The (Maastricht) Treaty required a consumer price inflation index; the Council Regulation required that it should be a Laspeyres-type index measuring the average change in prices of goods and services available for purchase in the economic territory of the MSs (member states). (See EU, 2000, p. 29) To compare regional differences in the inflationary process across the different member states would however need a PPP comparison and not a comparison based on national HICPs. The general level of inflation in the Euroland area should be based on a standard commodity basket for the whole Euroland area. This would be fully in line with the Council Regulation as follows: HICPs shall be considered to be comparable if they reflect only differences in price changes or consumption patterns between countries. (EC, 1995, p. 80) It is, however, the second part related to differences in consumption patterns between countries, which obscures results related to pure price differences between countries. HICPs measure both kinds of differences while PPPs do not.

Food and non-alcoholic beverages Alcoholic beverages and tobacco Clothing and footwear Housing, water, electricity, gas and other fuels 7.0%

Furnishings, household equipment and routine maintenance of the house

16.7%

8.5% 0.9%

4.2%

9.7% 8.0%

Health Transport Communication Recreation and culture

2.3%

Education 15.6%

15.8% 3.2%

8.1%

Restaurants and Hotels Miscellaneous goods and services

Figure 4.1 European Monetary Union Index of Consumer Prices Item Weights in HICP in 2000

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57 Food and non-alcoholic beverages Alcoholic beverages and tobacco 7.6%

Clothing and footwear

17.4%

10.2%

Housing, water, electricity, gas and other fuels

1.1% 7.4%

2.9%

Furnishings, household equipment and routine maintenance of the house Health Transport

11.1%

2.8%

3.4%

Communication Recreation and culture

10.1%

15.0%

Education

11.0%


Figure 4.1a Italian Index of Consumer Prices Item Weigths in HICP in 2000

Food and non-alcoholic beverages Alcoholic beverages and tobacco 4.6%


15.2%

24.4%

Housing, water, electricity, gas and other fuels

1.6% 6.5%

Furnishings, household equipment and routine maintenance of the house Health Transport 3.4%

1.4% 10.6%

13.7% 2.3%

Recreation and culture Education

10.5%

5.9%

Communication


Figure 4.1b Spanish Index of Consumer Prices Item Weights in HICP in 2000

German index of consumer prices item weigths in HICP in 2000 Food and non-alcoholic beverages Alcoholic beverages and tobacco

0.7%

5.1%


7.0%

14.0% 4.8%

11.5%

7.5%

Housing, water, electricity, gas and other fuels Furnishings, household equipment and routine maintenance of the house Health Transport Communication

2.1%

Recreation and culture 15.4%

20.8% 3.4%

7.7%

Education Restaurants and Hotels Miscellaneous goods and services

Figure 4.1c German Index of Consumer Prices Item Weights in HICP in 2000

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Macroeconomics, Finance and Money French index of consumer prices item weigths in HICP in 2000 Food and non-alcoholic beverages Alcoholic beverages and tobacco Clothing and footwear

7.0%

17.0%

8.4%

4.1%

0.5% 9.3%

5.9%

Housing, water, electricity, gas and other fuels Furnishings, household equipment and routine maintenance of the house Health Transport Communication

2.7%

Recreation and culture 18.0%

15.1% 3.2%

7.2%

Education Restaurants and Hotels Miscellaneous goods and services

Figure 4.1d French Index of Consumer Prices Item Weights in HICP in 2000

Comparing the differences in consumption patterns between the Eurozone and the four big Euroland countries it is striking that substantial differences between the member countries prevail. This has significant impacts on the comparison of national HICPs as indicators of national inflation rates and their respective convergence/divergence processes (Figure 4.1).

2.

Convergence of national inflation rates in the Eurozone?

Figures 4.2 and 4.3 summarize the convergence/divergence process of national inflation rates of the EMU member countries since the beginning of 1995 using monthly data published regularly by Eurostat. To maintain consistency we use 1996 as a base year since for the actual base year 2005 Eurostat does not offer calculations for the years before 2000. Therefore the biases of artificially chained price indices with different base years are avoided for our analysis. The price index for the whole Eurozone includes the changing number of Eurozone member countries, but even keeping those four small countries entering the Eurozone after 2001 outside this index would only change the overall inflation rate of the whole monetary union by a tiny margin. Of the 12 new EU members admitted to the EU since 2004, four – Slovenia in 2007, Malta together with Cyprus in 2008 and Slovakia in 2009 – have adopted the euro. However, we exclude these four countries from our analysis because of their late membership in the Eurozone and their relative insignificance concerning their relevance on the sustainability of the

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59 160 150 140 130 120 110 100 90 80 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Austria UK

Germany Luxembourg

Belgium Netherlands

France Eurozone

160 150 140 130 120 110 100 90 80 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Denmark Italy

Spain Portugal

Finland Eurozone

Greece Sweden

Ireland

Figure 4.2 HICP indices (1996 ⫽ 100) for Eurozone member and some other EU-member countries, monthly values, 1995–2009

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60 10 9 8 7 6 5 4 3 2 1 0

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

⫺1 Austria France Netherlands

Germany UK Eurozone

Belgium Luxembourg ECB HICP-taget

10 9 8 7 6 5 4 3 2 1 0

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

⫺1 Denmark Ireland Sweden

Spain Finland Italy Portugal ECB HICP-target

Greece Eurozone

Figure 4.3 Annualized monthly inflation rates for Eurozone member and some other EU-member countries, 1995–2009

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Eurozone due to internal tensions related to insufficient convergence. All four are so tiny that their impact on the overall monetary system is negligible. Monthly inflation rates are calculated by taking the monthly HICP values and comparing the annualized growth rates for the respective month a year before (year-by-year, y-b-y). By this we eliminate the seasonal fluctuations otherwise present in the data. We can see that a significant convergence process towards a low common inflation rate took place from 1995 onwards during the period when the future Eurozone member states were chosen according to their 1997 performance in spring 1998. However, these efforts seem to have come to an end afterwards. Instead of a sustainable long-term convergence between the inflation rates in the Eurozone at least since the start of the Eurozone in January 1999 a divergence between the majority of EMU countries emerged that prevails to the present day. It is noteworthy that the three non-Eurozone countries – i.e. the UK, Denmark and Sweden – show no worse inflationary performance than Eurozone member countries such as Greece, Ireland or Spain. So the evidence in the data confirms that membership or non-membership has not been an essential advantage or disadvantage for those EU countries which did not commit to the Eurozone ten years ago. However, Denmark has officially entered the European Exchange Rate Mechanism II (ERM-2) to become a member after fulfilling the stability conditions for at least two years. Therefore Denmark is an exception from the two other countries, UK and Sweden, which have never formally applied to enter the ERM-2. Beside Denmark the Baltic states (Lithuania, Latvia and Estonia) have entered the ERM-2 to become Eurozone member countries as soon as possible. However, the global financial market crisis cast some doubt that this could happen according to the established rules of the ERM-2 anytime soon. Instead of including Denmark, Sweden and the UK into our analysis we use these countries as a control group to better understand how much it matters to become a formal member of the Eurozone, instead of using a pegged exchange rate to the euro together with an independent central bank to establish price stability at the national level. With the entry of Greece to the Eurozone at the beginning of 2001 the country weights changed modestly. However, if one looks at the data one quickly notices that the Greek inflationary process has been far different from that of the other countries.3 Therefore it is not surprising that in 2004 it became officially known that Greece cheated with their statistics to become a member without fulfilling the criteria of the ERM-2

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Macroeconomics, Finance and Money Official country weights in the EMU harmonized consumer price index in 2001

5.5

10.0

3.9

33.7

8.8

17.8

20.3

Germany France Italy Spain Belgium Netherlands Other

Figure 4.4 Country weights in the EMU harmonized consumer price index in 2001

process properly.4 However, this again is an interesting case study to find out whether the institutional framework of the Eurozone works towards greater convergence even if the initial starting conditions to enter it have been violated. Considering the past history before and after the start of the monetary union in 1999 it seems reasonable to view convergence and divergence between the EMU countries not as permanent but rather as transitory or idiosyncratic. This poses the future risk of tension between the member countries of the Eurozone to agree on a common monetary policy of the ECB. If the convergence process of the EMU countries is not persistent, the long-term perspectives of a successful monetary union would be bleak (see Figure 4.4).

3. ␤- and/or ␴-convergence of national inflation rates inside the Eurozone? A different representation of the convergence perspective of the member countries could be obtained by using the concept of ␤-convergence by Barro and Sala-i-Martin (1995). The reference point to measure convergence is again the national HICP inflation rates within the EMU. The differences of the national inflation rates are summarized in Figure 4.5. From this figure we can see by ‘eyeball econometrics’ that a steady and persistent convergence process between the national HICPs is currently not observable.5 If stochastic convergence should occur in the long-run – i.e. after some decades – this would be a very cumbersome process still lying ahead of the monetary union in the coming years. The high expectation of a much more rapid convergence towards a persistent common Sawyer

63 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 ⫺1.0 ⫺2.0

19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09

⫺3.0

Austria Belgium

Germany France

UK Luxembourg

Netherlands

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 ⫺1.0 ⫺2.0

97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09

19 9

19

6

⫺3.0

Denmark Spain

Finland Greece

Ireland Italy

Portugal Sweden

Figure 4.5 ␤-Convergence of selected EU-member countries towards the Eurozone national annualized monthly inflation rates

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inflationary process across all member countries has to be buried without further institutional reforms on the institutional framework of the monetary union. Even after a decade there is still a quite persistent heterogeneity between all member countries potentially causing more problems for the monetary union in the future because of the asymmetric reactions due to external shocks. In particular during the present global financial and overall economic crisis of the world economy the monetary union is currently experiencing such a stress test.

4. Econometric testing for ␤-convergence/divergence of the national HICPs In his paper on convergence among economies Barro (1991) considered an approach for testing the long-term ␤-convergence by an AR (1) autoregressive process of the ␤’s for a cross-section of countries. We will use this approach to estimate ␤-convergence with longitudinal data for each country separately. ␤’s are defined as in note 5 below. bi ,t ⫽ (1⫹ pi ) ⭈ bi ,t ⫺1 ⫹ ut

with ui ,t ~ N ( 0, s u2,i ⭈ I ) and ⫺ 1 ⱕ pi ⱕ 0

(1)

If the parameter pi was significantly below zero this would lead to a mean reversion, i.e. a state where the deviations of inflation rates of a particular country from the inflation rate of the Eurozone would vanish. If an econometric estimate of the model of equation (1) is empirically supported by the data it has become common practice to say that the variables under consideration are ␤-convergent. However, this kind of ␤-convergence does not necessary imply longterm convergence to the Eurozone rate of inflation. As Quah (1993) has shown, long-term convergence of the inflation rate of a member country to the one of the Eurozone would also depend on the ratio of the variances of the error-process to the variance of the ␤’s of a member country. This can be easily seen if one derives the standard deviation of the stochastic process of the ␤s. If the ␤s and the error term are independently distributed random variables we obtain from equation (1): s b2i ,t ⫽ (1⫹ pi )2 ⭈ s b2i ,t ⫺1 ⫹ s u2,i

(2)

From expression (2) one can easily derive the following s b2i ,t ⫺1 s

2 bi ,t

⫽

1 (1⫹ pi )2

⎡ ⎛ s2 ⎞ ⎤ ⭈ ⎢1 − ⎜ 2u ,i ⎟ ⎥ ⎢⎣ ⎝ s bi ,t ⎠ ⎥⎦

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(3)


Since the long-term stochastic convergence hypothesis assumes that p lim t →∞

( )

d ⎡⎣Var bi ,t ⎤⎦ =0 dt

{⫺1 ⱕ pi ⱕ 0}

iff

∧ s u2,i ⬍ s b2i ,t

(4)

the expression of equation (3) only vanishes over time if the ratio of the variance of the external shocks of the error variable u is smaller than the variance of the ␤-variable. A stochastic convergence process is therefore approaching a long-term stochastic convergence only if the two conditions of ␤-convergence and ratio of the variance ratios are satisfied. This form of long-term convergence has become known as ␴-convergence. The following estimates for ␤-convergence of the HICP inflation rates confirm what we expected already based on the visual inspection of the data. For all countries a negative sign can be confirmed from the regression estimates but only for six Eurozone countries, Germany, Italy, Belgium, Luxembourg, Austria and Finland, the t-values are large enough to guarantee a statistical significance level of at least 5%. For the remaining six countries, France, Spain, Netherlands, Ireland, Portugal and Greece ␤-convergence cannot be empirically confirmed for the time period February 1996 until January 2009. This should be worrying for the Euroland members since the Maastricht treaty assumed that convergence would occur after the Monetary Union has started. Other tests try to confirm the existence of a persistent ␤-divergence between Euroland countries. The corresponding model is just extended by adding a constant term to the estimation equation (1). bi ,t ⫽ gi ⫹ (1⫹ pi ) ⭈ bi ,t ⫺1 ⫹ ui ,t

with ui ,t ~ N ( 0, ␴2u ,i ⭈ I )

(5)

and ⫺1 ⱕ pi ⱕ 0 If the constant term ␥ were statistically significantly different from zero, there seems to be a persistent difference between the respective country and the Eurozone. In Table 4.1 the estimation results are summarized for the 12 member countries. Looking at the estimation results from this test for the Eurozone member countries, we notice that we obtain significant estimation values for the constant term only for France and Austria. Both have a negative sign, which would imply that the two countries have a persistently lower inflation rate than the whole Eurozone. While the relationship for Austria is generally fairly weak if one looks at the coefficient of determination of only 0.12, the results for France are more pronounced. Even if accepting that a coefficient

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Table 4.1 OLS-estimation results for persistent differences between selected Eurozone member countries plus the UK, Denmark and Sweden

Germany France Italy Spain Netherlands Belgium Luxembourg Austria Finland Ireland Portugal Greece UK Denmark Sweden

pi

t-value

gamma

t-value

F-test

R2

DW

⫺0.155 ⫺0.092 ⫺0.122 ⫺0.066 ⫺0.037 ⫺0.189 ⫺0.136 ⫺0.182 ⫺0.054 ⫺0.032 ⫺0.065 ⫺0.047 ⫺0.044 ⫺0.077 ⫺0.104

⫺3.675 ⫺2.635 ⫺4.459 ⫺1.873 ⫺1.787 ⫺4.053 ⫺3.286 ⫺3.943 ⫺2.112 ⫺1.517 ⫺2.010 ⫺2.369 ⫺1.583 ⫺2.560 ⫺2.891

⫺0.091 ⫺0.038 0.014 0.042 0.010 ⫺0.014 0.039 ⫺0.074 ⫺0.009 0.024 0.029 0.048 ⫺0.006 ⫺0.004 ⫺0.049

⫺2.986 ⫺1.853 0.684 1.163 0.396 ⫺0.461 0.921 ⫺2.551 ⫺0.346 0.736 0.797 1.055 ⫺0.347 ⫺0.162 ⫺1.414

402.380 675.780 1029.350 710.060 2186.120 302.850 439.310 313.130 1375.020 2158.710 826.230 2349.730 1156.220 936.720 621.440

0.72 0.81 0.87 0.82 0.93 0.66 0.74 0.67 0.90 0.93 0.84 0.94 0.88 0.85 0.80

2.22 2.24 2.09 1.76 1.92 2.38 2.35 2.36 2.28 1.99 2.02 2.46 2.16 2.17 1.99

Notes: number of observations 156, estimation period Feb-1996 until Jan-2009, method: OLS.

of determination of 0.59 is not very large, the whole equation gives significant estimates for the two coefficients and a good Durbin-Watson value, i.e. no significant first-order autocorrelation. This difference from the remaining Eurozone countries is supported in part by the work of Blanchard and Muet (1993), who have argued that after its bad experiences with expansionary fiscal policy in the early 1980s, France has shifted its policy in the direction of competitiveness through disinflation.6 This particular kind of policy still seems to be valid in the second half of the 1990s and at the beginning of the new millennium. It has even become more pronounced since the year 2000 if one looks at the respective charts for ␤-convergence. The estimation results for the persistent differences between the Eurozone countries also give us an opportunity to test for the ␴-convergence criterion of the convergence process. Only if a constant term is included in the regression equation the variance of the endogenous ␤-variable can be decomposed into the variance of the ␤ estimates explained by the deterministic part of the model and the variance of the residuals. The ratio of both estimated variances of both parts of the model will be F-distributed with 60 degrees of freedom. The critical value for a 5%-significance level would be 1.54 so that we can conclude from the F-test values in the table below that only Belgium and Austria do not pass the test for ␴-convergence. Even if the t-test for Belgium and

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Austria would imply that they fulfill the ␤-convergence test, they fail to fulfill the ␴-convergence test leaving the true convergence club of the Eurozone only to four members, i.e. Germany, Italy, Luxembourg and Finland. This hardly seems enough to have a high credibility for the sustainability of the Eurozone as a monetary union with a convergence to a common inflation rate measured by the Eurozone HICP. Another test concerning the stability of the ␤-convergence process between the Eurozone countries relates to the possibility of a structural break after the Maastricht process to select members of the Eurozone club has been completed with the year 1997, which was chosen as a reference year for the decision to accept 11 EU member countries to enter the monetary union in 1999. One possible explanation of the changed behavior might be that the commitment to strictly follow the convergence process could have weakened after the countries had become members of the club. Only Greece, which had to stay outside because of its failure to meet the Maastricht criteria, had to intensify its efforts after the 1998 decision to begin moving toward monetary union in 1999, which finally led to the decision to let Greece enter the Eurozone in 2001. The following model equation therefore included a dummy variable d with its value set equal to zero until December 1997 and set equal to one afterwards. If some EU countries were just making a strong commitment to become a member of the Eurozone club it would be expected that the sign of the d-coefficient estimated should be significantly positive, i.e. indicating a weakening of the ␤-convergence process. bi ,t ⫽ (1 + pi ⫹ di ⭈ D97 ) ⭈ bi ,t ⫺1 ⫹ ui ,t

(6)

with ui ,t ~ N ( 0, s u2,i ⭈ I ) and ⫺ 1 ⱕ pi ⱕ 0 Looking at the estimation results summarized in Table 4.2 we notice that only three countries have statistically significant values at the 5% significance level, which are different from zero. France as one of the key Eurozone members shows a significant weakening in its convergence to the Eurozone mean. Taking the magnitude of the two coefficients the ␤-convergence process stopped completely. In contrast, Belgium and Greece show a significant acceleration of convergence towards the Eurozone HICP level after 1997. For Greece this was a necessary step to become a member of the Eurozone club in 2001. These results show at least that up to January 2009 – the last date included in our estimation – only very few countries have started to accelerate their speed of convergence significantly. Looking at the signs of the d-coefficients most countries even tend to have weakened their efforts to converge towards a common HICP level.

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Table 4.2 SUR-estimation results for persistent differences between selected Eurozone member countries plus the UK, Denmark and Sweden

Germany France Italy Spain Netherlands Belgium Luxembourg Austria Finland Ireland Portugal Greece UK Denmark Sweden

pi

t-value

gamma

t-value

R2

DW

⫺0.177 ⫺0.095 ⫺0.120 ⫺0.446 ⫺0.039 ⫺0.169 ⫺0.089 ⫺0.207 ⫺0.065 ⫺0.040 ⫺0.068 ⫺0.033 ⫺0.042 ⫺0.090 ⫺0.067

⫺4.991 ⫺3.174 ⫺5.377 ⫺2.766 ⫺2.293 ⫺4.201 ⫺2.675 ⫺5.636 ⫺3.411 ⫺2.707 ⫺2.827 ⫺2.931 ⫺1.800 ⫺2.898 ⫺2.681

⫺0.108 ⫺0.039

⫺3.963 ⫺2.029

⫺0.095

⫺4.102

0.72 0.81 0.87 0.81 0.93 0.66 0.73 0.67 0.90 0.93 0.84 0.94 0.88 0.88 0.80

2.17 2.24 2.08 1.78 1.91 2.41 2.44 2.29 2.25 1.96 2.00 2.47 2.14 2.16 2.03

Notes: number of observations 1872, estimation period Feb-1996 until Jan-2009, method: SUR

Summing up the results of this short study of the convergence/ divergence in HICP-inflation rates inside the Eurozone countries we conclude that one must be cautious in assuming that the beginning of the Eurozone and the entry of new members like Greece has already led to a long-term convergence process with regard to the HICPs of the different countries. However, looking at national HICPs might give a biased view, because the structural heterogeneity between the expenditure shares is quite substantial even between the key countries Germany, France, Italy and Spain.

5. Testing for HICP-convergence clubs in the Eurozone So far we have estimated only single equations. In this section we use seemingly unrelated regressions (SUR) (see e.g. Zellner, 1962) to test the joint hypothesis concerning the membership or non-membership of Eurozone countries to the ␤-convergence club of the Eurozone. The comparative advantage of this kind of estimation is that it utilizes the covariance between the error terms to increase the efficiency of the estimation. Furthermore, it is possible to test the joint hypothesis concerning the model parameters across the single equations. The estimation results do not change dramatically in comparison to the Ordinary Least Square (OLS) estimates. However, because of the increased

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efficiency of the SUR estimation relative to the OLS estimation we observe that nine instead of six Eurozone countries have significant negative coefficients to support ␤-convergence. These nine countries excluding France, Germany and Austria would constitute a ␤-convergence club. For similar reasons concerning ␴-convergence one would have to exclude Germany and Austria from the convergence club which fulfills ␤- and ␴-convergence. A corresponding Wald-test for the hypothesis of non-convergence to the Eurozone HICP-level confirms the joint nonconvergence for these three countries (the Chi-square-value is 2.33 and accepts the joint hypothesis that all three ␲’s are equal to zero. The following graph for the estimates of the endogenous variables (␤-convergence-rates) illustrates these developments (Table 4.2). For France one reason to fail the ␤-convergence test might be attributed to the fairly small variance of its ␤-values which makes it difficult to obtain significant estimates for the ␲-coefficient. Similar considerations might hold for Austria and Germany. Since both countries are already fluctuating around the Eurozone HICP-level for quite some time this already high degree of convergence cannot generate a steady ␤-convergence rate. Random fluctuations around the Eurozone HICP-level do not lead to significant steady convergence rates. The low values of the coefficient of determination for these countries might just denote an already realized high level of convergence. Looking at the results of the SUR-estimation including the significant persistent differences in inflation rates of the three countries Germany, Austria and France of the previous OLS-estimation, the findings are confirmed again. Therefore from our analysis it follows that all three countries have a persistent disinflationary bias relative to the overall inflation rate in the Eurozone. The most pronounced one is related to Germany with -0.108, followed by Austria with 0.095 and France with ⫺0.039. Even if the magnitude of this bias seems not too dramatic at first sight, it becomes so if it accumulates in the long-run. Therefore it will be important to convince the German government and public that their strict attitude towards price stability is harmful for the long-term stability of the Eurozone. There seems to be a pattern in this structure related to the close relationship between Austria and Germany, where Germany is the leader with its too high price stability bias. France, on the other hand, is always worried about losing price competitiveness relative to Germany and by this emulates the price stability bias to some extent. Therefore a more relaxed attitude towards a somewhat less strict price stability in Germany to become a more ‘normal’ Eurozone

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member would most likely solve the problem of persistent divergence in the Eurozone. Although it is understandable that the suspicion in Germany that the Eurozone would become too inflationary because of the inclusion of member countries with a more pronounced inflation history than Germany after the Second World War, it seems that the ECB together with the highly price-stable core of the EMU is sufficient to cause even countries like Greece to become less inflationary in the long run. One might argue that convergence should take place much more rapidly, and adjustment speeds should be more homogenous as they currently are. However, it is undeniable that up to now the Eurozone member countries have reached a fairly high degree of ␤-convergence in inflation rates. Without Germany as a champion of price stability the system would be internally convergent in the long run. Furthermore, one observes that the three outsiders of the Eurozone, the UK, Denmark and Sweden could become members of the Eurozone without having to change too much of their current attitudes toward inflation rate adjustment. Probably the current global financial market crisis increases the incentives for these countries to rethink the cost and benefits of membership. In particular after Iceland had to learn the bitter lesson that a small open economy is highly vulnerable to speculative attacks to its currency and the solvency of its banking system cannot be guaranteed by the national central bank and government alone.

6.

␴-Convergence of convergence clubs

Instead of looking for ␴-convergence for a single Eurozone country it makes sense to look for a joint convergence by calculating the dispersion of the ␤-convergence across the whole Eurozone community. An appropriate measure for this kind of ␴-convergence is given by the following expression: s mb,t ⫽

P euro ⎞ 100 m ⎛ Pit ⫺ teuro ⎟ ⭈ ∑⎜ m i⫽1 ⎝ Pit ⫺1 Pt ⫺1 ⎠

2

⫽

1 m 2 ⭈ ∑ bit m i⫽1

(7)

with Pit are the national HICPs for the respective time periods (see as well definition in note 5). This descriptive statistic can be calculated not only for the whole of the 12 Eurozone countries but also for a subset to see how far this subset of countries matches the path of the Eurozone HICP. In Figure 4.6 this ␴-convergence has been calculated and plotted for the whole community and selected subsets.

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Georg Erber and Harald Hagemann 71 30

25

20

15

10

5

19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09

0

EU15

EU12

EU6 non-founding members

EU11

EU3

EU6 founding members

EU3 Non-members

EU15 – EU12 plus UK, Sweden, Denmark EU12 – Austria, Belgium, Germany, Spain, Finland, France, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal EU11–EU12 minus Greece E3 – Germany, France, Italy E3 non-members – UK, Sweden, Denmark

Figure 4.6 ␴-Convergence of EU-member countries towards the Eurozone HICPinflation rate, January 1996 until January 2009

We observe from these calculations that there is little empirical evidence that the variance between the Eurozone member countries had decreased up to the outbreak of the global financial crisis in mid2007 followed by a steep oil-price shock in the first half of 2008. Only since then, due to the external global shocks – first inflationary and afterwards disinflationary – the internal heterogeneity in the Eurozone inflation process has diminished significantly. This indicates a common trend of global inflation which dominates as an external factor the internal inflation dynamics of the Eurozone (see e.g. Borio and Filardo, 2006). Oil price shocks and global disinflationary pressures in the global recession overrule the internal heterogeneity within the Eurozone when their impact is strong enough (Rüffer and Stracca, 2006).

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7. Conclusions Beside other conceptual problems related to choosing chain indices and ignoring hedonic price measurements, the decision of the ECB-Council to use different country weights instead of a common commodity basket for the whole Eurozone leads to significant distortions of the measurement of the inflation rates of the Eurozone member countries. The ECB would therefore be well advised to look at PPPs as well or even better to replace the HICPs by a PPP-measurement concept for the overall inflation rates. European economic integration should lead to a significant degree of convergence within the whole area. Taking a representative ‘Eurolander’, i.e. a citizen of the euro area, with her/his expenditure structure as a benchmark for general inflation measurement, would therefore improve the accuracy for the ECB to target general price stability for the Eurozone. However, our study – using HICPs for the analysis of the convergence/divergence process of the Eurozone – casts doubt on the idea that the monetary union has accomplished a high degree of persistent convergence. Observed heterogeneity between countries’ performances would as well be better measured by looking at differences in PPPs instead of differences in HICPs. This would also make inflation measurement more robust against any attempt to manipulate the national inflation rate by weighing high inflation items lower and low inflation items higher, through country-specific expenditure shares. It would therefore be an important next step to calculate the convergence/divergence dynamics between the Eurozone member countries on the basis of PPPs and compare the differences with those results obtained from our study using HICPs. Another consequence of our analysis is that the ECB should be very cautious in using the current HICP inflation rate for the Eurozone as a correct indicator for inflation rate targeting of her monetary policy. The Bank should even start to regularly publish reports on the convergence/divergence process of the Eurozone not only taking into account the key macroeconomic criteria of public debt and deficits but looking as well for the structural heterogeneity which leads to internal tensions inside the Eurozone. Some EU countries like the UK, Sweden or Denmark will pose few challenges when they become official members of the Eurozone since they track their inflation dynamics already as if they were members. Germany should become a little less obsessed with her price stability against the rest of the member countries.

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An optimal monetary policy for the ECB will become more and more a ‘mission impossible’ if the commitment of its member countries to foster a sustainable long-term convergence process weakens because the ability of the ECB to have strong incentives for member countries to address cumulative structural imbalances is not credible. A lacking credibility to combat divergent developments early on could well damage the international reputation of the euro as an international reserve currency in the near future. The current insufficient fiscal policy coordination to fight the current global recession will therefore create an important stress test for the sustainability of the Eurozone.

Notes 1. For a thorough investigation of the performance of monetary policy in 11 EMU countries for the whole period of the European Monetary System (EMS) see Arestis and Mouratidis (2004) who base their analysis on the trade-off between inflation variability and output-gap variability. 2. Cf. the list of country weights is published in EU (2000), pp. 85–95. The following number of charts of the EMU average weights and the national weights of the big 4 EMU countries taken from this source illustrates this. While for Spain the national weight for restaurants and hotels is 15.2% the corresponding weight for Germany is 5.1%. The weight in Spain is therefore three times larger than in Germany. On the contrary the weights for housing, water, electricity and other fuels is 20.8% in Germany while the corresponding weights for Spain and Italy are 10.1% and 10.5% respectively. This shows a significant degree of heterogeneity even across the big 4 EMU countries even at the highly aggregate level of consumer expenditure break down. 3. Asymmetries in the euro area due to different economic structures and the distinction between convergence of inflation rates and convergence of inflationary mechanisms and tendencies are discussed by Arestis et al. (2002). 4. ‘In the most embarrassing episode yet to hit the EU’s flagship project, the European Commission started legal action against Greece for “vast discrepancies” in its accounts over a seven-year period. Revised data show that the country’s finances were in such poor shape that it broke the public borrowing rules every year and has still not met the euro entry criteria. A European Commission spokeswoman said: “It is clear that Greece would not have joined the euro with the figures we have now”’; see e.g. Anthony Browne: Greece a ‘euro cheat’, in: Times Online message from 2 December, 2004. 5. The values for the ␤-convergence of the national HICPs were calculated by

⎛ Pit P Euro ⎞ ⫺ t Euro ⎟ ⎝ Pit ⫺1 Pt ⫺1 ⎠

using the following formula bi ,t ⫽ 100 ⭈ ⎜

6. According to the interpretation of Blanchard and Muet a macroeconomic policy of competitiveness through disinflation emerged in France to avoid the previous sequence of devaluations of the French Franc especially in the period

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Macroeconomics, Finance and Money of ECU preceding the Maastricht period. The failure of the first Mitterand government to stimulate its domestic economy by Keynesian fiscal policy and to maintain its international competitiveness necessitated occasional exchange rate realignments, especially against the German Mark. Since currency devaluations opposite the German DM have become impossible with the beginning of the Eurozone, and Germany and France being members, the only way to re-establish France’s competitiveness against Germany lies again in a policy of disinflation.

References Arestis, P., Brown, A., Mouratidis, K. and Sawyer, M. (2002), The Euro: reflections on the first three years, International Review of Applied Economics, 16 (1), 1–17. Arestis, P. and Mouratidis, K. (2004), Is there a Trade-Off Between Inflation Variability and Output-Gap Variability in the EMU Countries?, Scottish Journal of Political Economy, 51, November, 691–706. Barro, R.J. (1991), Economic Growth in a Cross-Section of Countries, Quarterly Journal of Economics, 106, 407–43. Barro, R.J., Sala-i-Martin, X. (1995), Economic Growth, New York: McGraw Hill. Blanchard, O.J. and Muet, P.A. (1993), Competitiveness Through Disinflation: An assessment of the French macroeconomic strategy, Economic Policy, April 1993, 1–56. Borio, C. and Filardo, A. (2006), Globalisation and Inflation: New cross-country evidence on the global determinants of domestic inflation, Bank of International Settlements Working Paper, Geneva, March 2006. EC (1995), Council Regulation No 2494/95 of 23 October 1995 concerning harmonized indices of consumer prices, Official Journal L 257, 27/10/1995 pp. 0001–0004. ECB (1999), Inflation differentials in a monetary union, ECB Monthly Bulletin, October 1999, 35–44. EU (2000), On Harmonization of Consumer Price Indices in the European Union, Report from the Commission to the Council, COM(200) 742 final, Brussels, 21. November 2000. Eurostat (2002), Eurostatistics, Data for short-term economic analysis, Theme 1, General Statistics, Series, Short-term statistics, published on a monthly basis, Luxembourg. FSO (2001), Fachserie 17, R7, published on a monthly basis, Federal Statistical Office, Wiesbaden. OECD (2002), Purchasing Power Parities and Real Expenditures, 1999 Benchmark Year, Paris. Quah, D. (1993), Galton’s Fallacy and Test for the Convergence Hypothesis, Scandinavian Journal of Economics, 95, 427–43. Rüffer, R. and Stracca, L. (2006), What is global excess liquidity, and does it matter?, in: ECB-WP 696, European Central Bank, Frankfurt am Main, November 2006. Zellner, A. (1962), An Efficient Method of Estimating Seemingly Unrelated Regressions and Tests for Aggregation Bias, Journal of the American Statistical Association, 57, June, 348–68.

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5 Macroeconomic Consensus and Political Economy Aspects of Monetary Policy Design Georgios Chortareas

1. Introduction Philip Arestis’s contributions in modern macroeconomics span an impressively wide range of topics and appear in the large number of papers that he authored. The common characteristic shared by all those contributions is the timeliness and relevance to the main macroeconomic debates that have arisen over the years. Philip Arestis’s contributions cover topics as diverse as the link between financial development and economic growth (e.g., Arestis and Demetriades, 1997; Arestis et al. 2001; Arestis et al. 2006), the potential of Keynesian economic policies (e.g., Arestis and Sawyer, 1998), the role of fiscal policy, the endogeneity of money (e.g., Arestis and Sawyer, 2006), monetary policy, the housing market and its implication for the macroeconomy (e.g., Arestis and Karakitsos, 2008), and the effectiveness of inflation targeting (Arestis et al. 2001; Angeriz and Arestis, 2007, 2008), to name just a few. A main focus of his work has been the ‘new consensus’ in macroeconomics as it emerged over the last two decades, that is, the ‘New Neoclassical Synthesis’ (e.g., Arestis, 2007; Arestis and Sawyer, 2008). Studying Philip Arestis’s writings one can also learn some valuable lessons on how to approach modern macroeconomics. I have learned at least two things. First, he never approaches his topics with the arrogance that is typical for other economists of his calibre. His attitude can better be described as that of an enthusiastic and vigorous student of macroeconomics whose ceaseless genuine interest in theory and policy always leads him to new ideas. Second, he uses a variety of methodological approaches and techniques instead of limiting himself to just one or a selection of them. Different models and methodological approaches have their strengths and weaknesses and they may pertain to analysing 75

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some problems better than others. Philip Arestis is aware of that and he does not confine himself to one ‘recipe’ that is good for all economic issues. Instead, he masterfully uses elements from various macroeconomic toolkits to develop the approach or technique that seems more appropriate for addressing the question in hand. The ‘new consensus’ in macroeconomics emerges as one of the main topics that have attracted the interest of Philip Arestis (e.g., Arestis, 2007). The last two decades of the twentieth century witnessed a new macroeconomic environment, a shift in macroeconomic theory, and unprecedented changes in the design of monetary policy. In the real economy, the developed capitalist economies experienced the ‘great moderation’, the ‘New Neoclassical Synthesis’ gradually dominated the field of macroeconomic theory and the central banks transformed to independent and transparent institutions. The recent crisis puts this broad consensus among policy-makers and analysts to the test. Two extreme types of attitudes emerge: the ‘I told you so’ crowd and the ‘unrepentant’. Though it is too early to judge, one should not expect a radical change in the way we understand macroeconomics or in the way that macroeconomic and in particular monetary policies are designed. The ‘current consensus’ in macroeconomics consists of two types of ingredients, a set of elements reflecting the main assumptions of the neoclassical equilibrium approach and a set of elements reflecting some form of rigidities. Those two sets of ‘New Classical’ and ‘New Keynesian’ elements lead different economists to call the current consensus either ‘New Neoclassical Synthesis’ or ‘New Keynesian Macroeconomics’ in an interchangeable fashion. Admittedly this consensus is quite broad, at least within the policy-making institutions. Nevertheless, there exist a number of issues on which the macroeconomists disagree and constitute the challenges ahead. The recent crisis, however, adds a new dimension, prompting us to ask whether the way one addresses questions such as the above is different before and after the current crisis? A number of macroeconomists suggest indeed that a consensus exists today. Moreover, they emphasize that its existence is desirable (e.g., Blanchard, 2008; Woodford, 2009; Mankiw, 2006; Chari and Kehoe, 2007). Others suggest that the existing consensus is not sufficient for substantiating the current policy choices (e.g., Chari et al., 2009). Finally others suggest that such a consensus doe not really exist or if it exists it is misplaced (Solow, 2008; Akerlof, 2007). Why should one want a consensus? Recent lines of research emphasize issues such as private sector’s misperceptions and communication policy, etc. Developing a consensus on what the model of the economy

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is may reduce such misperceptions. From the perspective of a monetary policy one can view central bank’s analysis as a public good (convergence of views, agreement on the true model, better anchoring of expectations, etc.). One can argue that three or four decades ago another macroeconomic consensus existed. The macroeconomic consensus of up to the early 1970s, however, is very different from the current consensus. The theoretical frameworks we use for analysing the macroeconomy have evolved over the last three or four decades. Without overlooking the traditional debate between Keynesians and monetarists, up to the early 1970s a consensus existed on the role of stabilization policy and how to model the macroeconomy. The IS-LM, framework, a Phillips curve, and large scale macroeconometric models constituted key elements of this consensus. As Mankiw (1990) mentions, ‘twenty years ago it was easier being a student of macroeconomics’. It would be a big mistake to think that those entire elements are only part of the history of economic thought. The IS-LM framework is quite resilient, at least for teaching macroeconomics (see Mankiw, 2006). Over the last 30 years, however, the macroeconomists’ toolbox acquired elements that emerged in the context of different theoretical frameworks, as the rational expectations revolution, the real business cycles approach, and the early ‘New Keynesian’ models. While some elements of the above schools of thought have been discredited, other elements of those approaches survive and are currently incorporated in the toolkit of modern macroeconomists. No doubt, there is a long list of dimensions along which macroeconomic theory (and monetary policy) design will need to move towards. Such aspects include modelling the financial and banking sector, and more persuasive modelling of the labour market and the goods market, etc. In this chapter we want only to emphasize one aspect relating to the design of monetary policy and some political economy considerations. The current macroeconomic consensus incorporates many simplistic elements. One of its key features, however, namely that of the representative agent assumption, renders it particularly inadequate to address political economy issues. Ruling out agent heterogeneity renders the model incapable of analysing such issues. In this chapter we introduce some political economy considerations focusing on the institutional design of the central bank. Over the last two decades the framework of monetary policy-making has been considerably modified incorporating a number of new institutional features. Those features emerged either in response to the

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theoretical developments and results or by practical policy concerns. The recent approaches to central banking emphasize the institutional design rather than reputation. In practice the current central bank design incorporates features from many theoretical perspectives. Thus, central banks have some degree of ‘conservatism’ (i.e., inflation aversion) exceeding that of society, in line with Rogoff’s (1985) suggestion, and recognize price stability as the main goal of monetary policy. The move toward independent central banks was possibly the most fundamental of all those changes. The negative correlation between inflation and the degree of central bank independence provided the main argument for this trend. The relevant theoretical concepts underlying central bank independence have been developed in the context of the literature on policy-makers’ credibility. After resolving the issue of central bank independence the profession focused on new and other features of the monetary policy regime such as transparency and accountability. Transparency refers to the removal of information asymmetries between the central bank and the economic agents and the relevant literature identifies many types of transparency e.g., regarding the policy instruments, data, the decisionmaking process, etc. Transparency in monetary policy not only reduces the uncertainty of the private sector about central bank intentions and policy but also renders the central bank accountable. All above features have been incorporated into the inflation targeting frameworks adopted by a number of industrial countries including New Zealand, Canada, United Kingdom, Sweden, Australia, Iceland and Norway and in a larger number of emerging economies. Inflation targeting in one form or another emerged as the consensus of monetary policy design in the dawn of the new millennium. Inflation targeting requires the recognition of price stability as the primary objective of monetary policy and incorporates all the above mentioned features that characterize the successful modern monetary policy frameworks. Central banks publicly announce and set explicit quantitative inflation targets (in line with the approach of Svensson, 1997). Monetary policy is viewed more as an ‘economist’s’ rather than as a ‘politician’s’ job and uses a wide information set. This has to be done in transparent fashion. The inflation targeting approach has been proved a very popular way of delegating monetary policy because it meets all the above criteria. At the beginning of 2009 at least 26 countries are operating under a fully-fledged inflation-targeting regime. In this chapter we use the principal–agent approach to central banking to consider some political economy issues. The principal–agent

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approach to monetary policy can be shown to be analytically equivalent to the popular inflation targeting approach (e.g., see Svensson, 1997; Walsh, 2003). Moreover, Chortareas and Miller (2010) argue that inflation targeting can be interpreted as a contractual arrangement and as a special case of the principal–agent approach. Central bank contracts imply limited political independence of the central banker (since the targets of monetary policy are set by the political principal), but plenty of economic (or functional) independence. The principal–agent framework derives punishment and transfers mechanisms that incentivize the central banker to deliver policy outcomes as close as possible to that of the commitment benchmark. The seminal work on central banker incentives is by Walsh (1995) and Persson and Tabelinni (1993). Nevertheless Informal discussions of government (society) and central bank interaction in a context consistent with the principal–agent framework appear in Brunner (1985) and Mayer (1990). The bulk of the literature of the principal–agent approach to central banking focuses on delegated bilateral agency and almost exclusively considers the supply side of monetary policy. In this chapter we build on Chortareas and Miller (2004) to develop a simple common agency model of central bank decision making turning attention to the demand side for policy outcomes and relevant institutions. In particular we allow the demand side to incorporate not only the government as the single principal, but also an interest group. To the extent that the central banker cares about the incentive scheme an optimal response of disaffected sections of society can attempt to ‘capture’ the policy-maker. Following Chortareas and Miller (2004) we develop a principal–agent with two principals that have differing preferences. The model is quite simplistic indeed as the different preferences are assumed in an ad hoc fashion instead of being modelled on solid microfoundations. The redeeming feature of the model, however, is that it allows us to explicitly introduce conflicting interests and political economy considerations in an otherwise standard model of the Barro–Gordon tradition. We show that when monetary policy is delegated through inflation contracts and a second potential principal offers a competing inflation contract, the government contract cannot always deliver the commitment-equivalent results, under given assumptions. The next section discusses the rationale for a common agency model in central banking, and section 3 develops a common-agency of monetary policy. Finally, section 4 concludes.

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2. Conflicting interests and monetary policy A lengthy literature exists on policy-making when various interest groups attempt to influence policy-maker’s decisions, but there are limited direct applications to monetary policy. Conflicting interests and how they affect macroeconomic policy have been discussed in connection with stabilization policies, monetary policy, fiscal policy, economic growth, regulation, trade policy, and so on. Alesina and Drazen (1991) assume that heterogeneity in the population explains the timing of stabilization efforts. Delayed stabilizations can reflect interest groups’ lobbying activity, aiming to shift the burden of adjustment to other socioeconomic groups. Posen (1993, 1995) describes both monetary policy institutions and outcomes in terms of conflicting interests. Fiscal policy with geographically specific programmes implies dispersed costs and concentrated benefits (e.g., Weingast et al., 1981). The theory of regulation puts interest groups (lobbies) representing industry and consumers in a struggle to influence government decisions (e.g., Spiller, 1990; Laffont and Tirole, 1993). Krusell and Rios-Rull (1996) explore the role of vested interest groups and lobbying in economic growth. Dixit (1996a) and Grossman and Helpman (1994a, 1995) consider how different interest groups that earn sector-specific rents lobby to affect commodity taxation. Arestis and Sawyer (2005) show how inflationary pressures may arise from conflict over income shares, and from cost elements. They view supply-side constraints as arising from capacity constraints, rather than from the operation of the labour market. Arestis and Sawyer (2005) argue that supply-side factors impinge on the inflationary process, arising from the level of productive capacity relative to aggregate demand. Little systematic analysis explains if and how various interest groups may influence central banker policy. That interest groups may play a role in monetary policy is mentioned (e.g., Hetzel 1990 and Waller 1995), but no clear description exists of what the objectives of such interest groups are, and how interest groups may affect central banker behaviour. The central bank represents an institution that incorporates the public-interest view of government agencies. Deviations from the view that central bankers are social welfare maximizers are found in models that assume full fiscal policy dominance over monetary policy, or subordination of central banker policy to the will of elected officials. Thus, models of seignorage, and partisan and opportunistic political business cycles emerge. The recent trend towards greater central banker independence, however, renders the above approaches less relevant.

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In addition, the introduction of central bank contracts identifies the central banker as a self-interested or selfish person rather than a benevolent social welfare maximizer. Brunner (1985) argues that the principal (society) is a heterogeneous group that cannot be captured by the representative household. Society (principal) ‘contains a variety of conflicting, shifting and frequently fuzzy interests’ (p. 14). This fuzziness, according to Brunner, allows more latitude for the central banker to set and interpret monetary policy objectives. To treat central banker policy-making as an agency problem, one must identify the principals and appropriately model their utility functions. The existing literature considers only the government (society) as a potential principal for the central bank. Discussions of central banker contracts within the political process include Fratianni, et al. (1997), Waller (1995), and Alesina (1995). Fratianni et al. (1997) combine central banker contracts and rational political business cycles. They consider an opportunistic political business cycle model, where an expansionary bias by the government signals competency to voters. The immediate principal (government) who negotiates and enforces the contract with the central banker has a utility function that differs not only from that of the central banker, but also from society, since re-election is the main concern. Alesina et al. (1997) argue that in the existing contracting models of central bankers, the principal is a ‘social planner who embodies social preferences’ (p. 224) and that the relaxation of this assumption introduces fascinating issues in both academic and practical terms. Further, McCallum (1995, 1997) disputes the assumption that the preferences of the population and the central banker are systematically different in democracies. This view comes close to the public interest approach to bureaucracies. McCallum argues that the contracting approach does not eliminate the time-inconsistency problem, but simply reallocates it. That is, McCallum asks why it is only the central banker who is tempted to follow excessively expansionary policies and not the government (principal). Jensen (1997) shows how the political principal can exert pressure on the central banker when the possibility of rewriting central banker contracts exists. He elaborates on McCallum’s (1997) observation that contracts may simply shift rather than alleviate the time inconsistency problem. This model shows that if the principal has time-inconsistent preferences, and if no restrictions exist on rewriting the contract, then the government can write a new contract with the central banker that will be compatible with time-consistent policies.

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3a. Monetary policy delegation and common agency Within the bilateral agency literature on central bank contracts, the single principal is the government or society, who can write explicit (formal) contracts with the central banker. Models that permit heterogeneous preferences in society typically assume, at least implicitly, that social groups and organized interests with differing agendas advance them through the electoral channel. Competition between political parties for (re)election responds to those heterogeneous preferences. If the group of potential principals designs and offers a collective incentive scheme, then the existing models of central banker contracts apply. That observation includes those models that incorporate political competition also. Political parties may have conflicting objectives, but if institutional procedures generate a collective decision regarding the central banker’s contract, the single principal approach still holds (especially after bargaining occurs). What if co-operation among potential principals does not occur? What if a number of principals with conflicting goals do not internalize their conflicts through the political (electoral) process? The effort to influence monetary (economic) policy follows multiple channels and emerges not only through the electoral process and pressure from other arms of government (e.g., parliament), but also through additional political activity such as lobbying, press criticism, and so on. This chapter considers the potential role of interest groups in an extended principal–agent framework that includes a multiplicity of potential principals. The central banker can enter into a formal contract with the government as well as an informal contract with a private interest group. The government contract emerges from the political process as the collective decision of society; the interest group contract reflects a significant disaffected minority. This model corresponds partly to an intrinsic common-agency problem, which according to Bernheim and Winston (1986a) refers to the situation ‘when an individual is “naturally” endowed with the right to make a particular decision affecting other parties, who may in turn attempt to influence that decision’. In contrast to Bernheim and Winston (1986a), however, who restrict attention to principals with a constitutionally guaranteed power to offer incentive contracts, we consider the possibility of informal contracts, as in Grossman and Helpman (1994a,b, 1995). The present model incorporates elements of both delegated and intrinsic agency, the former referring to the society–government relationship, and the latter to both the government– central banker and interest group–central banker relationships.

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Let the central banker be a self-interested utility maximizer, whose decision depends on private rewards. Laffont and Tirole (1993) discuss in detail the explicit form such transfers can take. Dixit (1996b) suggests that the incentives (penalties or rewards) in policy-making whether financial or non-monetary should be interpreted broadly to include career concerns and status (power). Brunner (1985) argues that central bankers carefully evaluate their actions because they affect their ‘political status and future market opportunities in the private and public sector’ (p. 15). Blinder (1998) also indicates that the promised rewards by the private sector to a central banker (i.e., the implicit interest group–central banker contract) can overshadow his pecuniary incentives as a public official. We abstract from discussing the explicit form of the central banker’s reward scheme, since we focus on the theoretical efficacy of central banker contracts. A contract between an interest group and the central banker must be informal, and typically not explicitly announced. Laffont and Tirole (1993) label such contracts as quasi-enforceable, meaning that the parties willingly enforce their own promises rather than turning to the courts. Blinder (1998) criticizes the principal–agent contacts in central banking, arguing that changes in central banker salaries probably cannot affect their motives seriously. Blinder, however, imagines government contracts. Private sector contracts, as in this chapter, may negate Blinder’s point. As Dixit (1996a) argues, ‘the marginal rewards for producing an outcome of greater value to society, or the marginal penalties for doing worse, are generally a very low percentage of the value added or lost’ (p. 94).

3b. A simple model This section presents a simple model of monetary policy when policymakers (central bankers) have time-inconsistent preferences, which mirrors the Barro–Gordon model of monetary policy based on Walsh (1995) and Chortareas and Miller (2004). The government’s preferences are given by 1 U g a(p p e ) p 2 (t 0 t p ) 2

(1)

where p is the inflation rate, p e = Et(pt+1|It ) is the expected inflation conditional on information available at time t. The last term in the government’s utility function shows the contract costs for the government.

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The central banker’s incentive scheme takes the form (t0 tp), where t0 is a fixed reward and t a marginal penalty rate. These costs are typically negligible in monetary terms but one cannot ignore them: they can be important in political economy terms as an excessive transfer to the central banker may be politically unacceptable (see, Chortareas and Miller, 2003). Suppose now that a disaffected interest group exists, as in Olson (1965), which can offer the central banker a formal or informal contract. The interest group offers a contract of the form [t0 t (p p e)] or, for simplicity t [t0 tp], where t0 is a fixed reward and t a marginal reward rate. That is the interest group has an output objective that implies a higher rate of inflation in order to generate inflation surprises. Thus the lobby’s preferences are given by: 1 U l b(p − p e ) p 2 (t 0 tp ). 2

(2)

We assume that b a, that is, the lobby places greater weight on output expansions than does the government. Finally, under the simplistic assumption that t0 t0 0, about the participation constraint, the central bank’s preferences are given by 1 U cb a(p p e ) p 2 (t 0 tp ) (t 0 t p ). 2

(3)

The central bank will set inflation to p nl a t

(4)

and the government will pick t subject to p nl (a t)/b and p p e with the first order condition implying t nl a.

(5)

In other words the government disciplines the central bank by setting the marginal penalty rate equal to the marginal benefit of inflation. In the presence of a lobby the central bank will move last, taking expectations, t0 , t, t0 and t as given and will set inflation to p a t t.

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(6)


The timing of the game between the central bank and the two principals starts with the government setting its contract and the lobby following. Then the public forms expectations, knowing that the contracts have been offered but not the details. Finally the central bank acts. The lobbying group can the public forms its expectations rationally, i.e., p e a t t.

(7)

Then the question emerges as to whether the public can observe the exact value of t. If so, the lobbying group can act as a Stackelberg leader choosing the penalization/reward rate t to maximize 1 max p 2 (t sp ). t 2

(8)

The first order condition renders t independent of b: t s 2p ,

(9a)

or ⎛ 2⎞ t s 2( a t t ) ⎜ ⎟ ( a t ). ⎝ 3⎠

(9b)

Turning to government’s optimal behaviour, we assume that it takes the expected inflation rate as given to solve the following problem 1 max a(p p e ) p 2 t p t 2

(10)

taking t as given and knowing that the public forms its expectations rationally, i.e., p e = p and thus p e a t t . The corresponding first order condition is t 2p ⎛ 2⎞ t 2( a t t ) ⎜ ⎟ ( a t ). ⎝ 3⎠

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(10a)

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Equilibrium is defined from (9a) and (11a), that is, ⎛ 2⎞ t ⎜ ⎟ ( a b ), ⎝ 5⎠

(11a)

⎛ 3b 2a ⎞ , t⎜ ⎟ ⎝ 5 ⎠

(11b)

⎛ 1⎞ p ⎜ ⎟ (a b) 0 ⎝ 5⎠

(11c)

and

That is, in the presence of two competing contracts by the government and a disaffected interest group, and under the assumption that the government cares about the contract costs, the inflation rate now will be higher than the one that would emerge under a single principal. The intuition behind the seemingly innocuous assumption about the government’s concern for the contact costs becomes now more apparent. If the government cares about the contract costs the interest group can always offer a more attractive contract to the (responsive) central banker. Another key assumption here is that the central banker responds to the incentive schemes. But that is exactly the point of the principal–agent approach to central banking. If the central bank does not respond to incentives schemes, then this approach is irrelevant.

4. Conclusion Over the last two decades or so, a strong consensus in the field of macroeconomic theory and policy has been developed. This consensus incorporates microeconomic foundations, intertemporal considerations, and rational expectations about future events. At the same time it allows for nominal rigidities, monopolistic firm behaviour, and acknowledges the real effects of monetary policy in the short run. This consensus permeates the frameworks that most policy institutions use for policy analysis. Nevertheless this consensus confronts a number of challenges. The representative agent assumption that the typical dynamic general equilibrium macroeconomic models incorporate allows them to base their analytical results on sound microfoundations. The same assumption,

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however, renders these models spineless when it comes to analysing political economy issues. In this chapter we present a simple model of political economy in monetary policy design and show that the typical results from a standard model of delegation can be overturned when the model fails to recognize the role of conflicting interest in macroeconomics.

References Akerlof, G.A. (2007), ‘The Missing Motivation in Macroeconomics’, American Economic Review, 97(1), 5–36. Alesina, A. (1995), ‘Comment to “The Unending Search for Monetary Salvation,” by S. Fischer’, in NBER Macroeconomics Annual, MIT Press. Alesina, A., and A. Drazen (1991), ‘Why Are Stabilizations Delayed?’, American Economic Review, Vol. 81, 1170–88. Alesina, A., N. Roubini and G.D. Cohen (1997), Political Cycles and the Macroeconomy, MIT Press. Angeriz, A. and P. Arestis (2007), ‘Assessing the Performance of “Inflation Targeting Lite” Countries’, The World Economy, Vol. 30(11), 1621–45. Angeriz, A. and P. Arestis (2008), ‘Assessing inflation targeting through intervention analysis’, Oxford Economic Papers, Vol. 60(2), 293–317. Arestis, P. (ed.) (2007), Is There a New Consensus in Macroeconomics?, Basingstoke: Palgrave Macmillan. Arestis, P. and P. Demetriades (1997), ‘Financial Development and Economic Growth: Assessing the Evidence’, Economic Journal, Vol. 107(442), 783–99. Arestis, P., G.M. Caporale and A. Cipollini (2002), ‘Does Inflation Targeting Affect the Trade-Off between Output Gap and Inflation Variability?’, Manchester School, Vol. 70(4), 528–45. Arestis P., G. Chortareas and E. Desli (2006), ‘Financial Development and Productive Efficiency in OECD Countries: An Exploratory Analysis’, Manchester School, Vol. 74(4), 417–40. Arestis, P., P. Demetriades and K. Luintel (2001), ‘Financial Development and Economic Growth: The Role of Stock Markets’, Journal of Money, Credit and Banking, Vol. 33(1), 16–41. Arestis, P. and E. Karakitsos (2008), ‘The U.S. housing slump and the consumer’, Journal of Post Keynesian Economics, Vol. 30(3), 335–52. Arestis, P. and M. Sawyer (1998), ‘Keynesian Economic Policies for the New Millennium’, Economic Journal, Vol. 108(446), 181–95. Arestis, P. and M. Sawyer (2005), ‘Aggregate demand, conflict and capacity in the inflationary process’, Cambridge Journal of Economics, Vol. 29(6), 959–74. Arestis, P. and M. Sawyer (2006), ‘The nature and role of monetary policy when money is endogenous’, Cambridge Journal of Economics, Vol. 30(6), 847–60. Arestis, P. and M. Sawyer, (2008), ‘A critical reconsideration of the foundations of monetary policy in the new consensus macroeconomics framework’, Cambridge Journal of Economics, Vol. 32(5), 761–79. Barro, R. and D. Gordon (1983), ‘Rules, Discretion, and Reputation in a Model of Monetary Policy’, Journal of Monetary Economics, Vol. 12(1), 101–21.

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Bernheim, B.D., and M.D. Winston (1986a), ‘Common Agency’, Econometrica, Vol. 54(4), 923–42. Bernheim, B.D., and M.D. Winston (1986b), ‘Menu Auctions, Resource Allocation, and Economic Influence’, Quarterly Journal of Economics, Vol. 101, Issue 1, 1–31. Blanchard, O.J. (2008), ‘The State of Macro’, National Bureau of Economic Research (NBER), working paper no. W14259. Blinder, Alan S. (1998), Central Banking in Theory and Practice. MIT Press. Brunner, K. (1985), ‘Monetary Policy and Monetary Order’, in Monetary Policy and Monetary Regimes, Graduate School of Management, University of Rochester. Chari, V.V. and Patrick J. Kehoe (2007), ‘The Heterogeneous State of Modern Macroeconomics: A Reply to Solow’, NBER working paper no. 13655, November. Chari, V.V., Patrick J. Kehoe, and Ellen R. McGrattan (2009), ‘Convergence in Macroeconomics: New Keynesian Models Are Not Yet Ready for Monetary Analysis’, AEJ Macroeconomics, Vol. 1(1), 242–66. Chortareas, G.E., and S.M. Miller (2003), ‘Monetary Policy Delegation, Contract Costs, and Contract Targets’, Bulletin of Economic Research, Vol. 55(1), 101–12. Chortareas, G.E., and S.M. Miller (2004), ‘Optimal Central Banker Contracts and Common Agency’, Public Choice, Vol. 121, 131–55. Chortareas, G.E., and S.M. Miller (2010), ‘The Principal–Agent Approach to Monetary Policy Delegation’, forthcoming in P. Siklos and M. Wohar (eds), Frontiers of Central Banking, Cambridge University Press. Dixit, A. (1996a), ‘Special-Interest Lobbying and Endogenous Commodity Taxation’. Eastern Economic Journal, Vol. 22(4), 375–87. Dixit, A.K. (1996b), The Making of Economic Policy: A Transaction-Cost Politics Perspective. MIT Press. Dixit, A.K. and H. Jensen (2000), ‘Equilibrium Contracts for the Central Bank of a Monetary Union’, mimeo. Dixit, A., E. Helpman, and G.M. Grossman (1997), ‘Common Agency and Coordination: General Theory and Application to Government Policy Making’, Journal of Political Economy, Vol. 105(4), 752–69. Eichengreen, B. (1996), ‘A More Perfect Union? The Logic of Economic Integration’, Essays in International Finance, No. 198, Princeton University. Fratianni, M., J. Von Hagen and C. Waller (1997), ‘Central Banking as a Political Principal–Agent Problem’, Economic Inquiry, Vol. 35, 378–93. Garfinkel, M.R., and S. Oh (1993), ‘Strategic Discipline in Monetary Policy with Private Information’, American Economic Review, Vol. 83(1), 99–117. Gordon, R.M. (1975), ‘The Demand and Supply of Inflation’, Journal of Law and Economics, Vol. 18(3), 807–36. Grossman, G. and E. Helpman (1994a), ‘Protection for Sale’, American Economic Review, Vol. 84, 833–50. Grossman, G. and E. Helpman (1994b), ‘Electoral Competition and Special Interest Politics’, Review of Economic Studies, Vol. 63, 265–86. Grossman, G. and E. Helpman (1995), ‘Trade Wars and Trade Talks’, Journal of Political Economy, Vol. 103(4), 675–708. Henning, R.C. (1994), Currencies and Politics in the United States, Germany and Japan. Institute for International Economics. Hetzel, R. (1990), ‘The Political Economy of Monetary Policy’, in T. Mayer (ed.) The Political Economy of American Monetary Policy, Cambridge University Press.

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Georgios Chortareas 89 Jensen, H. (1997), ‘Credibility of Optimal Monetary Delegation’, American Economic Review, Vol. 87(5), 911–20. Krusel, P. and J. Rios-Rull (1996), ‘Vested Interests in a Positive Theory of Stagnation and Growth’, Review of Economic Studies, Vol. 63, 301–29. Laffont, J.J. and J. Tirole (1993), A Theory of Incentives in Procurement and Regulation. MIT Press. Leiderman, L. and L.E.O. Svensson (eds) (1995), Inflation Targets, London, Centre for Economic Policy Research; distributed in North America by the Brookings Institution, Washington, D.C. Levy, P.I. (1999), ‘Lobbying and International Cooperation in Tariff Setting’, Journal of International Economics, Vol. 47(2), April, 345–70. Mankiw, N.G. (2006), ‘The Macroeconomist as Scientist and Engineer’, Journal of Economic Perspectives, Vol. 20(4), 29–46. Mankiw, N.G. (1990), ‘A Quick Refresher Course in Macroeconomics’, Journal of Economic Literature, Vol. XXVIII (December), 1645–60. Mayer, T. (ed.) (1990), The Political Economy of American Monetary Policy. Cambridge University Press. McCallum, B.T. (1995), ‘Two Fallacies Concerning Central Bank Independence’, American Economic Review Papers and Proceedings, Vol. 85, 207–11. McCallum, B.T. (1997), ‘Crucial Issues Concerning Central Bank Independence’, Journal of Monetary Economics, Vol. 39(1), June, 99–112. Olson, M. (1965), The Logic of Collective Action: Public Goods and the Theory of Groups, Cambridge: Harvard Economic Studies 124, Harvard University Press. Persson, T. (1998), ‘Economic Policy and Special Interest Politics’, Economic Journal, March, 310–27. Persson, T. and G. Tabellini (1993), ‘Designing Institutions for Monetary Stability’, Carnegie-Rochester series on Public Policy, Vol. 39, 33–84. Posen, A. (1993), ‘Why Central Bank Independence Does Not Cause Low Inflation: There Is No Institutional Fix for Politics’, in Richard O’Brien (ed.) Finance and the International Economy: 7. Oxford University Press for The Amex Bank Review, 41–54. Posen, A. (1995), ‘Declarations Are Not Enough: Financial Sector Sources of Central Bank Independence’, in NBER Macroeconomics Annual, MIT Press, 252–74. Rogoff, K. (1985), ‘The Optimal Degree of Commitment to an Intermediate Monetary Target’, Quarterly Journal of Economics, Vol. 100 (November), 1169–89. Solow, R. (2008), ‘Comments’, Journal of Economic Perspectives, 22(1): 243–7. Spiller, P.T. (1990), ‘Politicians, Interest Groups, and Regulators: A Multiple Principals Agency Theory of Regulation, or “Let Them Be Bribed”’, Journal of Law and Economics, Vol. 33, April, 65–101. Svensson, L.E.O. (1997), ‘Optimal Inflation Targets, “Conservative” Central Banks, and Linear Inflation Contracts’, American Economic Review, Vol. 87, 98–114. Waller, C.J. (1992), ‘The Choice of a Conservative Central Banker in a Multisectoral Economy,’ American Economic Review, Vol. 82(4), 1006–12. Waller, C.J. (1995), ‘Performance Contracts for Central Bankers’, Federal Reserve Bank of St Louis, Economic Review, September/October, 3–14.

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Walsh, C.E. (1995a), ‘Optimal Contracts for Central Bankers’, American Economic Review, Vol. 85(1), 150–67. Walsh, C.E. (1995b), ‘Is New Zealand’s Reserve Bank Act of 1989 an Optimal Central Bank Contract?’, Journal of Money, Credit and Banking, Vol. 27(4), 1179–91. Walsh, C.E. (2003), Monetary Theory and Policy, Cambridge, MA: MIT Press. Weingast, B.R., K.A. Shepsle and C. Johnsen (1981), ‘The Political Economy of Benefits and Costs: A Neoclassical Approach to Redistributive Politics’, Journal of Political Economy, Vol. 89(4), pp. 642–64. Woodford, M. (2009), ‘Convergence in Macroeconomics: Elements of the New Synthesis’, AEJ Macroeconomics, Vol. 1(1), 267–79.

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6 Central Bank Communication, Transparency and Interest Rate Volatility: Evidence from the USA Iris Biefang-Frisancho Mariscal and Peter Howells

1. Introduction The evidence of monetary policy transparency drawn from money market data is based largely on the behaviour of market rates (of various maturities) on the day of an interest rate decision. A significant reaction is termed a ‘surprise’ and is evidence of a lack of transparency. Generally speaking, the evidence suggests that most central bank interest rate decisions are well anticipated (for the US, for instance, Poole and Rasche (2000), Lange et al. (2003), and Demiralp and Jorda (2004)). This chapter moves the debate on by seeing what ‘openness’ means, if anything, for the behaviour of market interest rates between decision dates. The motivation for this is threefold. First, if a central bank has a target for short-term market rates which it sets at discrete intervals, it is reasonable to suppose that it would like market rates to reflect the target rate on a day-to-day basis for the inter-decision period. Secondly, where the central bank is releasing ‘forward-looking’ information regarding the likely future path of interest rates, it presumably wishes that information to be taken seriously by markets. Thirdly, if the release of forward-looking information has any impact on financial markets, then we would expect it to be revealed in a reduction of uncertainty about the next policy-rate change between decision dates and we should expect the path of money market rates to reflect more accurately the rate theoretically implied by the previous and the next expected official decision. Moreover, in the last few years the Federal Open Markets Committee (FOMC) has modified its information releases in ways that have given progressively increasing attention to the future outlook and should, therefore, have had a marked effect on inter-meeting interest rate 91

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volatility. For example, since the beginning of 2000, the FOMC began releasing a press statement after every meeting which described the current state of the economy and, in a somewhat formulaic description, the so called ‘balance-of-risk’ with respect to inflationary pressures and economic conditions in the foreseeable future. The ‘balance-of-risk’ part of the statement also provided information about the likely course of monetary policy, but it did so indirectly by describing the Committee’s assessment of the potential risks to its two objectives, high sustainable employment and price stability. Since August 2003, the FOMC has become more explicit, by directly commenting on the policy rate, and its likely future evolution. Since then, the statements convey information to the markets about the FOMC’s economic outlook and its policy approach. By additionally releasing information of near-term policy implications, the Committee is surrendering an information advantage it previously enjoyed over private agents. As a consequence, those agents may base their judgment more heavily on future policy moves by FOMC on the Committee’s press statements after the meeting than on its other communications. Consequently, the pricing of financial instruments will be different under the three regimes. The chapter is organized as follows: in section 2, we describe the changes in disclosure practice and institutional settings at the Federal Reserve between February 1994, when the FOMC first began to release a press statement describing its policy action and March 2006. In section 3, we turn to the hypothesis that market rate adjustments should be smoother in the post-2003 period. We give some theoretical reasons and we provide some indicative empirical evidence. In section 4, we test whether market interest rate volatility has changed over the period, applying an exponential GARCH model. If ‘balance-of-risk’ and ‘forward looking’ language indicate to agents the likely policy outcome of future FOMC meetings then, under this regime, market rate volatility should be lower between meetings than it was before 2000. Further, we expect that previous day market rate changes have, on average, a greater effect on today’s change in the later periods than in the pre-2000 period. We find that inertia is higher for the ‘balance-of-risk’ period than for the period before. Additionally, there is evidence that Fed communication effects on volatility differ between regimes. However, there is no unique evidence that the information content of other (than Fed press statements after FOMC meetings) has fallen over time. Section 5 summarizes and concludes.

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Iris Biefang-Frisancho Mariscal and Peter Howells 93

2. Communication at the Fed A key date in Fed disclosure practice is February 1994, when the FOMC began to announce its target federal funds rate on the day of the meeting. Previously, markets needed to infer the intended rate from the type and size of its open market operations until, at a subsequent meeting, the decision by the FOMC was published. There is substantial evidence that this change in procedure improved markets’ understanding of Fed policy. For instance, Poole and Rasche (2000), Lange et al. (2003), and Demiralp and Jorda (2004) find that since 1994, the announcement of the federal funds target rate and the FOMC meeting schedule improved markets’ anticipation of the timing and nature of future policy moves. Lee (2002) shows that interest rate volatility has fallen in response to Fed announcements. Exceptionally, however, Bonfim and Reinhart (2000) did not find evidence that the change in disclosure policy over the period five years after 1994 by the Fed had a significant effect on price setting. From May 1999 until February 2000, the FOMC began to issue a press statement immediately after every meeting at which there were either major shifts in the Committee’s view about future economic development, or, when the Committee decided to change the policy rate. The public statement regarding shifts in the Committee’s view on future economic development, was intended to inform the public quickly about FOMC’s assessment and to provide an indication of the likelihood of a future rise or fall in the official interest rate. An example of such a statement communicating the shift in the FOMC’s view is the press release on 18 May 1999. It says ‘the Committee was concerned about the potential for a build-up of inflationary imbalances that could undermine the favourable performance of the economy and therefore adopted a directive that is tilted toward the possibility of a firming in the stance of monetary policy.’ In the following meeting on 30 June 1999, the policy rate was increased by 25 basis points. 2.1 ‘Balance of risk’ statements From February 2000 until May 2003, the FOMC used a different disclosure procedure (Federal Reserve Board, 2000). First, the Committee determined that a press release was issued immediately after every meeting, regardless of whether monetary action was taken or whether there was a shift in the Committee’s view on prospective developments. Further, the FOMC changed its language so that the statement indicated how the Committee assessed the risk of greater inflationary pressure or

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economic weakness in the foreseeable future. While under the previous procedure, the Committee’s statement referred to the relative likelihood of a future increase or decrease in the federal funds rate, the new statement addressed a balance of risk to the target of price stability and economic growth. The language used to describe the FOMC’s judgment on the future development is pre-set: ‘Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that the risks are [balanced with respect to prospects for both goals] [weighted mainly toward conditions that may generate heightened inflation pressures] [weighted mainly toward conditions that may generate economic weakness] in the foreseeable future’ (Federal Reserve Board, 2000, p. 2). Further, the Committee clarified that ‘the foreseeable future’ is meant to convey a horizon that extends beyond the next FOMC meeting. 2.2

‘Forward-looking’ language

In August 2003, the FOMC introduced a ‘forward-looking’ language into its post-meeting statements with the aim of conveying the probable direction of the federal funds target rate over the next one or more meetings. On 12 August 2003, the statement read: ‘in these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period’ (Federal Reserve Press Release, 2003). The language was modified again in January 2004 to: ‘the Committee believes that it can be patient in removing its policy accommodation’ (Federal Reserve Press Release, 2004, January). These statements informed markets on FOMC economic outlook and policy approach. At the time, when the Committee used the phrase ‘considerable period’, strong economic growth in the third quarter of 2003 may have influenced markets to think that a rise in the policy rate was imminent and agents incorporated this expectation into prices. However, the FOMC believed that the strong growth was due to a sharp rise in labour productivity with little or no effect on inflationary pressure. At the same time, capacity utilization and inflation were low, so that the Committee did not see any reason for raising rates as the market seemed to anticipate. The language of the statement in August 2003 and the following statement convinced markets that a tightening was not imminent and market rates at all maturities fell (Bernanke, 2004). In May 2004, the language changed to ‘the Committee believes that policy accommodation can be removed at a pace that is likely to be measured’ (Federal Reserve Press Release, 2004, May) and, in the subsequent meetings, the federal funds rate was raised by 25 basis points. The language changed

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again in December 2005 to: ‘The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance’ (Federal Reserve Press Release, 2005, December), indicating that the FOMC intended to continue with a tightening of its policy.

3. Market rate volatility between FOMC meetings Before we turn to discuss agents’ pricing of instruments in the intermeeting period, we first turn to the policy direction the FOMC gave in the two periods January 2000 until May 2003, and since August 2003. In this section, our main interest lies in the degree of coherence between FOMC’s announcements and policy actions. Clearly, investors will only change pricing behaviour, if the Committee’s statements are credible. Table 6.1 compares the formulaic wordings of the ‘balance of risk’ period with the policy decision in the subsequent meeting. Table 6.1 FOMC statements and subsequent policy action in the period January 2000 until June 2003 Date 2.2.2000 21.3.2000 16.5.2000 28.6.2000 22.8.2000 3.10.2000 15.11.2000 19.12.2000 3.1.2001 20.3.2001 18.4.2001 15.5.2001 27.6.2001 21.8.2001 17.9.2001 2.10.2001 6.11.2001 11.12.2001 30.1.2002 19.3.2002 7.5.2002

Announcement for next meeting (and beyond)

Action next meeting

2 2 2 2 2 2 2 3 3 3 3 3 3 3 3 3 3 3 3 1 1

25 50 0 0 0 0 0 50 50 50 50 25 25 50 50 50 25 0 0 0 0 (Continued )

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Table 6.1 Continued Date 26.6.2002 13.8.2002 24.9.2002 16.11.2002 10.12.2002 29.1.2003 18.3.2003 6.3.2003 25.6.2003

Announcement for next meeting (and beyond)

Action next meeting

1 3 3 1 1 1 * 3 1

0 0 50 0 0 0 0 25 0

Notes: ‘1’ stands for the formulation ‘...balanced with respect to prospects for both goals …’; ‘2’ is for the phrase ‘… weighted mainly toward conditions that may generate heightened inflation pressures…’; ‘3’ signifies the expression ‘… weighted mainly toward conditions that may generate economic weakness…’ (see Federal Reserve Board, 2000) . ‘*’ indicates an occasion with no official statement.

Table 6.1 shows that most of the time (73 per cent) the Committee followed its balance of risk assessment in the next meeting. There is no occasion where the Committee announced a potential tightening or easing and then acted in a contrary manner in the subsequent meeting. There are five cases where the Committee indicated a tightening of policy, but did not endorse it in the following meeting. On three occasions, an easing in policy was announced but the target rate remained unchanged in the next meeting. On 18 March 2003 (denoted * in the table), the press statement did not contain a balance of risk assessment, since the FOMC felt that the geopolitical situation was too uncertain. Table 6.2 lists the relationship between press releases and subsequent policy action between August 2003 and October 2006. The last column states whether the announcement was consistent with the action. The results in Table 6.2 show that there were no occasions where the FOMC changed policy direction from what was announced in the previous meeting, though we do find two recent occasions where the FOMC indicated that its action in the following meetings was to depend on incoming economic information. In this section we discuss whether the regime switch to providing information at an earlier stage for a period covering the next and meetings beyond the next, has reduced market rate volatility. We examine the hypothesis that there is lower volatility of forward rates between FOMC meetings during the two regimes in comparison to the

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97 Table 6.2 FOMC statements and subsequent policy actions, since 2003 Date

12.8.2003 16.9.2003 28.10.2003 9.12.2003 28.1.2004 16.3.2004 4.5.2004 30.6.2004 10.8.2004 21.9.2004 10.11.2004 14.12.2004 2.2.2005 22.3.2005 3.5.2005 30.6.2005 9.8.2005 20.9.2005 1.11.2005 13.12.2005 31.1.2006 28.3.2006 10.5.2006* 29.6.2006* 8.8.2006 20.9.2006 25.10.2006

Announcement for next meeting (and beyond) No change No change No change No change Not yet Not yet Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes, 25bp Yes/No Yes/No No change No change Yes/no

Action next meeting

As announced?

0 0 0 0 0 0 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 25bp 0 0 0 0

Yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes Yes/no Yes/no yes yes

Notes: No change ‘...in these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period’; Not yet ‘… the Committee believes that it can be patient in removing its policy accommodation’; Yes, 25bp ‘… the Committee believes that policy accommodation can be removed at a pace that is likely to be measured’, which we have interpreted as ‘Yes, 25 bp’; Yes/no either ‘…the Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information’ (10.5.06), or ‘The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.’ (29.6.06); Yes/no* ‘The extent and timing of any additional firming … will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information’ (Federal Reserve Board press statement, October 2006).

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period before 1999. Why should this be the case? If agents know after a FOMC meeting the policy intentions of the central bank for the subsequent meeting, or, even subsequent meetings, market agents can adjust money market rates with less error and thus reduce interest rate volatility. The reasoning is as follows. Imagine a central bank that meets every 40 days (for simplicity). On day t 1 it confirms the existing official rate (say 4 per cent) and simultaneously releases its outlook which uses official language to hint at a rise at the next meeting, t 40, of 25 bp. If the bank’s release is believed, then the price of a one month’s ( 30 days) forward contract for purchase one month ahead, must reflect the expected rise at t 40. For example, suppose (in the case of the USA) we were looking to buy a one month federal funds (‘FF’) contract to start in one month’s time (‘one month forward, for one month’) immediately after the announcement on t 1. We would be buying a contract which would run from t 31 to t 61 and during that period it would pay nine days ( 40 31) at 4 per cent and 21 days ( 61 40) days at 4.25 per cent. The corresponding contract (still ‘one month forward, for one month’) priced the following day, t 2, would deliver eight days at 4 per cent and 22 days at 4.25 per cent. And so on. The interest paid on the contract would be a continually changing weighted average of the two interest rates, where the weights would be the term of the contract before the next Fed meeting and the term afterwards. Figures 6.1 and 6.2 should be viewed in this light. They show the actual movement in forward rates during the two Fed disclosure regimes, as discussed above. Both figures show the development of the 1-month forward rate from a few days before a meeting when the federal funds target rate was not changed (the date is denoted by t 0 and the first vertical line) until a few days after the second meeting (denoted by the vertical line on the right), when the target rate was increased in both cases by 25 bp.1 Figure 6.1 shows the movement of the market rate in anticipation of the policy rate increase in May 1997 and Figure 6.2 depicts the market rate movement under the new disclosure regime when the Committee raised the rate in June 2004. Both market rates rise over time in anticipation of the expected policy rate rise. However, the market rate movement between meetings in 1997 is more erratic with periods in which it falls and shows various jumps, before it increases more steadily. When we compare the movement of the rate between announcements in 2004, the rate movement looks almost like a straight, upward sloping line, which is what we would expect on the basis of the previous discussion.

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These graphs can only be regarded as illustrative since each represents a snapshot of two inter-meeting periods in the pre- and post-Fed communication change. Allowing for all sample observations (see Figure 6.3) we find that volatility is comparatively lower in the period since 2001. This may support the view that when agents adjust rates gradually and smoothly in anticipation of a future rate change, we expect a fall in market rate volatility.

1-month forward rate until March 1997 5.70

f11

5.60

5.50

5.40

5.30 0.00

10.00 20.00 Observations

30.00

Figure 6.1 Forward rate movement prior to increase in March 1997

1-month forward rate until June 2004 1.60 1.50

f11

1.40 1.30 1.20 1.10 0.00

10.00 20.00 Observations

30.00

Figure 6.2 Forward rate movement prior to increase in June 2004

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0.10 0.08 0.06 0.04 0.02 0.00 1994

1996

1998

2000

2002

2004

2006

USA: Squared change in 1-month forward rate (no outliers)

Figure 6.3 Volatility of the forward rate measured as the squared change

4. The EGARCH model We test the hypotheses that changes in disclosure practice in 2000 and 2003 (by reducing uncertainty) have increased dependence between previous and current changes in the market rate. We do this by allowing for varying effects caused by changes in disclosure regimes, measured by the coefficient of the first lag of the dependent variable. The hypothesis is that current interest rate changes depend more strongly on previous ones in the later periods than in the pre-2000 period (see section 3). Further, in the previous section, we pointed out that particularly in the period since 2003, volatility in market rates between meetings has fallen. We test two hypotheses. First, it is generally expected that ‘news’ increases interest rate volatility (Chadha and Nolan, 2001; Kohn and Sack, 2003). Since we examine the short end of the yield curve, ‘news’ is measured by central bank communication such as speeches and other central bank releases.2 If the ‘balance-of-risk’ statement and the interest rate prediction of the FOMC for the next meeting contains ‘all’ shortterm relevant information, then we expect that the effect of releases of other Fed communication in the pre-2000 period is higher than in the following two periods. In other words, we expect that communication news induces less volatility in the post-2000 than pre-2000 period. We begin with testing for the effect of the change in disclosure regimes by employing an exponential GARCH (EGARCH) model. The conditional mean equations for the changes in market rates are explained by policy rate surprises polsurt , and two dummy variable D1t and D2t interacting with first lags of the dependent variable. The dummy

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variable D1t has the value 1 between January 2000 and 11 August 2003 and, D2t is after 11 August 2003 and is zero otherwise. Dfrt , j a b1 D1t Dfrt 1, j + b2 D2t Dfrt 1, j b3 (1 D1t D2t ) Dfrt 1, j + b4 Dpolsurt + b5i ∑ Dayti + b6i ∑ Doutti + εt , j

(1)

The dependent variables are daily changes in CD forward rates at maturities (j) of 1, 3, and 6 months and the variable Doutt is a 1-0 dummy variable to account for two outliers. The coefficient b4 measures agents’ degree of surprise of FOMC policy on the day of announcement. Further, we distinguish between lagged effects of forward rate changes in the pre- 2000 ( b3 ), 2000 to 2003 ( b1 ) and post-August 2003 ( b2 ) regimes. The aim is to test the hypothesis that in the second and third period, inertia is higher compared to the early period. This should be so when markets adjust rates more gradually than before the regime change, in which case b3 b1 and b3 b2 Additionally, day of the week effects are included in the variable Day. The conditional variance of the exponential GARCH (EGARCH) model is: log st 2 v x log st 12 d

3 εt 1 ε u t 1 f 1i ∑ Dti comt st 1 st 1 i =1

(2)

+ l1 DSeptt + l2 i ∑ Dayti

The logarithmic formulation implies that the conditional variance t2 is always non-negative, regardless of the possible negative parameter values. The innovations t , are divided by the standard deviation of the conditional variance, resulting in standardized shocks, so that the effect of these terms depends on their relative size. The coefficient measures the existence of an asymmetric impact if differs from zero. The coefficient measures the degree of volatility persistence. All communication variables comt are dummy variables which take the value 1 when central bank communication occurs and are zero otherwise. The variable comt summarizes various forms of Fed communication. It accounts for speeches given by the chairman of the Board of Governors and releases of the Monetary Policy Report to Congress (formerly the HumphreyHawkins Testimony to Congress). These are semi-annual reports delivered in February and July where the chairman of the Board of Governors of the Fed reports the basic state of the US economy. The report consists of two sections, with the first section summarizing past policy decisions and their impact on the economy and the second section focusing on recent financial and economic developments. It is expected that

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both channels of communication have a positive impact on volatility. Further, communication includes also hearings on economic outlook, minutes of Board discount rate meetings, releases of the Minutes of the Federal Open Market Committee and other monetary announcements as well as all other testimony by the chairman before the Senate and the House Budget Committees.3 The dummy variable Dt3 is defined as Dt3 (1 Dt1 Dt2 ). Furthermore, we included an impulse dummy variable accounting for increased volatility on 11 September 2001 and a few days thereafter ( DSept t ). The main interest lies in the coefficients i 1, which measure the effect of news communication (other than FOMC statements after the meetings) on market rate volatility. It is expected that volatility rises in response to news releases by members of the FOMC, but volatility should respond less to Committee news releases during the two disclosure periods compared to the earlier period. We expect the latter two coefficients to be positive and have comparably lower values for the two periods since 2000.

Table 6.3 The estimation results of the mean equation (1) frt, j (j3)

frt, j (j1)

0.0025 *** (0.000) 0.0463 frt1, j pre- 2000 (0.173) frt1, j first change 0.1665*** (0.000) frt1, j second change 0.0833** (0.040) polsurt 0.5688*** (0.000) R2 0.202 F-statistic 18.36*** (0.000) ARCHLM(15) 9.69 (0.839)

0.0020*** (0.000) 0.0355 (0.257) 0.1191*** (0.000) 0.0403 (0.365) 0.485*** (0.000) 0.221 23.28*** (0.000) 8.06 (0.922)

frt, j (j6) 0.0020*** (0.005) 0.0155 (0.701) 0.1230*** (0.002) 0.0113 (0.781) 0.4059** (0.014) 0.037 2.67*** (0.000) 9.79 (0.833)

Notes: The estimated coefficients for outlier dummies and day effects are not reported here. The values in brackets under the estimated coefficients and diagnostics are the probability levels. For ease of reading, ‘*’ indicates significant at less than 10%, ‘**’ at less than 5% and ‘***’ at less than 1%. ‘first change’ refers to the period 2000-August 2003 and ‘second change’ refers to the period since August 2003.

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Table 6.4 Estimation results of the effect of communication in the conditional volatility equation frt, j (j1)

speech testimony econout disc min other

frt, j (j3)

frt, j (j6)

before

first

second

before

first

second

before

first

second

0.251*** 0.245 1.025*** N/A 0.762*** 0.448***

0.367*** 0.050 0.987*** 0.512*** 0.094

0.121* 0.202 0.144 0.407*** 0.388***

0.168*** 0.483*** 0.812*** N/A 0.266*** 0.410 ***

0.456*** 0.400*** 0.271 0.637*** 0.265***

0.065 0.458*** 0.331 0.418*** 0.381***

0.098** 0.510*** 1.438*** N/A 0.309*** 0.175**

0.198*** 0.178 0.084 0.031 0.244**

0.129** 0.426** 0.468 0.181 0.232*

Notes: The estimated coefficients for outlier dummies are not reported here. For ease of reading, ‘*’ indicates significant at less than 10%, ‘**’ at less than 5% and ‘***’ at less than 1%. NB: We included a dummy variable to account for the rise in volatility on and shortly after 11 September 2001. N/A indicates no data availability.

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Tables 6.3 and 6.4 show the results of the mean and conditional volatility estimations, where we included Fed communication in the variance equation. Throughout the maturity spectrum there is greater inertia over the period 2000 and 2003 than in the earlier period. But, for the shortest maturity, we find significant inertia in the later disclosure period, too. We will turn to the difference in the coefficients when we discuss Table 6.5, below. There are no remaining ARCH effects and with the exception of the third equation, the explanatory power is reasonable. The results of the conditional volatility are presented in Table 6.4. In the columns of Table 6.4, ‘before’ refers to the period 1997–2000, ‘first’ covers the period 2000–2003, and ‘second’ is the period from August 2003 until mid-July 2006. The variable ‘speech’ refers to speeches made by the chairman of the Board, ‘testimony’ is the release of the Monetary Policy Report to Congress, ‘econout’ stands for economic outlook, ‘disc’ is for Minutes of Board discount rate meeting, ‘min’ stands for the release of the minutes of the FOMC and the variable ‘other’ denotes other monetary announcements. The latter were rather few and were not split over the three regimes. The results of the conditional volatility estimates show that the various forms of Fed communications are overwhelmingly significant. All forms of communication show significant coefficients over all maturities, with the exception of the Testimony to Congress variable, which is insignificant with respect to the shortest maturity. Our main interest lies in finding out whether the changes in statements after the FOMC meetings affected (i) market participants’ pricing behaviour, shown in the degree of inertia, and (ii) the news value of other Fed communications. Table 6.5 shows the results of Wald tests for the equality of the coefficients of the lagged dependent variables over the three periods (inertia from the mean equation) and the communication coefficients (in the volatility equation). The column with the heading ‘All’ shows the test result of the null hypothesis of all coefficients being equal to zero. The notation ‘B F’ indicates that we test for equality of the coefficients for the first (pre-2000) and the second (2000–03) period, ‘B S’ stands for testing coefficient equality for pre-2000 and post-2003 period, and, finally, ‘F S’ compares coefficients of the last two periods. ‘lags’ refers to the first lag of the dependent variable in the mean equation.4 Turning to the first row and the shortest maturity, the test results show that coefficients differ between the three periods (‘All’). This difference is mostly due to the difference in coefficients between the first and the second regime (‘B F’). There is no significant

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Iris Biefang-Frisancho Mariscal and Peter Howells 105 Table 6.5 Test results on the equality of coefficients in the three regimes frt, j (j3)

frt, j (j1)

lags speech testimony econout disc min

frt, j (j6)

All

BF BS FS

All

BF BS FS

All

BF BS FS

*** *** no *** N/A ***

*** *** no *** N/A ***

* *** no ** no no

** *** no *** no no

** no no *** N/A ***

*** no no *** N/A ***

no * no *** N/A ***

* *** no *** no ***

no no no no no no

no *** no ** no no

no no no *** N/A no

** no no ** no ***

Notes: The estimated coefficients for outlier dummies are not reported here. For ease of reading, ‘*’ indicates significant at less than 10%, ‘**’ at less than 5% and ‘***’ at less than 1% and ‘no’ stands for insignificant.

difference between the coefficients of the last and the first regime (‘B S’), but a significant difference between the first and the second regime (‘F S’). All tests indicate that the inertia effects discussed before are only present in the period between 2000 and 2003, but not in any of the other periods. This result is similar over all maturities. We find differences in coefficients between the three regimes, but not as we had expected in that inertia is highest during the last or the last two regimes. Turning to the communication variables and their differences over the three regimes, we find that most of the differences between regimes are found at the shortest maturity and the least at the longest maturity. Notably, the news content of the economic outlook has changed between regimes over all maturities. Speeches by the chairman of the Board have distinct impacts over the three regimes on the two shorter maturities. In general, there is evidence that other than statements, communication by the Fed has had different effects on volatility during the three regimes. We expected that the news content of Fed communication (other than press statement) did not only differ between regimes, but that, if the communication in the statements after the FOMC meeting has become more effective over time, that the impact of other Fed communication on market rate volatility would be less over time. This result does not hold.5

5. Summary and conclusion The FOMC changed its press statements after its meetings by releasing forward-looking information and, most recently, by releasing

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information of near-term policy implications. The release of this type of information should reduce uncertainty about the near-future policy rate changes. This should impact on inter-meeting volatility in short-term market rates. We began by looking at the impact of this information release on market agents’ expectations. In line with other studies, we found that on the day of the meeting, market rates were well anticipated. The novelty of the chapter is to consider the effect of the news release on the inter-meeting period. We examine both, the effect on the market rate change and the volatility of the market rate, using an EGARCH model. We find there is some evidence that adjustment is smoother in the ‘balance-of-risk’ period than in any other period. Further, there is evidence that other Fed communication impacts mostly on the very short end of the yield curve. Further, this communication affects volatility differently under the different regimes. Most important seem to be speeches by the chairman and releases on economic outlook.

Notes 1. Both figures are scaled to the maximum of 30 at the end of the scale. 2. Fleming and Remolan (1999) find that macroeconomic announcement surprises are relatively weak for short maturities and stronger for intermediate maturities. Haldane and Read (2000) also point out that macroeconomic announcement effects may induce hump-shaped responses with sharper yield changes for intermediate maturities than shorter ones. This is also a rather intuitive result. Central banks tend to change interest rates gradually in response to relevant macroeconomic surprises, thus creating a monetary policy cycle of tightening or easing. Consequently, macroeconomic news is important for agents’ prediction of the entire monetary policy cycle when long-term instruments are concerned. However, agents may ignore the Fed’s ultimate target rate (deduced from economic surprises), when only short-term instruments are considered. 3. Data are from www.federalreserve.gov/boarddocs/ 4. With reference to Table 6.4, B is short for ‘before’, ‘F’ is short-form of ‘first’ regime and ‘S’ stands for ‘second’ regime. 5. There is no reason to assume that central bank communication should only affect volatility and not the mean market rates.

References Bernanke, B.S. (2004) ‘Fedspeak’, Remarks at the meeting of the American Economic Association, San Diego, 3rd January. Bomfin, A.N. and V.R. Reinhart (2000) ‘Making news: financial market effects of Federal Reserve disclosure practices’, Federal Reserve Board Finance and Economics Discussion Series, no 2000-14.

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Iris Biefang-Frisancho Mariscal and Peter Howells 107 Chadha, J. and Nolan, C. (2001) ‘Inflation Targeting, Transparency and Interest Rate Volatility: Ditching “Monetary Mystique” in the UK’, Journal of Macroeconomics, 23. Chortareas, G., Stasavage, D. and Sterne, G. (2003) ‘Does Monetary Policy Transparency Reduce Disinflation Costs?’, Manchester School, 71 (5), September, 521–40. Connolly, E. and M. Kohler (2004) ‘News and interest rate expectations: a study of six central banks’, Economic Group Reserve Bank of Australia, Research discussion paper 2004–10. Coppell, J. and Connolly, J. (2003), ‘What Do Financial Market Data Tell Us About Monetary Policy Transparency?’, Reserve Bank of Australia, Research Discussion Paper 2003/05. Demiralp, S. and Jorda, O. (2004) ‘The response of term rates to Fed announcements’, Journal of Money, Banking and Credit, 36 (3), 387–405. Federal Reserve Board (2000) ‘Modifications to the FOMC’s Disclosure Procedures’, http://www.federalreserve.gov/boarddocs/press/general/2000/20000119/ attachment.pdf Federal Reserve Press Release, 20 March 2001 http://www.federalreserve.gov/ boarddocs/press/monetary/2001/20012003/default.htm Federal Reserve Press Release, 12 August 2003 http://www.federalreserve.gov/ boarddocs/press/monetary/2003/20030812/default.htm Federal Reserve Press Release, 28 January 2004 http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040128/ default.htm Federal Reserve Press Release, 4 May 2004 http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040504/ default.htm Federal Reserve Press Release, 31 January 2006 http://www.federalreserve.gov/boarddocs/press/monetary/2006/20060131/ default.htm Federal Reserve Press Release, 13 December 2005 http://www.federalreserve.gov/boarddocs/press/monetary/2005/20051213/ default.htm Fleming, M.J. and Remolona, E.M. (1999) ‘The term structure of announcement effects’, Fed Reserve Bank of NY staff reports, May, no 76. Haldane, A.G. and Read, V. (2000) ‘Monetary Policy Surprises and the Yield Curve’, Bank of England Working Paper no 102. Hardy, D.C. (1998) ‘Anticipation and surprises in central bank interest rate policy: The case of the Bundesbank’, IMF working paper 98/43 King, M. (1997) ‘The Inflation Target Five Years On’, Bank of England Quarterly Bulletin, 37 (4), 431–42. Kohn, D.L. and Sack, B.P. (2003) ‘Central Bank talk: Does it matter and why?’, in Macroeconomics, Monetary Policy and Financial Stability. Ottawa: Bank of Canada. Kuttner, K.N. (2001) ‘Monetary Policy Surprises and Interest Rates: Evidence from the Fed Funds Futures Market’, Journal of Monetary Economics, June 2001, 47 (3), 523–44. Lange, J., Sack, B. and Whitesell, W. (2003) ‘Anticipation of monetary policy in financial markets’, Journal of Money, Credit, and Banking, 35 (6), 889–909.

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Lee, J. (2006) ‘The impact of federal funds target changes in interest rate volatility’, International Review of Economics and Finance, 15 (2), 241–59. Poole, W. and Rasche, R.H. (2000) ‘Perfecting the market’s knowledge of monetary policy’, Federal Reserve Bank of St Louis working paper 2000–010A, http://research.stlouisfed.org/wp/2000/2000–010.pdf Poole, W., Rasche, R.H. and Thornton, D.L. (2002) ‘Market Anticipations of Monetary Policy Actions’, Federal Reserve Bank of St Louis Review, 84(4), 65–94. Ross, K. (2002) ‘Market Predictability of ECB Monetary Policy Decisions: A Comparative Examination’, IMF Working Paper no. 02/233.

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Part 2 Inflation and Economic Policy

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7 The Thatcher Monetarist Experiment, 1979–85: An Assessment John McCombie

Introduction 1979 marked a watershed in UK macroeconomic policy. For many policy-makers, the stagflation of the early 1970s had discredited Keynesian macroeconomic policy with its emphasis on the simple Phillips curve and the putative trade-off between unemployment and inflation. Repeated attempts to curb inflation by incomes policies had proved a costly failure. The result was industrial unrest culminating in the 1979 ‘winter of discontent’ that cost the Labour government the election in that year. Consequently, on coming to power, the Thatcher government was determined to try a new approach and found it in its radical ‘monetarist experiment’, implemented through the Medium Term Financial Strategy (MTFS).1 This was the explicit targeting of initially the broad money supply, sterling M3 (£M3), by using both the nominal interest rate and the public sector borrowing requirement (PSBR). At this time, control of the money supply also became the macroeconomic policy in the United States. But the experiment was short lived and is generally regarded as a failure. Targeting the money supply was effectively abandoned in the UK in 1985 (and a couple of years earlier in the US). The money supply growth targets were almost never achieved, in spite of continual rebasing, and, over the period 1979–84, the economy was plunged into the worst recession since the Second World War (with unemployment rising from 5.3% in 1979 to a peak of 12.1% in 1984). This was notwithstanding Friedman’s (1991, p.61) optimistic evidence to the 1980 House of Commons Select Committee on Monetary Policy that from the ‘best evidence … only a modest reduction in output and employment will be a side-effect of reducing inflation to single figures by 1982’.2 But by 111

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1982, ‘the retreat from monetarism began to resemble a rout’ (Britton, 1991, p.109). However, the coup de grâce seemed to come from Friedman himself when he said many years later, ‘the use of the quantity of money as a target has not been a success … I’m not sure I would as of today push it as hard as I once did’ (London, 2003). Nevertheless, it has been argued by some that, in the long run, the theoretical concepts behind monetarism did triumph. From the early 1990s until the credit crunch of 2007/10, the advanced counties experienced an exceptionally long period of non-inflationary continuous expansion (the NICE years, to borrow King’s, 2003, acronym). Many commentators put this success down to the ‘new consensus in macroeconomics’ (NCM) and the introduction of both inflation targeting and an independent central bank. NCM effectively combined the New Keynesian macroeconomics with sticky prices and the New Classical economics’ use of the assumption of rational expectations. Yet many of the ideas of the NCM, especially the elements from the New Classical macroeconomics, could equally be said to have their antecedents in monetarism (DeLong, 2000; Mayer and Minford, 2004; Congdon, 2004; Goodfriend, 2007). Philip Arestis, both separately and in collaboration with Malcolm Sawyer, has long proved a convincing and severe critic of the NCM, arguing that the essential insights of Keynes into the functioning of the macroeconomy and the usefulness of fiscal policy have been lost (see, for example, Arestis and Sawyer, 2004; Arestis, 2007a). By implication these flaws can also be traced back to monetarism. Consequently, in this chapter, I assess the conduct of monetary policy in the UK during the early Thatcher years and briefly trace its influence on the NCM.

The rise of monetarism and the Medium Term Financial Strategy The Medium Term Financial Strategy, which was introduced in 1980, was not an attempt to control the money supply directly by changes in the base money stock. Consequently, to some purist monetarists, it was not ‘monetarism’ and it came as no surprise to Friedman that the MTFS was abandoned as a failure in 1985. Rather, the policy objective was to target an intermediate indicator; namely, the growth of the money supply. There are, of course, many definitions of the money supply, but £M3 was initially chosen for the pragmatic reason that it was easily understood by the public. The instruments available to the government were, as noted above, the nominal interest rate and the size of the budget deficit.

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The focus on the budget deficit arose from the definition that links the budget deficit, or public sector borrowing requirement (PSBR) to the change in the money supply. From the consolidated accounts of the banking system, the change in £M3 is given by: D£M3 ⫽ DBL G ⫹ DBL PS ⫹ DNOF

(1)

where BLG and BLPS are bank lending to the government sector and the private sector respectively. NOF is the net overseas finance to the UK, expressed in sterling. Furthermore, the change in bank lending to the government sector is definitionally equal to the unfunded PSBR (PSBRU) or, equivalently, to the PSBR minus the sale of net public sector debt to the non-bank private sector (DSPS): DBL G ⫽ PBSR U ⫽ PSBR ⫺ DS PS

(2)

Substituting equation (2) into equation (1), it can be seen that an important component of the change in £M3 is the unfunded PSBR. But from this the erroneous inference was made that reducing the latter would necessarily reduce the increase in the money supply and, hence, inflation. It was argued that if the budget deficit was funded by borrowing from the banking system, this would directly increase the money supply and hence inflation. This would also drive up interest rates and ‘crowd out’ private investment. As Dow and Saville (1988, p. 112) put it, there was ‘a “triangular relationship” between the size of the deficit, the growth of broad money and the level of interest rates’. Consequently, it was seen as essential to reduce the PSBR through substantial cuts in public spending, even when the economy plunged into a severe recession. The policy was abandoned around June 1985 (Goodhart, 1989, pp. 327–8; Dow and Saville, 1988, pp. 159–63). There is little doubt that the central plank in the MTFS, the relationship between the PSBR and the growth of the money supply, was deeply flawed. As Allsopp (1985, p.3) put it, ‘the intellectual basis of the MTFS [is] profoundly unsatisfying, apparently unfounded either in relevant theory or empirical evidence’. The reason is not difficult to see. Equation (1) is derived from an accounting identity and this does not imply any direction of causation. Just because the unfunded PSBR could be large relative to the change in £M3 does not imply that it is the main determinant of the latter’s growth. The likely extent of the failure of the MTFS was clearly foreseen by Kaldor (1980) in one of his few pieces of empirical research. For the period 1966–79, he showed that there was no statistically significant

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relationship between the change in the money stock (∆£M3) and the unfunded PSBR. There was, however, a significant relationship between the change in the money stock and bank lending to the UK private sector (∆BLPS in equation (1)) which we shall see plays an important role in the Post Keynesian view, which is discussed below. (See Kaldor, 1980, Tables 6 and 7, pp.308–9.) Friedman (1991, p.53) was equally scathing in his 1980 memorandum to the Treasury Select Committee commenting that ‘only a Rip Van Winkle, who had not read any of the flood of literature’ could believe that the principal means of controlling the money supply must be fiscal policy and interest rates. Strange bedfellows, indeed! The outcome of the MTFS was that although the UK plunged into a deep recession during 1979/80, government spending was still cut in a vain attempt to reduce the growth of the money supply. Such was the confusion over monetary policy that it was not even clear whether macroeconomic policy was too tight or too lax. The growth of the money supply was overshooting its target, but the cyclically-adjusted budget surplus was a massive 7% of GDP. The deflationary 1981 budget further worsened unemployment (Nickell, 2006). At this time there was also a marked increase in the exchange rate by 30%, partly due to North Sea Oil coming on stream and partly due to the tight monetary policy. This undoubtedly contributed to the rapid decline of manufacturing during this period by 20 per cent (the so-called ‘Dutch Disease’). Indeed, it has been suggested that one of the perverse results of the policy at this time was that many firms had to resort to distress borrowing because of the collapse in demand. This increased bank lending to the private sector and hence increased the growth of £M3. By 1982, it became clear that the demand for money had become unpredictable and other indicators were considered (the exchange rate, M1 and Private Sector Liquidity, Second Definition) in trying to determine the optimal level of the interest rate. The MTFS and the targeting of £M3 were effectively abandoned in 1985 which ‘represented a considerable volte-face’ (Goodhart, 1989, p.309). M0 replaced £M3 as the monetary target, but by then a more pragmatic approach considering a number of indicators had been adopted. Given the failure to control £M3 and the growing awareness of the damage that a volatile exchange rate could do, from 1987 interest-rate adjustment was determined by the policy of shadowing the Deutsche Mark and then by entry into the Exchange Rate Mechanism (ERM) in 1990. This was followed by Black Wednesday, 16 September 1992, when the UK was forced to leave the ERM by a sustained speculative attack on the currency. It was at this date that inflation targeting was introduced in the UK.

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Was monetarism ever really tried? The debate over monetary base control Monetarism did not fail because it simply was never properly implemented. At least this is the view of some monetarists. Friedman pointed out in his 1980 evidence to the Select Committee that the sine qua non of monetarism is the direct control of high-powered money or the monetary base. The Bank of England as the monopoly supplier of currency had the power to do this. But the failure of the Government to introduce monetary base control was not for want of careful consideration. There was a fierce debate, which included an official Green Paper, Monetary Control (Treasury/Bank of England 1980), over its merits in the years just before and after Thatcher came to power. The monetary base may be specified as the reserves of the commercial banks held at the Central Bank. If the Bank sells more debt than the central government needs to borrow domestically, the commercial banks will buy this debt and run down their reserves. Given the money multiplier, this will reduce the broad money stock. This is a radically different from the policy of controlling the growth of the money stock by interest rate adjustments. Friedman was highly sceptical of the latter, arguing that it was effectively trying to control the money stock by controlling the growth of income via fiscal policy3 and the price of money substitutes (via changes in interest rates). The correct procedure, Friedman argued, was to control the availability of base money. The advocates of monetary base control did not see as necessary the use of mandatory ratios of reserves to deposits. Rather the Bank should decide in advance how much to buy and sell through open market operations and leave the market to determine automatically the interest rate. But the Bank would still be required to use its discretion to determine the path of base money. The key question in the debate over the effectiveness of monetary base control was how quickly it could bring down inflation. If it was slow because it needed to work through the Keynesian mechanisms of a fall in aggregate demand and hence a reduction in the demand for money, then nominal interest rates would have to rise substantially. Hence, many policy-makers saw the disadvantage of using the monetary base control was that short-run interest rates would become highly volatile. ‘It would be as if an irresistible force – continued excess growth of bank lending – met an immovable objective – the prescribed path of base money; and something would have to give. In the process interest rates might, it seems, inevitably be driven to unprecedented levels’ (Dow and

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Saville, 1988, p. 145). Friedman accepted that this might occur in the short run, but in the long run (‘movements over periods of more than a few weeks’), because short-run interest changes removed the cumulative effects of disequilibrium that forced periodic sharper changes, the result would be ‘precisely the opposite’ (Friedman, 1991, p.56). But sceptics of monetary base control pointed out that if it were pursued, it could lead to the banks economizing on their reserves (it was even suggested that one of the larger banks could take over the Bank’s role) and to the rise of other unregulated financial institutions. Eventually, the fact that there was a very weak correlation between £M3 and base money and that ‘we in the UK have very little idea of the size of the cash balances the banks would wish to hold if we were to move to a system of monetary base control’ (Lawson, 1981, cited by Goodhart 1989, p.324) won the day. ‘Pure’ monetarism was never tried in the UK.4

The Post Keynesian view of the monetarist experiment One of the early arguments of Friedman that the money supply was essentially exogenously determined was that changes in it preceded changes in the rate of inflation, although with a variable lag. This view was always open to the criticism of post hoc ergo propter hoc. But more importantly, Tobin (1970) constructed a simple Keynesian model with endogenous money that gave the same result. Perhaps more graphic was Kaldor’s (1970) point that increased drawings of cash in November did not cause Christmas. Moore (1988), in considering the transmission mechanism, plausibly argued that the money supply is credit driven. The central bank’s main objective is to maintain orderly conditions in the money markets. ‘In short, a central bank’s job is to maintain a perfectly elastic money supply’ (Moore, 1988, p.216). (See Fontana and Setterfield, 2009, which examines how the endogeneity of money supply may be included in the textbook macroeconomic models.) The evidence suggests that changes in the broad money stock (£M3) is explained by the growth of bank advances to the private sector rather than by the PSBR or net overseas finance, a view shared, inter alios, by Dow and Saville (1988). As production takes time and receipts for goods and services are received after the costs have been paid, a firm has to cover the difference largely through bank borrowing. In an inflationary situation, when the cost of inventories is rising rapidly and firms need credit to finance these inventories, then the demand for credit will rise, especially if firms base their mark-up on historic costs.

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Moore (1988) provides econometric evidence that total bank borrowing is determined by the change in the total wage bill, the change in the import bill (a proxy for the change in the cost of all materials), a change in the tax bill, stock building, the own rate of interest, and a term to capture round tripping (borrowing to relend at a higher interest rate). An implication of the estimated coefficients is that total bank borrowing rises equiproportionately with the costs of production. Moore and Treadgold (1985) show in a graph the very close correlation between bank lending to the UK private sector and £M3. In other words, in terms of equation (1), the causation is predominantly from the change in bank lending to the private sector, ∆BLPS, to the change of the increase in the money supply (∆£M3) – not as postulated in the MTFS. The change in the value of bank lending is a function of the increase in the price level. The latter is determined through the mark-up by the increase in nominal wages and the prices of intermediate inputs. Once rapid inflation sets in, the nominal value of firms’ assets and other forms of collateral increase pari passu with the rate of inflation and provide the requisite security demanded by the banking sector for their increased nominal loans. This provides a far more convincing explanation of inflation than that of monetarism. Inflation is, consequently, primarily determined by the weighted growth of the nominal wage rate and the prices of domestic and foreignsourced intermediate inputs (after an allowance has been made for any increases in productivity). Consequently, the focus of attention should be on what determines the growth of money wages and the costs of materials. The growth of money wages is the outcome of a bargaining process between firms and workers and the NAIRU will occur whenever the workers’ target real wage increases are the same as the firms are willing to concede (Rowthorn, 1977). The important point to note is that this need not be at full employment, (i.e., the NAIRU does not necessarily equal the monetarist natural rate of unemployment). As the pressure of demand increases, so does the workers’ bargaining power. The latter can be, and indeed was, affected by labour market reforms and deregulation. Consequently, the NAIRU is not necessarily stable. The key question that confronts the Post Keynesian explanation of inflation is how to explain both the initial rapid increase in costs and what subsequently precipitates a downturn in inflation. Once the price level starts rising, then the existence of lags and a targeted growth of real wages will set in motion a vicious circle of rising prices and wages. One of the factors in explaining the rapid increase in inflation in 1974/5 and 1979 was that it was world-wide – no industrial country escaped.

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This suggests that there was a common cause and the most commonly accepted explanation is that it was initiated by the rapid increases in commodity prices (Bosworth and Lawrence, 1982). In 1974/5 not only was there the quadrupling of oil prices, but many other commodity prices rose rapidly; inter alia, there was a shortage of capacity in many ore-refining industries and agricultural buffer stocks had been run down. Inflation in the UK really started increasing after 1972 when it rose from 6.8% per annum to 10.4% (1973) and 19.0% (1974). Wage increases had, in fact, taken off two years earlier; in 1969 the rate was 7.7%; in 1970, 13.9%; and in 1972, 11.0%. An explanation of the inflation rate up until 1969 was that the economy had been run at too high a level of demand pressure and there is an element of truth in this. It was in 1969 that the first wage explosion occurred with a number of headline settlements in excess of 15%. At this time, the growth of the money supply was low – £M3 was growing at just over 3% in this year. Williamson and Wood (1976) argue that the rapid increase in nominal wages over 1969/1973 was due to changes in the labour market, notably workers’ greater militancy. Wages had been held down in the previous two years and there is ample evidence that unions had become more militant, an explanation that they consider to be uncomfortably ad hoc. But, nevertheless, it was the only one to fit the facts. The inflation explosion in 1973/4 was clearly aggravated by the increase in the price of commodities: ‘surely the clearest cost-push inflation in history’ (Williamson and Wood, 1976, p.528). However, the impact is probably greater than they allow (they place more emphasis on the rapid expansion of demand in 1973), as falling demand in 1975 had no effect on inflation. Moreover, the increase in inflation by 10 percentage points from 1978 to 1980 was largely due to the second oil price shock that occurred in 1979. The increase in import prices has a much greater effect on the price level in the long run than its immediate impact through its share in the retail price index. If workers succeed in maintaining their real wage then the overall effect will be that the general price level will rise equiproportionately with the increase in import prices, regardless of the size of the share of imports in GDP (Wilson, 1976). Beckerman and Jenkinson (1986) also emphasize the role of commodity prices in the inflationary process. They provide evidence that suggests that the fall in annual inflation of 12 advanced countries from a peak over the two years of 1979/81 of 11.5% p.a. to 6.5% p.a. over the two years 1981/3 was almost entirely due to a sharp fall in commodity prices, with no

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role for the rise in unemployment in the individual countries. However, this does not preclude the fact that the rise of unemployment in the advanced countries as a whole may have depressed the rate of growth of commodity prices. Wilkinson (2000) has also shown how import prices are closely correlated with the general price level. Considering the whole period 1969–97, he concludes, ‘the import price effect therefore provides a credible explanation of changes in domestically generated prices and leaves little room for an independent role of unemployment’ (p.657). Confirmation of the importance of the growth of commodity prices and wages as an explanation of inflation has also been found for the United States over the period 1900 to 2001 by Bloch et al. (2004).

The legacy of monetarism To what extent did the monetarist experiment pave the way for policies that led to the NICE years that lasted from the mid-1990s until the credit crunch of 2007? The monetarist model of Friedman introduced the concept of the natural rate of unemployment, the importance of the role of expectations and the assumption that inflation was due to excess demand, a consequence of unemployment being below the natural rate. All of these theoretical developments are central to the development of the core model of the new consensus in macroeconomics (NCM), which forms the basis for current monetary policy, namely inflation targeting. Goodfriend (2007) provides a succinct historical discussion of the development of the NCM model. The NCM extended the theoretical monetarist model by incorporating rational expectations and it is based on rigorous, although narrow, microfoundations, which Goodfriend (2004) terms the ‘New Neoclassical Synthesis’. However, use is made of the concept of the representative agent and there is no consideration of aggregation issues (see Wren-Lewis, 2007). Kirman (1992) presents a devastating critique of the use of the representative agent. Goodfriend (2004) provides a good introduction to the underlying theoretical model. Households optimize their intertemporal consumption patterns so that the latter coincide with their income (total output) over time, caused by the rate of interest adjusting relative to the rate of time discount. Prices are determined by a mark-up policy, the size of the profit maximizing mark-up being a function of the elasticity of demand. Profits are simply paid to households (there is no investment, fluctuations of which can generate real demand shocks). The core of the approach is the real business cycle model, but with the assumption

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imperfect competition. It is a consensus approach in that it also includes New Keynesian sticky prices, due to menu costs. While the real business cycle model was originally developed to explain output and employment fluctuations independently of monetary factors, it has now become the benchmark against which to judge optimal monetary policy. This should be, it is argued, to make the economy behave as if it were the imperfectively competitive business cycle model (Goodfriend, 2004). The key macroeconomic policy inference is that it should only respond to core inflation, i.e., inflation that is caused by excess demand. Meyer (2001) presents a stripped-down macroeconomic version of the NCM model based on three equations. There is an aggregate demand equation based on households’ inter-temporal optimization, an expectations augmented Phillips curve, and a rather ad hoc (Taylor) monetary rule.5 In this model, the money supply is merely a residual and therefore has no independent role to play. Consequently, the LM curve, which is derived with endogenous money, is omitted from the model. ‘The consensus model may bypass money, but it has retained the key conclusion that central banks ultimately determine the inflation rate’ (Meyer, 2001, p.3). In this, the influence of monetarism can clearly be seen. Moreover, like monetarism, the NCM also denigrates the role of fiscal policy. This is notwithstanding the empirical evidence that the multipliers from fiscal policy can be substantial, especially if fiscal policy is used in coordination with monetary policy as Philip Arestis has repeatedly shown. (See, for example, Arestis and McCombie, 2009.) But what monetarists see as a central tenet of monetarism, namely, that control of the money supply is a necessary and sufficient condition for the control of inflation has gone. No monetary authority apart from the European Central Bank (ECB)6 now plays any significant attention to the growth of money supply and it is hardly ever mentioned in policy debates. But what the NCM shares with monetarism is the use of a single instrument, the nominal interest rate, and the target has merely changed from the growth of the money supply to core inflation. Fiscal policy is deemed ineffective and the budget should be balanced over the economic cycle (Gordon Brown’s ‘golden rule’). But, of course, the term ‘consensus’ is a misnomer, as the model is incompatible with Keynes’s notion of involuntary unemployment which is not due to the inflexibility of wages or prices (Tobin, 1993, p.48). By focusing on the microfoundations with no consideration of the implications of aggregation, the approach suffers from the fallacy of composition of which Keynes many years ago accused the classical

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economists. It merely assumes away involuntary unemployment and postulates that the economy automatically moves to full employment subject to price rigidities in the short run. Keynes, of course, saw price inflexibility as a policy prescription, not a behavioural assumption. Price flexibility could not remedy lack of aggregate demand. Of course, the proof of the pudding is in its eating and, since the mid-1990s, both the volatility of output and inflation has fallen, and the rate of inflation was on average around 3–4% per annum for the vast majority of the advanced countries. While these developments preceded the independence of many central banks, and it has been argued that it coincided with inflation targeting, either explicitly or implicitly. But as Philip Arestis has shown with colleagues, there is no significant difference in inflation rates between countries that adopted and did not adopt an independent central bank (Angeriz et al., 2009) and/or inflation targeting (Angeriz and Arestis, 2007). In the UK, inflation targeting effectively began in 1992, but were the NICE years the result of inflation targeting? As the Bank of England (2005) has questioned, has this been due to ‘good luck’ and factors that were independent of the conduct of monetary policy or was it due to regime change? In particular, the former includes, perhaps most importantly, the effect of globalization which effectively doubled the world labour supply and increased the share in imports of the low-cost products from China, India and the Asian tigers. Globalization also puts pressure on domestic producers to resist excessive wage demands. It has also accelerated deindustrialization in the advanced countries. It was often the industrial sector (which was more heavily unionized than the service sector) that had the industries with the highest productivity growth. As these were the pace setters in the demand for inflationary wage settlements (Eatwell et al., 1974), this may have reduced the level of wage demands. The jury is still out on this question of whether or not it was just coincidental that inflation fell when inflation targeting was introduced. The Bank of England (2005) and Henry (2008) provide reviews of the literature. Henry’s study suggests that the fall in inflation in the 1980s was a slow recovery from the oil price hike of 1979 and the resurgence of inflation in the late 1980s was due to a perception that the natural rate was lower than it actually was. ‘Inflation targeting and central bank independence can, at best, be only part of the story’ (Henry, 2008, p.34). But as Henry points out his model does not incorporate any possible effects from globalization and import prices which, in all probability, will reduce further the importance of the role of inflation targeting.

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When it comes to be written, the economic history of the 2007/10 credit crunch is likely to show the shortcomings of the NCM. It will be written in terms of the failure of adequate regulation of the banking institutions (the latter excluded from the NCM), the development of highly risky financial instruments, the collapse of bank lending, the increase in credit rationing and the rise of unemployment, due to a collapse of aggregate demand. It will show the resurgence of fiscal policy and the impotence of monetary policy in deep recessions. It will confirm the sterility of modern monetary theory, with its emphasis, for example on complete markets and the efficient markets hypothesis (see the scathing critiques by the former members of the Monetary Policy Committee, Blanchflower, 2009, and Buiter, 2009). The recession of 2008 has very little to do with the degree of price flexibility as either the cause or cure. But that is another story. Nevertheless, there are shades of monetarism in the ‘unconventional measures’ (King, 2009) introduced by the Bank of England in March 2009. With inflation well below the target of 2% and nominal interest rate at 0.5%, leaving little scope for future significant cuts, the MPC decided to expand the money supply by ‘quantitative easing’ or the large-scale purchase of public and private sector assets (Benford et al. 2009). This is reminiscent of monetarism to the extent that the Bank is seeking to increase the quantity (supply) of money. Assets purchased from the banks increase narrow money and those from the private non-bank sector increases both the monetary base and broad money. The theoretical rationale behind quantitative easing is analogous to Friedman’s ‘helicopter money’, although the Bank does not directly inject money into the economy. If a financial company sells assets to the Bank, it finds it has excess money holdings with which it may extinguish by buying other assets, driving prices of all assets up (the ‘portfolio balance effect’). Other sellers of assets may simply use their excess money balances to increase their spending. The shadow of monetarism is again present in the Bank of England’s (2009) pamphlet where it states that ‘the money supply needs to keep growing at a steady rate to keep pace with the expansion of the economy, and to ensure inflation remains close to the Government’s 2% target’ (emphasis added). Whether or not quantitative easing will be successful is not clear at the time of writing. There is some evidence of the beginnings of a recovery in the UK. The major effect is likely to be from expansionary fiscal policy. Given that the credit crunch was caused by failure of adequate bank regulation and led to severe credit rationing, it is a scenario on which neither monetarism nor the NCM can shed any light. The resultant

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fall in aggregate demand will require a substantial boost through fiscal policy. Monetary policy alone is almost certainly to be ineffective. In terms of this chapter, a counterfactual question is ‘had the theoretical developments in the NCM been available to policy-makers in 1979 and had inflation targeting been the macroeconomic policy, would the outcome have been any different?’ Given that the use of nominal interest was at that time the main policy instrument and given that the Thatcher government had, for at least a short time, credibility (‘there is no alternative – TINA’; ‘the lady’s not for turning’7), it is extremely doubtful.

Notes 1. However, the previous Labour government had begun to have doubts about Keynesian policies. In 1976, the then Prime Minister, James Callaghan famously told the Labour Party conference that ‘we cannot spend our way of a recession’. 2. The Select Committee was not, however, convinced that there was a causal relationship from the growth of the money supply to inflation as the monetarists argue. 3. In this ironically he agreed with Kaldor. 4. The Fed did adopt of a form of monetary base control over the period 1979–82 but it ‘led to a very bumpy ride’ (Goodhart, 1989, p.326). 5. It is ad hoc in that it was originally derived empirically with no theoretical basis. 6. The ECB uses M3 as a ‘reference value’ which is the growth of M3 deemed to be compatible with price stability. However, the ECB does not target the growth of the money supply, but it also claims not to follow direct inflation targeting (European Central Bank, 2004). 7. Speech by Thatcher to the 1980 Conservative Party Conference.

References Allsopp, C.J. (1985), ‘The Assessment. Monetary and Fiscal Policy in the 1980s’, Oxford Review of Economic Policy, vol. 1, pp.1–20. Angeriz, A. and Arestis, P. (2007), ‘Inflation Targeting. Assessing the Evidence’, in McCombie, J.S.L. and Rodriguez, C. (eds), Issues in Finance and Monetary Economics, Basingstoke: Palgrave Macmillan. Angeriz, A., Arestis, P. and McCombie, J.S.L. (2009), ‘Does Central Bank Independence Affect Persistence and Volatility?’, Cambridge Centre for Economic and Public Policy, University of Cambridge, (mimeo). Arestis, P. (2007a), ‘What is the New Consensus in Macroeconomics?’, in Arestis (2007b). Arestis, P. (ed.) (2007b), Is there a New Consensus in Macroeconomics?, Basingstoke: Palgrave Macmillan. Arestis, P. and McCombie, J.S.L. (2009), ‘On the Effectiveness of Fiscal Policy as an Instrument of Macroeconomic Policy’, Economic Affairs, vol. 29, pp. 77–9.

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Arestis, P. and Sawyer, M. (2004), ‘Can Monetary Policy Affect the Real Economy?’, European Review of Economics and Finance, vol. 3, pp. 9–32. Bank of England (2005) ‘The Bank of England’s Submission Regarding the Economic Context’, House of Commons Treasury Committee Inquiry into Monetary Policy of the Bank of England: Ten Years On. Bank of England (2009), Quantitative Easing Explained. (http://www.bankofengland .co.uk/monetarypolicy/assetpurchases.htm). Beckerman, W. and Jenkinson, T. (1986), ‘What Stopped the Inflation? Unemployment of Commodity Prices?,’ Economic Journal, vol. 96, pp. 39–54. Benford, J., Berry, S., Nikolov, K., Young, C., and Robson, M. (2009), ‘Quantitative Easing’, Bank of England Quarterly Bulletin, Q2, pp. 90–100. Blanchflower, D.G. (2009), ‘The Future of Monetary Policy’, Open lecture given at Cardiff University on 24 March 2009. (Available at www.bankofengland .co.uk/publications/speeches/2009/speech382.pdf.) Bloch, H., Dockery, M. and Sapsford, D. (2004), ‘Commodity Prices, Wages and U.S. Inflation in the Twentieth Century’, Journal of Post Keynesian Economics, vol. 26, pp. 523–45. Bosworth, B.P. and Lawrence, R.Z. (1982), Commodity Prices and the New Inflation, Washington, D.C.: The Brookings Institute. Britton, A. (1991), Macroeconomic Policy in Britain, 1974–87, Cambridge: Cambridge University Press. Buiter, W.H. (2009), ‘The Unfortunate Uselessness of Most ‘State of the Art’ Academic Monetary Economics’, Financial Times (http://blogs.ft.com/ maverecon/2009/03/) Congdon, T. (2004), ‘Monetarism: A Rejoinder’, World Economics, vol. 5, pp. 179–97. DeLong, J.B. (2000), ‘The Triumph of Monetarism?’, Journal of Economic Perspectives, vol. 14, pp. 83–94. Dow, J.C.R. and Saville I.D. (1988), A Critique of Monetary Policy: Theory and British Experience, Oxford: Oxford University Press. Eatwell, J., Llewellyn, J. and Tarling, R. (1974), ‘Money Wage Inflation in Industrial Countries’, Review of Economic Studies, vol. 41, pp. 515–23. European Central Bank (2004), The Monetary Policy of the ECB, 2004, Frankfurt: European Central Bank. Fontana, G. and Setterfield, M. (eds) (2009), Macroeconomic Theory and Macroeconomic Pedagogy, Basingstoke: Palgrave Macmillan. Friedman, M. (1980), ‘Evidence. Memorandum: Response to Questionnaire on Monetary Policy’, The House of Commons Treasury and Civil Service Committee: Memorandum on Monetary Policy. London, HMSO. Reprinted in Friedman, M. (ed.), Monetarist Economics, Oxford: Basil Blackwell, (1991). Goodfriend, M. (2004), ‘Monetary Policy in the New Neoclassical Synthesis: A Primer’, Federal Reserve Bank of Richmond, Economic Quarterly, pp. 21–45. Goodfriend, M. (2007), ‘How the World Achieved Consensus on Monetary Policy’, Journal of Economic Perspectives, vol. 21, pp. 47–68. Goodhart, C.A.E. (1989), ‘The Conduct of Monetary Policy’, Economic Journal, vol. 99, pp. 293–346. Henry, S.B.G. (2008), ‘Monetary Policy, Beliefs, Unemployment and Inflation: Evidence from the UK’, National Institute of Economic and Social Research, Discussion Paper 305.

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John McCombie 125 Kaldor, N. (1970), ‘The New Monetarism’, Lloyds Bank Review, July, pp. 1–7. Kaldor, N. (1980), ‘Monetarism and UK Monetary Policy’, Cambridge Journal of Economics, vol. 4, pp. 293–318. King M.A. (2003), Speech given to the East Midlands Development Agency/Bank of England Dinner, Leicester, 14 October 2003. King, M.A. (2009), The Governor’s Speech to the CBI Dinner, Nottingham, January. Kirman, A.P. (1992), ‘Whom or What Does the Representative Individual Represent?’, Journal of Economic Perspectives, vol. 6, pp. 117–36. Lawson, N. (1981) ‘Thatcherism in Practice: A Progress Report’, Speech to the Zurich Society of Economics, 14 January, HM Treasury Press Release. London, S. (2003), ‘Lunch with the FT – Milton Friedman: The Long View’, Financial Times Magazine supplement, 7 June, pp. 12–13. Mayer, T. and Minford, P. (2004), ‘Monetarism. A Retrospective’, World Economics, vol. 5, pp. 147–70. Meyer, L.H. (2001), ‘Does Money Matter?’, Federal Reserve Bank of St Louis Review, September/October, pp. 1–16. Moore, B.J. (1988), Horizontalists and Verticalists: The Macroeconomics of Credit Money Cambridge: Cambridge University Press. Moore, B.J. and Treadgold, A.R. (1985) ‘Corporate Bank Borrowing in the UK, 1965–1981’, Economica, vol. 52, pp. 65–78. Nickell, S. (2006), ‘The Budget of 1981 was Over the Top’, in Booth, P. (ed.), Were 364 Economists All Wrong? London: Institute of Economic Affairs. Rowthorn, R.E. (1977), ‘Conflict, Inflation and Money’, Cambridge Journal of Economics, vol. 1, pp. 215–39. Tobin, J. (1970), ‘Money and Income: Post Hoc Ergo Propter Hoc?’, Quarterly Journal of Economics, vol. 84, pp. 301–17. Tobin, J. (1993) ‘Price Flexibility and Output Stability: An Old Keynesian View’, Journal of Economic Perspectives, vol.7, pp. 45–65. Williamson, J. and Wood G.E. (1976), ‘The British Inflation – Indigenous or Imported?’, American Economic Review, vol. 66, pp. 520–31. Wilkinson, F. (2000), ‘Inflation and Employment: Is there a Third Way?’, Cambridge Journal of Economics, vol. 24, pp. 643–70. Wilson, T. (1976) ‘Effective Devaluation and Inflation’, Oxford Economic Papers, vol. 28, pp. 1–24. Wren-Lewis, S. (2007) ‘Are there Dangers in the Microfoundations Consensus?’, in Arestis (2007b).

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8 Phillips’ Curve, Independence of Central Banks and Inflation Targeting Malcolm Sawyer

1. Introduction Philip Arestis has contributed to many areas of macroeconomics and monetary economics. Those contributions have included theoretical and empirical investigations of inflation, and the development of critiques of inflation targeting, again both in the theoretical dimension and the empirical.1 The purpose of this chapter is to focus on particular aspects of inflation and inflation targeting, namely the Phillips’ curve and its role in the arguments for independence of the Central Bank and the adoption of inflation targeting. In doing so, I draw heavily on discussions and joint work with Philip over many years.

2. The Phillips’ curve The Phillips’ curve has been a central feature of most macroeconomic analysis and policy discussion since it arrived just over half a century ago (Phillips, 1958).2 It initially portrayed an empirical relationship between wage inflation and unemployment for the UK, which could be interpreted as a ‘menu’ of choice or trade-off between inflation and unemployment. This relationship between inflation and unemployment had major impacts on macroeconomic analysis and policy discussion in the following ways. Although the Phillips’ curve and the immediate debates surrounding it involved a relationship between wage inflation and unemployment, Phillips (1954) had portrayed a price inflation–output relationship. Samuelson and Solow (1960) translated the relationship into one between price inflation and unemployment. Increasingly (as exemplified in the new Keynesian Phillips’ curve) the focus has been on a relationship between price inflation and output gap (difference 126

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between actual output and trend or normal output). Here the term Phillips’ curve is used to signify a relationship between price or wage inflation and some measure of economic activity (e.g. unemployment, output gap). The relationship generally would also involve expected (price or wage) inflation. But we would not include under the heading of Phillips’ curve an equation for price or wage inflation which involved other variables such as profits share, level of real wages, or the rate of change of economic activity. At first the Phillips’ curve appeared to complete the Keynesian model with a demand-push view on the causes of inflation with a link from the demand-determined level of unemployment to the rate of (wage) inflation. The empirical findings of Phillips (1958) and his theoretical arguments in Phillips (1954) suggested some element of downward nominal price inflexibility. Although, following Phelps (1967) and Friedman (1968), the argument soon developed that there was no long-run trade-off between inflation and unemployment, the Phillips’ curve mechanism has been retained as a short-run relationship between unemployment and wage inflation, and specifically lower (higher) unemployment is viewed as leading to higher (lower) inflation. Part of the rationale for the use of interest rate policy to target inflation rests on this mechanism in that interest rate is taken to influence the level of demand, and then the level of demand influences the rate of inflation, i.e. the Phillips’ curve. Based on the papers of Phelps (1967) and Friedman (1968), the incorporation of the role of expectations leads to the notion of a vertical Phillips’ curve at the ‘natural rate of unemployment’. The use of this term had overtones of unemployment being inevitable (the ‘dismal science’) though Friedman denied that he meant ‘to suggest that it [the ‘natural rate’] is immutable and unchangeable. On the contrary, many of the market characteristics that determine its level are man-made and policy-made’ (Friedman, 1968, p.9). He argued that he used ‘the term ‘natural’ for the same reason Wicksell did – to try to separate the real forces from monetary forces’ (Friedman, 1968, p.9) and hence to emphasize the ‘classical dichotomy’ and that movements on the demand side have no lasting effect on the supply-side. The supply-side equilibrium corresponded to the ‘natural rate of unemployment’. The use of the term unemployment here (rather than say some measure of output relative to capacity) and the link between the ‘natural rate of unemployment’ and labour market clearing position portrayed the constraint on economic activity (in terms of levels of output and employment) as arising from the labour market. He cited minimum

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wages, legislation on industrial relations and trade unions and the strength of trade unions as factors influencing and increasing the ‘natural rate of unemployment’. In contrast, ‘improvements in employment exchanges, in availability about job vacancies and labor supply, and so on, would tend to lower the natural rate of unemployment’ (Friedman, 1968, p.9). The Phillips’ curve is known for its inclusion of some measure of economic activity and of expected inflation as the determinants of the rate of inflation, and should be known for what it excludes. It clearly excludes direct mention of costs, although in the New Consensus Macroeconomics (NCM) formulation cost changes are said to be reflected in the random term. It excludes elements such as the rate of change of economic activity and distribution of income (or related variables such as real wages) which we have argued elsewhere (Arestis and Sawyer, 2008a) to be relevant. Thus the Phillips’ curve provides a simple, if not simplistic, picture of inflation. This view of inflation with its portrayal of a positive relationship between the level of economic activity and inflation was highly influential with its portrayal of a link between a ‘good’ (higher economic activity) and a ‘bad’ (inflation). It could be viewed in a causal manner with the level of economic activity determining the future rate of inflation. The argument was then developed that since a higher level of economic activity (and lower level of unemployment) would be electorally popular, then politicians in power may be tempted to boost the economy (whether through monetary or fiscal policy) to generate a higher level of economic activity even though it would bring higher inflation later on. The Phillips’ curve moved from being a relationship between wage inflation and unemployment to being regarded as one between unexpected (wage) inflation and unemployment (and then in other formulations between unexpected price inflation and the output gap). Write • • • • this as w = we + f (U ) where w is the rate of (wage) inflation, we the expected rate of (wage) inflation and U the rate of unemployment. This had two important implications. First, it leads into an accelerationist • • view of inflation, that is w − we comes close to being the change in the rate of inflation. A lower level of unemployment would lead to inflation being higher than expected, and the maintenance of that lower level of unemployment along with adjustment of expectations to the experience of inflation would lead to inflation rising and rising. The danger of low unemployment becomes not just a higher rate of inflation but a rising rate of inflation, opening the spectre of hyperinflation. There

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is a strong accelerationist view of inflation in that analysis, that is, an unemployment rate somewhat below the natural rate would involve inflation above the expected level, and as the expected rate of inflation adjusts to the experience of inflation, there would be a tendency of inflation to continually rise. It is this ‘knife-edge’ accelerationist view which seems to underpin a fear not only of inflation but of having unemployment at all below the perceived ‘natural rate’ as the damage could be accelerating inflation into hyperinflation. This leads to an ‘unemployment bias’ in macroeconomic analysis, particularly in the NCM (Fontana, 2009). Second, expectations on inflation come to play a key role in the generation of inflation. If people are convinced that inflation will be low (high), it will be low (high). Although Phillips’ curve began as a demand-push view of inflation, while in the expectations formulation this demand-push view is retained, it is in effect swamped by the role of expectations in the sense that variations in expectations would have a much more significant impact on inflation than would variation in demand.

3. Lack of theoretical basis for the Phillips’ curve It is well known that Phillips (1958) was an empirical exercise with little immediate theoretical justification, though Phillips himself (Phillips, 1954) had portrayed a curve relating price inflation and output. Phillips (1954) was a theoretical paper on stabilization policy which included a ‘a relationship between the level of production and the rate of change of factor prices’ which was close to an reverse L-shape with ‘the fairly sharp bend in the curve where it passes through zero rate of change of prices being the result of the greater rigidity of factor prices in the downward than in the upward direction’ (p. 308). He provided some discussion to justify this curve, which is noted for a lack of clarity between level of prices and rates of change. For example, ‘if the prices of the services of the factors of production (which will be referred to for brevity as factor prices) are absolutely rigid, product prices, tending to move with marginal costs, will vary directly with the level of production. This component of the change in product prices is probably not very large, and will be neglected in the following analysis’ (p.307). The proposition of the Phillips’ curve is that inflation is related (in effect caused by) the level of economic activity and the expected rate of inflation, and that other variables such as costs are either not relevant or operate in a random fashion (as in the representation of the

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Phillips’ curve in the new consensus model and the new Keynesian version). There are two central claims which underpin the approach here. First, there is a lack of a convincing and robust theoretical framework from which the Phillips’ curve can be derived. This proposition is examined in detail in Sawyer (2010). The essential basis of the argument is the following. A particular feature of the Phillips’ curve is that it relates the rate of change of a variable (price or wages) to the level of another variable (economic activity). Because of the role played by expected inflation, it could be said that it is closer to the acceleration of a variable (inflation minus expected inflation). This stands in contrast with a more usual situation in economics where the level of price (relative to cost) is related with the level of output. The notion that rate of change of prices is related with the level of output (reflecting the level of economic activity) is not obviously compatible with the level of prices being related with the level of output. Consider, for example, a simple monopoly model in which the profit maximising price is given by p = (e/e⫺1).m.mc(q) written as θ.m.mc(q), where e is elasticity of demand, mc real marginal cost which depends on the level of output, q, and m is an input price index. From this type of equation, we can derive an equation for price change: this could be the differential with respect to time of the price level equation, i.e.: •

•

•

p⫽ u ⫹ m ⫹

∂mc( q ) • q ∂q

(1)

where a dot above a variable signifies rate of change of that variable. An alternative view would be to treat the price level equation as the desired price which may not be immediately attained and then the price change has two elements, one based on changes in the variables on the right hand side of the price level equation and the other an adjustment of price towards the desired level, i.e.: •

•

•

p⫽ u ⫹ m ⫹

∂mc( q ) • q ⫹ l( p⫺1 ⫺ u.m.mc( q⫺1 )) ∂q

(2) •

•

A Phillips’ curve type relationship would take a form such as p ⫽ g ( y ) ⫹ p e • where y is output gap and p e the expected rate of inflation. This gives a contrast between a relationship between rate of price change and the rate of change of output (as in equation (2)) and one between rate of price change and the level of output. There is then a clear inconsistency between the standard pricing models (of which there are numerous versions and monopoly pricing is used as an example here) and the

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Phillips’ curve. Clearly we could move in the reverse direction, that is, start from an equation which relates inflation (rate of change of price) with the level of economic activity, and integrate over time to reach an equation which relates the price level to the cumulative level of economic activity since time began. A rather similar argument can be readily developed with respect to wages. The notion of a ‘wage curve’ relates the level of real wages with the level of unemployment. Blanchflower and Oswald (1994) conclude for their large empirical study across a range of countries that A worker who is employed in an area of high unemployment earns less than an identical worker in a region with low joblessness. The nature of the relationship appears to be the same in different countries. ... As a crude characterisation of the data ... the wage curve is described by the formula ln w = ⫺0.1 ln U ⫹ other terms, where ln w is the log of the wage, ln U is the log of unemployment in the worker’s area .... A hypothetical doubling of unemployment is then associated with a drop in pay of 10% (that is, a fall of one tenth) (p. 5: emphasis in original). They postulate three ways of interpreting these results. ‘First, the relationship might be the equation of a contract curve. Second, it might be a no-shirking condition. Third, it might be a kind of bargainingpower locus’ (p.93). Sawyer (2002, 2010) similarly discusses a range of approaches to wage determination, including target real wages, trade union bargaining models, and ideas of efficiency wage, all of which would lead to some form of relationship between level of wages and level of (un)employment, though the precise specification would differ (particularly with regard to the relevant measure of wage, whether real wage, wage relative to unemployment benefit, etc.). There is again an essential inconsistency between any form of ‘wage curve’ which involves the level of wages and the Phillips’ curve which involves the rate of change of wages. The Phillips’ curve can be seen as a reduced form single equation which summarizes the postulated relationship between inflation and the level of economic activity. The New Keynesian Phillips curve (NKPC) does appear to provide a theoretical framework for the Phillips’ curve. However, we have argued (Arestis and Sawyer, 2007, Sawyer, 2010) that this approach does not successfully overcome the essential problem indicated above, namely how to move from a relationship between the level of prices and the

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level of output to one involving change in price and the level of output. It may also be noted that the NKPC has not been an empirical success. For example, ‘[a]lthough the new Keynesian Phillips curve has many virtues, it also has one striking vice: It is completely at odds with the facts’ (Mankiw, 2001, p.C52). Galí and Gertler (1999) have noted that ‘it is often difficult to detect a statistically significant effect of real activity on inflation using the structural formulation implied by the theory, when the measure of real activity is an output gap (i.e., real output relative to some measure of potential output). Failure to find a significant short-run link between real activity and inflation is unsettling for the basic story’ (p.196). The evidence of authors such as Galí and Gertler (1999), Galí, Gertler, and López-Salido (2005) suggest that real marginal cost is the appropriate variable to include than output: real marginal cost is measured by labour share for which it would be a good approximation under some stringent assumptions such as a Cobb–Douglas production function and marginal productivity theory. This evidence should be seen as more supportive of a conflict over income distribution approach than the NKPC. The use of a single equation raises a range of difficulties. The first one can be seen by reference to the idea of the Phillips’ curve as a trade-off between unemployment and inflation in the sense that a specified rate of unemployment would be associated with a particular level of inflation. This notion of a trade-off was ‘defeated’ by the arguments of Phelps (1967) and Friedman (1968) in the sense that a persistent rate of inflation would involve an adjustment to expectations of inflation. But the notion remains that for a given state of inflationary expectations, there is a negative relationship between wage inflation and unemployment which can be exploited in the sense that higher unemployment would bring lower inflation (for a given state of expectations). It is that linkage which, of course, forms the final link in the transmission mechanism of monetary policy. When the Phillips’ curve is viewed as an adjustment process (as in Lipsey, 1960), then there is a presumed change involved. In particular, when unemployment differs from the equilibrium ‘natural’ level of unemployment, and hence when there is excess demand or supply, then real wages will change, and as they do so the extent of excess demand (supply) and thereby unemployment change. Thus unemployment cannot be held at a particular level. The key difficulty of the Phillips’ curve being viewed as describing an adjustment process is that an observed level of unemployment (which may be associated with a particular rate of inflation) is merely a step en route to another level of unemployment.

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If it is not an adjustment process, then some external force has to be invoked. Some form of aggregate demand adjustment is often invoked. A familiar one has been the operation of some form of real balance effect: as inflation remains, real value of money stock declines, and the real balance reduces the level of demand, back towards the ‘natural rate of unemployment’ (or the non-accelerating inflation rate of unemployment, NAIRU). A more recent mechanism (and that implicit in the transmission mechanism of monetary policy) is that adjustments in the rate of interest bring inflation in line with target and also establish the level of demand consistent with the ‘natural rate of unemployment’.

4. Independence of Central Banks and inflation targeting The arguments for an ‘independent’ Central Bank with the task of securing an inflation target through interest rate policy relies on the expectations-augmented Phillips’ curve in a number of ways. In a general way, the accelerationist approach serves to bring control of inflation and avoidance of high levels of demand and economic activity centre stage since it suggests that hyperinflation (and collapse of money) as the consequence of allowing inflation to start. The Phillips’ curve is an expression of demand-pull (rather than cost-push or conflict) inflation, and the control of inflation is envisaged to run through the route: interest rate → level of demand → inflation. Portrayed as a ‘menu of choice’, the Phillips’ curve chimes with the argument that politicians will be tempted to pursue policies of low unemployment (even though subsequent inflation is the cost) whereas ‘conservative’ Central Bankers place more weight on the avoidance of inflation. When there is belief that Central Bankers will act to constrain inflation and a belief that such actions will be successful, there would be favourable effects on expected inflation. If expected inflation remains low (and specifically if expectations on inflation are around the inflation target) then the achievement of low inflation becomes that much less difficult. The ‘independent’ Central Bank and inflation targeting provides a ‘one instrument–one objective approach’. The ‘one objective’ (inflation) perspective has been criticized on the grounds that it ignores employment and output as objectives of macroeconomic policy (and indeed other variables as well, though (un)employment is our focus). However, within the rationale of the Phillips’ curve that criticism can be readily deflected in that the level of economic activity which has to be achieved is the one consistent with constant inflation. When the level of economic activity is seen in terms of unemployment, this would

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be the NAIRU; when in terms of output it is generally taken as a zero output gap, that is, actual output equal to trend or potential output. Any other level of economic activity would lead to continuously rising or falling inflation. But the assumption is that the NAIRU or the zero output gap correspond to supply-side equilibrium positions, and more significantly are unaffected in either the short run or the long run by the levels of aggregate demand and economic activity. In Sawyer (2002), Arestis and Sawyer (2005) and elsewhere, we have argued for the impact of economic activity (through capacity utilization, profitability) on the level of investment, which in turn is an addition to the capital stock and productive capacity. In those papers we present models in which the position corresponding to constant inflation shifts over time as additions to (or deletions from) the capital stock occur. In Arestis and Sawyer (2008a) and elsewhere we have pointed to the need for a more sophisticated approach to inflation than that given by the Phillips’ curve. At a minimum we suggest that while the level of economic activity may have some influence on the pace of inflation, there are many other factors, notably international inflation, the rate of change of output and the distribution of income (notably between wages and profits) linked with the conflict over income shares. It can then be expected that the relationship between the level of economic activity and inflation is at most a weak and unpredictable one. The ‘one instrument–one objective’ approach also depends on the effectiveness of the instrument (interest rate) and the absence of significant ‘spill-over’ effects. We have cast doubt on inflation targeting along four lines (see, for example, Arestis and Sawyer, 2008b). First, the difference in inflation performance between inflation targeting and noninflation targeting countries appears small in a general environment where inflation had been declining, and that inflation targeting was often introduced after inflation had been reduced (see also, Angeriz and Arestis, 2007, 2008). Second, variations in the rate of interest appear to have little effect on the rate of inflation (though rather more on the level of output). The evidence on this is typically obtained from econometric estimation results undertaken within Central Banks or by those closely associated with them. A 1 percentage point hike in policy interest rate leads to a significant drop in output but reduction in inflation of the order of 0.1 to 0.2 percentage points (Arestis and Sawyer, 2004). Goodhart (2005b), drawing on his experience on the Monetary Policy Committee and the work done within the Bank of England, commented that ‘unless the shocks hitting the system were really quite small, the extent of policy-induced demand management, even if perfectly

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calibrated, could not be responsible for the achievement of the stability and successful growth that we have enjoyed’ (p. 169). Third, there is the attempt at ultra fine tuning in the sense that monthly decisions (and hence potential change) on interest rates are made seeking to target inflation up to two years ahead. Fourth, the lack of strong theoretical link running from interest rate to economic activity to inflation. Sawyer (2009) examines a number of the proposed links. The essence of the argument is that the interest rate and the level of economic activity are in levels whereas inflation is a rate of change (of prices). Thus a higher rate of interest may lead to lower prices (though that may be doubted on the lines of Gibson’s paradox or by observing that interest is a cost and higher costs lead to higher prices), but not to falling prices. In the monetary policy transmission mechanism, it is generally recognized (as in, for example, the Bank of England framework: see Bank of England, 1999) that a change in the rate of interest has an effect on asset prices and on the exchange rate. These effects are generally presented as aiding the transmission process in that an increase in the rate of interest is deemed to reduce asset prices and to lead to appreciation of the exchange rate. Then the wealth effect of lower asset prices and the effects of the exchange rate appreciation in reducing the demand for exports both lead to lower demand, and there is also a more direct effect of exchange rate appreciation on import prices. In this context, asset prices and exchange rate are viewed in terms of the transmission of monetary policy, rather than as variables which are of relevance in their own right. Further, it is assumed that the effects of interest rates on those variables are benign. Asset prices have attracted attention in recent years, notably during the era when house prices were rising. Some have argued that in so far as the cost of housing is included in measures of price inflation, asset price inflation is captured in inflation targeting. But the issue was more whether there was some form of price bubble with the inference that the bubble would eventually burst with adverse consequences – though few realized the dramatic effects that the end of the house price bubble would have. The question here is whether the use of interest rates in pursuit of inflation targeting (or some other objective) contributed to the asset price bubble. One argument would be that lower interest rates would lead to higher asset prices, but that would not be surprising since the present value of the streams of income associated with the assets would have risen. The higher asset prices would merely be a reflection of changes in ‘fundamentals’ – in this case the rate of discount used to evaluate present values. However, a lower interest rate leads to higher asset prices and at least initially rising asset prices.

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It has in practice turned out to be difficult to predict the effects of interest rate changes on the exchange rate. In part this may come from a consideration of the rates of interest (and more generally returns on financial assets) which are relevant for asset portfolio decisions when assets denominated in different currencies are considered. For example, the anticipated movements in the stock markets in two countries may be a consideration for decisions over whether to move capital from one to another. But stock market prices and dividends may not be closely related to the policy interest rate set by the Central Bank. A further aspect comes from considering the relationship between interest rate and exchange rate. The interest rate parity approach involves a linkage between the interest rate differential and the rate of change of the exchange rate such that a relatively high interest rate in a country would be associated with a decline in the country’s exchange rate. But the portfolio approach indicates that an (unexpected) increase in the interest rate would be associated with an appreciation of the exchange rate. A combination of those two arguments suggest a form of ‘overshooting’ with an increase in the policy rate leading first to a sharp appreciation of the exchange rate, followed by gradual depreciation. Goodhart (2005a) argues that a focus on domestic variables only in interest rate determination may provide ‘a combination of internal price stability and exchange rate instability’ (p. 301).

5. Concluding remarks This chapter has sought to indicate that the Phillips’ curve, and particularly developments with regard to the role of expectations, has presented a demand-pull, ‘accelerationist’ view of inflation. The argument has been put that the Phillips’ curve lacks any firm theoretical foundations, and that understanding of inflation requires a more sophisticated approach. Yet the ideas of the Phillips’ curve have been highly influential in the development of inflation targeting, independent Central Banks and use of interest rates to influence inflation.

Notes 1. A small selection of such papers include Arestis (1986), Arestis and BiefangFrisancho Mariscal (2000), Arestis and Sawyer (2005), Angeriz and Arestis (2006). 2. Phillips (1958) had a range of forerunners both with respect to empirical relationships between (wage) inflation and the level of unemployment and in theoretical terms (see Sawyer, 2010 and Leeson, 1997).

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References Angeriz, A. and Arestis, P. (2006) ‘Has Inflation Targeting Had Any Impact on Inflation?’ Journal of Post Keynesian Economics, Vol. 28, No 4, (Summer, 2006) Angeriz, A. and Arestis, P. (2007), ‘Assessing the Performance of ‘Inflation Targeting Lite’ Countries’, World Economy, Vol. 30, No 11, pp. 1–25. Angeriz, A. and Arestis, P. (2008), ‘Assessing Inflation Targeting Through Intervention Analysis’, Oxford Economic Papers, Vol. 60, No 2, pp. 293–317. Arestis, P. (1986), ‘Wages and Prices in the UK: The Post Keynesian View’, Journal of Post Keynesian Economics (Spring). Arestis, P. and Biefang-Frisancho Mariscal, I. (2000), ‘Capital Stock, Unemployment and Wages in the UK and Germany’, Scottish Journal of Political Economy, Vol. 47, No 5 (November). Arestis, P. and Sawyer, M. (2004), ‘Can monetary policy affect the real economy?’, European Review of Economics and Finance, Vol. 3, No 3, pp. 9–32. Arestis, P. and Sawyer, M. (2005), ‘Aggregate Demand, Conflict, and Capacity in the Inflationary Process’, Cambridge Journal of Economics, Vol. 29, No 6 (October). Arestis, P. and Sawyer, M. (2007), The Weak Foundations of the Phillips Curve, mimeo. Arestis, P. and Sawyer, M. (2008a), ‘Price and wage determination and the inflation barrier: moving beyond the Phillips curve’, pp. 30–44, in C. Gnos and L.-P. Rochon (eds), Monetary Policy and Financial Stability: A Post-Keynesian Agenda, Cheltenham (UK): Edward Elgar. Arestis, P. and Sawyer, M. (2008b), ‘New consensus macroeconomics and inflation targeting: Keynesian critique’, Economia e Sociedade, Campinas, v. 17, Número especial, pp. 629–54. Bank of England (1999), Economic Models at the Bank of England, London: Bank of England. Blanchflower, D.G. and Oswald, A.J. (1994), The Wage Curve, Cambridge, Mass.: MIT Press. Fontana, G. (2009), ‘The “Unemployment Bias” of the New Consensus View of Macroeconomics’, pp. 131–48, in P. Arestis and J. McCombie (eds), Unemployment: Past and Present, Basingstoke (UK): Palgrave Macmillan. Friedman, M. (1968), ‘The role of monetary policy’, American Economic Review, Vol. 58, pp. 1–17. Galí, J. and M. Gertler (1999), ‘Inflation dynamics: a structural econometric analysis’, Journal of Monetary Economics, Vol. 44, No 2, pp.195–222. Galí, J., Gertler, M. and López-Salido, J.D. (2005), ‘Robustness of the estimates of the hybrid New Keynesian Phillips curve, Journal of Monetary Economics 52, pp. 1107–18. Goodhart, C.A.E. (2005a), ‘Safeguarding good policy practice’ in ‘Reflections on Monetary Policy 25 Years after October 1979’, Federal Reserve Bank of St Louis Review, March/April, 87(2, Part 2), pp. 298–302. Goodhart, C.A.E. (2005b), ‘The experience of inflation targeting since 1993’, in P. Arestis, M. Baddeley and J. McCombie, The New Monetary Policy, Cheltenham: Edward Elgar. Leeson, R. (1997), ‘The political economy of the inflation-unemployment tradeoff’, History of Political Economy, Vol. 29, pp. 117–56.

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Lipsey, R.G. (1960), ‘The relations between unemployment and the rate of change of money wage rates in the United Kingdom 1862–1957: A Further Analysis’, Economica, pp.1–31. Mankiw, N.G. (2001), ‘The inexorable and mysterious tradeoff between inflation and unemployment’, Economic Journal, Vol. 111 (May), pp. C45-C61. Phelps, E.S. (1967), ‘Phillips Curves, Expectations of Inflation and Optimal Employment over Time’, Economica, Vol. 34, No 3, 254–81. Phillips, A.W. (1954), ‘Stabilisation Policy in a Closed Economy’, Economic Journal, Vol. 64, No 254 (June), pp. 290–323. Phillips, A.W. (1958), ‘The relation between unemployment and the rate of change of money wages in the United Kingdom’, Economica, Vol. 25, pp. 283–9. Samuelson, P. and Solow, R. (1960), ‘Analytical aspects of anti–inflation policy’, American Economic Review, pp. 177–94. Sawyer, M. (2002), ‘The NAIRU, aggregate demand and investment’, Metroeconomica, Vol. 53, No 1, pp. 66–94. Sawyer, M. (2009), ‘Interest rates and inflation: what are the links?’, Intervention, Vol. 6, No 1, pp. 83–98. Sawyer, M. (2010), The Political Economy of the Phillips’ curve, Cheltenham: Edward Elgar, forthcoming.

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9 Monetary Policy Rules and Phillips’ Curve Tradeoffs in a Kaleckian Framework Tracy Mott1

Though some have suggested that price inflation is inimical to economic growth, it is the case that policies to limit inflation by restricting aggregate demand must restrict economic growth in the short run. In a Kaleckian framework we can portray the process by which increases in aggregate demand affect the overall price level as follows. Michał Kalecki (1991 [1954]) made a distinction between ‘costdetermined’ and ‘demand-determined’ prices. In industries in which firms can increase their productive capacity to keep ahead of forecasted demand for their products, he held that prices should be determined by unit production costs plus a mark-up to cover overhead costs plus whatever profits the state of competition allows. Changes in demand for these products should not cause changes in these cost-determined prices unless demand for an industry’s product exceeds the industry’s ability to meet demand with existing productive capacity before new productive capacity has been created. Kalecki called the prices of goods where supply cannot be increased very quickly demand-determined prices, which are those for products in which supply cannot be varied easily in the short-run without incurring higher production costs because increased production of them requires the use of more expensive methods. This will often be the case for agricultural or mineral products, where increased production at first at least will require the use of harder to access sites or poorer grades of land or more intensive working of existing land or veins of ore. They will rise and fall of course with short-run changes in demand in their particular markets, but in most cases these demand changes will go along with changes in aggregate demand. To the extent that these commodities serve as inputs into the production of those goods and services whose prices are cost-determined, increases in aggregate demand which push 139

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up the demand-determined prices can feed into the direct unit costs of the industries where prices may be said to be cost-determined. If firms in these industries then raise their own prices to preserve their profit margins, these price increases will in turn feed into higher costs elsewhere. Any increases in the prices of products bought by wage-earners will lower real wages. If this is met by successful demands for money wages to rise higher than labor productivity is increasing, this will raise unit labor costs and put even more pressure on product prices. A general climate of high aggregate demand will of course make desires for higher prices and money wages more likely to be achievable. Decreases in aggregate demand should send this process into reverse.

Modeling the inflationary process Mott (2010, Chap. 9) has modeled this as follows: Following our Kaleckian assumptions about pricing, as the rate of growth of prices should be associated positively with the rate of growth of output and negatively associated with the rate of growth of productivity, we should have: g p k (g Y g B ),

(1)

where gp the rate of growth of the price level, or the rate of inflation ( p p ), gy the rate of growth of real output (Y Y ), gB the rate of growth of labor productivity, and κ is a positive parameter perhaps equal to one. In Kalecki’s formulation of mark-up pricing, it must be the case that gp gφ gw gB, where gφ the rate of growth of the mark-up, gw the rate of growth of the money wage, and B output per unit of direct labor input. So, we are assuming here that growth in output is associated with growth in the aggregate mark-up and/or growth in money wages. When gY gB, so that g P 0 , the rate of inflation will be constant. This means that if output and productivity are growing at the same rate, the existing rate of inflation will persist. Labor productivity growth itself is normally associated positively with output growth due to better utilization of the workers already employed and to any installation of better equipment, which is also more likely to occur in the upswing of a cycle. If it is the case that both output and productivity should rise faster in roughly the first half of a cycle upswing and then both should rise more slowly in the later stages of the boom, it may be sensible to posit the following linear relationship: g B x g Y c ,2

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where χ and ψ are positive parameters, ψ representing exogenous influences on productivity. The time derivative of the rate of growth of output, g Y , might be supposed to follow the following process: g Y εg B i gY .

(3)

Here is the time derivative of the rate of interest, and ε, ν, ω are positive parameters. The idea behind the first right-hand side term is that while other influences will also be determining the rate of growth of output, a rise or fall in the rate of productivity (output per worker) growth will foster an acceleration or deceleration of the rate of output growth. The rate of output growth itself enters negatively in the equation on the grounds that the higher the rate of growth, the more likely it is to slow down due to bottlenecks and the like. The negative effect on output growth of changes in the interest rate of course represents effects on housing and consumer durables spending, as well as whatever effect changes in interest rates will have on the country’s foreign exchange rate and so on exports and imports, and this will allow us to examine the choices facing monetary policy.

The effects of monetary policy Mott (2010, Chap. 9) shows that if policy operates by changing interest rates and policy reacts solely to changes in the inflation rate, we will most likely get the results of cyclical movements in gp and gy which are explosive. In this framework, monetary policy can only be stabilizing if interest rates react to output growth as well as to inflation. Our policy rule then must have a term which contains gy, as in i g P g Y .3

(4)

This gives us the following differential equation system: g Y (ε ) g Y g P ε .

(5)

g P (1 ) g Y .

(6)

The Jacobian determinant of this system is J (1 ) ,

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and the trace of the Jacobian is tr( J ) ε ,

(8)

which will be negative if is high enough, meaning that the equation system will now give us dampened cycles around an equilibrium of ( 1 , ( ε ) (1 )) . The phase portrait appears in Figure 9.1. So we have a stable system, and raising or will also make the equilibrium inflation rate lower, but the stability and ability to keep inflation down comes at the expense of having to use interest rate policy to restrict output, and thus employment, growth. If is a small number, and is dependent upon exogenous innovation, stabilizing the system by means of policy will often mean very low average economic growth. We would have Schumpeterian-type cycles, in which innovations cause upswings which then peter out, pushing us eventually perhaps into negative growth until new innovations revive us, unless policy takes steps to increase output and employment, allowing inflation to rise for a while.4 And, if innovations or their installation and use are themselves dependent upon a favorable growth climate, the situation should become worse, since must also then become a function of gy. The equilibrium will now be at (0,0), meaning that stabilizing the system will lead to zero growth in output. gp

gp = 0

gy = 0 κψ ντ

ψ 1−χ

Figure 9.1 Cycles with a stabilizing policy rule

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εψ νυ + ω + εχ

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Taylor rules We observed in note 3 the relation between the monetary rule we are using and Taylor rules. The ‘classic’ Taylor rule is i 2

(

)

1 1 ( 2) q q * , 2 2

(9)

where i the targeted interest rate, p the inflation rate, and q the level of real output, so that (q q*) is the difference between actual and potential output, or the output gap. This is a particular variation on a formula

(

)

(

)

i i ∗ ∗ q q q∗ ,

(10)

developed in a project at the Brookings institution (Bryant et al., 1993). This rule provides that the targeted interest rate should differ from a baseline level (i*) in proportion to deviations of actual inflation from desired inflation and of actual real output from its desired level. Taylor set i* to the sum of the ‘natural’ rate of interest and the inflation rate and then set the real natural rate of interest and the target rate of inflation each equal to 2 and and q each equal to ½. A generalized form of the Taylor rule (see Orphanides, 2008) has been derived that appears as

(

)

(

)

(

)

(

)

i (1i ) r ∗ ∗ ii1 ∗ q q q∗ q q q∗ . (11) For our purposes here we only need to note that this generalized Taylor rule nests a simplification, in which i 1 and q 0, that gives a family of rules similar to Knut Wicksell’s (1936 [1898]) original ideas about the condition for price stability being that the market rate of interest (im) must be equal to the natural rate of interest (in), i.e., the rate that makes desired saving equal to desired investment. Wicksell realized the difficulty of knowing the level of the natural rate of interest, but since im in would be the condition for zero inflation, he said that raising interest rates when prices were rising and lowering them when prices were falling would provide the guide for policy. Using this Wicksellian simplification of the generalized Taylor rule, we get i ( ) q (q ),

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(12)

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which is easily transformed into

(

)

(

)

P g P g P∗ Y gY gY∗ ,

(13)

which fits easily into the model we used earlier by substitution into equation (5). This yields g Y (ε Y ) gY P g P εP g P∗ Y g Y∗ ,

(5)

which gives us dampened movements around the equilibrium

(

)

⎛ (Y ε ) (1 ) P g P∗ Y g Y∗ ⎞ , ⎟. ⎜ (1 ) ⎠ ⎝ 1

This allows us to target whatever rate of inflation we like, which we could then achieve following any shocks to the system if we know the right values for the necessary parameters, but it does not allow us to avoid the problems we identified above concerning output growth. The equilibrium level of gy is still /1 . The Taylor rule and variations on it of course have been used as a tool for interpreting historical monetary policy as well as a potential guide for carrying out policy. If the economy behaves as our Kaleckian assumptions suggest it should, we could say that we have not seen the smooth movements of the model we have set up and that this could be attributed either to sufficient exogenous shocks to the economy or to the policy-makers not being willing or able to follow the ‘correct’ version of the rules we have discussed so far. It is unlikely anyone would doubt the likelihood of both of these factors having come into play.

‘Phillips curve’ tradeoffs Yet this analysis has more than just this to say about the historical patterns of output growth and inflation we have observed and about the future conduct of monetary policy. It should not be surprising if nations have not wanted and in fact have not been able to conduct policy in ways that dampen growth as much as a strict application of our policy rule would indicate. It appears that the implications of the Kaleckian framework for policy conduct and ‘Phillips curve’ tradeoffs between output growth and inflation should be as follows. Starting at whatever rates of output growth and inflation we find ourselves, any increase in aggregate demand will put upwards pressure on both

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output and prices. The closer the economy is to full capacity output, the more likely (in the absence of wartime price controls and output rationing) we are to see price increases versus output increases. Other than this, the degree of price versus output pressure will depend on what is going on in respect of the cost increases faced when attempting to produce more in the demand-determined price industries and with the rate of growth of productivity and the state of business and labor pricing power in the economy overall. If we are not threatened by capacity constraints or by bottlenecks in agriculture and mining, an increase in aggregate demand should largely spur much more output growth than inflation. As expansion proceeds, a rise in the demand-determined prices should occur, increasingly feeding into the level of costs elsewhere, as we described at the beginning of this chapter. A decrease in aggregate demand should first lower output growth before it starts to relieve price pressures. In other words, as in Newton’s first law of motion, there is inertia in the rate of inflation, a point implicitly or explicitly recognized by most schools of macroeconomics. An expansion in aggregate demand from a point of low growth should also bring with it productivity increases which offset price pressures. Beginning from a point of low growth is also likely to find business and labor less likely to feel the ability to pass on whatever cost increases may be present. A graphical treatment of this appears in Figure 9.2.

gp

Inflation barrier

gy

Figure 9.2 Phillips’ curve tradeoffs

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The inevitable unevenness in movements in any series of economic data makes even the number of possibilities depicted above unable to capture all of the possible scenarios, but the general pattern is that increases or decreases in aggregate demand tend to affect mainly output growth for a time before the rate of inflation starts to respond. An ‘inflation barrier’ (to use Joan Robinson’s term) prevents demand increases from doing anything but raising prices once we reach a rate of growth equal to the rate of labor force plus productivity growth (Roy Harrod’s ‘natural rate of growth’), but anywhere to the left of that, the pattern of near-horizontal movements preceding any more vertical movements should prevail. ‘Supply shocks,’ like the 1970s oil price increases, will push up inflation at any rate of output growth. Productivity growth will give less inflation at any rate of growth. The ways in which the inflationary process works according to the Kaleckian perspective and the attendant inertia in inflation mean that fighting inflation by policy manipulation of aggregate demand has to stop inflation by stopping output growth. This of course is what we have been worried about in our consideration of Taylor-type monetary policy rules. That such policies may not be able to be followed precisely may be a blessing. That anti-inflation policy has been pursued more aggressively since the 1970s explains why inflation rates have been lower in most economies since then, but it also may explain why productivity performance has been lower on average than it was in the 1950s and 1960s and why whatever productivity gains we have had have not shown up in the real wages of production and nonsupervisory workers in the US outside of the later years of the 1990s.5 The late 1990s are also a good example of the advantages of productivity growth as a better inflation fighter than tight monetary policy. Alan Greenspan’s decision that productivity growth would allow higher output growth without inflationary pressures gave us in the US the best respite from austerity that we have had since the 1970s. That this did not last was due to other problems in the economy, most notably the unsustainable use of debt to keep the economy going in the face of the stagnation in real wages since the early 1970s.6 Monetary policy has other dilemmas to face at the time of writing, since we are in a zero interest rate liquidity trap where inflation is hardly a concern and monetary policy cannot do much to help us out of a tremendous collapse in output and employment, so we must rely on fiscal policy.7 Yet even now we still hear anti-inflation hysteria in some circles.

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New Consensus Macroeconomics and its biases The argument of this article is that no rules-based policy is going to manage to fight inflation without increasing unemployment and retarding productivity. Of course we don’t want to allow price inflation to destroy the usefulness of money itself, much less to redistribute income and wealth unfairly.8 To the extent that inflation-fighting policy restricts output and productivity growth, however, it also limits and redistributes incomes. Philip Arestis, alone or with co-authors, has produced a body of work critiquing the New Consensus Macroeconomics (NCM), which provides the theoretical framework in which Taylor-rule types of policies seem to fit the best.9 The NCM does not worry about the effects of monetary policy on productivity because of its acceptance of the ‘supply-side,’ real business cycle determinations of long-run productivity. That is, as a ‘new neoclassical synthesis’ which embraces New Keynesian sticky prices and monopolistic competition allowing aggregate demand to affect output and employment in the short run with long-run exogenous shocks in the neoclassical model determining output and employment in the long run, it ignores the effects of short-run demand fluctuations on the level of productivity over longer periods of time.10 Indeed, NCM proponents argue for an anti-inflationary bias for monetary policy precisely because they believe that it tends to keep the economy closest to the state predicted by real business cycle theory, where we might then be dependent on the type of Schumpeterian developments described above. For example, if the present (2007–??) world economic slump were to be characterized as the result of exogenous financial misadventures, then the best that we could expect from policy would be for it to help along financial restructuring. If aggregate demand changes do affect the level of productivity not only in the short-run but over longer stretches of time as well, then we should want policy to be demand-stimulating even if it triggers some inflationary pressures, not only to relieve the immediate distress of unemployment but also to raise the standard of living over time. Ironically, the NCM approach, in wanting to stabilize the economy at levels of long-run productivity plus labor force growth, would tend to lower the long-run productivity growth rate, and by doing so, would make the inflationary consequences of aggregate demand increases worse.

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Notes 1. I would like to thank participants in a seminar at the University of Denver, especially Mike Jackson and Rudi Von Arnim, along with the editors of this volume, for helpful comments on this chapter, while absolving all of them of any responsibility for any errors that may appear here. 2. This type of relation between productivity growth and output growth is also found in the Kaldor–Verdoon hypothesis. See, e.g., Thirlwall (1983, 1986). 3. This of course is like a Taylor rule. See Taylor (1993) or Orphanides (2008). 4. Kalecki (e.g., 1991 [1967]) thought that a capitalist economy would experience zero growth in the long run in the absence of innovations. 5. See Mishel et al. (2007, pp. 109–209) for a thorough discussion of the evidence and the myriad explanations offered to explain this compensation-productivity divergence and the growth in wage-inequality over this period. 6. See Mott (2010), Chap. 11, for a more thorough discussion of this. 7. Fiscal policy is likely to be a more powerful force on the macroeconomy even in normal times, as argued historically by Kalecki (1990 [1943]) and more recently by Arestis and Sawyer (2003). 8. The evidence concerning the effects of the high rates of inflation of the 1970s on the US economy, though, indicate that it redistributed wealth from higher income households to middle-income households. See Wolff (1979). 9. See Arestis and Sawyer (2008) and Arestis (2009). 10. See, e.g., Goodfriend and King (1997) and Goodfriend (2007).

References Arestis, Philip (2009). ‘New Consensus Macroeconomics: A Critical Appraisal,’ Levy Economics Institute Working Paper. Arestis, Philip, and Sawyer, Malcolm (2003). ‘Reinstating Fiscal Policy,’ Journal of Post Keynesian Economics 26, pp. 125–48. Arestis, Philip, and Sawyer, Malcolm (2008). ‘A Critical Reconsideration of the Foundations of Monetary Policy in the New Consensus Macroeconomics Framework,’ Cambridge Journal of Economics 32, pp. 761–79. Bryant, R.C.; Hooper, P.; and Mann, C., eds. (1993). Evaluating Policy Regimes: New Research in Empirical Macroeconomics, Washington: Brookings Institution Press. Goodfriend, Marvin (2007). ‘How the World Achieved Consensus on Monetary Policy,’ Journal of Economic Perspectives 21, pp. 47–68. Goodfriend, Marvin, and King, Robert (1997). ‘The New Neoclassical Synthesis and the Role of Monetary Policy,’ NBER Macroeconomics Annual 12, pp. 231–83. Kalecki, Michał (1990 [1943]). ‘Political Aspects of Full Employment,’ in Collected Works of Michał Kalecki, Vol. I, ed. Jerzy Osiatyn ˇski, Oxford, UK: Clarendon Press, pp. 347–56. Kalecki, Michał (1991 [1954]). ‘Costs and Prices,’ in Collected Works of Michał Kalecki, Vol. I, ed. Jerzy Osiatyn ˇski, Oxford, UK: Clarendon Press, pp. 209–25. Kalecki, Michał (1991 [1967]). ‘The Problem of Effective Demand with TuganBaranovsky and Rosa Luxemburg,’ in Collected Works of Michał Kalecki, Vol. II, ed. Jerzy Osiatyn ˇski, Oxford, UK: Clarendon Press, pp. 451–58.

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Tracy Mott 149 Mishel, Lawrence; Bernstein, Jared; and Allegreto, Sylvia (2007). The State of Working America, 2006–2007, Ithaca, NY: Cornell University Press. Mott, Tracy (2010). Kalecki’s Principle of Increasing Risk and Keynesian Economics, London: Routledge. Orphanides, Athanasios (2008). ‘Taylor Rules,’ in The New Palgrave Dictionary of Economics, 2nd edition, eds., Steven Durlauf and Lawrence Blume, Houndmills, Basingstoke, UK: Palgrave Macmillan. Taylor, John (1993). ‘Discretion Versus Policy Rules in Practice,’ Carnegie-Rochester Conference Series on Public Policy 39, pp. 195–214. Thirlwall, A.P. (1983). ‘A Plain Man’s Guide to Kaldor’s Growth Laws,’ Journal of Post Keynesian Economics 5, pp. 345–8. Thirlwall, A.P. (1986). ‘A General Model of Growth on Kaldorian Lines,’ Oxford Economic Papers 38, pp. 199–219. Wicksell, Knut (1936 [1898]). Interest and Prices. London: Macmillan. Wolff, Edward (1979). ‘The Distributional Effects of the 1969–75 Inflation on Holdings of Household Wealth in the United States,’ Review of Income and Wealth 25, pp. 195–207.

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10 The Banking Crisis, Nationalization of Banking and the Mixed Economy Yiannis Kitromilides

1. Introduction The decision to nationalize the Northern Rock bank in February 2008 was presented by the British government as a temporary measure of last resort. The preferred option of keeping the bank in the private sector by selling it to a number of prospective buyers did not materialize. Bankruptcy, which would have resulted in the failure of a major bank, was ruled out because of the potential threat that it could pose to the stability of the entire financial system. Nationalization was, therefore, the only alternative course of action. The ‘temporary expedient’ of nationalizing Northern Rock was soon to be followed in the UK and the USA by a number of other spectacular bailouts and formal or effective nationalizations of some of the world’s largest banks and financial institutions not to mention some of the world’s largest car companies.1 The unexpected reappearance, after a long absence, of the dreaded N-word – nationalization – in economic discourse has been initially presented, possibly in order to be made politically more palatable, as unavoidable, a necessary evil and above all a temporary measure to be reversed as soon as market conditions permit. No-one, of course, is prepared to hazard a guess as to how short or long this period of temporary nationalization would be. The general expectation is that it may take years rather than decades for these institutions to be returned to the private sector. This expectation is based on the experience of past nationalizations, in the USA and Europe especially those associated with the so-called ‘Scandinavian Model’ of bank nationalization. On the other hand, considering the size and complexity of the financial institutions that have been or are candidates for future nationalizations, 150

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there may be, perhaps, an element of truth in the saying that ‘there is nothing more permanent than a temporary arrangement’. However, my aim in this chapter is not to speculate on the length of time it would take for the process of banking nationalization to be reversed; more simply it is to examine the possibility of a ‘third way’ of viewing bank nationalization. The first way is to reject the idea of nationalization of banking completely or only accept it as a temporary expedient. The second way is to view nationalization in general and bank nationalization in particular as an instrument of achieving a socialist society. The third way is to consider bank nationalization not as a short-term temporary measure but as a more permanent feature in a radical reform of the financial system in a mixed economy. The need for reform of national and global financial systems is not in question. The overwhelming interest and focus of debate, however, has been almost entirely concentrated on how to reform the regulatory system rather than on whether there is a place in a reformed global financial system for nationalized banking. Section 2 examines the conventional view that rules out permanent nationalization of banking. Section 3 considers in detail some problems of financial regulation and section 4 examines whether nationalization should be temporary or permanent. Section 5 offers some conclusions.

2. The conventional wisdom: The ‘privatization and regulation’ paradigm Nationalization involves the ownership, control, organization and the day-to-day running by the state of a part or a whole of an industry in a market economy. Is there a place for nationalization in a market economy? In terms of mainstream welfare economics, the answer to this question can be summarized by the following two, well-known propositions. First, nationalization in peacetime can only be justified in a limited and rare number of cases, which involve the provision of pure public goods – goods that are ‘non-rival’ and ‘non-excludable’ – such as national defence, maintenance of law and order, street lighting etc.2 In all other cases, competitive markets can be relied upon to provide a Pareto-optimal allocation of resources. Second, although the scope for nationalization is extremely limited, there is nevertheless plenty of scope for state intervention. There are numerous cases of market imperfections and market failures, which require some form of state intervention. However, state intervention need not take the form of state provision.

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The bottom line, therefore, for mainstream economics is that nationalization is, indeed, a measure of last resort – the unavoidable outcome of a catastrophic market failure caused by the presence of ‘pure’ public goods. For ordinary market failures, including the cases of externalities and natural monopoly, the conventional wisdom has a very simple prescription: private provision combined with some form of state intervention, which may include taxation, subsidy and public regulation. Nationalization, of course, can be and has been justified and advocated on grounds other than the narrow economic criterion of allocative efficiency. Education and health care in the UK are publicly provided, free at the point of delivery, even though neither is a pure public good.3 Similarly, natural monopolies such as water, gas and electricity,strategic industries such as coal and steel and failing industries such as shipbuilding and parts of the car industry have been in the UK and they still are in some countries, albeit at a diminishing rate, under public ownership. Parts of the economy therefore are and have been nationalized even though they can easily conform to the formula of privatization and public regulation. In all these cases, allocative efficiency is not the main argument in support of nationalization. Instead, the decisive arguments relate to the achievement of a mixture of social and political objectives such as fairness, equality of opportunity, equality of access, promoting social cohesion, or redistributing political and economic power in society. Opponents of nationalization tend to emphasize another major disadvantage and shortcoming: productive inefficiency. Nationalization is not only unnecessary for achieving allocative efficiency (except in the case of pure public goods) but it also invariably fails to achieve productive efficiency. This claim is based on a number of well-known theoretical and empirical arguments concerning the relative efficiency of public and private production. A detailed examination of this debate is beyond the scope of this paper.4 There is, however, an important claim in this debate, which is worth examining further because it has an important bearing on our discussion of banking regulation and nationalization. The claim relates to the role of incentives in the two sectors and the way they affect decision-making behaviour. Public and private sectors have different incentive mechanisms. The monetary rewards for success as well as the monetary consequences of failure (except in the case of the CEO of RBS) are far greater in the private sector than in the public sector and this induces notable and significant differences in decision-making behaviour. These differences are often summarized using some very familiar descriptions: public production

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is bureaucratic, slow, easy-going, dominated by red tape and political control or interference and it is usually unable to respond quickly to market opportunities. This behaviour leads to productive inefficiency. The private sector, by contrast, is enterprising, innovative and creative, responding quickly and effectively to market challenges. The freedom from state interference and control unleashes the creative potential of competitive capitalism with spectacular results in terms of economic growth and increases in general economic welfare. Nationalization, therefore, is to be avoided not only because it is stale and inefficient but also because the alternative, privatization, is dynamic, efficient and progressive. The triumph of this paradigm reached its peak with the implementation by Margaret Thatcher of the privatization programme in the UK in the 1980s and 1990s, the subsequent collapse of the centrally planned economies in Eastern Europe and the widespread adoption of the privatization agenda globally. A paradigm shift against nationalization and in favour of privatization, deregulation and liberalization has taken place. Regulation was always a central element in this approach. Since in the majority of cases some form of market failure is present, the appropriate alternative to nationalization is not simply privatization but privatization AND regulation. This is because the allocative inefficiencies of, for example, unregulated natural monopolies may outweigh any possible gains in productive efficiency. Moreover, in the financial sector regulation is essential to deal with problems caused by ‘moral hazard’ and the threat of ‘systemic failure’. In fact in the history of banking, this was recognized early on and the development of central banking was partly in response to the need for regulation and supervision so that ‘excesses’ in one part of the banking system do not threaten the stability of the whole system. Regulation, however, although essential is not without its problems.

3. Reformed regulation or nationalization? The ‘privatization and regulation’ paradigm contains some paradoxical even contradictory elements: on the one hand, it claims that the public sector cannot be trusted, owing to productive inefficiency, with the running of an industry even if there are clear problems of market failure. On the other hand, the public sector can be trusted with the vital function of running the regulatory system of that industry efficiently. Furthermore, although the private sector cannot be trusted to operate without regulation, yet too much or too little regulation can defeat the whole object of privatization. Too ‘heavy handed’ regulation

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can stifle creativity and innovation; too ‘light touch’ regulation may fail to protect consumers and more ominously in the case of the financial system, could fail to prevent the collapse of the whole system. Regulation therefore, especially the regulation of banking and financial markets, is not a straightforward operation but an extremely complex and uncertain exercise of being vigilant but treading carefully, maintaining delicate balances and reconciling conflicts and tensions inherent in the incentives systems of competitive market capitalism such as the conflict between safety and flexibility. Yet, these complicated, delicate and potentially risky tasks are to be carried out by public officials – the same public officials that cannot be entrusted with the day-to-day running of the industries they are asked to regulate. These paradoxical features of regulation are particularly striking and pertinent in the case of financial regulation. The primary objective of regulation is consumer protection. Consumers need protection because of market imperfections such as monopoly power and asymmetric information. This usually means that the regulators must ensure that the system produces products that are ‘fairly’ priced and ‘safe’. In financial regulation, however, there is the additional and crucial objective of banking supervision – ensuring that the system itself is stable and safe. Because of the pivotal role of banking in the economy the public at large needs protection from the risk of systemic failure, which can have serious and widespread macroeconomic repercussions. It is primarily failures in this aspect of financial regulation – traditionally the function and responsibility of central banking – that are generally considered to have been responsible for bringing about the global financial crisis. Is a better regulatory framework, therefore, the answer? In October 2008, the British Chancellor of the Exchequer asked Lord Turner ‘to review the causes of the current crisis, and to make recommendations on the changes in regulatory and supervisory approach needed to create a more robust banking system for the future’ (FSA, 2009, p. 5). A clamour for better regulation usually follows a banking crisis. The most famous historical precedent is the passing in the USA of the famous Glass–Steagall Act of 1933. The act established the Federal Deposit Insurance Corporation and introduced many banking and regulatory reforms, arguably the most significant one being the separation of ‘retail’ from ‘investment’ banking – a provision that remained in force until the repeal of the act in 1999, under President Clinton. Economists and economic historians have debated in the past and will debate in the future many questions concerning this legal separation in banking activities. Was the absence of a separation responsible

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for the banking crisis before 1933 or after 1999? Was the repeal of the 1933 act unavoidable in a liberalized global financial system? Should the separation between ‘narrow’ (or ‘boring’) banking and ‘risky’ (or ‘casino’) banking be re-introduced now? Should it take the form of a formal legal separation or of new regulatory requirements designed to discourage excessive risk-taking by banks? Above all, how are these or other reforms of banking regulation and supervision to be co-ordinated internationally? These are important questions about the future direction of financial regulation, requiring urgent answers. The ‘privatization and regulation’ paradigm, however, may not be the only game in town. Is it possible that ‘better regulation’ may not be the only way of resolving the crisis or preventing its re-appearance? As the world economy enters what is sometimes described as ‘uncharted territory’ it is important that we be prepared to challenge past assumptions and be ready to consider previously rejected policy options. It may even be necessary to think the unthinkable: Is banking nationalization a less risky alternative than a system of private banking even with improved regulation and supervision?

4. Banking nationalization: temporary or permanent? Two different problems require resolution in the global financial crisis: First, there is an immediate problem of sorting out the mess in the global financial system and restoring the normal functioning of the banking system. Second, there is a long-run problem of ensuring that a reformed financial system is put in place whereby trust and confidence in the system is restored and future crises averted. There are two contrasting viewpoints concerning the role of nationalization in dealing with these problems. One viewpoint sees nationalization as a way of dealing with the short-run crisis but not as a long-term solution. The alternative point of view is in favour of nationalization for dealing with both short-run and long run problems. In this section, I will compare the two viewpoints and in the next section I will draw some conclusions. One of the most basic functions of banking is to facilitate payments in the economy. If that were its only function, the issue of nationalization would not be so controversial. However, the most crucial function of banking in the economy is the task of allocating resources to those uses that would yield the highest, risk-adjusted returns. Who is best equipped to fulfil this function? The consensus view is that the

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private sector of competitive capitalism can perform this function more efficiently than the government, if a proper system of regulation and supervision is in place and assuming that there is no ‘credit crunch’. In a credit crunch, there is anecdotal evidence that banks are denying credit to otherwise viable projects.5 In these circumstances, the private sector performs this function less efficiently than the government which may intervene through initiatives like the Enterprise Finance Guarantee scheme introduced in the UK in 2009 or more directly through nationalization. In exceptional circumstances therefore, usually following a banking crisis, one or more banks may be nationalized, either, if they are small, as a punishment for irresponsibility or, if they are big, to prevent systemic failure, or if there is a general credit crunch to re-start bank lending and prevent a prolonged recession. After nationalization, the banks are cleaned-up, returned to profitability and then re-privatized. This approach, considers bank nationalization as a means to an end, not an end in itself. The ultimate aim is a privately owned, privately run but properly regulated and supervised banking system. Temporary nationalization may be, in some critical circumstances, the best way of achieving this goal. In the current crisis supporters of temporary nationalization emphasize different aspects of the short-term problem that nationalization can help to resolve. First, when some major banks are ‘zombie banks’, basically, bankrupt and kept alive through government support the government should stop ‘throwing good money after bad’ and go the whole way and take them over, clean them up, sort them out and then sell them off to new owners. Second, when the banking system, despite the injection of huge sums of taxpayers’ money and loan guarantee schemes, stops performing its most crucial function of allocating credit to creditworthy customers the state can assume this role through temporary nationalization. There is, of course, opposition to nationalization even as a temporary measure. This is partly because of the many legal and other technical difficulties of bringing into public ownership financial institutions with assets running into trillions of dollars and whose operations are diverse, complex and global; and partly because, even if all the technical difficulties are surpassed, nationalization of these large and complex financial institutions (LCFI) is unlikely to be temporary. Nationalization, therefore, may be difficult to implement and even more difficult to reverse, in which case support for temporary nationalization is tantamount to effectively supporting permanent nationalization.6

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What is wrong with permanent nationalization of banking? Can nationalization be more than a temporary short-term measure? Can it become part of a reform agenda, which can help to prevent future crises? The arguments in favour of permanent nationalization fall into two different categories. There are socialist arguments for nationalization and there are arguments based on more conventional economic reasoning. There is a long history of socialist support for nationalization of banks as part of a wider plan of nationalizing key parts of the economy and developing a democratic, socialist society. Socialist banks will be nationalized but not run along ‘capitalist’ lines.7 On the other hand, under temporary nationalization, banks will be run according to ‘capitalist’ or normal commercial lines, but they will not remain nationalized for long. Is there any place for non-socialist banks, run along capitalist lines but under permanent public ownership? Before the global financial crisis, the nationalization of giant banks like Citigroup, Bank of America, Lloyds TSB or even Northern Rock could not even be contemplated let alone advocated publicly. Such a proposal would have been dismissed as (a) politically naïve, (b) not technically feasible, and (c) without any theoretical basis. The crisis, undeniably, has changed these perceptions. First, it is no longer so fanciful or politically naïve to discuss the nationalization even of mega-banks some of whom are already nationalized or semi-nationalized. Politicians sense that there may be political capital to be gained from public anger against bankers and financiers. Nationalization can be presented as being in the best interest of taxpayers and as a way of punishing greedy bankers rather than bailing them out.8 Second, on the question of feasibility, prominent and eminent supporters of temporary nationalization, including among others, Nobel Laureate Paul Krugman, ex-Federal Reserve Chairman Alan Greenspan and respected economic journalist Anatol Kaletsky,9 do not envisage any insurmountable practical difficulties in implementing bank nationalization especially since a number of major banks are already effectively semi-nationalized. If there are no practical difficulties for temporary nationalization, it is unlikely that there will be practical difficulties for a permanent one. Third, the crisis has brought into question both the basic assumptions in favour of privatization and the main theoretical objections to temporary nationalization. Nationalization of banking as a political and practical proposition can now, therefore, be considered feasible. Does permanent nationalization also make theoretical sense?

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In section 2 above, I presented the standard conclusions of mainstream welfare economics concerning permanent nationalization. On grounds of allocative efficiency, permanent nationalization can only be justified in the case of pure public goods. In all other cases private provision with appropriate state intervention is sufficient to ensure allocative efficiency. In the real world of course nationalizations, such as that of education and health care, non-economic arguments play a much more significant and decisive role. In banking, state intervention takes the form of public regulation and supervision. The supervisory role is by far the most vital responsibility of the monetary authorities. The danger of ‘systemic failure’ means that reckless behaviour by individual parts – especially, if they are considered ‘too big to fail’ – may threaten the stability of the whole system, which in turn may have widespread and grave macroeconomic consequences. There is clearly a very serious ‘moral hazard’ problem in banking supervision. The threat of bankruptcy and failure normally acts as sufficient restraint to prevent reckless behaviour and excessive risk-taking by firms.10 In the financial sector, however, if failure by one firm can destabilize and even bring down the entire system with all its repercussions, the authorities may have no alternative but to bail out the failing part in order to preserve the whole. Knowledge that this may be the likely response of the authorities to the threat of systemic failure may encourage reckless behaviour and excessive risk-taking by individual parts. The rational solution to the ‘moral hazard’ problem is to have a regulatory and supervisory system in place that detects, discourages and prevents reckless behaviour before it happens rather than having to deal with its consequences. Nationalization may reduce but not eliminate the ‘moral hazard’ problem, since state banks could also cause systemic failure. The existence of the ‘moral hazard’ problem by itself, therefore, does not provide sufficient theoretical justification for permanent nationalization of the banking system. In principle, permanent nationalization is neither necessary nor sufficient for solving the ‘moral hazard’ problem. Regulation in a privatized banking system, on the other hand, is necessary but may also not be sufficient. Privatization of banking without effective regulation is exposing society to the high risks of systemic failure and the huge costs associated with such failure. Nationalization will almost certainly reduce these risks because it can stop much more easily and effectively than any regulator the type of reckless behaviour that caused the crisis – excessive risktaking, inappropriate incentive systems or dubious financial innovations. The position taken regarding the prospects of effective financial

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regulation and supervision at national and international levels is, therefore, very important in the debate on bank nationalization. Those who oppose nationalization or advocate it only as a temporary expedient, take an optimistic view about the future prospects of a well designed and efficiently run system of regulation while those who favour permanent nationalization take a more pessimistic view.

4. Concluding comments It is apparent that the financial crisis has forced a reappraisal of some basic assumptions about the workings of competitive market capitalism in general and financial markets in particular. Before the crisis, the widely held assumption was that the social benefits of a privatized banking system – mainly the superior efficiency of private production – exceed the social costs – mainly the resource costs of regulation. It is becoming increasingly clear that, after the crisis, this assumption also needs re-examination. In the first place, the benefits – in terms of efficiency gains and innovations – may have been exaggerated: what exactly were the social benefits of innovations such as sub-prime mortgages, collateralized debt obligations or credit default swaps to mention only a few? Alternatively, what is the social loss if these innovations were, presumably, to be sacrificed under a system of nationalized banking? If they were such great innovations, of great benefit to society, why did they end up as ‘toxic waste’, impossible to price and polluting the balance sheets of global banking? A more vigilant and less inept regulatory system could, admittedly, have foreseen the dangers and prevented these innovations from infecting the global financial system. What is the point, however, of encouraging them in the first place? Furthermore, if as it seems likely, a future regulatory framework will insist on a separation, legal or otherwise, between ‘boring’ banking and ‘casino’ banking, the efficiency gap between the two sectors will certainly be reduced. If bureaucrats were to run ‘boring’ banking, they will probably be less efficient than their private sector counterparts but the gap will be narrower than under the present system; and the need for and cost of regulation will be less. Clearly, the assumption of superior efficiency as well as the assumption that public officials cannot run banks efficiently should be re-examined in the light of recent events. Who would be running the banks under ‘temporary’ nationalization? Presumably, they will be run by banking professionals, under government control. If banking under

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government control is expected to be restored to health and full profitability, why not remain under government control? More significantly, however, not only the benefits may have been exaggerated but also the costs – particularly the cost of regulatory failure – have been grossly under-estimated. The resource costs of regulation may be comparatively low (although these costs are bound to rise if a more ‘hands on’ approach to regulation is adopted). The social costs of regulatory failure, however, are huge and they transcend both geographical and inter-generational boundaries. The costs of regulatory failure must include not only the cost of government expenditure on the various bailouts, bank re-capitalizations, guarantees, etc., which may or may not be recoverable in a future upturn and re-privatization of banking, but also the huge tangible and intangible costs of a deep and long global recession – costs that are certainly not recoverable. If the probability that systemic failure is much greater when banking is located in the private rather than the public sector of the economy the cost of subjecting society to this risk must be estimated and added to the total cost of regulation. Naturally, if these costs exceed the social benefits, permanent nationalization of banking would be a better alternative to privatization. A great deal of complex cost–benefit calculations, involving analysis of risk and uncertainty as well as issues of inter-generational equity are, therefore, necessary before a solid case for permanent nationalization of banking can be established. What this means however is that the same is true for the opposite model of privatization and regulation. It is no longer self-evident, as the remit to the Turner Review assumes, that what is needed for the establishment of a more robust banking system is simply ‘changes in regulation and supervisory approach’. If the crisis has taught us anything is that it is too dangerous and risky to accept and not to challenge this assumption. Questioning and challenging the assumptions of the status quo is not the same thing as rejecting them. It may well be the case that all that is necessary to restore confidence in the banking system and prevent future catastrophes, is simply a change in the regulatory and supervisory framework along the lines proposed by the Turner Review.11 On the other hand, these reforms, however well thought out and based on the lessons learned from past mistakes, they may still not work. Therefore, as long as the uncertainty is present it must be properly assessed in deciding how to reform the financial system. The probability of regulatory failure after the reforms may be small but the consequences – another global recession – are very large. Analysing this type of uncertainty

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concerning large catastrophic events with small probabilities,12 is not an easy undertaking. However, this is not a reason for ignoring the problem. In the aftermath of the global financial disaster, when the ‘unthinkable’, in the words of Alan Greenspan, has happened, the ‘privatization and regulation’ paradigm is no longer sacrosanct. It is legitimate to ask, in a comprehensive review of how to establish a robust banking system, whether it is safer in the long run and, on balance, less costly for society if banks – like schools and hospitals – become not only a temporary but also a permanent part of the public sector in a mixed economy.

Notes 1. A month after the Northern Rock nationalization, Bear Sterns was acquired by JP Morgan Chase in a deal backed by $30bn of central bank loans. On 7 September 2008 Fannie May and Freddie Mac, America’s two largest lenders were rescued by the US government in one of the county’s largest bailouts and on 16 September 2008 America’s largest insurance company AIG was also rescued by an $85bn loan in return for 80% stake in the firm. In the UK the mortgage lender Bradford and Bingley was nationalized on 29 September 2008 while on 13 October 2008 the British government announced plans to inject £37bn, thus effectively nationalizing, Royal Bank of Scotland, Lloyds TSB and HBOS. On 19 December 2008, President Bush announced that $17.4bn of the $700bn intended for the banking sector was to be used to help US car makers General Motors, Ford and Chrysler. 2. It is generally accepted that Samuelson (1954) provided the first formal definition of a pure public good. See also the important contributions of Musgrave (1959) and Buchanan (1968). 3. They are publicly provided private goods although as Atkinson and Stiglitz (1980) point out they are not, because of externalities, ‘pure’ private goods either. For a comprehensive review of the debate on the role of the state in the provision of education and health care, see Barr (2004). 4. For a survey of the theoretical arguments and empirical evidence on the relative efficiency of public and private enterprise see Millward and Parker (1983), Pryke (1986). 5. See Bridge (2009). 6. For a fuller discussion of the advantages and disadvantages and technical problems of temporary bank nationalization, see Elliott (2009). 7. See Walsh (2008) for a discussion of banking nationalization from a socialist perspective. 8. Note the popularity of British opposition politician Vince Cable, an early advocate of bank nationalization as a means of preventing the socialization of risk and privatization of profit. 9. See Krugman (2009) and Kaletsky (2009). Greenspan stated his support for temporary banking nationalization as ‘the least bad solution’ in an interview in the Financial Times 18 February 2009. 10. In the current crisis, lack of ‘transparency’ in global banking – the practice if ‘hiding’ bad assets from their balance sheets – has prevented the normal

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functioning of markets of spotting and punishing delinquent parts of the system. 11. See FSA (2009) for a 32-point summary of the main proposals for regulatory reform. 12. For a discussion of ‘thick-tail uncertainty’ – large consequences with small probabilities in relation to the climate change problem – see Weitzman (2007).

References Atkinson, A.B. and Stiglitz, J.E. (1980) Lectures on Public Economics. Maidenhead: McGraw-Hill. Barr, N. (2004) Economics of the Welfare State. 3rd edn, Oxford: Oxford University Press. Bridge, R. (2009) ‘Banks let 120 small businesses go under every day’, The Sunday Times, 29 March, pp. 8–9. Buchanan, J.M. (1968) The Demand and Supply of Public Goods. Rand McNally: Chicago. Elliott, D.J. (2009) Bank Nationalization: What is it? Should we do it? Washington D.C.: The Brookings Institution. Financial Services Authority (2009) ‘The Turner Review. A regulatory response to the financial crisis’, Available at: http://www.fsa.gov.uk/pubs/other/turner review.pdf. Kaletsky, A. (2009) ‘Radical surgery is required to save this patient’, The Times, 12 February. Krugman, P. (2009) ‘Wall Street Voodoo’, New York Times. 18 January. Millward, R. and Parker, D.M. (1983) ‘Public and private enterprise: comparative behaviour and relative efficiency’, in R. Millward et al. (eds) Public Sector Economics. Harlow Essex: Longman. Musgrave, R.A. (1959) The Theory of Public Finance. New York: McGraw-Hill. Pryke, R. (1986) ‘The Comparative Performance of Public and Private Enterprise’, in Kay, J., et al. (eds) Privatization and Regulation. Oxford: Clarendon Press. Samuelson, P.A. (1954) ‘The Pure Theory of Public Expenditure’, Review of Economics and Statistics 36, 387–9. Walsh, L. (2008) ‘Nationalizing Northern Rock’, Socialism Today, Issue 116, March. Weitzman, M.L. (2007) ‘A Review of the Stern Review on the Economics of Climate Change’, Journal of Economic Literature. Vol. XLV, 703–24.

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11 How Does a Capitalist Economy Work in the Real World? Paul Davidson

Introduction ...the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. John Maynard Keynes Since biblical times humans have tried to understand the world about them and what caused things to happen. For most of the history of mankind, and for many primitive tribes today, explanations of events were due to the design of God or the Gods. Beginning in the seventeenth century, some philosophers argued that explanations should be based on human reasoning rather than religious belief. This was the beginning of the intellectual movement we call The Enlightenment or The Age of Reason. Reasoning requires the development of a theory to explain what people observe happening about them. Although in today’s society there are people of religious belief who will still attribute certain events to the will of God, most of society believes that understanding comes with the development of scientific theories. A theory is a logical device that begins with accepting one or more axioms that the theorist believes are universal truths that need not be proven. From this foundation, the theorist uses the laws of logic to reach an explanation of how the economy in which we live actually operates. ‘Classical economic theory’ is such an analytical device that uses some fundamental axioms. Mainstream economists, building on these classical axioms, employ the tools of logical deduction to reach one or 163

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more conclusions. These conclusions are then presented to the public as the explanation of economic events occurring in the world of experience. The theory’s explanation can then be used to suggest the cure for real world economic problems. The current economic crisis that began in 2007 as a small sub prime mortgage default problem in the United States has created the greatest economic catastrophe world-wide since the Great Depression. Clearly the crisis started in the financial sector of the American economy, where the central bank, the Federal Reserve System, is supposed to operate. How could this happen and what does it imply about how a central bank is suppose to function in a capitalist economy in the real world? There are two fundamentally alternative economic theories that attempt to explain the operation of a central bank and its effects on a capitalist economy. These alternative theories are: (1) the classical economic theory which is sometimes referred to as ‘the theory of efficient markets’ or ‘mainstream economic theory’. The mantra of this analytical system is that free markets can cure any economic problem that may arise, while government interference in free markets always cause economic problems. In other words, interventionist government economic policy is the problem, the free market is the solution. Classical theory’s logical deduction results in a laissez-faire philosophy where government must not interfere with operation of a free market economy. (2) the Keynes liquidity theory of an entrepreneurial economy. The conclusion of this analysis is that government has the capacity to cure, with cooperation of private industry and households, economic flaws inherent in the operation of a capitalist economy. Keynes stated that classical economists: resemble Euclidean Geometers in a non Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet in truth there is no remedy except to throw over the axiom of parallels and to work out a non Euclidean geometry. Something similar is required today in economics. To create a non-Euclidean economics to explain why these unemployment ‘collisions’ and economic and financial crises occur in the world of experience Keynes had to deny (‘throw over’) the relevance of several classical axioms, namely the ergodic axiom the neutral money axiom, and the

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gross substitution axiom (See Davidson, 2007). Since an axiom is defined as a ‘universal truth that does not have to be proved’, then Keynes’s theory attempts to explain the operation of a capitalist economy that is not constrained by these three ‘universal truths’ which limit the operation of capitalist economy in all logically consistent classical models. The classical ergodic axiom which assumes that the future is known and can be calculated as the statistical shadow of the past was one of the most important classical assertions that Keynes rejected. Instead Keynes argued that when crucial economic decisions had to be made, decision makers could not merely assume that the future can be reduced to quantifiable risks calculated from already existing market data. A second and just as important classical axiom is the ‘neutral money axiom’. For purposes of discussing the role of a central bank in a capitalist financial sector, we will initially focus on the neutral money axiom.

The neutral money axiom Neutral money was a fundamental axiom of nineteenth century classical theory. The neutral money axiom states that changes in the quantity of money in the economy have absolutely no effects on the aggregate level of employment and production in the system. In a neutral money economy, employment and output are determined solely by non-monetary factors in the economic system, e.g., technology, available labor supply, existing stock of plant and equipment. By the early twentieth century, this neutrality of money presumption became one of the basic axioms of the prevailing orthodoxy in economics textbooks. Even today, neutral money remains one of the fundamental axioms of modern mainstream economic theory. For those who are trained in classical economic theory, therefore, the neutrality of money is an article of faith, requiring no proof or justification. For example, in a moment of surprising candor, Professor Oliver Blanchard, a prominent member of the economics faculty of the Massachusetts Institute of Technology, the prestigious National Bureau of Economic Research, and the chief economist of the International Monetary Fund (IMF) has characterized all the macroeconomic models widely used by mainstream economists as follows: All the models we have seen impose the neutrality of money as a maintained assumption. This is very much a matter of faith, based on theoretical considerations rather than on empirical evidence. (Blanchard, 1990, p. 828)

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In other words, even though there is no empirical evidence underlying the fundamental classical presumption of neutral money, all mainstream macroeconomic models including those used by the Federal Reserve, the Council of Economic Advisors, the National Bureau of Economic Research, etc. are ultimately built on a neutral money foundation. This unshakable belief in neutral money is merely the creed (dogma) of mainstream economists that permits them to claim that if governments individually and via international cooperation remove all regulation from markets, i.e., ‘liberalize all markets’, then the national and global economy will achieve its goal of full employment prosperity. If the neutral money axiom is a fundamental belief of classical theory, then changes in the quantity of money can not affect real output and employment. Consequently the only thing that changes in the quantity of money can affect is the price level, given the classical assumption that output (at least in the long run) will follow a full employment real trend level. Moreover if we add rational expectations to the model, as both New Keynesians and New Classical Economists do, then even in the short run, output will follow the full employment long-run trend. All economists recognize that the central bank is the legal Monetary Authority. If one accepts the neutral money axiom as a universal truth, then the primary (only?) function of central bank in a classical theory neutral money capitalist economy is to affect the level of prices. Thus, logically consistent classical theorists argue that an independent central bank should target the rate of inflation. This ‘targeting function’ is an assumption of classical theory based on the neutral money axiom. It is not a conclusion. In other words, since mainstream theorists and their models are, as Blanchard states, based upon a neutral money foundation, mainstream economists are assuming what they pretend to be proving.1 In 1933 Keynes explicitly indicated that the ‘monetary theory of production’ that he was developing explicitly rejected the classical neutrality of money assumption as applicable in either the short run or the long run. Keynes (1933, pp. 408–11) wrote: An economy which uses money but uses it merely as a neutral link between transactions in real things and real assets and does not allow it to enter into motives or decisions, might be called – for want of a better name – a real-exchange economy. The theory which I desiderate would deal, in contradistinction to this, with an economy in which money plays a part of its own and affects motives and decisions and is, in short, one of the operative factors in the situation, so that the

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course of events cannot be predicted either in the long period or in the short, without a knowledge of the behavior of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy … . Booms and depressions are peculiar to an economy in which … money is not neutral. I believe that the next task is to work out in some detail such a monetary theory of production. That is the task on which I am now occupying myself in some confidence that I am not wasting my time. Here, in Keynes’s own words, is his claim that a theory of production for a money-using economy must reject what mainstream economists have always believed is a ‘universal truth,’ the neutrality of money. This neutrality axiom had been the foundation of classical economic theory for 125 years before Keynes. No wonder Keynes’s General Theory was considered heretical by most of his professional colleagues who were wedded to the classical analysis. Keynes was delivering a mortal blow to the very foundation of classical faith. No wonder the further elaboration and evolution of Keynes’s system by Post Keynesian economists in recent decades has not been understood by the majority of economists who, as Professor Blanchard has expressly noted, are ideologically bonded to the classical traditional axiom of neutral money. One of the more vocal advocates of a neutral money economy is Alan Greenspan, the former Chairman of the Federal Reserve System from 1987 to 2004. In an amazing ‘mea culpa’ testimony before Congress on 23 October 2008, Alan Greenspan admitted that he had overestimated the ability of free financial markets to self-correct and he had entirely missed the possibility that deregulation could unleash such a destructive force on the economy. Greenspan stated: This crisis, however, has turned out to be much broader than anything I could have imagined. ... those of us who had looked to the self interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief. ... In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize [in economics] was awarded for the discovery of the [free market] pricing model that underpins much of the advance in [financial] derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, [has] collapsed.

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Under questioning by members of the Congressional committee Greenspan admitted: I found a flaw in the model that I perceive is the critical functioning structure that defines how the world works. That’s precisely the reason I was shocked. ... I still do not fully understand why it happened, and obviously to the extent that I figure it happened and why, I shall change my views. Had Greenspan understood the alternative theory of the operation of a capitalist system, the Keynes liquidity theory, then he would have understood what caused this greatest recession since the Great Depression.

Taming uncertainty in Keynes’s liquidity theory For decisions that involved potential large spending outflows or possible large income inflows that span a significant length of time, people ‘know’ that they do not know what the future will be. Nevertheless, society has attempted to create institutions that will provide people with some control over their uncertain economic destinies. In capitalist economies the human institutional use of money and legally binding money contracts to organize production and sales of goods and services permits individuals to have some control over their cash inflows and outflows and therefore some control of their monetary economic future. Purchase contracts provide household decision makers with some monetary cost control over major aspects of their cost of living today and for months and perhaps years to come. Sales contracts provide business firms with the legal promise of current and future cash inflows sufficient to meet the business firms’ costs of production and generate a profit. People and business firms willingly enter into contracts because each party thinks it is in their best interest to fulfill the terms of the contractual agreement. If, because of some unforeseen event, either party to a contract finds itself unable or unwilling to meet its contractual commitments, then the judicial branch of the government will enforce the contract and require the defaulting party to either meet its contractual obligations or pay a sum of money sufficient to reimburse the other for monetary damages and losses incurred. Thus, as the biographer of Keynes, Lord Robert Skidelsky has noted, for Keynes ‘injustice is a matter of uncertainty, justice a matter of contractual

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predictability’. In other words, by entering into contractual arrangements people assure themselves a measure of predictability in terms of their contractual cash inflows and outflows, even in a world of economic uncertainty. In their book, Arrow and Hahn wrote: The terms in which contracts are made matter. In particular, if money is the goods in terms of which contracts are made, then the prices of goods in terms of money are of special significance. This is not the case if we consider an economy without a past or future. … if a serious monetary theory comes to be written, the fact that contracts are made in terms of money will be of considerable importance. (1971, pp. 256–7, emphasis added) Only Keynes’s liquidity theory explaining the operation of a capitalist economy provides this serious monetary theory as a way of coping with an uncertain future. And in so doing suggests that the primary function of a Central Bank – as the Monetary authority – is to prevent financial markets for liquid assets from failing. Money is that thing that government decides will settle legal contractual obligations. This definition of money is much wider than the definition of legal tender which is ‘This note is legal tender for all debts, private and public’. An individual is said to be liquid if he/she can meet all contractual obligations as they come due. For business firms and households the maintenance of one’s liquid status is of prime importance if bankruptcy is to be avoided. In our world, bankruptcy is the economic equivalent of a walk to the gallows. Maintaining one’s liquidity permits a person or business firm to avoid the gallows of bankruptcy. Since the future is uncertain, we never know when we might be suddenly be faced with a payment obligation at a future date that we did not, and could not, anticipate, and which we could not meet out of the cash inflows expected at that future date. Or else we might suddenly find an expected cash inflow disappear for an unexpected reason, Accordingly we have a precautionary liquidity motive for maintaining a positive bank balance plus further enhancing our liquidity position to cushion the blow of any unanticipated and possible unforeseeable events that may occur in the uncertain future. If individuals suddenly believe the future is more uncertain than it was yesterday, then it will be only human to try to reduce cash outflow payments for goods and services today in order to increase our liquidity position to handle any uncertain adverse future events since our fear

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of the future has increased. The most obvious way of reducing cash outflow is to spend less income on produced goods and services – that is to save more out of current income. In a Keynes analysis, on the other hand, the civil law of contracts and the importance of maintaining liquidity play crucial roles in understanding the operations of a capitalist economy – both from a domestic national standpoint and in the context of a globalized economy where each nation may employ a different currency and even different civil laws of contracts. I can not pursue, in this chapter, the international aspect of money and contracts, but I do discuss it in my books (Davidson, 2007 and 2009). In Keynes’s theory, The sanctity of money contracts is the essence of the entrepreneurial system we call capitalism. Since money is that thing that can always discharge a contractual obligation under the civil law of contracts, money is the most liquid of all assets. Nevertheless other liquid assets exist that have some lower degree of liquidity than money since these other assets cannot be ‘tended’, i.e., handed to the party, to discharge a contractual obligation. As long as these other assets can be readily resold for money (liquidated) in a well organized and orderly financial market, however, they will possess a degree of liquidity. A rapid sale of the liquid asset for money will permit people to use the money received from the sale of financial assets to meet their contractual obligations. By an orderly public financial market we mean that the price on the next sale of a financial asset transaction to be executed will not differ by very much from the price of the previous transaction. As Peter L. Bernstein, author of the bestseller Against the Gods, has noted that the existence of orderly financial markets for liquid assets encourage each holder (investor) of these securities to believe they can execute a fast exit strategy at any moment when they suddenly decide they are dissatisfied with the way things are happening. Without liquidity for these stocks, the risks of being a minority stock holder (owner) in a business enterprise would be intolerable. Nevertheless the liquidity of orderly equity markets and its promotion of fast exit strategies make the separation of ownership and control (management) of business enterprises an important economic problem that economists and politicians have puzzled over since the 1930s. In fact, Greenspan’s surprise that the managers of large investment bankers were not protecting the interests of the owners of these corporations indicates he does not understand the difference liquid markets make in driving a wedge between ownership and control. In classical theory there can never be a separation in the decision making between owners and managers.

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In my paper ‘Securitization, liquidity and market failure’ (Davidson, 2008) I explain why, as long as the future is uncertain and not just probabilistically risky, the price that liquid assets can sell for at any future date in a free market could vary dramatically and almost instantaneously. In the worse case scenario liquid financial assets could become unsaleable (illiquid) at any price as the market collapses (fails) in a disorderly manner creating toxic assets. This is what happened in the mortgage backed securities (MBS) markets which precipitated the current international financial crisis. To assure holders of liquid securities that the market price for their holdings will always change in an orderly manner, there must exist a person or firm called a ‘market maker’. The existence of this market maker assures the public that if, at any time, most holders of the financial asset suddenly want to execute a fast exit strategy and sell, while few or no people want to buy this liquid asset, the market maker has the obligation to enter the market and purchase a sufficient volume of the asset being offered for sale to assure that the new market price of the asset will change continuously in an ‘orderly’ manner from the price of the last transaction. In essence the market maker assures the holders of a liquid asset that they can always execute a fast exit strategy at a price not much different than the last price. In the New York Stock Exchange these market makers are called ‘specialists’. Orderliness is a necessary condition to convince holders of the traded asset that they can readily liquidate their position at a market price close to the last publicly announced price. In other words, orderliness is necessary to maintain liquidity in these markets. Orderliness provides preventive medicine against toxic assets. In other words, in a world where the future is uncertainty and not just probabilistically risky, for an orderly liquid resale market to exist, there must be a ‘market maker’ who assures the public that he/she will swim against any rip-tide of sell orders. The market maker must therefore be very wealthy, or at least have access to significant quantities of cash if needed. Nevertheless, any private market maker could exhaust his/her cash reserve in fighting against a cascade of sell orders from holders. Liquidity can be guaranteed under the harshest of market conditions only if the market maker has easy direct or indirect access to the central bank to obtain all the funds necessary to maintain financial market orderliness. Only market makers having such preferred access to the central bank can be reasonably certain they always can obtain enough cash to stem any potential disastrous financial market collapse. Consequently, the primary function of central banks is to promote

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orderliness in public financial markets by providing as much liquidity as these markets need. If the central bank is on its toes, it will provide such liquidity before a financial crisis can develop. Thus we can conclude that in a Keynes theory world, the primary function of the central bank is to provide liquidity and assure orderliness in all important financial markets. In sum, although the existence of a market maker provides, all other things being equal, a higher degree of liquidity for the traded assets, this assurance could dry up in severe sell conditions unless the central bank is willing to take direct action to provide resources to the market maker or, even indirectly to the market. If the market maker runs down his/her own resources and is not backed by the central bank indirectly, the asset becomes temporarily illiquid. Nevertheless, the asset holder ‘knows’ that the market maker is providing his/her best effort to bolster the buyers’ side and thereby restore liquidity to the market. In action to support financial markets, a central bank abandons the function that classical theory rationalizes, i.e., to set the inflation rate, and instead accepts the Keynes function of being the market maker of last resort. In markets without a market maker there can be no assurance that the apparent liquidity of an assets can not disappear almost instantaneously. Moreover, in the absence of a market maker, there is nothing to inspire confidence that someone is working to try to restore liquidity to the market. Modern financial efficient market theory suggests that these quaint institutional arrangements for market maker specialists to create orderliness are antiquated in this computer age. With the computer and the internet, it is implied that the meeting of huge numbers of buyers and sellers can be done rapidly and efficiently in virtual space. Consequently there is no need for humans to act as specialists who keep the books and also make the market when necessary to assure the public the market is well organized and orderly. The computer can keep the book on buy and sell orders, matching them in an orderly manner, more rapidly and more cheaply than the humans who had done these things in the past. In the many financial markets that failed in the Winter of 2007–08 (e.g., the markets for mortgage-backed assets, auction rate securities, etc.), the underlying financial instruments that were to provide the future cash flow for investors typically were long-term debt instruments. A necessary condition for these markets to be efficient is that the probabilistic risk of the debtors to fail to meet all future cash flow contractual debt obligations can be ‘known’ with actuarial certainty.

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In a non-ergodic system, past probabilities cannot be used to provide actuarial certainties. What can be done to prevent future reoccurrences of this widespread failure of public financial markets? According to the web page of the United States Securities and Exchange Commission (www.sec.gov) ‘the mission of the US Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.’ The SEC web page then goes on to note that the Securities act of 1933 had two basic objectives: ‘require that investors receive financial and other significant information concerning securities being offered for public sales, and prohibit deceit, misrepresentations, and other frauds in the sale of securities.’ The SEC regulations apply to public financial markets where the buyer and the seller of an asset do not ordinarily identify themselves to each other. In a public financial market each buyer purchases from the impersonal marketplace and each seller sells to the impersonal market. It is the responsibility of the SEC to assure investors that these public markets are orderly. In contrast, a private financial market would be where both the buyer and the seller of the any financial asset are identified to, and know, each other. For example, bank loans were typically a private market transaction that would not come under the purview of the SEC. In the past, there were no resale markets for bank loan securities created in private financial markets. The loan debt contract resulting from a transaction in a private market traditionally has been an illiquid asset that the lender ‘knew’ he/she would have to keep on the asset side of his/her balance sheet until the loan was paid off or the borrower went into default. Under such conditions, the lender knew enough to carefully check the borrower for the three C’s – Collateral, Credit History, and Character – before granting a loan. On its web page, the Securities and Exchange Commission also declares that: ‘As more and more first-time investors turn to the markets to help secure their futures, pay for homes, and send children to college, our investor protection mission is more compelling than ever.’ Given the current experience of contagious failed and failing public financial markets, it would appear that the SEC has been lax in pursuing its stated mission of investor protection. Accordingly the United States Congress should require the SEC to enforce diligently the following rules: 1. Public notice of potential illiquidity for public markets that do not have a credible market maker. In the last quarter of a century, large financial

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underwriters have created public markets, which, via securitization, appeared to convert long-term debt instruments (some of them very illiquid, e.g., mortgages) into the virtual equivalent of high yield, very liquid money market funds and other short-term deposit accounts. Given the celebrated status of the investment bank-underwriters of these securities and the statements of their representatives to clients, individual investors were led to believe that they could liquidate their position at an orderly change in price from the publicly announced clearing price of the last public auction. This perceived high degree of liquidity for these assets has now proven to be illusionary. Purchasers might have recognized the potential low degree of liquidity associated with these assets if the buyers were informed of all the small print regarding market organization. In markets such as the auction rate security markets, for example, although the organizer-underwriter could buy for their own account, they were not obligated to maintain an orderly market. Since the mandate of the SEC is to assure orderly public financial markets, and ‘require that investors receive financial and other significant information concerning securities being offered for public sales, and prohibit deceit, misrepresentations, ... in the sale of securities’, it would seem obvious that all public financial markets that are organized without the existence of a credible market maker should, either (a) be shut down because of the potential for disorderliness, or (b) at a minimum, information regarding the potential illiquidity of such assets should be widely advertised and made part of essential information that must be given to each purchaser of the asset being traded. The draconian action suggested in (a) above is likely to meet with severe political resistance, as the financial community will argue that in a global economy with the ease of electronic transfer of funds, a prohibition of this sort would merely encourage investors looking for higher yields to deal with foreign financial markets and underwriters to the detriment of domestic financial institutions and domestic industries trying to obtain capital funding. Elsewhere (Davidson, 2007), I have proposed an innovative international payments system,2 that could prevent US residents from trading in foreign financial markets that the US deemed detrimental to American firms that obeyed SEC rules while foreign firms did not follow SEC rules. If, however, we assume that the current global payments system remains in effect, and there is a fear of loss of jobs and profits for American firms in the FIRE (Finance, Insurance, Real Estate) industries, then the SEC could permit the existence of public financial markets

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without a credible market maker as long as the SEC required the organizers of such markets to clearly advertise the possible loss of liquidity that can occur to holders of assets traded in these markets. A civilized society does not believe in ‘caveat emptor’ for markets where products are sold that can have terribly adverse health effects on the purchaser. Despite the widespread public information that smoking is a tremendous health hazard, government regulations still require cigarette companies to print in bold letters on each package of cigarettes the caution warning that ‘Smoking can be injurious to your health’. In a similar manner, any purchases on an organized public financial market that does not have a credible market maker can have serious financial health effects on the purchasers. Accordingly, the SEC should require the following warning to potential purchasers of assets traded in a market without a credible market maker: ‘This market is not organized by a SEC certified credible market maker. Consequently it may not be possible to sustain the liquidity of the assets being traded. Holders must recognize that they may find that their position in these markets can be frozen and they may be unable to liquidate their holdings for cash.’ 2. Prohibition against securitization that attempts to create a public market for assets that originated in private markets The SEC should prohibit any attempt to create a securitized market for any financial instrument or a derivative backed by financial instruments that originate in a private financial market (e.g., mortgages, commercial bank loans, etc.). 3. Congress should legislate a twenty-first century version of the Glass– Steagall Act. The purpose of such an act should force financial institutions to be either an ordinary bank lender creating loans for individual customers in a private financial market, or an underwriter broker who can only deal with instruments created and resold in a public financial market.

Notes 1. A religious person who accepts as a fundamental truth the Bible’s story of creation where a Divine Being created humans and all the animals in six days must reject any ‘scientific’ evolutionary evidence that purports to demonstrate that humans evolved from lower life forms over thousands of years. Similarly, a true believer in the axiomatic foundations of classical theory will deny that money can be shown to be ultimately non-neutral in the long run. This is not to deny that some members of the ‘New Keynesian’ school and even some Old Classical school Monetarists accept the notion that money

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may be non-neutral in the short run, because of some ‘temporary’ supply-side failure of the free market. Nevertheless all mainstream economists believe that in the long-run money is neutral. 2. My proposed international payments system is a variant of the Keynes Plan that was presented by Keynes at the Bretton Woods conference in 1944 and rejected by the United States.

References Arrow, K.J. and Hahn F.H. (1971), General Competitive Equilibrium, San Francisco, Holden-Day. Bernstein, P.L. (1996), Against the Gods, New York, Wiley. Blanchard, O. (1990), ‘Why Does Money Affect Output?’, in Handbook in Monetary Economics, vol. 2 , edited by B.M. Friedman and F.H. Hahn, New York, North Holland. Davidson, P. (2007), John Maynard Keynes (Great Thinkers in Economics Series), Palgrave Macmillan, London and New York, 2007. Davidson, P. (2008), ‘Securitization, Liquidity and Market Failure’, Challenge, 51, May/June. Davidson, P. (2009), The Keynes Solution: The Path to Global Economic Prosperity, Palgrave Macmillan, New York. Keynes, J.M. (1933), ‘A Monetary Theory of Production’, reprinted in The Collected Writings of John Maynard Keynes, vol. 13 (1973) edited by D. Moggridge, London, Macmillan. All references are to reprint.

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Part 3 Finance, Crisis and Bubbles

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12 Bubbles Lead to Long-term Instability Elias Karakitsos

1. Introduction Excessive liquidity has financed a series of bubbles in the last ten years. Central banks have not tried to prevent bubbles from ballooning but have raised interest rates once inflation exceeds the target or there is persistent overheating, thereby pricking the bubble. Moreover, central banks have added liquidity every time a bubble has burst and cut interest rates to offset the deflationary gap. By doing so, the central bank has prevented the necessary de-leveraging and has perpetuated the excessive liquidity thus sowing the seeds for the next bubble. This explains how successive bubbles have been created and subsequently pricked. The house bubble is a transformation of the internet bubble and the commodities bubble a transformation of the house bubble. The story keeps repeating but, in every cycle, liquidity increases. In the long run this is an unstable situation as, in every business, cycle the liquidity in the system is further expanded and the new bubble is bigger than the previous one. At the peak of each cycle lower interest rates than before are sufficient to prick the bubble, but the resulting downturn is worse than before. Thus, US interest rates peaked at 6.5% in the early 2000s downturn, but peaked at 5.25% in the recent downturn. The current downturn is far worse than that of the early 2000s. In the current credit crisis the Fed has flooded the system with more liquidity than ever before and a new bubble in US Treasuries has emerged. Rising government bond yields will prick this bubble in the future as default risk premia, inflation risk premia and exchange rate risk premia increase because of the huge issuance of Treasuries necessary to cover the cost of the bailout of the financial system and/or because of monetization of the government debt. The burst of the Treasury bubble 179

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will either prolong and deepen the current recession or will cause another recession later on. Although a host of reasons may be responsible for this mess, the New Consensus Macroeconomics (NCM) or Neo-Wicksellian model (see Arestis, 2007), which forms the intellectual basis of the policies pursued by central banks, has certainly played a vital role, as it does not assign any importance to liquidity and therefore it is not capable of detecting the roots of the credit crisis and monitoring its developments. Arestis and Karakitsos (2008) have suggested an overhaul of the NCM model by endogenizing the natural interest rate and potential output, while Karakitsos (2009) has further expanded the model by including a wealth effect in consumption and explaining the constituent components of wealth – house wealth and equities – bringing to the fore the equity risk premium and credit risk. This chapter shows that such a model is capable of explaining the stylized facts of asset and debt deflation that characterize the current downturn. The inherent instability of the policies pursued by the Fed (i.e., injection of liquidity every time a bubble bursts) is demonstrated by simulating a highly leveraged version of this model. As the degree of leverage increases, the actions of the central bank lead to instability. The chapter is organized as follows: section 2 explains the stylized facts of the last two asset-led business cycles and highlights the inadequacy of the NCM model in a credit crisis. It also points to the errors of monetary policy that aggravated the current downturn. Section 3 presents an overhaul of the NCM model. Section 4 analyses the dynamic effects of a credit crisis. Section 5 demonstrates the instability that a central bank causes if the economy is highly leveraged. Section 6 uses the model to explain the stylized facts of the last ten years, while Section 7 concludes and summarizes.

2. The stylized facts of the last two asset-led business cycles The excessive liquidity1 that has financed three major bubbles in the last ten years (internet, house and commodities)2 and two minor ones (shipping and private equity) in terms of their impact on the economy has been created since the repeal of the Glass–Steagall Act in 1999 (see Arestis and Karakitsos, 2009). This Act was introduced in the 1930s, separating commercial banks from investment banks so that the former would be prohibited from speculating and taking excessive risks with the deposits of ordinary people. Investment banks, on the other hand,

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could take bets and leverage them by borrowing from the money and capital markets. The Act was successful in reducing banking crises for the remainder of the twentieth century. However, in the late 1990s, lobbying pressure on Capitol Hill mounted on the grounds that the Act discriminated against US banks when competing with their European rivals, where no such distinction exists. The repeal of the Act enabled banks to shift from the ‘originate-and-hold’ model of loans to the ‘originateand-distribute’ one. In the traditional ‘originate-and-hold’ model bank loans are held in their own portfolios. This makes banks prudent in granting loans as they carry the risk of non-performing loans or the risk of write-downs in case of insolvency of the borrower. Before the repeal of the Act banks applied the principle of three C’s (collateral, credit history and character) in granting loans to manage their own risk. With the repeal of the Act banks adopted the ‘originate-and-distribute’ model, according to which the original loans were re-packaged and sold to other banks, foreign banks and the domestic and foreign personal sector. This transferred the loan risk from the banks to whoever bought these asset-backed securities (ABS). To accelerate this process banks set up Structured Investment Vehicles (SIV) or conduits as separate legal entities outside the regulation and control of the authorities. The SIV took the form of a simple limited liability company or even a trust and required a very small capital base. The SIV financed their operations by borrowing from the London money market. They used this money to buy the risky portfolio from the mother bank then repackaged it in the form of collateralized debt obligations (CDO) and sold it to third parties. This securitization of the original loans fostered the expansion of the subprime market, as banks were no longer prudent in originating new loans, since the risk was transferred to the buyers of the CDO. The buyers of CDO were not in a position to identify the risk inherent in these exotic assets, as they were packaged in tranches of varying risk with no way of identifying those responsible for the loans. This securitization process was applied to home mortgages, commercial estate loans, student loans and car loans. The sale of CDO was facilitated by the credit rating institutions that erroneously assigned a triple-A status to worthless assets. The liquidity created by the process of securitization was not reflected in ordinary monetary aggregates. The original loan was counted in the consolidated banking balance sheet and therefore in the overall liquidity. However, it was removed from the banking balance sheet once it was securitized. Therefore, this huge liquidity was not detected by central banks, which continued as late as the spring of 2007 to believe that

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the subprime market was not posing a threat to the economy, as the size of this market was small, around 10% of the overall market. The SIV made profits as long as the Libor rate at which they borrowed from the London money market was lower than the CDO rate. But a small inversion of the yield curve was sufficient to make SIV insolvent, as their capital base was too small. The fall in house prices and the losses of SIV alerted the holders of CDO that they were overvalued and triggered a sell-off. The losses of financial institutions mounted as a result and forced them to sell each other’s assets for fear that the others are holding the ‘queen of spades’.3 While there is no doubt that financial engineering is the major culprit in creating this huge liquidity central banks have also contributed to its creation. Greenspan lowered interest rates to stem the systemic risk from the Asian–Russian crisis in 1997–98 by cutting the Fed funds rate from 5.5% to 4.75%, at a time when the US economy was overheated. The easing of monetary policy resuscitated the shattered confidence and growth in the US remained intact. But this episode added liquidity into the system, which was only partially drained later on. The second episode occurred after the burst of the internet bubble, when Greenspan cut interest rates from 6.5% to 1% to deflect the asset and debt deflation process. The final phase of the rate cuts occurred in 2003 when the economy was recovering and the slack in capacity had been eliminated by mid-2003. The over-accommodative monetary policy not only was maintained for one more year, until mid-2004, but it was removed very sluggishly at a ‘pace that can be measured’, using Greenspan’s well-known phrase, which meant 25 basis points in each FOMC meeting. Greenspan’s successor, Bernanke, retained the same sluggish pace in removing the accommodation bias and interest rates hit 5.25% by mid-2006, a level that was maintained until mid-2007, the time of the eruption of the credit crisis. Japan also contributed to the huge liquidity in the global economy. The Bank of Japan created money aggressively in 2001–04 by buying back government bonds from financial institutions. The monetary base increased at nearly 20% per annum in the three years to 2004, in what is called the era of ‘quantitative easing’. But even before that the monetary base was increasing at 7% per annum in 1993–99. This huge liquidity bolstered the yen ‘carry-trade’, acquiring its own momentum by leading to yen depreciation which further bolstered yen carry-trade. The huge liquidity financed in the first instance the internet bubble and subsequently the house bubble (see Leamer, 2007). The low interest rates prompted households to accumulate mortgage debt. Between

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1998 and 2007 mortgage debt as a proportion of disposable income was increased by more than 50% from 61% to 101% (see Figure 12.1a). This debt spurred house prices and the gross house wealth of the personal sector soared to 230% of disposable income by the end of 2005 from 144% in 1998. The increase in gross house wealth was less than 50%, which is lower than the more than 50% increase in debt, making the marginal efficiency of leverage less than unity – a sign of diminishing returns from extra borrowing. In the last two years of the house bubble, when the subprime market thrived, additional debt was not adding to the gross house wealth. Instead, gross house wealth was decreasing. Accordingly, gross and net house wealth peaked at the end of 2005 and according to the K-model4 both will continue falling probably beyond the forecast period, end of 2010. Gross house wealth will return by the end of 2010 to its level at the beginning of the bubble in 1998. Net wealth, on the other hand, will probably diminish to a much lower level than the beginning of the bubble in 1998 as a result of the irreversibility of debt – households cannot easily get rid of their debt (see Figure 12.1a). House wealth and financial wealth moved in opposite directions for most of the past ten years (see Figure 12.1b). But since the credit crisis erupted in mid-2007 both equities and house prices moved in tandem

Projection

250%

200%

150%

100%

50%

Ja n

-4 Ja 6 n4 Ja 9 n5 Ja 2 n5 Ja 5 n5 Ja 8 n6 Ja 1 n6 Ja 4 n6 Ja 7 n7 Ja 0 n7 Ja 3 n7 Ja 6 n7 Ja 9 n8 Ja 2 n8 Ja 5 n8 Ja 8 n9 Ja 1 n9 Ja 4 n9 Ja 7 n0 Ja 0 n0 Ja 3 n0 Ja 6 n09

0%

(a)

Home mortgages as % of disposable income level M Net real estate of households as % of disposable income NRE Gross real estate of households as % of disposable income RE

Figure 12.1a Gross, net real estate of households and mortgage debt

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Macroeconomics, Finance and Money Projection 16%

650%

14% 12%

600%

10% 8%

550%

6% 500%

4% 2%

450%

0% –2%

400%

M ar -5 M 2 ar -5 M 5 ar -5 M 8 ar -6 M 1 ar -6 M 4 ar -6 M 7 ar -7 M 0 ar -7 M 3 ar -7 M 6 ar -7 M 9 ar -8 M 2 ar -8 M 5 ar -8 M 8 ar -9 M 1 ar -9 M 4 ar -9 M 7 ar -0 M 0 ar -0 M 3 ar -0 M 6 ar -0 9

–4%

Household net worth as a % of disposable income Long term average household net worth Personal saving as a % of disposable income 4-quarter MA (RHS) (b)

Average savings ratio (RHS)

Figure 12.1b Household net wealth

lower thus magnifying the fall of net wealth. The fall in asset prices has made debt unsustainable and the only way households can restore the value of their net wealth is by saving a higher proportion out of their current income (i.e., a higher savings ratio). The K-model predicts that the savings ratio will increase to more than 8%. The credit crisis has been reflected in a widening of credit spreads in the London money market where banks lend to each other and in a widening of the spread between corporate bonds and US Treasuries (see Figure 12.1c). The widening of these spreads makes banks unwilling to lend to each other and raises the cost of borrowing for businesses, thus plunging the economy into recession. Central banks have attributed the widening of credit spreads to lack of liquidity and responded by flooding the system with liquidity. However, this is the wrong diagnosis as banks are not worried about liquidity, but insolvency of the banking system. An aggregate measure of the insolvency risk of the banks can be obtained by decomposing the risk implicit in the Libor rate into interest rate risk, liquidity risk and credit (or counter-party) risk. The overnight three-month interest rate swap (OIS) is a measure of the interest rate risk, as it reflects market expectations of what the fed funds rate will be over the next three months.

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Elias Karakitsos 185 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5

(c)

Spread 3-M libor and 3-m interest rate swap

M ar -0 9

M ay -0 8 Ju l-0 8 Se p08 N ov -0 8 Ja n09

M ar -0 8


M ar -0 7


M ar -0 6

Ja n06

0.0

3-M libor and 3-M repo spread

Figure 12.1c Liquidity and credit risk vs credit risk (Libor OIS vs Libor Repo)

Thus, the spread between Libor and OIS is a measure of the combined liquidity and credit risk, as it has eliminated the interest rate risk. A measure of credit risk, in turn, is the spread between secured and unsecured borrowing by the banks. One form of secure loans is government-backed Repos between banks. Thus, the spread between Libor and repo rates provides a measure of credit risk. Figure 12.1c shows the close correlation between the Libor–OIS spread and Libor–repo spread. This suggests that the banks are concerned more about credit risk than liquidity risk and hence they are worried about the insolvency of the entire financial system. Hence, central banks have made the wrong diagnosis and have applied the wrong medicine. This highlights a fundamental difference between the Great Depression and the current credit crisis. The former was due to liquidity risk and therefore the remedy was an increase in the supply of money. But the current crisis is mainly due to credit risk. The stylized facts of the current crisis highlight the key role of the net wealth and the savings ratio in household decisions on how much to spend and save. Net wealth, on the other hand, requires an analysis of house wealth and financial wealth. The last two, in turn, are influenced by monetary policy, credit risk and profitability. The NCM model cannot detect and monitor the current credit crisis as these variables do not enter the model.

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3. A reformulated Neo-Wicksellian model The micro-foundations of the NCM or Neo-Wicksellian model are established in Rottemberg and Woodford (1995, 1997). The similarities of the NCM with Wicksell (1898) are pointed out in Woodford (2003) and Fontana (2006). A review of the NCM model can be found in Arestis (2007) and Goodhart (2004). The reduced form of the model in Karakitsos (2009) consists of six equations: Yt ⫽ ao ⫹ a1Yt ⫹ a2Yt ⫺1 ⫹ a3 EtYt ⫹1 ⫹ a4[ Rt ⫺ Et ( Pt +1 ) ⫺ RRt ]⫹ a5 NWt ⫹ u1t

(1)

Yt g ⫽ a0 ⫺ q ⫹ ( a1 ⫺ b1 )Yt ⫹ a2Yt ⫺1 ⫹ a3 Et (Yt ⫹1 ) ⫹ a4[ Rt ⫺ Et ( Pt +1 )]

(2)

⫺ ( a4 ⫹ b2 )RRt ⫹ a5 NWt ⫹ u2t Pt ⫽ d0 ⫹ d1 Et ( Pt ⫹1 ) ⫹ d3 Pt ⫺1 ⫹ ( d4 )Yt g ⫹ u3t

(3)

RRt ⫽ q ⫹ f1[ Pt ⫺ Et ( Pt ⫹1 )]⫹ f 2Yt ⫹ f 3 Rt ⫹ f 4Yt g ⫹ u4t

(4)

Rt = (1 − g0 )[ Rt + Et ( Pt +1 )] + g1Yt g−1 + g2 ( Pt −1 − P T ) + g0 Rt −1 + u5t

(5)

NWt ⫽ ⍀1 Rt ⫹ ⍀ 2 RRt ⫹ ⍀ 3 RC ⫹ u6t

(6)

⍀1 , ⍀ 3 ⬍ 0 ,

⍀2 ⬎ 0

All variables are expressed as rates of growth (log-differences): Y is (the rate of growth of) output, which is equal to the rate of aggregate demand; Yg is the output gap, the difference between the growth rates of current output and potential output; R is the nominal short-term interest rate; RR is the natural interest rate or real profit rate; P is the inflation rate; PT is the central bank target inflation rate; and Et (Xt⫹1) NW is net household wealth; RC is credit risk; and is the expectation of variable X in period t⫹1, as with information at time t. The system of equations (1)⫺(6) determines the six endogenous variables: Yt g , Yt , Pt , Rt RRt and NWt The similarities and differences with the NCM (or Neo-Wicksellian) model are the following. The NCM model is simply equations (2), (3) and (5) with the last two terms in (2) being omitted. In the reformulated model there are three more equations: equation (1), which determines the equilibrium level of output from the level of demand in the

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economy; equation (4), which determines the rate of profit, which is treated as a constant in NCM models; equation (6), which determines net wealth. In the NCM model monetary policy is transmitted through the entire future path of short term interest rates, while in the reformulated model there are three more channels: (i) the profit rate; (ii) the wealth effect on consumption and (iii) the credit spreads. The stability of this system and its steady-state properties are analysed in Karakitsos (2009).

4. The dynamic effects of a credit crisis The dynamic effects of the credit crisis are analysed by simulating a numerical analogue of the theoretical model. The equation-coefficients are calibrated to fit the stylized facts and satisfy the stability conditions. The credit crisis is portrayed in the model by a widening of credit spreads – corporate bond yields increase over government bond yields. In the simulations it is assumed that credit spreads widen by 450 basis points for four years, consistent with the stylized facts of the current crisis. As a result, net wealth falls from its steady-state value of 3% to –10% in the next three years, as both equities and house prices plunge, but then gradually converges with some overshooting to its initial steady-state. The whole dynamic adjustment lasts for ten years, which is consistent with the experience of the US in the 1930s and Japan in the 1990s. The fall in net wealth creates a recession with a negative output gap, which reaches a trough in three years at nearly –3% (see Figure 12.2a). But then the economy recovers and converges to its initial steady-state in ten years, while overshooting it for a short period of time. Potential output growth also diminishes during the credit crisis by a maximum of 1%, but ultimately returns to its initial steady-state (see Figure 12.2a). The fall in potential output mitigates the negative output gap and therefore it has a stabilizing effect on the deflationary impact of the credit crisis. The decrease in potential output is due to lower growth and the impact of declining profitability on the capital accumulation process. As a result of the negative output gap inflation falls nearly 1% in three years and then converges to its initial steady state, largely following the path of the output gap (see Figure 12.2b). The central bank has two targets, inflation and the output gap. As inflation falls below the central bank target and the economy falters with a negative output gap the central bank responds by cutting interest rates aggressively from 4.5% to less than 0.5% in four years, consistent with the stylized facts of Japan in the 1990s and the US in 2000s. A year after the economy begins to

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8% 6% 4% 2% 0% –2% –4%

Ja

nJa 06 nJa 07 nJa 08 nJa 09 nJa 10 nJa 11 nJa 12 nJa 13 nJa 14 nJa 15 nJa 16 nJa 17 nJa 18 nJa 19 nJa 20 nJa 21 nJa 22 nJa 23 nJa 24 nJa 25 nJa 26 nJa 27 nJa 28 nJa 29 n30

–6%

Y(g)

(a)

Potential output growth

Figure 12.2a Output gap and potential output 6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

Ja n

Ja 06 nJa 07 nJa 08 nJa 09 nJa 10 nJa 11 nJa 12 nJa 13 nJa 14 nJa 15 nJa 16 nJa 17 nJa 18 nJa 19 nJa 20 nJa 21 nJa 22 nJa 23 nJa 24 nJa 25 nJa 26 nJa 27 nJa 28 nJa 29 n30

0.0%

(b)

R

P

RR

Figure 12.2b Interest rate, inflation and natural interest rate

recover the central bank gradually removes the accommodation bias. During the overshooting it lifts the interest rate above the target level, but then it takes it back to its initial steady-state (see Figure 12.2b). The profit rate plays an equally important, if not greater, role than interest rates in weathering the credit crisis and restoring the initial steady-state.

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It falls initially, in response to the negative output gap, but it is the first to recover, as the central bank cuts interest rates and company pricing power returns early in the cycle (see Figure 12.2b). The simulations show that the model captures the stylized facts of asset and debt deflation, caused by bank losses during the burst of an asset bubble that trigger widening of credit spreads. A credit crisis causes larger swings in the output gap than in inflation, a characteristic of all asset and debt deflations and shows the importance of the output gap as a target of central bank policy.5 Reliance on inflation alone is likely to exacerbate and prolong the deflationary impact of a credit crisis.

5. The instability of leveraged economies The central role of wealth in the asset and debt deflation process reveals the drawback of NCM models to detect the roots of the current crisis and deal with its consequences. Net wealth depends on interest rates, as they affect house prices and equities. The other major determinant of net wealth is profitability that influences aggregate demand and equities. Both the interest rate and profit sensitivity of net wealth are related to the degree of leverage of the economy. In a highly leveraged economy both sensitivities are elevated; in fact, the more leveraged the economy, the higher these sensitivities are. As an example, consider the implications of SIV, which have contributed significantly to the expansion of liquidity. SIV used to finance their activities through the London money market. Their profitability depended on the yield curve. In fact, they went bust as the yield curve became slightly inverted, thus making them very sensitive to changes in interest rates. A small rise in money market rates above mortgage rates was sufficient to cause the collapse of SIV. Since the asset backed securities issued by SIV are held to a large extent indirectly (through pension funds and insurance companies) by the personal sector, the net wealth of households becomes very sensitive to changes in interest rates. As an example of the high sensitivity of net wealth to profitability consider the investment banks that are highly leveraged;6 they operate with 30–40 times leverage. Because of the high degree of leverage they are also very sensitive to short- and long-term interest rates. In the upswing of the asset cycle investment banks made huge profits that boosted the net wealth of households through direct and indirect holdings of their shares, but in the downswing they made huge losses that dragged down equities and hence the net wealth of households. Banks have operated with a smaller degree of leverage than investment

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banks – around 20 times their capital. Their profitability is also very sensitive to interest rates, which again contributes to fluctuations in personal sector wealth through equities. Thus, it is important to explore the sensitivity of the dynamic path of the economy to interest rates and profitability, as this enables the study of leveraged economies, a characteristic of the current credit crisis. The results of these simulations are reported in Figure 12.3 with respect to interest rates and Figure 12.4 with respect to profitability. The economy oscillates around the initial steady-state for a quarter of a century, instead of converging in ten years; moreover, interest rates and profitability tend to move away through time from their initial steady-state; in other words the system tends to instability. With a high net wealth response to profitability the output gap remains negative for 25 years, while the improvement in net wealth from profitability is offset by the higher interest rates engineered by the central bank (see Figure 12.4). Therefore, in a leveraged economy a central bank faces a much more difficult problem in stabilizing the economy. A high response of net wealth to interest rates and profitability would prolong the credit crisis, as the central bank is forced to move interest rates up and down the target rate (see Figure 12.3). An ever increasing response of net wealth to interest rates and profitability makes the system unstable and the economy never converges to its initial steady-state, following a temporary credit crisis. The oscillatory central bank behaviour, which ultimately 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0%

Ja n


0.0%

R

P

RR

Figure 12.3 High response of net wealth to interest rates

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Elias Karakitsos 191 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% –1.0% –2.0% –3.0% –4.0%

Ja n


–5.0%

R

P

RR

Figure 12.4 High net wealth response to profitability

causes instability, is due to the cyclical pattern of profitability. Given the differential speed of the economy to a change in interest rates and profitability with the former impacting slowly, while the latter rapidly, central bank action would delay, if not cause instability, to a credit crisis. This differential speed of adjustment is not just a feature of this model, but a stylized fact of the real world. Given that the real profit rate plays an important role in stabilizing the economy, as it moves faster than interest rates and, given the influence of the interest rate on the real profit rate, which is responding to economic developments, it is not unreasonable that the central bank may destabilize a highly leveraged economy.

6. An explanation of the stylized facts The stylized facts of the last three major bubbles (internet, housing and commodities) can be accounted for by this model. Financial engineering creates more liquidity than is consistent with long-run equilibrium and this boosts equities and/or house prices. The higher level of wealth stimulates output and inflation rises above the central bank target, prompting higher interest rates. This pricks the bubble triggering rising risk aversion (a widening of credit spreads), which leads to a fall in wealth that depresses demand. The central bank responds by cutting interest rates to offset the deflationary gap and with this action prevents the de-leveraging (i.e., the drain of liquidity). By doing so, the

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central bank perpetuates the excessive liquidity and sows the seeds for a new bubble. This explains how successive bubbles have been created and subsequently pricked. The house bubble is a transformation of the internet bubble and the commodities bubble a transformation of the house bubble. The story keeps repeating, but in every cycle liquidity makes another leap forward. In the current crisis the house bubble lifted output above potential and prompted the Fed to tighten monetary policy to control inflation. The high interest rates pricked the house bubble causing huge losses to financial institutions especially in CDO. These losses made them unwilling to lend to each other for fear that the others hold the ‘queen of spades’. This led to widening of credit spreads in the summer of 2007 and led the Fed to cut interest rates from 5.25% to 2.0% by mid-2008, which fuelled the commodity bubble and fanned CPI-inflation. Higher inflation prompted tightening of interest rates in some countries or prevented others from cutting interest rates and accelerated the path to recession. Tighter monetary policy led to the simultaneous falling off a cliff for all major economies in mid-2008, which pricked the commodity bubble. The downturn is now unravelling as the worst recession since the 1970s as the cost of money for households and business increases and banks tighten lending standards. Since the credit crisis erupted in the summer of 2007 central banks have repeated their old pattern – they have flooded the system with liquidity thereby sowing the seeds for another bubble in the future. In the long run this is an unstable situation, as in every business cycle the liquidity in the system is further expanded and the new bubble is bigger than the previous one. At the peak of each cycle lower interest rates than before are sufficient to prick the bubble, but the resulting downturn is worse than before. Thus, interest rates peaked at 6.5% in the early 2000s downturn, but peaked at 5.25% in the recent downturn. The early 2000s recession was by far milder than the current one. In the second half of 2008 the Fed cut interest rates to 0.25% and injected further liquidity into the system. The new bubble is now in the US Treasury market. Long-term interest rates (e.g. ten-year Treasury yields) hit 2% at the end of 2008, as investors fled all risky assets (e.g. equities, corporate bonds, CDO, and all synthetic assets) to the safety of government bonds. But the government in acting as lender of last resort is issuing huge amounts of Treasuries, which this year alone will mount to $2.5 trillion. In the current environment of fear and panic this huge supply might be absorbed without trouble. But it is unlikely that this will be tolerated by investors in the long run. If, or rather when, the

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Treasury bubble bursts, the US government runs the risk of becoming insolvent itself because of rising long-term interest rates. These rates are bound to rise either because investors will demand a higher yield to absorb the huge issuance of Treasuries or because the dollar will fall, as the debt is monetized. If none of these scenarios materializes, then once the economy begins to recover and the Fed lifts interest rates bond yields will soar. Hence, either in the current cycle or in the next one the Treasury bubble will burst leading the economy into a deeper and longer recession now or into a new recession later on. This may put an end to this unstable spiral. Every time a bubble bursts the stakes are raised with the government acting as a lender of last resort and liquidity being expanded. As the cost of the bailout increases with every new bubble, the government will ultimately become insolvent and de-leverage would ultimately take place.

7. Summary and conclusions The huge liquidity that has financed three major bubbles in the new millennium has been created by ‘bad’ financial engineering. Central banks have expanded it further by injecting more liquidity every time a bubble bursts. This is unstable in the long run, as the interest rates required to prick a bubble are lower than before, while the downturn is worse. Part of the problem lies in the deficiencies of the NCM model that forms the intellectual basis of central bank policy. This model is incapable of detecting the roots of the credit crisis and it cannot monitor its development. Arestis and Karakitsos (2008) have suggested an overhaul of the NCM model by endogenizing the natural interest rate and potential output, while Karakitsos (2009) has further expanded the model by including a wealth effect in consumption and explaining the constituent components of wealth – house wealth and equities – bringing into fore the equity risk premium and credit risk. This chapter shows that such a model is capable of explaining the stylized facts of asset and debt deflation that characterize the current downturn. The inherent instability of the policies pursued by the Fed (i.e., injection of liquidity every time a bubble bursts) is shown by simulating a highly leveraged version of this model. As the degree of leverage increases, the actions of the central bank lead to instability. In the current environment more liquidity than ever before has been injected into the system and a new bubble has already emerged in US Treasuries. Government bond yields are bound to rise causing either a deeper downturn now or another recession later on, as default risk

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premia, inflation premia or exchange risk premia soar because of the huge issuance of Treasuries and/or the monetization of government debt. There are two ways out of this long-term instability. First, the Fed reverses its actions in due course and allows liquidity to drain (deleverage takes place). Second, the insolvency risk of the US government increases to the point where higher bond yields force the required deleveraging.

Notes 1. Liquidity is defined as the total amount of credit in the form of bank loans, synthetic assets, such as CDO and derivatives such as credit default swaps. This liquidity is created to a large extent endogenously, but also exogenously by central banks in an effort to deflect asset and debt deflation when a bubble bursts. See the text for how this liquidity is created. 2. With the exception of the US housing bubble, all other bubbles are of global nature. 3. In the game of hearts you do not want to get stuck with the queen of spades. In this context the queen of spades was the securities with the bad mortgages which the holders of CDO did not know where they were. 4. The K-model is an econometric model of the US economy linking the real sector, including housing, with the financial sector. It is an empirical counterpart of the reformulated NCM model, explained in section 4. It is used in providing the investment strategy of the Guildhall Hedge Fund. See Arestis and Karakitsos (2004) for a detailed explanation of the model. 5. The output gap target is not without its problems, as potential output is affected by the capital accumulation process and multi-factor productivity. From this perspective, it has similar problems to the natural interest rate. 6. Leverage means that the asset side of a bank balance sheet expands through borrowing, i.e., by a corresponding expansion of the liability side. The best way of defining leverage is as the ratio of assets to equity capital.

References Arestis, P. (2007), ‘What is the New Consensus in Macroeconomics?’, in P. Arestis (ed.), Is There a New Consensus in Macroeconomics?, Palgrave Macmillan: Houndmills, Basingstoke. Arestis, P. and Karakitsos, E. (2004), The Post-Bubble US Economy: Implications for Financial Markets, Palgrave Macmillan: London and New York. Arestis, P. and Karakitsos, E. (2008) ‘Unemployment and the Natural Interest Rate in a Neo-Wicksellian Model’, in P. Arestis and J. McCombie (eds) Unemployment: Past and Present, Palgrave Macmillan: London and New York. Arestis, P. and Karakitsos, E. (2009), ‘Subprime Mortgage Market and Current Financial Crisis’, in P. Arestis, P. Mooslechner and K. Wagner (eds), Housing Market Challenges in Europe and the United States: Any Solutions Available?, Palgrave Macmillan: Houndmills, Basingstoke.

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Elias Karakitsos 195 Fontana, G. (2006), ‘The ‘New Consensus’ View of Monetary Policy: A New Wickselian Connection?’, Levy Economics Institute Working Paper No. 476, New York: Levy Economics Institute of Bard College. Goodhart, C.A.E. (2004), ‘Review of Interest and Prices by M. Woodford’, Journal of Economics, 82(2), 195–200. Karakitsos, E. (2009), ‘The “New Consensus Macroeconomics” in the Light of the Current Crisis’, Economia, forthcoming. Leamer, E. (2007), ‘Housing Is the Business Cycle’, Symposium sponsored by the Federal Reserve Bank of Kansas City Aug 30 – Sep 1, Jackson Hole, Wyoming, 1–74. Rottemberg, J.J. and Woodford, M. (1995), ‘Dynamic General Equilibrium Models with Imperfectly Competitive Product Markets’, in T.J. Cooley (ed.) Frontiers of Business Cycle Research , 243–93, Princeton University Press: Princeton. Rotemberg, J.J. and Woodford, M. (1997), ‘An Optimization-Based Econometric framework for the Evaluation of Monetary Policy’, NBER Macroeconomics Annual 1997, 297–346, National Bureau of Economic Research: Cambridge, MA. Wicksell, K. (1898), Geldzins und Güterpreise, Verlag Gustav Fischer: Frankfurt. English translation in R.F. Kahn (1965), Interest and Prices, Kelley: New York. Woodford, M. (2003), Interest and Prices, Princeton University Press: Princeton.

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13 The Subprime Crisis: A Minskyan Phenomenon? Elisabetta De Antoni

1. Introduction The widely touted Great Moderation and its calamitous end seemingly fit the financial instability hypothesis perfectly. Not by chance, the subprime crisis has been considered the result of a ‘Minsky credit bubble’, as the ‘Minsky moment’ preceding a ‘Minsky meltdown’ (Roubini, 2007a and 2007b; Whalen, 2007; Wray, 2007). The aim of this study is to analyse the Minskyan features of the subprime crisis. Is the recent turmoil a confirmation of the financial instability hypothesis? Does it provide evidence for Minsky’s ‘upward instability proposition’, according to which the fundamental instability of capitalism is upward? Does it reflect Minsky’s belief that growth does not converge to a uniform and steady rate, but instead leads to financial fragility, financial crises, debt deflations and deep depressions? Is it thus an endogenous result of the good performance of the real economy (Borio, 2008)? And what about Minsky’s prescriptions in terms of economic policy? With a view to answering these questions, section 2 sets out Minsky’s ‘financial instability hypothesis’. Section 3 analyses the subprime crisis. Section 4 wonders whether it can be interpreted as a Minskyan phenomenon. Section 5 concludes.

2. The financial instability hypothesis The following exposition will refer to the two keystones of Minsky’s financial instability hypothesis: the theses i) that capitalism is endogenously prone to growth, and ii) that growth endogenously turns into financial fragility and financial crises. 196

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2.1 Capitalism’s proneness to growth Minsky (1975, 1977) presented his ‘financial instability hypothesis’ as an interpretation of The General Theory. He is often considered as one of the most authentic interpreters of Keynes. The two authors undoubtedly have much in common. In our view, however, they also display crucial differences. Keynes experienced the tragedy of the Great Depression. Minsky was formed by the hopes for postwar political and economic renaissance. Their different experiences inevitably left marks. Thus, Keynes focused on a depressed economy tending to chronic underinvestment and to high and long-lasting unemployment. Minsky, on the other hand, referred to a vibrant economy naturally inclined to over-investment and over-indebtedness. This might be the reason why he (1975, 1986) preferred to speak of a financial instability ‘hypothesis’ rather than ‘theory’.1 Minsky’s starting point is the ‘upward instability proposition’ that ‘stability – or tranquillity – is destabilizing’ and ‘the fundamental instability is upward’.2 A period of tranquillity (in which profits are systematically greater than inherited debt commitments) fosters greater confidence in the future, giving rise to a wealth reallocation from money to non-monetary assets. The consequent rise in asset prices stimulates both the availability of credit and the propensity to borrow in order to invest, turning into an externally-financed increase in investments.3 In Minsky’s view, therefore, capitalism is endogenously prone to growth. Minsky applies his upward instability proposition to every ‘coherent’ situation, be it Keynes’s under-employment equilibrium,4 fullemployment equilibrium5 or steady growth.6 The afore-mentioned proposition, however, raises some important objections. From a theoretical point of view, tranquillity might increase the confidence in zero or negative profits, without having any expansionary effect on the economy. From the empirical point of view, the European experience shows that tranquillity does not inevitably lead to recovery: the calm may persist for ever. As far as the history of thought is concerned, the upward instability proposition cannot be attributed to Keynes as Minsky does.7 The main message of The General Theory seems to consist precisely in the possible persistence of the slump. Minsky’s upward instability proposition sweeps this crucial message under the carpet. Leaving these objections aside, let us come back to Minsky. According to his upward instability proposition, the tranquillity of the slump inevitably leads to a debt-financed investment recovery. The latter in turn triggers cumulative processes primarily based on the link investmentsprofits-investments. The initial externally financed rise in investment

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provokes an income expansion, which partly turns into a rise in profits. By improving profit expectations and confidence, the higher profits further stimulate debt-financed investment. The cumulative processes based on the link investments-profitsinvestments are strengthened by the money and financial markets. As profit expectations and confidence rise, bank credit and money supply also increase. At the same time, the speculative demand for money shrinks in favour of other assets. In either case, the money market fuels the increase in asset prices and wealth thus accentuating the debtfinanced investment expansion. In financial markets, the expectations of capital gains strengthen the rise in asset prices and wealth further stimulating both credit availability and the propensity to borrow in order to invest. Thanks to the afore-mentioned amplifying processes, expansion turns into a debt-financed investment boom. 2.2 Growth as a source of financial fragility and of financial crises At this point, Minsky (1975, 1982a, 1986) focuses on the drawbacks of the boom. To start with, he assumes that the actual gearing ratio (the ratio between external and internal financing) aligns itself with the desired gearing ratio. With the growing optimism of the boom, external financing thus increases faster than internal. In the general euphoria, firms’ debt commitments increase faster than profits and eventually exceed them. Put otherwise, debt commitments are no more financed by profits as hedge financing requires. Expecting a future bonanza, firms start financing their principal by resort to debt (speculative financing) and then even interest payments (ultra-speculative or Ponzi financing)8. In this way, an initially robust financial system becomes fragile.9 The persistence of the boom inevitably creates either bottlenecks in the financial system or inflationary pressures in the goods market that require a restrictive monetary policy. In either case, the result is a rise in the rate of interest.10 The higher interest rate ends the boom, and the investment-profit-investment chain reverts to a downward spiral. The unexpected rise in the cost of funds is thus associated with an equally unexpected fall in (already insufficient) profits. Given financial fragility, honouring inherited debt commitments would require and increase in indebtedness, but this is not only undesirable but actually impossible as confidence in the future collapses. Firms’ debt commitments can no longer be honoured in the ordinary way, i.e., by drawing on liquidity balances, profits or borrowing. This is Minsky’s definition of the financial crisis (1982b).

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With the outbreak of the crisis, the only solution for firms is to reduce indebtedness and the related debt service by selling assets, which by now are mainly illiquid. The resulting fall in asset prices is strengthened by the expectation of capital losses. The decrease in the net wealth of firms and financial intermediaries, the contraction of bank credit and money supply and the rise in liquidity preference aggravate the need to lower debt and to sell assets. Asset prices plummet. The fall in capital asset prices worsens the contraction of investment and profits and vice versa. As asset prices keep falling, the fulfilment of debt commitments becomes impossible and there is a wave of bankruptcies that ultimately leads to deep depression. According to Minsky, however, depression has also a cathartic role: only the hedge units will survive. Under these circumstances, Minsky’s upward instability proposition comes back into play: a new phase of tranquillity increases confidence and reactivates investment.11 The system again experiences debt-financed expansion, speculative boom, financial crisis, debt deflation and depression. Minsky (1982a, 1986) found empirical confirmation for his analysis. The financial instability of the American economy – which he had foreseen in advance (Minsky 1963) – surfaced in the mid-1960s, provoking the crises of 1966, 1970, 1974–75, 1979 and 1982. And financial instability had also marked the periods preceding and separating the two world wars. According to Minsky (1991), this confirms that financial crisis is systemic. To his own question Can ‘It’ Happen Again? (1982a), Minsky answered that another Great Depression was indeed possible. The task of stabilizing the economy falls to macroeconomic policies. Moreover, the financial system must be carefully regulated. This is the main message of his Stabilizing an Unstable Economy (1986). Given that a large part of the money supply is endogenous, Hyman Minsky (1986, pp. 303–4) did not place much faith in monetary policy. In his view, the central bank should focus on its function as a lender of last resort. By enabling the funding of financial institutions and by sustaining asset prices, it might mitigate the financial crisis and remove the threat of debt deflations and deep depressions. In Minsky’s view, ‘Fiscal policies are more powerful economic control weapons than monetary manipulations’ (Minsky, 1986, p. 304). Government intervention is not only necessary to sustain income and employment; it is also indispensable for containing financial instability. By limiting the rise (fall) in income and profits due to an investment expansion (slow-down), automatic fiscal stabilizers can hinder the tendency to a speculative boom (a debt-deflation) and to a financial crisis (a deep depression). Moreover, the anti-cyclical behaviour of the government

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budget implies an increase (decrease) in government bond issues during recessions (expansions) that raises (reduces) the liquidity and therefore contributes to stabilizing the financial system.12 As far as the ultimate targets of economic policy are concerned, Minsky’s (1975, 1986) crucial contribution consists in questioning the dominant myth of private investment-led growth. Investment is a highly unstable component of aggregate demand; it may turn out to be a failure and compromise financial solidity and economic activity.13 Growth does not converge on a uniform, steady rate. It jeopardizes the robustness of the financial system and consequently tends to be shaken by financial crises followed by debt-deflations and depressions.

3. The subprime crisis In order to analyse the Minskyan features of the recent financial turmoil, this section summarizes the developments that led to its occurrence. The double arrows in Figure 13.1 schematize the phenomena at the origin of the turmoil. From this perspective, the first important aspect is US monetary policy. According to the dominant approach, the New Macroeconomic Consensus, the main task of the central bank is to manoeuvre the interest rate in such a way as to keep inflation – and with it the exchange rate – under control. Following Leijonhufvud (2009), in the period under examination inflation was contained by competition from relatively cheap Chinese imports while the dollar was sustained by high capital inflows. The Fed consequently felt entitled not only to keep its expansionary stance, but also to sustain assets prices insofar as the good performance of the real economy required it. Following a script repeatedly adopted in the past (LTCM crisis in 1998, stock market crisis in 1987, etc.), the Fed thus mitigated the negative consequences of the 2000 dotcom crash by means of an unprecedented cut in interest rates. This reassured the public about the central bank’s availability to support financial markets and assets (the so called ‘Greenspan put’), increasing the propensity of financial operators to hold illiquid assets and to grant loans. As shown in Figure 13.1, the expansionary stance of the Fed and the confidence14 (Conf) in its support fuelled an increase in the volume of credit (Crd) and in the level of indebtedness of the non-financial sector (Ind). The second important aspect in Figure 13.1 is financial deregulation. In the past decades, orthodox theory had placed increasing faith in market mechanisms and, specifically, in the efficiency of financial markets. One of the main results was the 1999 repeal of the Glass–Steagall Act, i.e., removal of the financial compartmentalization inherited from the

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1930s. To quote Leijonhufvud (2009), ‘All financial institutions were allowed to engage in all kinds of transactions. The regulatory structure was not reworked. The old matching of regulators to industry segments was entirely lost, leaving a confused division of labour between agencies with many overlaps and many lacunae which the industry quickly learned to exploit’. Financial innovation took advantage of the absence of regulation. Following Krugman (2009), its main forms were loan securitization and the development of a shadow banking system. For the reasons explained below, in either case the result was a further increase in lenders’ confidence, in credit availability and in the volume of credit and indebtedness. Let us start with securitization. The repeal of the Glass–Steagall Act – which forced financial institutions to choose either to be simple lenders or underwriters – permitted bank-originated loans to be readily sold by the originators to other financial intermediaries (often affiliates of the parent bank or holding company). The underwriters in turn packaged the loans and sold tranches of them to investors in the form of structured collateralized debt obligations. The possibility of transferring loans (with the corresponding risks) to investors increased credit availability and the confidence of banks, inducing them to undertake more and riskier operations. Let us now consider the shadow banking system. Through massive recourse to recent and more and more imaginative financial instruments (auction rate securities, asset-backed commercial paper, etc.), non-bank financial intermediaries started issuing short-run liabilities in order to finance their long-term assets. The novelty, complexity and lack of transparency of the new financial instruments led investors to undervalue the risks associated with them. This favoured the development of the shadow banking system. While bank deposits were subject to constraints (supervision, reserve and capital requirements, insurance fees), however, the new financial instruments were subject to no restrictions whatsoever. The shadow banking system could therefore perform the same role as banks, but without restrictions. Accordingly, this system distinguished itself by a higher availability to lend and by a higher confidence. Its funds could be invested to a greater extent and in riskier assets, offering higher yields. The joint effect of the Fed’s policy, on the one hand, and of financial deregulation and innovation, on the other, was a widespread increase in credit availability and a generalized relaxation of credit standards. As shown in Figure 13.1, the overall result was an increase in the volume of credit (Crd) and in the level of indebtedness of the non-financial

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sector (Ind). This brings us to the analysis of what happened in the real sector of the economy. It was mainly the households sector that benefited from credit expansion. A first consequence was an increase in its demand for durable consumption goods (Cd) and consequently in income (Y). This triggered the known consumption-income-consumption upward spiral on the right of Figure 13.1. In the past decade, it has been consumption that has sustained the growth gap between the USA and Europe. Households’ indebtedness, however, also financed their demand for houses. This gave rise to the second upward spiral on the right of Figure 13.1: the demand for houses Hd raised home prices PH. By generating expectations of capital gains, the increase in house prices PH in its turn stimulated the demand for houses Hd. As known, it is precisely here that the subprime problem arose. In the euphoria of the housing boom, buyers were given loans requiring little or no down payment and with monthly bills that were beyond their ability to pay. After all, it did not matter whether the borrower could actually make the mortgage payments. Given the rising trend of house prices, troubled borrowers could always either refinance or pay off the mortgage by selling the house. This phenomenon is shown by the arrow from the real to the financial sector in Figure 13.1: expected capital gains on houses increased the lenders’ confidence; the consequent credit expansion in turn fuelled the demand for (and the price of) houses confirming and fostering the expectations of capital gains. With the housing boom, house prices rose to the point where purchasing a home became beyond the reach of many Americans. By Expansionary Monetary Policy +

+

Financial Deregulation

Conf +

+

+

+

+

Cd +

Crd and Ind

+

+ +

Hd +

+ Financial Innovation Figure 13.1 Subprime crisis: the antecedent facts

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the fall of 2005, sales began to slow down. Some months later house prices too began to fall, slowly at first, and then with growing speed. As soon as they fell below the mortgage’s value, many borrowers became insolvent. This triggered a wave of failures that undermined confidence in mortgage-backed assets. The downgrading of these assets by rating agencies exacerbated and spread the tensions. The prices of risky assets collapsed. This in turn jeopardized confidence in the banking system. The latter was unable to roll over its short-run liabilities. The result was a credit crunch and a general deleveraging that drove the economy into the worst recession since the 1930s.

4. A truly Minskyan phenomenon? If we consider the subprime crisis in itself, it is probably legitimate to interpret it as a ‘Minsky moment’ followed by a ‘Minsky meltdown’. Many features are actually the same. Our problem, however, goes beyond the labels and the episode in itself and focuses on the essence of the issue. To what extent does the subprime turmoil fit with the ‘core’ of Minsky’s financial instability hypothesis? We refer to the two pillars of Minsky’s construction, i.e., to the theses i) that the fundamental instability of capitalism is upward, and ii) that growth endogenously leads to financial fragility and consequently tends to be scanned by financial crises followed by debt deflations and deep depressions. Let us start with the second thesis. As we saw in section 2, Minsky over-indebtedness is rooted in the investments-profits-investments upward spiral: it concerns firms and is sustained by their over-optimistic profit expectations. The recent Great Moderation does not seem to have followed this script. To start with, it has not reflected an investmentled expansion.15 In the early 2000s, productive investments were suffering a standstill. Growth was then reactivated by the debt-financed boom of households’ expenditure on consumption goods and houses, in addition to the increased government deficit. In the 2000s, the chief protagonists were thus households instead of firms. Let us now focus on the behaviour of American households in the housing market. As we have seen, households’ over-optimism was rooted in the expected capital gains on houses. It did not concern future available incomes. As a consequence, households’ over-indebtedness was not a by-product of real growth. According to our reconstruction, it resulted from exogenous financial phenomena represented by the Fed’s expansionary policy and by financial deregulation with the following wave of innovations. Not by chance, the growth of households’

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indebtedness was associated with an unprecedented fall in the federal funds target rate. If this is true, the growth of households’ indebtedness seems to have been the cause – more than the consequence – of the expansion of the real economy. To conclude, the recent American experience does not seem to fit with Minsky’s fundamental belief that economic growth endogenously leads to financial instability and crises. As a second attempt to recover a Minskyan perspective, we may extend our time horizon and associate the subprime crisis with the Fed’s intervention to counteract the 2000 dotcom crash, in the attempt to keep growth alive. From this perspective, the recent turmoil might be considered as a delayed result of the stock bubble of the 1990s. As a matter of fact, that bubble did reflect the investments-profits-investments upward spiral envisaged by Minsky. The 1990s spiral, however, seems to have been the result of the widespread productive application of innovations in the field of information technology, which might not be entirely endogenous.16 In this case if we extend the time horizon to the 1990s, the American experience does not necessarily fit with the other cornerstone of Minsky’s theory: the upward instability proposition, according to which a capitalist economy is endogenously prone to growth. As we saw in section 2, the upward instability proposition (besides being highly questionable) seems to represent a radical departure by Minsky from Keynes. Minsky’s economy endogenously tends to a situation of over-indebtedness and over-investment. According to The General Theory, by contrast, the main tendency of a capitalist economy is towards the exhaustion of investment opportunities and stagnation. It was precisely the fall in the marginal efficiency of capital that halted the 1990s investment boom. The American experience of the past 15 years or so might then be interpreted as a Keynesian phenomenon. Under a Keynesian perspective, we might then deduce that – despite the 1990s technological innovations and the 2000s Fed support – the American economy has been unable to avoid a new depression. The contribution of Minsky as an interpreter of Keynes would thus consist in his highlighting of the crucial role of finance, showing that it can sustain and prolong growth, but not prevent (indeed, even accentuating) the collapse.17

5. Conclusion Considered as a whole, the recent US experience does not seem to fit with the core of the financial instability hypothesis. Specifically, it does not fit with Minsky’s fundamental belief that financial instability is a

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by-product of real growth. In the 2000s, households’ indebtedness has been the cause (not the consequence) of the expansion of the economic activity. In our view, the recent American experience would seem to be a Keynesian, rather than a Minskyan, phenomenon. If there is a fundamental instability in The General Theory, it is downwards: the main tendency of capitalism is towards the exhaustion of investment opportunities and stagnation. Reconsidering the last 15 years from a Keynesian perspective, we may then deduce that – in spite of the exogenous support from technological innovation in the 1990s and from the Fed in the 2000s – the American economy has failed to avoid a new depression. The contribution of Minsky as interpreter of Keynes would then consist in highlighting the crucial role of finance, showing that it can sustain and prolong growth but not prevent (indeed, even accentuating) the collapse. Despite these conclusions, what has happened confirms many crucial Minskyan insights, namely: i) the crucial and destabilizing role of finance; ii) the need for careful financial regulation, since ‘finance cannot be left to free markets’ (Minsky 1986, p. 292); iii) the importance of economic policy for the stabilization of the economy;18 iv) the comparatively greater reliability of fiscal policies; v) the extension of the stabilizing role of the government to the financial sphere of the economy;19 vi) the need to privilege full employment over growth as a target for economic policy. These are precisely the themes that have always been at the centre of Philip Arestis’s work.

Notes 1. On the relationship between Minsky and Keynes, see De Antoni (2009). 2. For the two quotations see, respectively, Minsky (1975, p. 127; 1978, p. 37) and Minsky (1974, p. 272; 1975, p. 165). Analogously, in Minsky (1986, p. 219) we read: ‘Any transitory tranquillity is transformed into an expansion.’ A similar concept is repeated many times in Minsky (1980). 3. To put it in Minsky’s words (1986, p. 183): ‘[B]ut tranquility diminishes the value of the insurance (liquidity) embodied in the dollar, so that a rise in the absolute and relative prices of capital and financial assets that are valued mainly for income will take place. Tranquility therefore leads to an increase

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4.

5.

6.

7.

8.

9.

10.

11.

Macroeconomics, Finance and Money in acceptable debt to equity ratios even as it raises the value of inherited capital assets. The endogenously determined value of liquidity means that each possible equilibrium of the economy contains disequilibrating forces.’ With regard to Keynes’s under-employment equilibrium, Minsky says (1978, pp. 36–7): ‘For the economy to sustain a virtual equilibrium of employment … profit flows must be sufficient to validate debts … But such fulfilment of debt commitments will affect the willingness to finance debts by bankers and their customers: the value of the insurance embodied in money decreases as the economy functions in a tranquil way. Stability – or tranquillity – in a world with a cyclical past and capitalist financial institutions is destabilizing.’ An analogous concept can be found in Minsky (1975, pp. 61, 127 and 165). With regard to full-employment equilibrium, Minsky says (1986, p. 177): ‘The ongoing processes tend to rupture a full-employment equilibrium in an upward direction; that is, once full employment is achieved and sustained the interaction among units tends to generate a more than full-employment speculative boom.’ An analogous concept can be found in Minsky (1974, p. 268; 1980, p. 26; 1986, p. 183). With regard to steady growth, Minsky expressly writes (1974, p. 267): ‘The fundamental instability is the way in which a period of steady growth evolves into a speculative boom.’ ‘Thus, recent experience is consistent with the interpretation of Keynes’s views that has been put forth here: we are dealing with a system that is inherently unstable, and the fundamental instability is “upward”.’ (Minsky, 1975, p. 165). The ratio of debt commitments to profits reflects the degree of confidence of firms and their financiers. In Minsky’s view, it thus acquires a more general significance as proxy for the whole set of safety margins existing within the financial system. Thus, an increase in this ratio does not only reflect a worsening in the time synchronization between cash receipts and debt commitments at the basis of Minsky’s distinction (Minsky 1986, pp. 206–7) between hedge, speculative and ultra-speculative or Ponzi finance; it also signals a fall in liquidity as a proportion of wealth and (more generally) an overall decrease in the robustness of the financial system. In expectation of a future bonanza, a fragile financial system allows its safety margin to fall below the danger level. Faced by even an ordinary negative shock like a rise in the interest rate or a fall in profits, debtors have insufficient liquidity, profits and borrowing capacity to meet inherited debt commitments. The only solution left is reducing indebtedness and debt commitments by liquidating non-monetary assets, but with the risk of having to sell them out and of becoming insolvent. Minsky (1978) puts it as follows: ‘However, the internal workings of the banking mechanism or Central Bank action to constrain inflation will result in the supply of finance being less than infinitely elastic leading to a rapid increase in short term interest rates’ (p. 45). In Minsky’s view, this increase will then spread from the short to the long run, with depressive effects on investment. To quote Minsky (1975, pp. 126–7): ‘A relatively low-income, highunemployment, stagnant recession of uncertain depth and duration will

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12. 13. 14. 15. 16.

17. 18.

19.

follow a debt-deflation process. As the subjective repercussions of the debtdeflation wear off, as disinvestment occurs, and as financial positions are rebuilt during the stagnant phase, a recovery and expansion begins.’ On fiscal policy in Minsky, see Arestis and De Antoni, 2008. Bad investments may generate profits too small to repay debt and thus result in a wave of bankruptcies that depress economic activity. By increase in confidence, we mean a Minskyan fall in required safety margins. According to Leijonhufvud (2009), in the 2000s the US business sector issued debt to buy back equities rather than to invest. With this, we do not intend to deny the endogenous nature of growth. According to Krugman (2009), however, after the invention of the microprocessor in 1971 it took more than 20 years (and big public investments) to introduce the new technology in business. This leads us to think that the afore-mentioned invention might not have been entirely endogenous. In chapter 22 of The General Theory devoted to the trade cycle, Keynes does not even mention firms’ indebtedness. In Minsky’s (1986) view, capitalism is an evolving system whose chameleonlike flaws are always in ambush. Economic policies cannot fold their arms or rely on comfortable fixed rules. Together with financial regulation, they must be constantly updated to the incessant evolution of the system. The recent support of the US Treasury for troubled financial institutions confirms the importance of the financial role that Minsky assigned to fiscal policy. Moreover, as envisaged by Minsky, government bonds have indeed represented a safe refuge during the storm.

References Arestis, P. and De Antoni, E. (2008), ‘Minsky’s financial instability hypothesis: the crucial role of fiscal policy’, in Sawyer, M. and Creel, J. (eds), Current Thinking on Fiscal Policy, New York: Palgrave Macmillan, pp. 51–77. Borio, C. (2008), ‘The financial turmoil of 2007–?: A preliminary assessment and some policy considerations’, Bank for International Settlements. Working Paper No 251. De Antoni, E. (2009), ‘Minsky’s “financial instability hypothesis”: the not-tooKeynesian optimism of a financial Cassandra’, in Zambelli, S. (ed.), Computable, Constructive and Behavioural Economic Dynamics. Essays in Honour of Kumaraswami Velupillai, London: Routledge, forthcoming. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Krugman, P. (2009), The Return of Depression Economics and the Crisis of 2008, New York: Penguin Books. Leijonhufvud, A. (2007), ‘The perils of inflation targeting’, Vox EU, 25 June, available online. Leijonhufvud, A. (2009), ‘Out of the corridor: Keynes and the crisis’, Cambridge Journal of Economics Advance Access published May 29. Minsky, H.P. (1963), ‘Can ‘It’ happen again?’, in Carson, D. (ed.), Banking and Monetary Studies, Homewood, Illinois: R.D. Irwin, pp. 101–11.

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Minsky, H.P. (1974), ‘The modelling of financial instability: An introduction’, in Instrument Society of America (ed.), Modelling and Simulation Vol. 5. Proceedings of the 5th Annual Pittsburg Conference, pp. 267–72. Minsky, H.P. (1975), John Maynard Keynes, New York: Columbia University Press. Minsky, H.P. (1977), ‘The financial instability hypothesis: An interpretation of Keynes and an alternative to standard theory’, Nebraska Journal of Economics and Business, 16(1), pp. 5–16. Minsky, H.P. (1978), ‘The financial instability hypothesis: A restatement’, Thames Papers in Political Economy, North East London Polytechnic. Reprinted in Arestis, P. and Skouras, T. (eds), 1985, Post Keynesian Economic Theory. A Challenge to Neoclassical Ecconomics, Brighton: Wheatsheaf Books, pp. 24–55. Minsky, H.P. (1980), ‘Capitalist financial processes and the instability of capitalism’, Journal of Economic Issues, 14(2), pp. 505–22. Minsky, H.P. (1982a), Can ‘It’ Happen Again? Essays on Instability and Finance, Armonk, NY: M.E. Sharpe. Minsky, H.P. (1982b), ‘Debt deflation processes in today’s institutional environment’, Banca Nazionale del Lavoro–Quarterly Review, 143(4), pp. 375–95. Minsky, H.P. (1986), Stabilizing an Unstable Economy, New Haven: Yale University Press. Minsky, H.P. (1991), ‘Financial Crises: Systemic or Idiosyncratic?’, Working Paper Series N. 51, Jerome Levy Economics Institute of Bard College, Annandaleon-Hudson, NY. Roubini, N. (2007a), ‘Is the recent episode of market turmoil a temporary shock or the beginning of a systemic risk episode?’, RGE Monitor, 2 August. Available online at http://www.rgemonitor.com./blog/roubini/208728. Roubini, N. (2007b), ‘Worse than LTCM. Not just a liquidity crisis; rather a credit crisis and crunch’, RGE Monitor, 9 August. Available online at: http://www. rgemonitor.com./blog/roubini/209779. Whalen, C.J. (2007), ‘The US Credit crunch of 2007. A Minsky moment’, Public Policy Brief N. 92, Jerome Levy Economic Institute of Bard College, Annandale-onHudson, NY. Wray, R. (2007), ‘Lessons from the subprime meltdown’, Working Paper Series N. 522, Jerome Levy Economic Institute of Bard College, Annandale-on-Hudson, NY.

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14 A Minsky Moment, or Not?* Korkut Ertürk and Gökcer Özgür

Introduction The financial crisis has been billed a ‘Minsky moment’ in the mainstream media, turning Hyman P. Minsky into a household name. One would think that this was at long last Minsky’s moment of posthumous vindication, and in a way it was. However, a couple of post-Keynesian luminaries, Paul Davidson and Jan Kregel have raised questions as to whether the current financial debacle qualified as a Minskyan crisis (Davidson, 2008; Kregel, 2007). Of course, whether we think Minsky is relevant for the current crisis or not depends on what we make of him. If Minskyan work means solely his own writings and their restatement, then Davidson and Kregel are probably right – one cannot help but focus on what is different about the current crisis. But, if instead Minskyan refers to an evolving literature that emanates from but transcends his work, the situation is different. In this chapter our objective is to sketch out an alternative understanding of Minsky as an evolving research agenda – inspired by the kind of approach visionary scholars like Philip Arestis has taken over the years. At the most general level we hold that a Minskyan way of looking at the world boils down to few basic propositions: (i) in a financial capitalist economy, credit is procyclical, especially in the absence of policies/institutions that can mitigate it, and, that, in turn (ii) causes systemic risk to rise endogenously over an expansion (iii) in a way agents fail to recognize, (iv) and has the potential to blow up badly, ending in debt deflation. Defined thus, there is little question that the current financial crisis is a quintessential Minsky moment. If nothing else, the very fact that credit supply has become much more procyclical following financial deregulation has vindicated Minsky’s basic insight. 209

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Who can now in hindsight deny that financial liberalization played an important role in both stoking the speculative boom as well as the difficulty of containing deleveraging after the crisis? Of course, at a less general level there is always a good deal that is unique about each crisis and every era, and that holds true for the current one as well. Among these particular characteristics, perhaps the single most important one in terms of its relevance for what happened is the way the credit mechanism had been transformed in the neoliberal era. Much of Minsky’s work refers to a time when commercial and industrial bank loans to nonfinancial firms made up the bulk of the overall credit supply in the economy. In that bygone era credit was essentially regulated by the loan officers of commercial banks. But, with financial deregulation the credit creation mechanism became transformed, came to be governed by financial markets rather than the banks. In this new world, about which Minsky (1987/2008) wrote presciently in the 1980s, asset prices and asset price expectations have become the overall regulator of credit supply – similar to the role played by bankers in the previous bank-based credit system. That in our view is the salient characteristic of the neoliberal era that needs to be assimilated by Minskyan analysis at the general level. No doubt the financial crisis today has made it much easier to argue that finance can be destabilizing or that financial variables can have a decisive influence on real activity. Discredited is the conventional wisdom according to which aggregate price stability is all a central bank need be concerned with to promote financial stability. Little argument now that asset price bubbles are real, that the crisis had everything to do with the unwinding of financial imbalances and little to do with price inflation. But, in our view, what might need more discussion is the role asset price bubbles have come to play in the credit creation process, which is the focus of this chapter.1 The next section lays out how the nature of the link between asset prices and credit had been transformed in the neoliberal era, and the section following gives an overview of recent advances in the theory of asset price bubbles, which in our view merit much closer scrutiny than what they have received so far among heterodox economists. We end with a few concluding comments on the import of a Minskyan perspective today.

Asset price–credit nexus in the neoliberal era According to Minsky (1986), the main driver of financial instability is the dynamic interaction between asset prices and bank credit.

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Rising profit expectations raise asset prices, increasing firms’ collateral and thus the ability to borrow and invest. As output and investment expands, profits rise and validate the initial increase in asset prices. This makes the credit supply even more elastic mainly because bankers, convention-bound as they are, cannot help but lower their risk aversion as the general business conditions around them steadily improve. Many of Minsky’s better-known disciples give rather lengthy descriptions – often recycling his own work – of how bankers and borrowers both tend to become overconfident, causing ‘margins of safety’ to erode during periods of sustained stability (Kregel, 1997, 2008, 2008a; Wray, 2008; Wray and Tymoigne, 2008; Papadimitriou and Wray, 1998). As a result financial imbalances build up steadily over the expansion, setting the stage ultimately for crisis. The trouble with this story, however, is its emphasis on bankers. It ignores the fact that bank loan officers’ importance as arbiters of credit has waned with financial liberalization as the progressive intrusion from nonbank financial organizations into banks’ traditional turf forced them to reinvent themselves.2 In fact, the recent decades saw the rapid decline of commercial and industrial bank loans’ importance in overall credit (Arestis and Howells, 1996, Özgür and Ertürk, 2008). Real estate loans, off-balance sheet activities, backup lines of credit and guarantees and lending for corporate takeovers and leveraged buyouts have all gained at the expense of traditional lending (Boyd and Gertler, 1995). The story is rather well-known. At the end of it all the link between asset prices and credit supply has actually become stronger, but the nature of the relationship changed. The crucial link between the two became the influence asset prices exert on banks’ level of capitalization rather than the endogenous variation in risk aversion over the cycle. For in this new brave world, banks themselves have become dependent on financial markets just as much as have their own customers. Neither bank deposits nor reserves were any longer a constraint on individual banks’ ability to supply credit. The certificates of deposits, increased access to the federal funds markets and use of credit market instruments in liability management had already lowered their dependence on deposits in the 1980s, if not earlier. And, in the 1990s, the Fed abolished reserve requirements for time deposit accounts, reduced them for checkable deposits and later introduced retail sweep accounts, following of which required reserves ceased to be a constraint as well (Bennett and Peristani, 2002). The only thing left was capital requirements. Consistent with the prevailing dogma of the time, they were meant to be the lynchpin of a system where bank credit was supposed to be

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regulated by market forces (Basset and Zakrajsek, 2000). Thus the only real constraint left was banks’ net worth, their level of capitalization, and that applied to investment banks firms as well. Higher asset prices were instrumental in relaxing this constraint, while at the same time making it easier for firms to borrow directly in financial markets at lower cost. Thus, they not only increased the borrowers’ collateral and willingness to borrow but also raised banks’ own collateral with their investors’ in financial markets, thus raising their ability and willingness to underwrite more lending in one shape or another.3 Also, just as higher asset prices stimulated credit, the increase in credit in turn stimulated spending as well as speculation, pushing up asset prices further. However, contrary to the traditional accounts of the Minsky cycle, the erosion of ‘margins of safety’ was hardly a hallmark of the expansion. On the contrary, as asset prices rose and credit became more elastic the indicators of risk and prudential standards such as loan-to-value ratios only fell. The driver of the credit boom was thus not so much the increased appetite for risk as it was the endogenous fall in indicators of risk. As long as asset prices continued to increase units faced what appeared to be diminishing ex ante risk, while the risk of a systemic collapse rose (Borio and White, 2004; Danielsson and Shin, 2003; Danielsson, 2002). For Minsky, the external financing of fixed investment was the main cause of rising indebtedness over a business cycle expansion which eventually became the main source of the problem when interest rates began to increase. Thus he foresaw a unilinear transition in his famous financing profiles, from hedge, to speculative and to Ponzi finance, culminating in a crisis when finally units are forced to sell their assets to meet their financial obligations. He defined margins of safety in terms of expected excesses of cash receipts over payment commitments, or, alternately, in terms of the excess of expected asset values over capitalized payment commitments with the presumption that the two definitions are to all intents and purposes interchangeable. However, note that during times of surging asset prices they can cease to be interchangeable. What is Ponzi finance from the point of the former definition can actually be hedge finance from the point of view of the latter. The discrepancy is a symptom of the fact that economic units have become constrained more by their asset price expectations than their cash flow in the neoliberal era, and that the two can diverge substantially – as was the case in the dotcom bubble, for instance. Or, put differently, the commodification of credit accorded firms much greater scope to defy the forces of gravity as credit became highly responsive to the expectations

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of increasing asset prices. Oddly, the world had become much more Minskyan just when what happened in the stock market began to matter much more than Minsky ever suspected. Likewise on the downside; more often than not, the expansion came to an end – both in the US and elsewhere – not through the corrosive effect of rising interest rates, but through a sudden collapse of asset valuations in the stock market. Firms’ financial obligations became excessive only when a large swath of anticipated future wealth ceased to exist.4

Asset price bubbles Despite his interest in asset prices, Minsky dwelled little on bubbles per se. That might have been because bubbles were in little evidence during the period of financial regulation when his ideas matured. The view that asset prices as a rule reflect fundamental values relied on an argument of backward induction and a belief in the effectiveness of arbitrage. The worth of any security in the period before the final payoff date would simply be equal to the discounted value of its terminal value. Extending this argument backwards it could then be shown that at any period the value of a security would simply be equal to the present discounted value of its future stream of revenue. Otherwise, an arbitrage opportunity would arise and the price would be pushed back to its true fundamental value. Admittedly, less than rational, socalled, noise-traders always exist in financial markets, but it was argued that informed arbitrageurs would undo any mispricing caused by them when their effect is not canceled out by each other (Fama, 1970; Malkiel, 2003). Thus, the argument was that uninformed noise-traders, while making losses themselves, would create riskless arbitrage opportunities that informed traders’ profit. Both Friedman’s argument on speculation and the idea that stock prices are completely unpredictable in an efficient market – in the sense of the Efficient Market Hypothesis which holds that markets always incorporate all available public information in its more widely accepted semi-strong form – rest on the belief that arbitrage is quick and effective, underpinning the view that asset price bubbles were highly improbable if not implausible. Thus, from this point of view, it is the changes in fundamental values that must have caused both the recent dotcom bubble (DeMarzo et al., 2008) as well as the historical episodes of ‘bubbles’ such as the Dutch Tulip Mania (1634–37), Mississippi Bubble (1719–20), South Sea Bubble (1720), etc. (Garber, 1990). Otherwise, bubbles could plausibly arise only in assets with an infinite horizon that lacked a

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terminal value, where backward induction did not apply.5 This case has defined pretty much the limits of initial theoretical interest in bubbles, going back to Samuelson (1958), and is the foundation of what often goes under the name ‘rational bubbles’,6 which has nothing to do – as we shall see – with the more recent breed of bubble models that do not rely on any irrational behavior. Since the recent rise of behavioral finance theory the view that asset prices always equal the discounted present value of future streams of revenue has been questioned on both theoretical and empirical grounds.7 In fact, with the waning influence of the Efficient Market Hypothesis much of the theoretical literature on asset pricing has been in a ‘vibrant flux’ (Hirshleifer, 2001). It is now widely recognized that the power of arbitrage is severely limited in the real world markets. For instance, when traders have relatively short trading horizons, those who sell overvalued assets short can find that by the time they close their position the true value has further increased or that the assets in question have become even more overpriced. In either situation informed traders would make losses by shorting assets they thought were overvalued. Thus, arbitrage almost always involves at least some degree of risk, and that can cause informed agents to limit the positions they would take in an over or undervalued asset, preventing current price from smoothly adjusting to its true value as Friedman (1953) had originally envisioned. In fact, it can pay for informed traders to act like noise traders themselves in the short run, bidding prices further away from what they think are true values rather than help close the gap between the two (De Long et al., 1990a). Of course, this skeptical view of arbitrage is quite consistent with Keynes’s (1936, Ch. 12) famous ‘beauty contest’ argument, where speculators base their expectations of future asset prices not only on what they think the true value is, but, more importantly, on what they think the average opinion about the average opinion is. This, in turn, implies that agents must not only form higher order expectations (i.e., on what others think others think) but also decide how much weight to assign them relative to what they themselves think the true value is. An agent observing the price of an already overpriced asset continuing to rise would be led to think that either his/her opinion about the true value is off the mark or that the price is rising on account of market sentiment. In either case, the information and opinion of others as revealed in current price changes are likely to gain in importance in how the trader forms his/her expectation about the future price. Such information becomes either a proxy for the higher order expectations

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or a corrective on opinions about the true value, or some combination of both. Under these conditions whether speculation is stabilizing or not crucially depends on the relative weight traders assign to their higher order expectations (i.e., what they think others think others think) relative to their own assessment of what the true value is. This basic idea in its simplest form goes back to Kaldor (1939), where whether speculation is stabilizing or not depends on the elasticity of future price expectations with respect to current price changes. In more recent analyses, destabilizing speculation likewise involves traders with elastic future price expectations who buy (sell) assets when the price is rising (falling). They are called ‘momentum-investors’ – and their actions ‘positivefeedback’ strategies – in these examples, where short trading horizons, sequential nature of trades and information costs are the real world market attributes that are emphasized. In contrast to standard models of asset pricing that implicitly assume long-term horizons, short-term trading horizons play an important role in explaining how asset prices can deviate from true values (Dow and Gorton, 1994). In a world characterized by market ‘imperfections’ and uncertainty speculators who tie up their resources in long-term investments can fail to exploit profitable investment opportunities that would unexpectedly arise (Shleifer and Summers, 1990). Professional traders also shun long-term arbitrage opportunities for fear that price would deviate even more from its fundamental value within a time frame within which they would have to report to their clients (Shleifer and Vishny, 1997). Moreover, the incentive structure that defines fund managers’ employment gives rise to agency problems, making it rational for speculators to have short trading horizons (Allen and Gorton, 1993). Because trading is sequential in real world markets traders observe and can learn from each other. By acting faster than the next trader, investors can rationally exploit information revealed by the actions of other agents, creating incentives for herding (Bikhchandani and Sharma, 2001). Profit-maximizing traders can thus successfully focus on what other traders also know rather than trying to learn information others do not have. A narrow set of information can then become the primary focus of attention even when it has little bearing on fundamentals (Froot et al., 1992). Finally, especially in foreign exchange markets, gathering information requires large fixed costs which generate economies of scale for large investors. Thus, the greater the cost of acquiring information the higher is the incentive for uninformed small traders to imitate large investors (Calvo and Mendoza, 2000). This also can cause small investors to be much more aggressive, especially in their selling

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in markets where large investors have a significant presence (Corsetti et al., 2001), accentuating asset price volatility. Quite often less than rational traders and irrational euphoria are thought to be the main cause of bubbles. However, in these models this is only true in the sense that noise traders’ behavior is often exogenously given, but otherwise not the case. In fact, in quite a few models all agents are rational in the sense that their behavior is explained. But, these agents live in an ‘imperfect’ world. The destabilizing asset price dynamics stem from the state of the world itself, characterized by attributes such as agency problems that give rise to short trading horizons and risk shifting from fund managers to the investor who are their clients. For instance, in a more recent body of work the main cause of the bubble is the uncertainty about higher order beliefs, i.e., rational agents not knowing what other rational agents will do (Allen et al., 2003). In Abreu and Brunnermeier (2002, 2003) fully rational traders know that the bubble will eventually burst, but in the meantime they can make profits riding it. They realize that they would not be able to individually bring down the price for lack of sufficient funds, but collectively could if they were to act in tandem. In other words, they all know that a common ‘arbitrage’ opportunity exists, yet they are in the dark as to when the other traders would act on it, if at all. Thus, the challenge traders face turns into an optimal timing problem under uncertainty where each one has to determine when is the right time to exit the market without any knowledge of the exit strategy of the others.8 The bubble persists as long as the opinion as to when one should exit remains dispersed among investors. Often, some news event can have a disproportionately strong effect beyond what its intrinsic information value would warrant by causing traders to synchronize their exit strategies, leading to a precipitous fall in price. However, irrationality – in the real sense of the word, as opposed to the artificial meaning neoclassical economics has given it – can also matter. Other behavioral models show that cognitive biases can cause destabilizing asset price dynamics as well. For instance, Lei et al., (2001) report results from experiments in laboratory asset markets where agents are precluded from reselling securities and thus from speculating. Bubbles and crashes are still observed even though speculation is not possible, suggesting that elements of irrationality can cause bubbles even when uncertainty about higher order beliefs is ruled out. A vast literature now exists on various cognitive biases that are thought to give rise to irrational agent behavior, such as overconfidence, overreaction, hyperbolic discounting, loss aversion, and regret, among others.9

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What have we yet to re-learn from Minsky? Before the crisis, the Fed policy was to ignore surging asset prices as long as it did not cause price inflation, and that appears to have reflected a consensus among mainstream economists also (Bernanke and Gertler, 1999 and Vickers, 1999).10 A Turkish proverb appears to capture the gist of thinking behind this rather well, which in loose translation says, ‘it is all too easy to show the way once the car is toppled off the road.’ Indeed, because an asset price bubble could not be identified ex ante, the argument went, the only thing to do was to focus on neutralizing its impact on aggregate demand to the extent they affected goods’ prices, whether before or after it burst. While it is true that the future can never be predicted with any certainty, there was ample reason to believe the car was about to tip over. For instance, Borio and Lowe (2002), using a data set compiled by the Bank of International Settlements (BIS) for 16 advanced market economies since the 1970s, used the deviations of variables from their trend values to help predict financial instability by building on a ‘noise/signal’ procedure first developed by Kaminsky and Reinhart (1999). Their index could show that credit supply and asset prices were excessive, signaling trouble ahead.11 More explicit warnings were issued repeatedly by the Bank of International Settlements during the housing bubble years (BIS 2002, 2003, 2004). Now, in the aftermath of the crisis, it is hard to think that monetary authorities will ever again ignore asset prices with such abandon, or that the mainstream consensus on asset prices will survive. Yet, there is the danger that the different bubble episodes we have gone through in the neoliberal era in the US and the rest of the world will be seen as aberrations tied to the breakdown of prudential supervision or some other idiosyncratic event or policy, rather than the very outcome of financial liberalization. For instance, it is true that the Gramm–Leach–Bliley Bank Reform Act in 1999 in the US played an important role in weakening the constraint posed by banks’ capital base. As both Kregel (2008a, 2008b) and Davidson (2008) relate in detail, US banks could as a result unload with much greater ease the securitized mortgages and loans they initiated off their balance sheets to the special trusts – the so-called, special investment vehicles – they set up for the purpose, all of which made it possible to extend themselves way beyond what was warranted by their capital base. Unsurprisingly, lending shifted even more heavily towards loans collateralized by real estate and a two-way relationship emerged between property prices and bank credit (Goodhart and Hoffman, 2008), not to say anything about the explosive increase in

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credit default swaps and derivatives about which we learned so much more only after the crisis. But, in our view, it would be missing the forest for the trees to conclude that the current financial crisis is caused by the housing bubble which had in turn resulted from a breakdown in macro prudential supervision under the conditions brought about by the Gramm–Leach–Bliley Bank Reform Act. Nor would we go far enough by focusing solely on the steady erosion of public control over credit (Greider, 2009; D’Arista, 2008) and permissive Fed policy, either its response to the stock market crash of 2000, Greenspan’s ‘put’, or Bernanke’s overconfident reliance on ‘Big Moderation.’ For equally important were the surge in the capital inflow that recycled international trade surpluses through the US, feeding the dotcom bubble, and, the fact that Bank of Japan and other Asian central banks underwrote the housing bubble by monetizing US debt after the dotcom crash with the aid of the carry trade. But, they alone would fail to give a satisfactory explanation either. In our view, a Minskyan approach is needed more than ever to help connect all these dots and learn anew the lesson that capital markets sooner or later self-destruct when left to their own devices. That however calls for a vibrant evolving research agenda with a focus on what is happening in the real world rather than repetitive restatements of his work. Minsky had all along argued that finance had to be kept under tight wraps to keep it from destabilizing the real economy. And, once again, when the genie was let loose by financial deregulation, the destruction predictably followed – with the difference that this time around asset price bubbles became the very mechanism of destabilizing finance under the changing conditions of the 1990s just as they were in the pre-Second World War era. As heterodox economists, our focus ought to be to show how the institutional evolution of the financial system in the neoliberal was in fact endogenous, the very outcome of the cumulative political and economic pressures that were unleashed by liberalization itself, in the hope of having an influence on how the financial system is reformed.

Notes * We would like to thank Ken Jameson for his helpful comments without implicating him for any possible mistakes there might be. 1. The editors remind us that a similar point is also made in Fontana (2003). 2. It appears that Minsky (1981) himself was a keen observer of the diminishing importance of traditional banking and the bank loan officer. On the

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3.

4. 5. 6. 7. 8.

9. 10. 11.

changing role of bank credit, see also: Samolyk, 2004; and Bradley and Shibut, 2006. Despite their restrictive emphasis on agency problems, Bernanke and Gertler, 1989 and Kiyotaki and Moore (1997) capture well the gist of the asset price – credit interaction in deregulated financial markets. Their analysis, featuring net worth as the pivotal variable in business cycle dynamics, has an unmistakable family resemblance to Kalecki’s (1937) principle of increasing risk. See also Toporowski (2000, ch.1) for a similar argument. I thank Doyoun Won for bringing this to my attention. It is also shown that bubbles can still emerge with a finite horizon if there are an infinite number of trading opportunities (Allen and Gorton, 1993). For a comprehensive survey, see Santos and Woodford (1997). See, among others, Campbell and Kyle (1993), Lo and Mackinlay (1999) and Shleifer (2000). ‘The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow’ (Keynes 1936: 155). See Kahneman and Riepe (1998) for a summary account. See Cechetti et al. (2000) for a dissenting view from within the mainstream. See also, Borio and Lowe (2004) and Borio (2005, 2006). Likewise, a similar index to predict crises is developed by Goodhart and Hofmann (2007, Ch. 8) who examine the two-way causation between property prices and credit during the housing bubble.

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Korkut Ertürk and Gökcer Özgür 221 Securitize Illiquid Noncomercial Mortgage Loans,’ Journal of Post Keynesian Economics, 30(4). DeLong, J.B., A. Schleifer, L. Summers, and R. Waldmann (1990a). ‘Noise Trader Risk in Financial Markets,’ Journal of Political Economy, 98(4), August, 703–38. DeLong, J.B., A. Schleifer, L. Summers, and R. Waldmann (1990b). ‘Positive Feedback Investment Strategies and Destabilizing Rational Speculation,’ Journal of Finance, 45(2), June, pp. 379–95. De Marzo, P., R. Kaniel, and I. Kremer (2008). ‘Relative Wealth Concerns and Financial Bubbles.’ Review of Financial Studies, 21(1). Dow, J. and G. Gorton (1994). ‘Arbitrage Chains,’ Journal of Finance, 49, pp. 819–49. Erturk, K. (2007) ‘On the Minskyan Business Cycle,’ in P. Arestis and G. Zezza (eds) Advances in Monetary Policy and Macroeconomics, Basingstoke, Palgrave Macmillan. Fama, E. (1970). ‘Efficient Capital Markets: A Review of Theory and Empirical Work,’ Journal of Finance 25(1), pp. 283–417. Farrell, M.J. (1966). ‘Profitable Speculation,’ Economica 33, pp. 183–93. Friedman, M. (1953). ‘The Case for Flexible Exchange Rates,’ Essays in Positive Economics, Chicago: Chicago University Press. Fontana, G. (2003). Money, Uncertainty and Time in the Post Keynesian Tradition, Routledge, London. Froot, K.A., D.S. Scharfstein, and J.C. Stein (1992). ‘Herd on the Street: Informational Inefficiencies in a Market with Short-Term Speculation,’ Journal of Finance, 47(4), September, pp. 1461–84. Garber, P. (1990). ‘Famous First Bubbles,’ Journal of Economic Perspectives, 4, pp. 35–53. Goodhart, C. and B. Hoffman (2008). House Prices and the Macroeconomy. Oxford University Press, New York. Geider, W. (2009). ‘Fixing the Fed,’ The Nation, March 30. Hirshleifer, D. (2001). ‘Investor Psychology and Asset Pricing,’ Journal of Finance, 56(4), pp. 1533–97. Kahneman, D. and M. Riepe (1998). ‘Aspects of Investor Psychology,’ Journal of Portfolio Management 24, pp. 52–65. Kaldor, N. (1939). ‘Speculation and Economic Stability.’ Review of Economic Studies, 6(3), pp. 1–27. Kalecki, M. (1937). ‘The Principle of Increasing Risk,’ Economica, New Series, 4(16), pp. 440–7. Kaminsky, G. and C. Reinhart (1999). ‘The Twin Crisis: The Causes of Banking and Balance-of-Payments Problems’, American Economic Review, 89, pp. 473–500. Kemp, M. (1963). ‘Speculation, Profitability, and Price Stability,’ Review of Economics and Statistics 45, pp. 185–9. Keynes, J.M. (1964 [1936]). The General Theory of Employment, Interest, and Money, Harcourt Brace Jovanovich, New York. Kiyotaki, N. and J. Moore (1997). ‘Credit Cycle,’ Journal of Political Economy, 105(2), pp. 211–48. Kregel, J. (2007). ‘Natural Instability of Financial Markets’, The Levy Economics Institute of Bard College, Working Paper No. 523.

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Kregel, J. (2008). ‘Changes in the US Financial System and the Subprime Crisis,’ Levy Economics Institute Working Paper No. 530. Kregel, J. (2008a). ‘Using Minsky’s Cushions of Safety to Analyze the Crisis in the US Subprime Mortgage Market,’ International Journal of Political Economy, 37(1). Kregel, J. (1997). ‘Margins of Safety and Weight of the Argument in Generating Financial Crises,’ Journal of Economic Issues, 31(2), pp. 543–48. Lei, V., Noussair, C. and C. Plott (2001). ‘Nonspeculative Bubbles in Experimental Asset Markets: Lack of Common Knowledge of Rationality vs. Actual Irrationality,’ Econometrica 69(4), pp. 831–59. Lo, A. and A. Mackinley (1999). A Non-random Walk down Wall Street. Princeton University Press. Princeton, NJ. Malkiel, B. (2003). ‘The Efficient Market Hypothesis and its Critics,’ Journal of Economic Perspectives, 17(1), pp. 59–82. Minsky, H.P. (1975). John Maynard Keynes. New York, Cambridge University Press. Minsky, H.P. (1981). ‘Financial Markets and Economic Instability, 1965–1980,’ Nebraska Journal of Economics and Business 20(4), pp. 5–16. Minsky, H.P. (1986). Stabilizing the Unstable Economy. New Haven, CT, Yale University Press. Minsky, H.P. (2008). ‘Securitization,’ Policy Note, The Levy Economics Institute of Bard Collage, with a preface and afterword by L.R. Wray. Özgür, G. and K. Ertürk (2008). ‘Endogenous Money in the Age of Financial Liberalization,’ The IDEAs Working Paper Series, 05/2008. Papadimitriou, D. and R. Wray (1998). ‘Economic Contributions of Hyman Minsky: Varieties of Capitalism and Institutional Reform,’ Review of Political Economy, 10(2). Samolyk, K. (2004). ‘The future of banking in America’, FDIC Banking Review, 16 (2), pp. 29–65. Samuelson, P. (1958). ‘An Exact Consumption-Loan Model of Interest With or Without the Social Contrivance of Money,’ Journal of Political Economy 66, pp. 467–82. Santos, M. and M. Woodford (1997). ‘Rational Asset Pricing Bubbles,’ Econometrica 65(1), 19–57. Shefrin, H. (ed.) (2001). Behavioral Finance. The International Library of Critical Writings in Financial Economics, Volume I – IV. Cheltenham, UK, Edward Elgar. Shleifer, A. (2000). ‘Are Financial Markets Efficient?’ Ch.1. in his Inefficient Markets, Oxford University Press. Shleifer, A. and L. Summers (1990). ‘The Noise Trader Approach to Finance.’ Journal of Economic Perspectives, 4(2), pp. 19–33. Shleifer, A. and R. Vishny (1997). ‘The Limits of Arbitrage.’ Journal of Finance, 52(1), pp. 35–55. Sohmen, E. (1961). Flexible Exchange Rates: Theory and Controversy. University of Chicago Press, Chicago. Telser, L.G. (1959). ‘A Theory of Speculation Relating Profitability and Stability,’ Review of Economics and Statistics 37, pp. 295–301. Thaler, R. (2003). Advances in Behavioral Finance II, New York, Russell Sage. Toporowski, J. (2000). The End of Finance. Routledge, New York.

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Korkut Ertürk and Gökcer Özgür 223 Vickers, J. (1999). ‘Monetary Policy and Asset Prices,’ Bank of England Quarterly Bulletin 39, pp. 428–35. Wray, R. (2008). ‘Financial Markets Meltdown. What Can We Learn from Minsky?’ Public Policy Brief No. 94, Levy Economics Institute. Wray, R. and E. Tymoigne (2008). ‘Macroeconomics Meets Hyman P. Minsky: The Financial Theory of Investment,’ Levy Economics Institute Working Paper No. 543.

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15 Does Financial Liberalization Help the Poor? Asena Caner1

1. Introduction In this chapter I examine the effects of financial liberalization policies on poverty and try to answer the question as to whether these policies have helped the millions of poor people in the world.2 In the past couple of decades, many developing countries adopted and implemented financial liberalization policies. Prior to financial liberalization, the financial sector of developing countries had a number of common characteristics such as domestic credit controls, direct controls on interest rates and high reserve requirements. Interest rates were kept below equilibrium level;3 furthermore, credit allocation was rationed and directed to chosen priority sectors. Such policies were expected to promote investment and economic growth. The assumption behind these expectations was that there were sufficient loanable funds, but that the cost of capital was the binding constraint for capital accumulation. McKinnon (1973) and Shaw (1973) in their separate works challenged the pursuance of such policies. They argued that repressed financial markets discourage savings, impede efficient allocation of resources and disallow the financial intermediation function of the banking system. Financial liberalization mobilizes savings and allocates capital to more productive uses, both of which help increase the amount of physical capital and its productivity. The McKinnon–Shaw thesis became the new conventional wisdom during the 1970s and 1980s. Naturally, the emphasis in policy priorities shifted. This thesis influenced the thinking of international development institutions, such as the IMF and the World Bank, and the policies recommended in their stabilization packages. When we look at the major development objectives, theories and policies prevailing in recent decades, we see the recognition that the 224

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growth-oriented development strategy dominant until the late 1960s had failed to cope with serious problems in developing countries. Some major problems that had become severe and could no longer be ignored included rising unemployment, a more unequal income distribution (or one that had not improved) and a large number of people living below the poverty level (Thorbecke, 2006). There was a deep sense of urgency of the need for poverty alleviation. During this time, the popular themes were the ‘basic needs’ approach to poverty and the ‘redistribution with growth’ strategy. Following a period of deep concern with poverty in the 1970s, a wave of neo-liberalism appeared in the 1980s during which most of the attention of the development community was focused on adjustment issues. Market-based policies were implemented in developing countries in collaboration with international financial institutions via stabilization and structural adjustment programs. The objective of poverty alleviation lost its appeal and the developmental role of the state was very much reduced. In the post-1990 period, poverty alleviation re-emerged as a dominant issue on the international agenda. The concept of poverty, relying earlier to a great extent on the income and consumption approach, has now been broadened to include education and health indicators, social exclusion, political rights, good governance, equity, gender equality, and social development. However, the dominant neo-liberal approach to development precludes the international development institutions from giving top priority to poverty reduction. This is because in this view it is not the governments who are mainly responsible for poverty alleviation, but it is the poor and the civil society to some extent (Senses, 2008). Financial liberalization4 (FL) policies that have been pursued since the 1970s are a part of the general agenda that emphasizes marketization, privatization, flexibilization and deregulation. Therefore, we should not expect these policies to be overly concerned with poverty alleviation. However, if, as the proponents of the FL thesis argue, the overall effect of these policies is to encourage investment and thereby economic growth, we can expect these outcomes to be beneficial to the poor. This trickledown effect of growth has indeed been thought to be the link between liberalization and poverty. However, the interaction between FL and poverty is much more complex than suggested by this simplistic approach. The overall effect of FL on poverty is in fact ambiguous and should be examined more closely. FL could change macroeconomic dynamics, increase financial instability and could also change the structure of the financial system and thereby make the economy more prone to crises.

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Hence, in this chapter, I describe some other channels of interaction between FL and poverty besides the economic growth channel and comment on the empirical evidence on the strength of these channels. These are, namely, the economic growth channel, the financial crises channel, the access to credit and financial services channel, and the income share of labour channel.

2. Channels of interaction 2.1

Economic growth channel

One channel of interaction between FL and poverty is the growth channel. Related literature has been based, to a great extent, on the view that economic growth caused, or accompanied, by FL increases incomes, reduces poverty and improves income distribution. In the following paragraphs, I explain the evidence on, first, how FL might affect economic growth and, second, how economic growth might affect poverty (see Arestis and Caner, 2005, for details on theory and further references). The empirical evidence on the relationship between FL and growth is mixed and inconclusive. Although a sizable literature finds that financial sector development is positively associated with economic growth, many studies disagree and show that the effect depends on the specific situation (see Arestis and Caner, 2005, for details). The experiences of numerous countries reveal that FL is neither a necessary nor a sufficient condition for achieving a high growth rate. Indeed, there may be ‘reverse causation’, i.e., faster growing economies may be more likely to choose to liberalize their economies, rather than FL causing economic growth (Arestis and Demetriades, 1997). One reason for the ambiguity in empirical results is the difficulty of identifying and quantifying FL in a consistent manner across countries. Also, there are differences in the country sample, the sample period, the dataset, and the estimation technique used in these studies. Another explanation, provided by Prasad et al. (2003), is that most of the variation in income per capita is explained by differences in total factor productivity and by ‘soft’ factors such as ‘social infrastructure’ and not by differences in the capital–labour ratio. Under these circumstances, FL and integration is unlikely to increase growth by itself. When we examine the empirical evidence on the link between growth and poverty, we see some researchers suggesting that the incidence of income poverty falls with growth on average. Furthermore, the poor in developing countries share in the gains from aggregate expansion and

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in the losses from aggregate contraction (Ravallion, 2001; World Bank, 2001: Beck et al., 2007b). However, there is substantial churning under the aggregate outcomes; for example, some people lose during spells of growth even though the poverty rate goes down. Therefore, one has to look ‘beyond averages’ (Ravallion, 2001). Dollar and Kraay (2002) find that the growth elasticity of the mean income of the bottom quintile is practically equal to one and that some determinants of growth, such as the rule of law, openness to international trade, and developed financial markets benefit the poorest fifth of society as much as everyone else. However, a recent study by Foster and Szekely (2008) challenges these results by arguing that the elasticities do not lie uniformly in the range of one or above; indeed, for the most bottom-sensitive income standards they are not significantly different from zero. The authors state that ‘this raises doubts about the ability of growth to improve poorer incomes and suggests a role for policies that specifically address distributional concerns’ (p. 1165). Some attempts to measure the effects of FL on poverty econometrically have been based on the assumption that there is only an indirect effect via growth, i.e., the trickle-down effect (see, for example, Jalilian and Kirkpatrick, 2002). A noteworthy study that attempts to link FL and poverty econometrically in a direct way is by Honohan (2004). It concludes that ‘a ten percentage point [increase] in the ratio of private credit to GDP should (even in the same mean income level) reduce poverty ratios by 2.5 to 3 percentage points’ (p. 10). However, the author warns that the analysis is too aggregative to be fully convincing and that the measures of financial development are weak. Another attempt to measure the direct effect is the study by Beck et al. (2007b; see also Demirgüç-Kunt and Levine, 2008). It is shown by these authors that financial development through its impact on the formal financial system affects the poor disproportionately. In Demirgüç-Kunt and Levine (2008), however, it is conceded that these results are not definitive because of problems with the study. The authors suggest that the ‘measure of financial development is not closely tied to theory. The study does not examine policy; rather, it examines a proxy for overall financial development that reflects many factors’ (p. 11). In a more recent study, Arestis and Caner (2008) find no statistically significant effect of capital account liberalization on poverty in developing countries, controlling for possible growth effect. These authors use cross-country and panel data analyses and a de jure measure of capital account openness (a policy variable unlike the ones used in the previously mentioned studies).

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Clearly, there is more agreement among economists on the existence and strength of the link between economic growth and poverty than that between FL and economic growth. That FL brings economic growth is a strong assumption in many cases. The growth and poverty reduction effects of FL depend on the distributional changes induced by growth and the set of institutions and policies that accompany liberalization. 2.2

Financial crises channel

Another channel of interaction between FL and poverty is via crises. During the 1980s and 1990s in the aftermath of pursuing FL policies, almost all developing countries experienced widespread banking sector problems, recessions and increases in poverty and income inequality (see Arestis and Caner, 2005, for details of the theory and further references). Empirical work on the impact of FL on macroeconomic volatility and crises provides evidence of an increased likelihood for countries that have gone through FL of eventually being hit by financial crises. Kaminsky and Schmukler (2003) observe that, although equity markets stabilize in the long run (i.e., in five years or longer) if FL persists, the amplitudes of booms and crashes substantially increase immediately following FL. Most of the empirical evidence on the effects of crises on poverty supports the argument that crises have an aggravating effect on poverty. We may refer to the South East Asian crisis to make the point, and to figures reported in Agénor (2001). Over the period 1997 to 1999, the incidence of poverty (as measured based on the national poverty line) increased from 11% to 18% in Indonesia, from 11.4% to 12.9% in Thailand; the urban poverty headcount rose from 8.5% to 18% in South Korea. The income of the poor fell as a result of both lower real wages and higher unemployment: in Thailand real wages fell by 4.5% (and unemployment increased from 2.2% in 1997 to 5.3% in 1998); in South Korea real wages fell by 10.6% (and unemployment increased from 2.6% in 1997 to 8.4% in early 1999); and in Indonesia real wages fell by 44% (and unemployment increased less dramatically than in the other two cases, but ‘disguised’ unemployment rose). It is clear that the crisis channel of interaction must be incorporated in any analysis of the impact of FL on poverty or inequality. Overall, the current evidence suggests that FL can increase a country’s vulnerability to financial crises, which are likely to hurt the poor disproportionately. Moreover, financial crises affect not only the current position of the poor, but also they lead to a reduction in the limited

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human capital of the poor, thereby affecting their ability to grow out of poverty. The challenge for policy-makers, then, is primarily to take measures to avoid crisis situations if FL is to be pursued. The roles of exchange rate policy, capital controls and counter-cyclical fiscal policy in generating or avoiding crises should be taken into consideration (see Lustig, 2000, pp. 6–11). Lustig (op. cit.) summarizes the relevant policies that include improved prudential regulation and supervision of financial intermediaries; new standards of data dissemination; and implementation of corporate bankruptcy reforms. It is equally important to choose pro-poor responses to crises in case the latter cannot be avoided. The incomes of the poor should be protected in the face of macroeconomic adjustment by using appropriate policy options, such as by maintaining safety nets and by carefully selecting the composition of fiscal adjustment. For it is the case that ‘[s]ocially responsible macroeconomic policy in crisis avoidance and crisis response can contribute simultaneously to lower chronic poverty and higher growth’ (Lustig, 2000, p. 18). Of great interest and relevance to this section is, of course, the world financial crisis that started in August 2007 and that is still troubling especially the poor. The difficulty with this financial crisis is that unlike the earlier relatively minor and transient kind of crises, the August 2007 crisis is a major global recession (even a possible depression). This financial crisis is being accompanied by direct policy measures to allocate credit to troubled firms and the housing poor in many countries. This is being done in the context of not FL but financial re-regulation in various ways. What is particularly interesting, however, is that this crisis has come about as a result of financial liberalization, which had been going on since the 1970s, along with financial innovations that emanated from that era, and the easy monetary policy over the period since the equity crisis of March 2000. These three factors have played a significant role in creating and promoting the August 2007 financial crisis (Arestis and Karakitsos, 2009). 2.3 Access to credit and financial services channel The proponents of FL argue that it leads to financial deepening and better access to credit for previously marginalized borrowers and savers. Nevertheless, it is not necessarily the case that financial sector reforms increase the supply of loans to small firms and the poor. From the banks’ point of view, it is more expensive to lend to the poor because of higher processing, administrative and monitoring costs and higher risk of default. Since banks emphasize profitability rather than other

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lending criteria, banks may naturally prefer doing business with established companies rather than the poor even after financial sector reforms (see Arestis and Caner, 2005, for references). The impact of FL on the poor could work through its effect on the interaction between formal and informal financial markets. In developing countries, the informal financial sector has usually a more important role than the formal banking sector. It has been shown that roughly 40 to 80% of economic agents in developing countries lack access to the formal banking sector (Beck et al., 2007a; World Bank, 2007). The informal lender, due to having better knowledge of the borrower, has better opportunities than a formal lender to discriminate among borrowers with high and low risks and to charge appropriate interest rates. If FL expands the formal sector to the detriment of the informal sector, it can hurt the poor substantially given that the poor operate mainly in the informal sector. Lensink (1996) finds that this actually happened in a number of sub-Saharan African countries. Empirical research on whether financial liberalization improves access to credit by the poor and the marginalized is so far rather limited. The findings are usually not very optimistic. The results by Bandiera et al. (2000) suggest that financial liberalization has had little impact on the availability of credit to consumers through the formal financial sector in eight developing countries: Chile, Ghana, Indonesia, Korea, Malaysia, Mexico, Turkey and Zimbabwe. Chigumira and Masiyandima (2003) report that in Zimbabwe financial sector reforms implemented beginning in 1991 had some positive effects such as increased financial depth, higher real incomes leading to higher savings. Both total domestic credit and private credit increased. However, high and unstable inflation starting from the late 1990s dampened savings as savers tended to switch back to physical inflation hedges as opposed to financial savings. Furthermore, ‘[m]uch of the increase in the private sector credit was mainly for established borrowers as opposed to the small and medium scale enterprises (SMEs), which got on average less than 5% of the total domestic credit supply even if their proportion of savings in the economy’s total financial savings is high’ (p. 52). Amonoo et al. (2003) provide some evidence on the effects of rising interest rates following financial liberalization in Ghana. They find lower credit demand and lower loan repayment rates. Hence, they infer that lowering interest rates would increase the demand by the poor and SMEs for credit and loan repayment at banks and non-bank institutions. Ayyagari et al. (2008) examine firm financing patterns in China in the case of 2400 firms (including 1720 non-publicly traded and non-state

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companies) from 18 cities. The authors find that a relatively small percentage of firms in the sample rely on formal bank finance; the informal financial sector plays a significant role. Firms that rely on the formal sector, though, grow faster, have higher productivity and profit reinvestment rates. However, when informal financing is defined to include internal financing, the informal finance sector has higher productivity growth and profit reinvestment rates, but not higher growth than the small formal sector. But, then, four large state-controlled companies dominate the Chinese financial system; state-owned banks enjoy a large share of bank lending. Ayyagari et al. (2008) produce evidence suggesting ‘that the firms which receive government help in obtaining bank financing do not grow as fast as firms which report no government help’ (p. 37). The role of microfinance institutions in terms of this channel cannot be emphasized enough. These institutions have the advantage of proximity to and better knowledge of the market they serve. Cull et al. (2008) analyse data from 346 of the world’s most important microfinance institutions dealing with 18 million borrowers and show that microfinance institutions can in fact provide reliable banking services in a commercially viable way to poor customers. They argue that although profit-maximizing investors would have limited interest in the institutions that attract the poorest customers, the microfinance sector has grown substantially with its emphasis on social objectives. Microfinance institutions have been able to expand services, improve quality, and successfully innovate to tackle problems of asymmetric information, yet the challenges of high costs remain. Such success has not yet proved to increase economic growth or to reduce poverty on a large scale. The World Bank (2007) suggests that microfinance is not overwhelmingly beneficial and displays a great deal of scepticism as to whether microfinance can produce a significant reduction to poverty. To sum up, it is yet unclear whether the consequences of FL for access to the financial market by small customers and the poor are beneficial. On the one hand, increased competition and improved distributional efficiency will lead financial institutions to seek markets normally rationed out. On the other hand, financial sector reforms may leave the basic structure of the banking system unchanged, thereby protecting or reinforcing the oligopolistic position of banks. In many countries, financial sector reforms so far have not embraced the broad agenda of developing the institutional structure and new instruments to satisfy the financial needs of small enterprises and the poor. FL is not sufficient to improve access to credit and financial services by the poor, given the

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empirical evidence from developing countries. Moreover, even if credit and financial services are extended to small customers and the poor, it is doubtful that improved access by itself will eradicate poverty. 2.4 Income share of labour channel Financial liberalization might affect poverty by changing the share of labour in national income. That financial capital is more mobile while labour (especially unskilled) is far less mobile across national boundaries than they used to be is one feature of today’s international labour and capital markets. According to Rodrik (1997), increasing capital mobility could give more bargaining power to capital over labour. As world-wide trade and investment opportunities for employers are increasing, they are able to move across borders more freely. This leads to an increase in the demand elasticities for immobile factors such as land and unskilled labour. Wages race to the bottom to attract capital. Another implication is that during a crisis, capital can threaten to flee unless it receives the world interest rate plus a risk premium, whereas labour cannot flee and has to bear the burden. On the other hand, increased reliance on domestic markets would require a rise in the purchasing power of the poor to enlarge the domestic market. Finding the right balance between an emphasis on external vs. domestic markets requires careful planning. So far, there are only a few studies on the link between FL and labour’s income share. One example by Jayadev (2007) estimates the effect of financial liberalization on the labour share of output using an index of capital account restrictions based on data from 140 countries over the period 1972–96, controlling for macroeconomic trends and changes in endowments. Panel data estimates reveal that capital account openness exerts a robust and significant negative effect on the labour share of income. The effect is robust across many subsets of developing and developed countries, except for the low-income country sample. Furthermore, the losses of labour are not temporary, but they persist through the medium term (five years). Harrison (2002) models the bargaining process between firms and workers on the division of excess profits between capital and labour in an imperfectly competitive theoretical framework where firms make excess profit. Applying the model to data for more than 100 countries over 40 years, she finds that rising trade openness and exchange rate crises reduce the output share of labour, while capital controls and government spending increases it. It has also been suggested that the effect of financial globalization on the inequality between the income shares of capital and labour does not operate monotonically and

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smoothly through time; rather it operates via short-term severe disputes during crises. Labour partially bails out capital in resolving the crises, and therefore it is not unintentionally hurt. As empirical support for this thesis, Diwan (2001) reveals an inclination for labour share to fall sharply during a financial crisis, recovering only partially in subsequent years. The decline during a crisis can be partly explained by the degree of leverage in the country, the nature of its financial structure, and the openness of its current and capital accounts. The very small amount of evidence produced so far on this channel provides support for the thesis that financial liberalization can actually reduce the share of labour in income. Since labour income is the major income source for the poor, this channel of interaction shows that there are possible detrimental effects for this group of people.

3. Conclusions This chapter presents a critique of the current approach to the relationship between FL and poverty in the literature and identifies other channels of interaction besides the growth channel mentioned (or implied) in the literature. These are the crises channel, the access to credit and financial services channel, and the income share of labour channel as explained in the text. This chapter also aims to provide an answer to the question in the title: does FL help the poor? The overall evidence on the channels of interaction suggests that it does not. There is no conclusive evidence in favour of a positive growth effect. Moreover, even if FL leads to faster growth, there is no guarantee that growth will benefit the poor as much as it benefits the rich. Evidently, when FL is applied without first maintaining macroeconomic stability and establishing the supporting institutions and policies, even when it brings economic expansion, it often comes at the cost of devastating crises and increasing economic inequality. The poor appear to pay a higher price in the aftermath of these crises. There is also no evidence that FL will increase the availability of credit or financial services to the poor. The reduction of extreme poverty by half by year 2015 as stated in the Millenium Development Goals (United Nations, 2000) is a big challenge for policy-makers world-wide. In fact, it is too optimistic to expect these targets to be reached. What is striking is that international institutions that are the most influential in determining development strategies are still highly influenced by the liberalization idea. It appears that although these institutions cannot deny the importance of the problem

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of poverty, they remain firmly attached to their policies, which forbid them from taking influential steps towards eliminating poverty. As a consequence, the solutions of these institutions have only a soothing effect rather than really curing the problem. What is actually needed to solve the poverty problem is a different vision, one that emphasizes employment creation, redistribution and planning for specialization in industries that create high value-added products. This vision would also need a re-thinking of the role of the state in development. Recent evidence supports that countries that designed their own strategies have become more successful than those that merely adopted the policies of international institutions. A new vision on poverty elimination would therefore bring the importance of basing development strategy on the specific conditions of a country to the forefront.

Notes 1. TOBB-Economics and Technology University, Department of Economics, Sög ˘ ütözü Cad. No. 43, Sög˘ ütözü, Ankara, Turkey, 06560. E-mail: acaner@etu. edu.tr, Phone: 011 90 312 292 4111, Fax: 011 90 312 287 1946. 2. Although this chapter is a single-authored piece, the subject matter is in fact based on previous work that I have done jointly with Philip Arestis. Needless to say, I have benefited greatly from his involvement and I am grateful to him for his guidance and encouragement. 3. That is the market interest rate that would prevail in the absence of a ceiling or any other intervention. 4. Financial liberalization (FL) takes on various meanings in the literature. Here, I adopt the definition provided by Kaminsky and Schmukler (2003). According to this definition, FL consists of the deregulation of the foreign sector capital account, the domestic financial sector, and the stock market sector viewed separately from the domestic financial sector.

References Agénor, Pierre-Richard (2001), ‘Business Cycles, Economic Crises, and the Poor: Testing for Asymmetric Effects’, mimeo, Washington, DC: World Bank. Amonoo, Edwin, P. Kojo Acquah and E. Ekow Asmah (2003), ‘The Impact of Interest Rates on Demand for Credit and Loan Repayment by the Poor and SMEs in Ghana’, IFLIP Research Paper 03–10. Arestis, Philip and Asena Caner (2005), ‘Financial Liberalization and Poverty: Channels of Influence’, ch. 3 in Philip Arestis and Malcolm Sawyer (eds), Financial Liberalization: Beyond Orthodox Concerns, International Papers in Political Economy Series, Basingstoke, UK: Palgrave Macmillan. Arestis, Philip and Asena Caner (2008), ‘Capital Account Liberalization and Poverty: How Close is the Link?’ TOBB University of Economics and Technology, Working Paper No. 08-11.

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Asena Caner 235 Arestis, Philip and Panicos Demetriades (1997), ‘Financial Development and Economic Growth: Assessing the Evidence’, Economic Journal, 107(442), 783–99. Arestis, Philip and Murray Glickman (2002), ‘Financial Crisis in South East Asia: Dispelling Illusion the Minskyan Way’, Cambridge Journal of Economics, 26(2), 237–60. Reprinted in R.E. Allen (ed.), The International Library of Writings on the New Global Economy:The Political Economy of Financial Crises, Edward Elgar Publishing, 2004. Arestis, Philip and Elias Karakitsos (2009), ‘Subprime Mortgage Market and Current Financial Crisis’, mimeo, Cambridge Centre for Economic and Public Policy, Department of Land Economy, University of Cambridge. Ayyagari, Meghana, Asli Demirgüç-Kunt and Vojislav Maksimovic (2008), ‘Formal versus Informal Finance: Evidence from China’, World Bank Policy Research Working Paper 4465, Washington DC: World Bank. Bandiera, Oriana, Gerard Caprio, Patrick Honohan and Fabio Schiantarelli (2000), ‘Does Financial Reform Raise or Reduce Saving’, Review of Economics and Statistics, 82(2), 239–63. Beck, Thorsten, Asli Demirgüç-Kunt and Maria Soledad Martinez Peria (2007a), ‘Reaching Out: Access to and Use of Banking Services across Countries’, Journal of Financial Economics, 85(2), 234–66. Beck, Thorsten, Asli Demirgüç-Kunt and Ross Levine (2007b), ‘Finance, Inequality and the Poor’, Journal of Economic Growth, 12(1), 27–49. Chigumira, Gibson and Nicolas Masiyandima (2003), ‘Did Financial Sector Reform Result in Increased Savings and Lending for the SMEs and the Poor?’, IFLIP Research Paper 03-7. Cull, Robert J., Asli Demirgüç-Kunt and Jonathan Morduch (2008), ‘Microfinance Meets the Market’, World Bank Policy Research Working Paper 4630, Washington DC: World Bank. Demirgüç-Kunt, Asli and Ross Levine (2008), ‘Finance and Economic Opportunity’, World Bank Policy Research Working Paper 4468, Washington DC: World Bank. Diwan, Ishac (2001), ‘Debt as Sweat: Labor, Financial Crises, and the Globalization of Capital’, mimeo, World Bank, July. Dollar, David and Kraay, Aart (2002), ‘Growth Is Good for the Poor’, Journal of Economic Growth, 7(3), 195–225. Foster, James E. and Miguel Szekely (2008), ‘Is Economic Growth Good for the Poor? Tracking Low Incomes Using General Means’, International Economic Review, 49(4), 1143–72. Harrison, Ann (2002), ‘Has Globalization Eroded Labor’s Share? Some CrossCountry Evidence’, mimeo, Berkeley: University of California. Honohan, Patrick (2004), ‘Financial Development, Growth and Poverty: How Close are the Links’, ch. 1 in G.A.E. Goodhart (ed.), Financial Development and Economic Growth: Explaining the Links, Basingstoke: Palgrave Macmillan. Jalilian, Hossein and Colin Kirkpatrick (2002), ‘Financial Development and Poverty Reduction in Developing Countries’, International Journal of Finance and Economics, 7(1), 97–108. Jayadev, Arjun (2007), ‘Capital Account Openness and the Labour Share of Income’, Cambridge Journal of Economics, 31(3), 423–43. Kaminsky, Graciela Laura and Sergio L. Schmukler (2003), ‘Short-Run Pain, LongRun Gain: The Effects of FL’, IMF Working Paper WP/03/34, Washington, DC: International Monetary Fund.

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Lensink, Robert (1996), ‘The Allocative Efficiency of the Formal versus the Informal Financial Sector’, Applied Economics Letters, 3(3), 163–5. Lustig, Nora (2000), ‘Crises and the Poor: Socially Responsible Macroeconomics’, Poverty and Inequality Advisory Unit Working Paper No. 108, Inter-American Development Bank (Sustainable Development Department): Brazil. McKinnon, Ronald I. (1973), Money and Capital in Economic Development, Washington, DC: Brookings Institution. Prasad, Eswar, Kenneth Rogoff, Shang-Jin Wei and M. Ayhan Kose (2003), ‘Effects of Financial Globalization on Developing Countries: Some Empirical Evidence’, IMF Board Document, Washington, DC: International Monetary Fund. Ravallion, Martin (2001), ‘Growth, Inequality and Poverty: Looking Beyond Averages’, World Development, 29, 1803–16. Rodrik, Dani (1997), Has Globalization Gone Too Far?, Washington, DC: Institute for International Economics. Senses, Fikret (2008), ‘Missing Links in Poverty Analysis in the Age of Neo-Liberal Globalization: Some Lessons from Turkey’, mimeo, Middle East Technical University, Department of Economics. Shaw, Edward S. (1973), Financial Deepening in Economic Development, New York: Oxford University Press. Stiglitz, Joseph E. and Andrew Weiss (1981), ‘Credit Rationing in Markets with Imperfect Information,’ American Economic Review, 71(3), 393–410. Thorbecke, Erik (2006), ‘The Evolution of the Development Doctrine, 1950– 2005,’ UNU-WIDER Research Paper No. 2006/155. United Nations (2000), United Nations Millenium Declaration. http://www. un.org/millenium/ World Bank (2001), World Development Report 2000/2001, New York: Oxford University Press. World Bank (2007), Finance for All? Policies and Pitfalls in Expanding Access, World Bank Policy Research Report, August, Washington DC: World Bank.

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16 Finance, Speculation and Stability: Post-Keynesian Policies for Modern Capitalism Geoff Harcourt

I Maynard Keynes’s best known remark is: ‘In the long run we are all dead’ (Keynes, 1923; C.W., vol. IV, 1971, 65, emphasis in original). This led an IMF wit some years ago to crack: ‘Well, he’s dead and we’re in the long run’. Though Keynes’s remark is well known, its context is not. It occurs in his 1923 Tract on Monetary Reform in which he is cheeking his old teacher, Alfred Marshall. For he continued: ‘Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again’ (65). He was arguing for a change in emphasis, from concentrating on the economics of the long period, of the long-period determination of normal competitive equilibrium prices and quantities by the forces of supply and demand, Book V of Marshall’s Principles, then the bible of most English-speaking economists, to more attention to analysis of, and policy for short-run happenings. But, just before he died, in his last article in the Economic Journal, in speeches to the House of Lords and at his Political Economy Club at Cambridge (by then presided over by Dennis Robertson), he bemoaned the fact that the pendulum had swung too far the other way, to an undue concentration on the short period and the neglect of fundamental and lasting truths to be found in the insights of our founder Adam Smith and Keynes’s own mentor, Marshall.1 If all this has a familiar and topical ring to it, so it should, as we are in the middle (or, perhaps, near the end of the start) of the most serious crisis in the interrelated capitalist world since the 1929–30s depression years. We have witnessed in recent decades undue concentration by decision-makers, not least in the private sector, the stock exchanges and the foreign exchange markets, on the short term and a relative 237

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neglect of the long-term consequences of their decisions. This has been reinforced by technical innovations which have had the effect in many areas of shrinking the length of the short run from months, or even years to weeks, or even days or hours. While these ‘real world’ events have been unfolding we have also seen a major change in the characteristics of the dominant mainstream analysis of the economy, a return to what Joan Robinson (1964) called many years ago, ‘Pre-Keynesian theory after Keynes’. Starting with Friedman and the monetarists, and reinforced by Hayek’s philosophical views, we have seen, if not the overthrow then at least the very considerable downgrading of Keynes’s and the post-Keynesians’ ‘vision’ and analysis of the world. At the same time the contributions of another great interpreter of the essential fundamentals of the capitalist process have virtually vanished, for illogical reasons. The overthrow of the so-called socialist economics of Eastern Europe and of the Communist regime of the former USSR do not in themselves refute Marx’s insights into how capitalism works, though it was and is so interpreted, not least by Mrs Thatcher as she then was. Yet I have argued that Keynes, Kalecki and Marx, were they still with us, would have made far more sense of what has been happening over the last 30 years and more than do the Lucasians, modern classical macroeconomists, the inappropriate application of Frank Ramsey’s model, or even the New Keynesians’ concentration on imperfections. Not least does Marx come into his own with his insight that when financial capital is out of kilter with industrial and commercial capital, instability and crises are likely to result, see Harcourt (2007a).

II Before setting out the framework of analysis that lies behind the policy proposals I shall tentatively suggest, I first pay tribute to, in particular, my Australian mentors, Eric Russell and Wilfred Salter. Because they both died far too young (Salter when he was 34, Eric at 55) and because Eric did not publish a lot, their contributions may not be as well known as they should be. What I write is very much influenced by them and by my Cambridge mentors, especially Joan Robinson, Richard Kahn, Nicky Kaldor, Piero Sraffa, Dick Goodwin and Luigi Pasinetti. Last but certainly not least, discussions with Philip Arestis and reading his papers have much influenced my approaches to economic theory and policy. Before setting out policies, I need to sketch the characteristics of a post-Keynesian analysis of the processes at work in modern capitalism.

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What Joseph Schumpeter called ‘vision’ and its implications for analysis have profound effects on what policies to propose. I start by quoting Joan Robinson (1978; C.E.P., vol. V, 1979, 210): ‘To me, the expression post-Keynesian has a definite meaning; it applies to an economic theory or method of analysis which takes account of the difference between the future and the past’ (emphasis in original). So we start by asking how key decision-makers behave, sometimes sensibly, sometimes not, in an environment of inescapable uncertainty, themes about which Keynes wrote incisively in The General Theory. Witness his account in Chapter 12 of the working of the stock exchange in different situations and economies: If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In … New York, the influence of speculation … is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare … for an American to invest, as many Englishmen still do, ‘for income’; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is … a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism – which is not surprising, if … the best brains of Wall Street have been in fact directed towards a different object. (Keynes 1936; C.W., vol. VII, 1973, 158–9, emphasis in original)

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Secondly, there is a vast divide between how post-Keynesians think of how markets, indeed, systems as a whole, behave, on the one hand, and the mainstream view, on the other (though there has been some convergence in recent years with the emergence of path-dependent processes, hysteresis, and so on). Nevertheless, there is still a stranglehold of equilibrating notions on the mainstream in contrast to the increasing emphasis on cumulative causation processes by postKeynesians. (Cumulative causation originated in Adam Smith’s writings, was brought into the modern age by Kaldor’s teacher at LSE, Allyn Young, Kaldor himself, and, independently, by Gunnar Myrdal.) For many years I have illustrated the difference by a wolf pack analogy (which may be untrue of their actual behaviour – I am not a zoologist – but is, I believe, an accurate description of the respective economic theories). The mainstream approach is that akin to a wolf pack running along. If one or more wolves get ahead or fall behind, powerful forces come into play which return them to the pack. (The parallels with the existence of a unique equilibrium that is stable, and that the forces responsible for existence are independent of those responsible for stability are, I hope, obvious.) The other approach has it that the forces acting on the wolves who stray make them get further and further ahead or fall further and further behind, at least for long stretches of time. (This also corresponds with Goodwin’s and the late Kalecki approach that the trend and cycle are indissolubly mixed, not separable concepts determined by independent factors, see Goodwin (1967), Kalecki (1968), Harcourt (2006).) Why does the difference matter for policy? Let me illustrate this with Friedman’s case for freely floating exchange rates, Friedman (1953). Underlying his arguments is the first wolf pack analogy, that in a competitive setting there exists a set of stable long-period exchange rates that quickly would be found and kept by a free float. In this setting the systemic effects of speculation would be beneficial, for speculators with their superior knowledge, intelligence and information would help the market to reach the equilibrium pattern more quickly than in their absence, and to sustain it there. But suppose the second scenario is at least the more correct description of how foreign exchange markets work. Then there is no set of stable long-period rates ‘out there’ waiting to be found so that now a float combined with speculation will be systemically harmful, accelerating the movements away in both directions of exchange rates from one another and also of systems, at least for long periods of time. The

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second scenario is more akin to what has happened over recent decades, and provides the rationale for various schemes suggested to curb the actions of speculators. Next, consider a lesson from Marx, Keynes and Kalecki which was put most neatly by James Meade: ‘Keynes’s intellectual revolution was to shift economists from thinking normally in terms of a model of reality in which a dog called savings wagged his tail labelled investment to thinking in terms of a model in which a dog called investment wagged his tail labelled savings’ (Meade 1975, 82, emphasis in original). This profound insight is often forgotten in, for example, discussions of the coming pensions crisis, whereby all sorts of ingenious schemes are suggested to induce more saving over people’s working lives but little, if any, mention is made of the necessary condition for them to be successful is that simultaneously there has to be accompanying private and public investment expenditure, otherwise the paradox of thrift will come into its own, see Harcourt (2007b). Next, in view of the over-, or even sole, reliance in recent years on the rate of interest to control the economy, especially as an anti-inflationary measure, let me paraphrase a wise saying from a very fine but much neglected economist, the late Sir Dennis Robertson: ‘People tell me that the bank rate is a beautiful and delicate instrument but I think it is coarse and blunt.’ With this should be coupled the insightful comment of the late Tommy Balogh that ‘Monetarism is the incomes policy of Karl Marx’ (Balogh, 1982, 77). He meant, of course, that the manipulation of either the quantity of money and/or the rate of interest through monetary policy has its (uncertain) effects on inflation and activity by its impact on employment, that the creation of a cowed and quiescent workforce by making the sack an effective weapon reduces money-wage demands and so reduces one major cause of inflation. Michal Kalecki was one of the first political economists to articulate this truth. In his famous paper, ‘Political aspects of full employment’ (published in 1943!), he analysed the essential difference in the political economy of getting back to full employment after a deep slump when all classes and vested interests would be in an (uneasy) accord, on the one hand, and the political economy of sustaining full employment, on the other, when what I call the Kaleckian dilemma occurs. Kalecki wrote of the second situation: the maintenance of full employment would cause social and political changes which would give a new impetus to the opposition of the business leaders [to full employment]. Indeed, under a regime of

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permanent full employment, the sack would cease to flag its role as a disciplinary measure. The social position of the boss would be undermined and the self-assurance and class-consciousness of the working class would grow. Strikes for wage increases and improvements in conditions of work would create political tension … true … profits would be higher under a regime of full employment than they are on average under laisser-faire, and even the rise in wage rates resulting from the stronger bargaining power of the workers is less likely to reduce profits than to increase prices, and thus affect adversely only … rentier interests. But ‘discipline in the factories’ and ‘political stability’ are more appreciated than profits by the business leaders. Their class instinct tells them that lasting full employment is unsound from their point of view, and that unemployment is an integral part of the normal capitalist system. (Kalecki 1943;. C.W. Vol. I, 1990, 351, emphasis in original) I now draw on an insight by another great economist, John Hicks, whose insight concerning ‘Snatchers’ and ‘Stickers’, when writing on imperfect competition in the 1950s, Hicks (1954), helps to illuminate the recent behaviour of banks and other financial intermediaries. If I may be indulged, I quote here from the paper I presented in 1998 at the Conference in Bergamo in honour of Hy Minsky (Harcourt, 2000; 2001a, 201–2). Hicks presented a period analysis of price setting and identified when it would be ‘safe’ always to maximise short-period or immediate expected profits … to snatch completely what was immediately available, regardless of the consequences. … This … was contrasted with [a situation] where it would be necessary to take into account the longer-term consequences of snatching now … [T]he objective then became the maximisation of long-term expected profits, to stick [not] snatch, so foregoing some immediate opportunities because of … negative feedbacks on consumer goodwill, for example, in future periods. I cite Hicks’s article … because … commercial banks all around the world … have behaved more like Snatchers than Stickers in their lending behaviour, notably over the past twenty to thirty years [and more]. This has had disastrous consequences … for their customers and even themselves, [and] for the performance of the system as a whole. … [T]he conventional view of bankers [used to be] that they are sound, cautious, conservative people … But their actions in recent years belie such a stereotype; in fact they [are] either

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over optimistically euphoric about economic situations and lend accordingly – lots – without proper assessments of risks or creditworthiness generally, or they are unduly pessimistic …, calling in loans without any regard to the medium- to long-term viability and soundness of their customers’ situations. This behaviour … has also been characteristic of non-banking financial institutions over the same period … [T]heir behaviour has served significantly to reinforce the cyclical processes which Minsky identified in Keynes’s system. The essence of Minsky’s message was that investment expenditure is planned in anticipation of future cash flows, that finance is raised to make the investment possible, so building inescapable future commitments into balance sheets, extra liabilities on which extra interest and other payments have to be paid regardless of actual outcomes. One of Keynes’s greatest insights, on which Minsky has built, was that apart from the state of long-term expectations, availability of finance, not saving, is the binding constraint on investment expenditure – a corollary of Meade’s remark quoted above and set out by Keynes in 1937 in his discussions of the finance motive (see Keynes, 1937a, 1937b; C.W., vol. XIV, 1973, 201–23). So a major post-Keynesian tenet is that there is an inescapable logical sequence of finance → investment → saving, a proposition going by default in much recent discussion of both national and international processes (see Dalziel and Harcourt 1997; Harcourt 2001a, 72–87). Returning to Minsky’s analysis, if therefore actual cash flows turn out to be different from what was expected, because of the certain commitments, their effect is to accentuate the inescapable real fluctuations of the economy (if actual events exceed expected, in an upward direction, if they are less, in a downward direction). With banks and other financial intermediaries being overall often irresponsible Snatchers, fluctuations both real and financial have been greatly enhanced. A final consideration which characterises post-Keynesian analysis arose first in the work of Roy Harrod who laid the foundations of the modern theory of growth. In his pioneering article (1939) and book (1948), he distinguished between the demand side of growth, principally with his concept of the warranted rate of growth (gw) and the supply side with his concept of the natural rate of growth (gn). The factors which determined gn, were argued to be (or at least treated as if they were) independent of those determining gw. gn itself summed up the potential for long-term growth of the economy in terms of the growth and improvement of economies’ labour forces. But the separation of gn

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from gw (and the expected and actual rates of growth) is not acceptable for reasons cogently put forward by, especially, Salter’s analysis of the rate of embodiment of new methods through investment in capital stocks (see Salter 1960, 1965). Clearly the size of gn must be related to this. As I mentioned before, post-Keynesians go even further by their rejection of the distinction between trend and cycle, putting in their place theories of cyclical growth. This contrasts strongly with modern mainstream practice where growth is discussed in supply terms independently of demand, as though short-term fluctuations occur around a full employment trend, that is to say, gn.

III With this as background, what would a package deal of post-Keynesian policies look like? (While I shall not discuss climate change policies explicitly, I assume that the policies I suggest will take proper account of the long-term constraints that global warming and responses to it entail.) It is to be hoped that there will be international cooperation with, and coordination of, some of the individual policies, otherwise they would not have a chance to succeed. It may be that unfolding current events are making these possible; but I would not bet on it. While it will never be possible entirely to escape from cyclical fluctuations – Dennis Robertson again made this clear in his criticism of Keynes’s General Theory and the early Keynesians’ emphasis on trying always to be at full employment (see Anyadike-Danes, 1985) – the aim should be to minimize the amplitude of fluctuations and to keep average levels of employment as near as possible to full employment, allowing for frictional and seasonal unemployment and the necessary flexibility associated with restructuring processes. These last may take years to work themselves out but here Scandinavian practices are excellent guides – retraining, early pensions, keeping communities together. As a general rule I have come to favour spending by governments on infrastructure being determined by medium- to long-term needs (given the philosophical stances of the governments in power), with shortterm aggregate demand puzzles being tackled by changes in taxation. An overall tax structure which reflects equity and efficiency should be designed and the whole structure should be jacked up or down according to the anticipated state of aggregate demand from other sources. This view, however, has to be modified in the present crisis, as indeed has already occurred in Australia, China, the United States and the UK (with varying degrees of enthusiasm and competence). Increases in

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government expenditure associated with bringing forward plans already in the pipeline, or waiting their turn, makes good sense. We have been presented with a golden opportunity to do something substantial about deficiencies in social housing, city infrastructure, out-of-date or inadequate school buildings and hospitals, transport inadequacies and so on, not to mention reducing student–staff ratios in schools and in universities and increasing the provision of trained people to tackle reading and writing problems, and care for the disabled and elderly. Like Keynes, Kalecki, Kaldor and Robertson, I am very sceptical about over-reliance on changes in the rate of interest as an effective policy measure. The fiscal fine-tuners of earlier years were undoubtedly over optimistic but what of the monetary fine-tuners in independent central banks in more modern times? There is a lot to be said, within given constraints, of setting relatively low interest rates and keeping them there, using other measures to tackle short-term fluctuations and longterm needs. In Australia we have been blessed over the years with deep analysis of a permanent incomes policy, very much influenced by the contributions of Eric Russell and Wilfred Salter. Their arguments used to be wellknown. Allied with maintaining full employment, we need institutions which as a start allow money incomes to be adjusted for prices and overall productivity (reflecting the terms of trade in open economies). This would allow all citizens to share in the rising prosperity associated with the complementary relationship between capital and labour at the economy level. (On occasions they would take their fair share of any decline in real standards.) Not only would this be equitable, it would also be efficient because it hastens the disappearance of low productivity, often declining industries and enhances the growth of high productivity, often expanding industries. The associated faster growth of overall productivity when reflected in the increase in money incomes may serve to tackle the Kaleckian dilemma of sustaining full employment alongside the accompanying shift of economic, social and political power from capital to labour (see Harcourt, 1997; 2001b). Post-Keynesians are ‘horses for courses’ analysts and so each economy would need to try to achieve this goal through institutions which suited its sociological and historical experiences. (In Australia we have all but destroyed the institutions which could have delivered this goal.) The most difficult task in all these economies will be getting the currently grossly overpaid captains of industry and finance to accept such a rule. If we accept a cumulative causation view of the workings of markets and systems, there is a strong case for arguing that speculation

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is systemically harmful, not beneficial, in many markets. Therefore we have to design Marshallian/Pigovian carrot and stick measures to reduce overall the amount and therefore effects of speculation. (We do not have the luxury of authoritarian states of locking speculators up.) Here the tax system comes into play. The Tobin tax on foreign exchange transactions is an early example of this. The overall aim should be to reward legitimate, systemically beneficial economic activity and punish systemically harmful activity. In foreign exchange markets, this requires classifying overall transactions (turnovers) on both sides of the market into useful economic purposes – trade, investment, consumption – with the residual being prima facie speculative transactions. Overall, tax rates on transactors’ incomes should reflect penal rates associated with speculation (see Harcourt, 1995). Of course, it may still be thought profitable for individuals to speculate but the inducement is not to. Obviously there is need for international agreement on such measures, otherwise domestic taxpayers are induced to go offshore. In housing markets again the tax system could be directed towards encouraging economically and socially beneficial transactions – buying and selling (or letting and renting) houses because of changes in employment, arrival of a family, parents coming home to live – and discouraging speculative purchases where again penal rates of tax on incomes would apply to both buyers and sellers. On stock exchanges Keynes advocated measures which encourage buyers to look at the medium to long-term prospects of companies, the shares of which they were thinking of buying or selling, that is, being Stickers. This required rewards for the length of time shares were held, so offsetting the trend decline in the number and lengths of marriages by making portfolios more durable and lasting (see Keynes , 1936; C.W., vol. VII, 1973, 160–1). For the banking system, an implication of Minsky’s analysis for policy is that central banks should encourage trading banks to use their research departments to evaluate the medium- to long-term prospects of those who borrow from them for both investment and consumption purposes. This would make the granting of loans in the upturn more cautious and responsible and the pulling of plugs in the downturn, because of short-term cash flow problems, less frequent so, overall, reducing the amplitude of fluctuations in activity to its inescapable real patterns. The UK government has recently (January 2009) taken some faltering steps to implement these ideas. For non-banking financial intermediaries, we need to induce similar behaviour from both lenders and borrowers. The problem is that

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innovations in financial instruments have been so fast and complicated that credit-rating agencies have not the skills to make authoritative assessments of various instruments. This is especially true of derivatives and the behaviour of hedge funds. Yet, in principle, it should be possible to classify activity in these instruments and institutions into acceptable and not, and design tax impositions accordingly. Indeed, if this is not possible, their activities will continue to plague the stability of economies and attempts through policy to overcome instability and crisis. One of the greatest tragedies of the twentieth century was that the Americans (in the person of Harry Dexter White) won out over the United Kingdom (in the person of Maynard Keynes) at Bretton Woods. Had the latter prevailed, there would have been pressure on creditor nations to behave, so removing inbuilt contractionary forces which have plagued the system, and we would have had a world central bank and a world currency for settling international transactions. Moreover, the world would have moved towards freer trade without necessarily accompanying free capital movements. This would have allowed a system of fixed exchange rates with a provision for moveable pegs to have prevailed without being destroyed by speculators with their massive inflows and outflows of ‘hot money’. Today we have relatively free international capital movements but not a world central bank or a world currency. This is an inherently unstable situation which benefits developed economies, especially large ones, but harms developing economies, especially those only starting development and those which are small but open. Arestis et al. (2005) have argued the case for a world central bank playing a central coordinating and regulatory role, and a world currency as a second-best solution, the only way to have ‘true financial globalization’. But, given the choice, they would not have started from there in the first place.

IV I hope I have set out some ideas that other people might like to take up. I recently read John King’s superb new book on Nicky Kaldor (King, 2009), and I noted the overlap with his policy proposals, especially in his last book (Kaldor, 1996), which contained his 1984 Matteoli lectures. (In addition, he wanted buffer stock schemes to stabilize the prices of primary products and two-tier exchange rates.) Keynes wanted to save capitalism from itself; Marx (and Kalecki) thought that was impossible. Progressive people backed by Keynes’s sensible analysis will be more likely

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to make Keynes’s aims achievable and prove Marx and Kalecki wrong. (In this category I include Philip Arestis, a post-Keynesian optimist par excellence.) Had any society been prepared to accept and allow Kalecki’s plans for democratic socialism to prevail, that would have been a first-best solution. But, in the present circumstances, that time sadly is past, as Prue Kerr and I recognized in our 1980 paper, ‘The mixed economy’. So capitalism with a more human face is the most we can realistically hope for.

Note 1. See, for example, Keynes (1946), 185–6. In the House of Lords Keynes claimed that ‘There is an attempt to use what we have learnt from modern experience and modern analysis, not to defeat, but to implement the wisdom of Adam Smith’ (186). See also Keynes’s last time at the Political Economy Club: Editorial Introduction (2006), and Lloyd (2006).

References Anadike-Danes, M.K. (1985), ‘Dennis Robertson and Keynes’s General Theory’, in G.C. Harcourt (ed.) (1985), Keynes and His Contemporaries. Houndmills, Basingstoke: Macmillan. Arestis, Philip, Santanou Basu and Sushanta Mallick (2005), ‘Financial globalization: the need for a single currency and a global central bank’, Journal of Post Keynesian Economics, 27, 507–31. Balogh, T. (1982), The Irrelevance of Conventional Economics, London: Weidenfeld & Nicolson. Dalziel, P.C. and G.C. Harcourt (1997), ‘A note on ‘Mr Meade’s Relation’ and international capital movements’, Cambridge Journal of Economics, 21, 621–31, reprinted in Harcourt (2001a), 72–87. Editorial Introduction (2006), ‘Keynes’s last time at the Political Economy Club: Editorial Introduction’, Cambridge Journal of Economics, 30, 1. Goodwin, R.M. (1967), ‘A growth cycle’ in C.H. Feinstein (ed.) Socialism, Capitalism and Economic Growth: Essays presented to Maurice Dobb, Cambridge: Cambridge University Press. Harcourt, G.C. (1995), Capitalism, Socialism and Post-Keynesianism. Selected Essays of G.C. Harcourt. Cheltenham: Edward Elgar. Harcourt, G.C. (1997), ‘Pay policy, accumulation and productivity’, Economic and Labour Relations Review, 8, 78–89, reprinted in Harcourt (2001b), 263–75. Harcourt, G.C. (2000), ‘Investment expenditure, unrealised expectations and offsetting monetary policies’, in R. Bellofiore and P. Ferri (eds), (2000) Financial Fragility and Investment in the Capitalist Economy. The Economic Legacy of Hyman Minsky, Cheltenham: Edward Elgar, 69–75, reprinted in Harcourt (2001a), 197–205. Harcourt, G.C. (2001a), 50 Years a Keynesian and Other Essays, Houndmills, Basingstoke: Palgrave. Harcourt, G.C. (2001b), Selected Essays on Economic Policy, Houndmills, Basingstoke: Palgrave.

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Geoff Harcourt 249 Harcourt, G.C. (2006), The Structure of Post-Keynesian Economics. The Core Contributions of the Pioneers. Cambridge: Cambridge University Press. Harcourt, G.G. (2007a) ‘The theoretical and political importance of the economics of Keynes: or, what would Marx and Keynes have made of the happenings of the past 30 years and more’ in Mathew Forstater, Gary Mongiovi and Steven Pressman (eds), Post-Keynesian Macroeconomics. Essays in Honour of Ingrid Rima, London and New York: Routledge, 56–69. Harcourt, G.C. (2007b), ‘Markets, madness and a Middle Way revisited’, Economic and Labour Relations Review, 17, April, 1–10, corrected version in 18, 2007, 1–10. Harcourt, G.C. and Prue Kerr (1980), ‘The mixed economy’ in Jane North and Pat Weller (eds) Labor, Sydney: Ian Novak. Harrod, R.F. (1939), ‘An essay in dynamic theory’, Economic Journal, 49, 14–35. Harrod, R.F. (1948), Towards a Dynamic Economics: Some Recent Developments of Economic Theory and their Applications to Policy, London: Macmillan. Hicks, J.R. (1954), ‘The process of imperfect competition’, Oxford Economic Papers, 6, 41–54, reprinted as ‘Stickers and Snatchers’, Ch. 12 of John Hicks (1983), Classics and Moderns, Collected Essays on Economic Theory, vol. III, Oxford: Basil Blackwell, 163–78. Kaldor, N. (1996), Causes of Growth and Stagnation in the World Economy, Cambridge: Cambridge University Press. Kalecki, M. (1943), ‘Political aspects of full employment’, Political Quarterly, 14, 322–31, C.W., vol. I, 1990, 347–56. Kalecki, M. (1968), ‘Trend and business cycles reconsidered’, Economic Journal, 78, 263–76; C.W., vol. II, 1991, 435–50. Keynes, J.M. (1923), A Tract on Monetary Reform, London: Macmillan; C.W., vol. IV, 1971. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan; C.W., vol. VII, 1973. Keynes, J.M. (1937a), ‘Alternative theories of the rate of interest’, Economic Journal, 47, 241–52; C.W., vol. XIV, 1973, 201–15. Keynes, J.M. (1937b), ‘The “ex ante” theory of the rate of interest’, Economic Journal, 47, 663–9; C.W., vol. XIV, 1973, 215–26. Keynes, J.M. (1946), ‘The balance of payments of the United States’, Economic Journal, 56, 172–87. King, J.E. (2009), Nicholas Kaldor, Houndmills, Basingstoke: Palgrave Macmillan. Lloyd, Ian (2006), ‘Summary of an Address by Lord Keynes to the Political Economy Club, Trinity College, Cambridge on the 2nd of February 1946’, Cambridge Journal of Economics, 30, 2–60. Meade, J.E. (1975), ‘The Keynesian revolution’, in Milo Keynes (ed.) (1975), Essays on John Maynard Keynes, Cambridge: Cambridge University Press, 82–8. Robinson, Joan (1964), ‘Pre-Keynesian theory after Keynes’, Australian Economic Papers, 3, 25–35. Robinson, Joan (1978), ‘Keynes and Ricardo’, Journal of Post Keynesian Economics, 1, 12–18, reprinted in C.E.P., vol. V, 1979, 210–16. Salter, W.E.G. (1960), Productivity and Technical Change, Cambridge: Cambridge University Press, 2nd ed., 1966. Salter, W.E.G. (1965), ‘Productivity growth and accumulation as historical processes’ in E.A.G. Robinson (ed.) (1965), Problems in Economic Development, London: Macmillan, 266–91.

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17 ‘Financialization’, Capital Accumulation and Productivity Growth: a Post-Keynesian Approach* Eckhard Hein 1. Introduction Philip Arestis has been a pronounced critic of orthodox theories of financial liberalization and the finance–growth nexus for a long period of time, both for empirical and theoretical reasons.1 His critique has laid the ground for the integration of these issues into the framework of PostKeynesian demand driven distribution and growth models. Focusing on the changes in the relationship between financial and non-financial sectors in developed and developing economies during the recent three decades, which have been generally labelled as ‘Financialization’,2 a variety of models has been suggested recently.3 The following channels of influence of ‘Financialization’ have been introduced into these models:4 1. Both the objectives and the constraints of firms as a whole may be affected by increasing ‘Financialization’. On the one hand, rising shareholder power subordinates management’s and workers’ preference for (long-run) growth of the firm to shareholders’ preference for (shortterm) profitability. On the other hand, increasing dividend payments, share buybacks, etc. restrict the availability of finance for firms’ real investment projects. 2. New opportunities (and longer-term risks) for households in terms of wealth-based and debt-financed consumption arise. The reasons for this are financial asset price booms associated with shareholder value orientation of firms and financial market liberalization, and new credit instruments made available to households by banks. 3. Distribution of income will be affected due to changes in power relations between shareholders, managers and workers, which will then feed back on investment and consumption. 250

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Based on the contradictory effects of ‘Financialization’ on investment and consumption and the impact on distribution, different potential macroeconomic growth regimes have been suggested in the literature. Some authors have considered the possibility of a ‘finance-led growth’ regime (Boyer, 2000), in which shareholder value orientation has an overall positive impact on the rates of capacity utilization, profit and growth. Other authors, starting with Cordonnier (2006), have argued that a regime of ‘profits without investment’ might emerge. In this regime, rising interest or dividend payments of firms to rentiers (or share buybacks) are associated with increasing rates of profit and capacity utilization, but with a falling rate of capital accumulation. Finally, some authors have shown that a ‘contractive’ regime may arise, in which higher interest and dividend payments to rentiers have a restrictive effect on the rates of capacity utilization, profit and capital accumulation (Hein, 2008, 2009; van Treeck, 2008; 2009b). As shown in Hein (2009), the financial structure of the firm sector, i.e., the debt-capital or the outside finance–capital ratio, in ‘profits without investment’ and ‘contractive’ regimes are prone to cumulative instability. In the disequilibrium process, these regimes give rise to a ‘paradox of outside finance’ reminiscent of Steindl’s (1952: 113–22) ‘paradox of debt’: falling (rising) rates of capital accumulation induce firms to attempt to reduce (raise) the outside finance–capital ratio, but the macroeconomic effects of such a behaviour is that this ratio will keep on increasing (falling) feeding back negatively (positively) on capital accumulation. In the present chapter, we do not intend to add further variants of complete stock-flow consistent models to the literature, but we rather focus on the long-run effects of ‘Financialization’ on capital accumulation and productivity growth. In particular the effect on the latter has, to the best of our knowledge, not yet been addressed in Post-Keynesian distribution and growth models dealing with ‘Financialization’ issues and increasing shareholder power. This is surprising because, on the one hand, the early orthodox proponents of shareholder value orientation had argued that increasing shareholder power would induce managers to make more efficient use of the funds at their disposal and thus reduce the inefficiencies inherent in the ‘principal–agent’ conflict of modern corporations (Jensen and Meckling, 1976). Therefore, increasing shareholder power and shareholder value orientation of management should have a positive effect on productivity growth and the economy’s growth potential. On the other hand, those who have argued that ‘Financialization’, increasing shareholder power and rising shareholder value orientation of management would cause a policy of

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‘downsize and distribute’ (Lazonick and O’Sullivan, 2000), in order to satisfy shareholders’ demand for distributed profits and high stocks and share prices, should have expected that low capital stock growth associated with such a policy would also have negative effects on productivity growth and thus on long-run potential growth of the economy. We address these potentially contradicting effects of ‘Financialization’ on capital accumulation and productivity growth in a simple Kaleckian distribution and growth model for a closed private economy with endogenously determined productivity growth. Having presented the basic model features in section 2, we will make use of the distinction between demand and productivity regime suggested by Setterfield and Cornwall (2002), and we analyse the demand regime in section 3 and then the productivity regime in section 4. In section 5 the overall regime will be derived and the effects of increasing shareholder power will be discussed. Section 6 concludes.

2. The basic model The effects of ‘Financialization’ and increasing shareholder power will be integrated into the stagnationist version of the Kaleckian model, as proposed by Rowthorn (1981) and Dutt (1984) which has a basic investment function in the spirit of Kalecki (1954) himself. An increase in shareholder power will be considered to be the exogenous variable in our model, both for the demand and the productivity regime. For the analysis of the demand regime we will take productivity growth to be an exogenous variable, which will then be endogenized in the analysis of the productivity regime. Finally, in the overall regime, the equilibrium rates of capital accumulation and productivity growth will be determined endogenously and the effects of increasing shareholder power will be derived. We assume a closed private economy. Under given conditions of production, there is just one type of commodity produced which can be used for consumption and investment purposes. There is no overheadlabour and in order to simplify the following discussion we assume that technical progress is labour saving and capital embodied. Technical progress is hence associated with a falling labour–output ratio (a L/Y) and rising labour productivity (y Y/L). The capital–labour ratio (k K/L) increases at the same rate as labour productivity does, and the capital– potential output ratio (v K/Y v) therefore remains constant. This means we assume Harrod-neutral technical progress. For the sake of simplicity we also do not consider depreciations. The rate of capacity utilization (u)

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is given by the relation between actual real output and potential real output. Pricing and distribution of income between different social groups in the model can be described by the following equations: p ⎡⎣1 m ( )⎤⎦ wa, h

1 1 , pY 1 m ( )

r

m 0,

m 0,

h 0,

Y Yv 1 hu , v pK pY Y K v

F R i R d F R, rR

R , pK

r R 0,

(1)

(2)

(3) (4) (5)

F , pK

(6)

r rF rR

(7)

rF

Writing w for the nominal wage rate, we assume that firms set prices (p) according to a mark-up (m) on unit labour costs in incompletely competitive goods market (equation (1)). Following Kalecki (1954: 17–18), the mark-up is mainly determined by the degree of price competition in the goods markets and by the relative powers of capital and labour in the labour market (). The profit share (h), i.e., the proportion of total profits () in nominal output (pY), is therefore determined by the markup (equation (2)). The profit rate (r) relates the annual flow of profits to the nominal capital stock and can be decomposed into the profit share, the rate of capacity utilization and the reciprocal of the capital–potential output ratio (equation (3)). Since long-term finance of firms’ capital stock in our model consists of firms’ accumulated retained earnings controlled by owner/managers and equity and bonds held by rentiers’ households, total profits () split into firms’ retained profits (F ), on the one hand, and dividends paid on equity held by rentiers (Rd) as well as interest paid on debt (Ri) also accruing to rentiers’ households, on the other hand (equation (4)). In order to simplify further analysis, we synthesize dividend and interest payments to rentiers and thus only have to consider retained profits vs. distributed profits (R). Dividing by the nominal capital stock, we can distinguish

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a rentiers’ profit rate (rR) (equation (5)) and a firm’s profit rate (rF) (equation (6)), which sum up to the total profit rate (equation (7)). ‘Financialization’ and rising shareholder power will be associated with increasing rentiers’ demand for distributed dividends. An increase in distributed profits will cause an increase in the rentiers’ profit rate. With a given total rate of profit, a given capital–potential output ratio, given income distribution between capital and labour, and a given rate of capacity utilization, an increase in the rentiers’ rate of profit would cause a decrease in the firms’ rate of profit (equation (7)). However, as will be seen below, as the rate of capacity utilization is an endogenous variable in our model, the total rate of profit will generally not remain constant in the face of a change in the rentiers’ rate of profit. Further on, a persistent increase in shareholder power () is likely to affect distribution between capital and labour. If ‘Financialization’ and rising shareholder power reduce the degree of competition in the goods market as a consequence of mergers and acquisition, hostile takeovers, etc., and, in particular, if the bargaining power of labour unions in the labour market decreases as a result of firms’ ‘downsize and redistribute’ strategy and (the threat of) increasing unemployment, rising dividend payments to shareholders will be associated with an increasing mark-up in firms’ pricing (equation (1)). Under these conditions, increasing shareholder power will hence be accompanied by an increasing share of total profit in income (equation (2)) and by a falling share of labour income.

3. The demand regime Saving, investment and the goods market equilibrium of the model are described by the following equations:

S R sR R r ( 1 sR )r R , pK pK

g

0 sR 1,

I u (r r R )+ y , pK

(8)

(9)

r R

, , , 0, 1, 0, 0, g ,

(10)

g h 0 ⇒ (1 ) 0, u u v

(11)

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For the determination of the goods market equilibrium we assume a classical saving hypothesis, i.e., labourers do not save. The part of profits retained is completely saved by definition. The part of profits distributed to rentiers’ households is used by those households according to their propensity to save (sR). Therefore, we get the saving rate ( ) in equation (8) which relates total saving to the nominal capital stock. The determination of the accumulation rate (g), relating net investment (I) to the capital stock, in equation (9) assumes that investment decisions are positively affected both by expected sales and by retained earnings. Expected sales are determined by the rate of capacity utilization. Retained earnings are given by the difference between total profits and distributed profits, with each variable being normalized by the capital stock. An increase in shareholder power and an associated increase in the rentiers’ profit rate have a negative impact on investment through the ‘finance channel’: firms’ internal funds for long-term investment finance are adversely affected which also limits the access to external funds in imperfect capital markets, according to Kalecki’s (1937) ‘principle of increasing risk’. But increasing shareholder power will also affect investment through the ‘preference channel’. The constant in the investment function ( ) can be interpreted as representing ‘animal spirits’ and firms’ desire for growth, as usually seen in Post-Keynesian models of growth. Based on a ‘growth–profit trade-off’ at the firm level, as implied by the Post-Keynesian theory of the firm (Lavoie, 1992: chapter 3), pronounced shareholder value orientation is likely to be associated with a high preference for short-term profitability at the expense of the propensity to invest in real capital stock (Crotty, 1990; Stockhammer, 2005–6). An increase in shareholder power and in shareholders’ desire for distributed profits together with the subordination of management under shareholders’ interests will hence be associated with reduced ‘animal spirits’. We also include technical progress, which for the time being is assumed to be exogenous, into the investment function. Since technical progress is embodied in capital stock, it will stimulate investment. Firms have to invest in new machines and equipment in order to gain from ˆ ) which is made available by new technologies. productivity growth (y The goods market equilibrium is determined by the equality of saving and investment decisions (equation (10)). The goods market stability condition requires that the saving rate responds more elastically to changes in capacity utilization than capital accumulation does (11).

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Finally, we obtain the following goods market equilibrium values for the rates of capacity utilization, profit and capital accumulation: u*

ˆ r R ( 1 sR )

y , h ( 1 ) v

h⎡ R ⎤ ⎣ + y r ( 1 sR )⎦ v r* = , h ( 1 ) v

(

)

h h ⎤ ⎡

+ y r R ⎢ ( 1 sR ) sR ⎥ v v ⎦ ⎣ . g* h ( 1 ) v

(12)

(13)

(14)

In what follows, the discussion of the effects of increasing shareholder power on the demand regime will assume stable goods market equilibria, and we will focus here on the effects on capital accumulation only.5 We have two channels of influence of rising shareholder power via firms’ investment, the ‘preference channel’ with 0 and the ‘finance channel’ with r R 0. Further on we have a potential ‘distribution channel’ with h 0. For the demand regime of our model, we obtain the following total effects of an increase in shareholder power on capital accumulation: g*

h r R v

h ⎤ h u ⎡ ⎢⎣ (1 sR ) sR v ⎥⎦ v . h (1 ) v

(15)

As can be seen from the first term in the numerator, the effect of increasing shareholder power via the ‘preference channel’ is negative. The effect via the ‘finance channel’, however, may be negative or positive, because increasing dividend payments mean a loss of internal means of finance for firms with a negative impact on investment, but they also increase rentiers’ income with a direct positive impact on consumption and an indirect one on investment. The overall effect of the ‘finance channel’ will hence depend on the rentiers’ propensity to save and on the elasticities of firms’ investment with respect to internal means of finance and to capacity utilization, as can be seen from the second term in the numerator. Finally, if rising shareholder power has a positive effect on the profit share, the ‘distribution channel’ will negatively

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affect equilibrium capital accumulation, as can be seen from the third term in the numerator. The demand regime of our model is hence unambiguously wage-led. Therefore, depending on the parameter values of our model, the effect of increasing shareholder power on equilibrium capital accumulation in the demand regime may be ‘expansive’ or ‘contractive’: g * 0,

if:

⎛ h u ⎞ h ⎜ h ⎟ v . 1 sR ⎜ ⎟ R h r ⎜ ⎟ ⎝ ⎠ v

(16)

An ‘expansive’ demand regime is obtained if the following conditions are given: a low propensity to save out of rentiers’ income, little importance of internal funds for firms’ investment decisions, a high responsiveness of investment with respect to capacity utilization, and weak relevance of the ‘preference channel’ for firms’ investment decisions relative to the ‘finance channel’, and only a weak importance of the ‘distribution channel’. A ‘contractive’ demand regime will prevail under the opposite conditions.

4. The productivity regime Within Post-Keynesian distribution and growth theory, in particular Kaldor has developed different ways to endogenize technological change. In his technical progress function (Kaldor, 1957; 1961), productivity growth is positively affected by the growth of capital stock and capital intensity, because technical progress is capital embodied. Another possibility has been proposed by Kaldor (1966) looking for an explanation of the (slow) growth in the United Kingdom. There he applies Verdoorn’s Law. According to Verdoorn (1949), the growth rate of labour productivity in industrial production is positively associated with the growth rate of output. This can be explained by static and dynamic economies of scale. Following these approaches implies that the growth rate of labour productivity is positively affected by the dynamics of output and/or capital stock. Rowthorn (1981) and Dutt (2003), for example, have chosen the latter way of integrating productivity growth into Kaleckian distribution and growth models, and we will follow their suggestion here. However, apart from capital accumulation, we will consider a second determinant of productivity growth assuming a direct effect of increasing shareholder power on productivity growth, which is reminiscent of the introduction of wage push variables into productivity equations of recent theoretical and empirical work based on the Kaleckian model,

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as in Cassetti (2003), Naastepad (2006), and Hein and Tarassow (2008). Following the arguments put forward by early proponents of shareholder value orientation (Jensen and Meckling, 1976), we assume that increasing shareholder power and the associated higher dividend payouts demanded by shareholders, weaker ability of firms to obtain new equity finance through stock issues (which tend to decrease share prices), increased threat of hostile takeovers in a liberalized market for corporate control (Manne, 1965), as well as financial market-oriented remuneration schemes (Fama, 1980), push management to make more efficient use of the resources at their disposal. This should have positive effects on labour productivity growth and potential growth of the economy, at least initially.6 However, as Jensen (2005) and Rappaport (2005) have argued recently, there may be drawbacks if shareholder value orientation goes too far, productivity enhancing investment is undermined by share buy-backs and dividend payouts, and management’s short-termism becomes an obstacle to efficiency and productivity gains – and finally to shareholder value itself. The effect of shareholder power on productivity growth may thus be non-linear. However, in our simple model, we will only consider a positive partial effect of shareholder power on productivity growth and we will come back to potential drawbacks in the conclusions. Taking into account both capital stock growth and shareholder power as determinants yields the following simple equation for labour productivity growth: y = + εg + ,

, ε, 0.

(17)

The constant in (17) can be interpreted as representing ‘learning by doing’. Different from the demand regime, a change in shareholder power has a uniquely positive effect on the productivity regime.

5. Increasing shareholder power and the overall regime In order to calculate the total effect of a change in shareholder power on the demand and productivity regimes together, we first have to determine the overall equilibrium with given shareholder power. Graphically, we obtain this equilibrium in Figure 17.1, which contains the goods market equilibrium rate of capital accumulation from equation (14) and the productivity equation (17). With given shareholder power (), we obtain a joint equilibrium in which the rate of capital accumulation (g**) and the growth rate of labour productivity (y *) are determined endogenously.7 The ‘natural rate of growth’, or potential growth, is hence endogenous in our model.

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ˆ Ω) g∗(y,

yˆ

ˆ y(g, Ω) yˆ ∗

g∗∗

g∗

Figure 17.1 Growth equilibrium with endogenous productivity growth

The existence and stability of the overall equilibrium require that the slope of the capital accumulation equation exceeds the slope of the productivity equation in Figure 17.1. From equations (14) and (17) we obtain the following condition for this:

(1 )

h h ε 0. v v

(18)

Analysing the effects of a change in shareholder power on the overall equilibrium we have to distinguish between ‘expansive’ and ‘contractive’ demand regimes. With an ‘expansive’ demand regime the effects of a change in shareholder power on capital accumulation and on productivity growth are in the same direction: Increasing shareholder power (from 1 to 2) has partially positive effects on the demand and on the productivity regime, and these partial effects then reinforce each other. Figure 17.2 shows the total effect with respect to capital accumulation (increase * * from g1** to g** 2 ) and productivity growth (increase from y1 to y 2). yˆ

ˆ Ω1) g1∗(y,

ˆ Ω2) g2∗(y, yˆ 2∗(g, Ω2)

yˆ 2∗

yˆ 1∗(g, Ω1)

yˆ 1∗

g1∗∗

g2∗∗

g∗

Figure 17.2 Increasing shareholder power and ‘expansive’ demand regime

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Macroeconomics, Finance and Money a) Expansive overall regime

ˆ Ω1) g1∗(y,

ˆ Ω2) g2∗(y,

yˆ

yˆ 2 (g, Ω2)

yˆ 2∗

yˆ 1 (g, Ω1) yˆ 1∗

g1∗∗ g2∗∗

g∗

b) Intermediate overall regime

ˆ Ω1) g1∗(y,

ˆ Ω2) g2∗(y,

yˆ

yˆ 2(g, Ω2) yˆ 2

∗

yˆ 1(g, Ω1)

yˆ 1∗

g2∗∗

g1∗∗

g∗

c) Contractive overall regime

yˆ

ˆ Ω2) g2∗(y,

ˆ Ω1) g1∗(y, yˆ 2(g, Ω2) yˆ 1(g, Ω1)

∗

yˆ 1 yˆ 2∗

g2∗∗

g1∗∗

g∗

Figure 17.3 Increasing shareholder power and ‘contractive’ demand regime

Under the conditions of a ‘contractive’ demand regime, a change in shareholder power has opposite partial effects on capital accumulation and on productivity growth. The overall results will therefore depend on the relative strength of each of these partial effects. If the contractive

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Eckhard Hein 261 Table 17.1 Overall effects of a change in shareholder power Expansive demand regime: (g*/) 0 (g**/) 0 (yˆ */) 0 Overall regime when shareholder power is increasing

expansive

Contractive demand regime: (g*/) 0 expansive

intermediate

contractive

effect on the demand regime is rather weak, and the expansive effect on the productivity regime is strong, we obtain an overall expansive regime, as shown in Figure 17.3a: capital accumulation and productivity growth increase with rising shareholder power. However, if the negative effect on the demand regime is very pronounced and the positive effect on the productivity regime is weak, we obtain an overall contractive regime, as can be seen in Figure 17.3c: the rates of capital accumulation and productivity growth decrease in the face of rising shareholder power. With intermediate partial effects on demand and productivity regimes, an overall intermediate regime is possible also: increasing shareholder power triggers lower capital accumulation but higher productivity growth, as is displayed in Figure 17.3b. Table 17.1 summarizes the potential effects of a changing shareholder power on the overall regime.

6. Summary and conclusions Focusing on the long-run effects of ‘Financialization’ and increasing shareholder power in a simple Kaleckian endogenous growth model, we have found that under special conditions increasing shareholder power may indeed have positive effects on capital accumulation and productivity growth and hence on potential growth of the economy, as implied by the claims of the early protagonists of the concept of shareholder value orientation. However, such a regime does not only require directly positive effects of increasing shareholder power on firms’ productivity via management’s use of the resources at their disposal. It also requires expansive or only weakly contractive effects of increasing shareholder power on capital accumulation via the demand regime of the economy. The former condition has recently been questioned by the protagonists of the shareholder value concept themselves (Jensen, 2005; Rappaport, 2005) and it has also been questioned on empirical grounds (Graham et al., 2005). The latter condition requires extreme assumptions

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regarding the determinants of saving and investment and it has been put into question by empirical studies on the effects of ‘Financialization’ and increasing shareholder power on investment (Orhangazi, 2008; Stockhammer, 2005–6) and on the prevailing demand regime (van Treeck, 2008; 2009a; van Treeck et al., 2007): Although being able to generate high levels of demand and profits at the macroeconomic level for considerable periods of time, building on wealth-based and credit-financed consumption demand, increasing ‘Financialization’ and shareholder power seems to cause a general weakness of capital accumulation. This does not only generate financial and real instability, as has been analysed elsewhere (Hein, 2009). Depressed capital accumulation also feeds back negatively on productivity growth and hence on longrun potential growth of the economy. Therefore, an overall ‘contractive’ regime seems to be the likely outcome of ‘Financialization’, rising shareholder power and pronounced shareholder value orientation.

Notes * For their helpful comments I would like to thank Petra Dünhaupt, Till van Treeck and Klara Zwickl. Remaining errors are mine. 1. See Arestis and Sawyer (2005) for a summary and a list of further publications. 2. According to Epstein (2005: 3) ‘[…] financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies’. See Krippner (2005), Orhangazi (2008), Palley (2008), and the contributions in Epstein (2005) for a detailed treatment of the development in the US and other countries, van Treeck (2009a) and van Treeck, /Hein and/ Duenhaupt (2007) for a comparison of the macroeconomics of ‘Financialization’ in the US and Germany, and Stockhammer (2008) for the development in Europe. 3. See for instance the earlier work by Boyer (2000), the papers with partial models on the effects of ‘Financialization’ on investment by Stockhammer (2004; 2005–6) and on consumption by Bhaduri et al. (2006) and Dutt (2006), and complete, stock-flow consistent models, with either simulations or analytical solutions, by Dallery and van Treeck (2008), Hein (2009), Lavoie (2008), Skott and Ryoo (2008a; 2008b), and van Treeck (2009b). For a review see Hein and van Treeck (2008). 4. For a brief survey on empirical and econometric evidence for these channels of influence of ‘Financialization’ see Hein (2009). 5. For a more detailed discussion including the effects on the rates of capacity utilization and profit in similar models see Hein (2008; 2009). 6. It should also have a negative impact on the capital–potential output ratio, at least temporarily. This effect will be neglected in order to keep the analysis as simple as possible.

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References Arestis, P. and Sawyer, M. (2005), Financial liberalization and the finance–growth nexus: what have we learned?, in: Arestis, P., Sawyer, M. (eds), Financial Liberalization. Beyond Orthodox Concerns, Basingstoke: Palgrave Macmillan. Bhaduri, A., Laski, K., Riese, M. (2006), A model of interaction between the virtual and the real economy, Metroeconomica, 57: 412–27. Boyer, R. (2000), Is a finance-led growth regime a viable alternative to Fordism? A preliminary analysis, Economy and Society, 29: 111–45. Cassetti, M. (2003), Bargaining power, effective demand and technical progress: A Kaleckian model of growth, Cambridge Journal of Economics, 27: 449–64. Cordonnier, L. (2006), Le profit sans l’accumulation: la recette du capitalisme dominé par la finance, Innovations. Cahiers d’Economie de l’Innovation, 23: 51–72. Crotty, J. (1990), Owner-management conflict and financial theories of investment instability: a critical assessment of Keynes, Tobin, and Minsky, Journal of Post Keynesian Economics, 12: 519–42. Dallery, T. and van Treeck, T. (2008), Conflicting claims and equilibrium adjustment processes in a stock-flow consistent macro model, IMK Working Paper, 9/2008, Duesseldorf: Macroeconomic Policy Institute (IMK) at Hans Boeckler Foundation. Dutt, A.K. (1984), Stagnation, income distribution and monopoly power, Cambridge Journal of Economics, 8: 25–40. Dutt, A.K. (2003), New growth theory, effective demand, and post-Keynesian dynamics, in: Salvadori, N. (eds), Old and New Growth Theories: An Assessment, Cheltenham: Edward Elgar. Dutt, A.K. (2006), Maturity, stagnation and consumer debt: a Steindlian approach, Metroeconomica, 57: 339–64. Epstein, G.A. (ed.) (2005), Financialization and the World Economy, Cheltenham: Edward Elgar. Fama, E.F. (1980), Agency problems and the theory of the firm, Journal of Political Economy, 88: 288–307. Graham, J., Harvey, C. and Rajgopal, S. (2005), The economic implications of corporate financial reporting, Journal of Accounting and Economics, 40: 3–73. Hein, E. (2008), Rising shareholder power: effects on distribution, capacity utilization and capital accumulation in Kaleckian/Post-Kaleckian models, in: Hein, E., Niechoj, T., Spahn, P., Truger, A. (eds), Finance-led Capitalism? Macroeconomic Effects of Changes in the Financial Sector, Marburg: Metropolis. Hein, E. (2009), A (Post-)Keynesian perspective on ‘Financialization’, IMK Studies, 1/2009, Düsseldorf: Macroeconomic Policy Institute (IMK) at Hans Boeckler Foundation. Hein, E. and Tarassow, A. (2008), Distribution, aggregate demand and productivity growth – theory and empirical results for six OECD countries based on a Post-Kaleckian model, IMK Working Paper, 18/2008, Düsseldorf: Macroeconomic Policy Institute (IMK) at Hans Boeckler Foundation.

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Hein, E. and van Treeck, T. (2008), ‘Financialization’ in Post-Keynesian models of distribution and growth – a systematic review, IMK Working Paper, 10/2008, Duesseldorf: Macroeconomic Policy Institute (IMK) at Hans Boeckler Foundation. Jensen, M. (2005), Agency costs of overvalued equity, Financial Management, 34: 5–19. Jensen, M.C. and Meckling, W.H. (1976), Theory of the firm – managerial behavior, agency costs and ownership structure, Journal of Financial Economics, 3: 305–60. Kaldor, N. (1957), A model of economic growth, Economic Journal, 67: 591–624. Kaldor, N. (1961), Capital accumulation and economic growth, in: Lutz, F.A., Hague, D.C. (eds), The Theory of Capital, London: Macmillan. Kaldor, N. (1966), Causes of the Slow Rate of Economic Growth in the United Kingdom, Cambridge: Cambridge University Press. Kalecki, M. (1937), The principle of increasing risk, Economica, 4: 440–7. Kalecki, M. (1954), Theory of Economic Dynamics, London: George Allen and Unwin. Krippner, G.R. (2005), The financialization of the American economy, SocioEconomic Review, 3: 173–208. Lavoie, M. (1992), Foundations of Post Keynesian Economic Analysis, Aldershot: Edward Elgar. Lavoie, M. (2008), Financialization issues in a Post-Keynesian stock-flow consistent model, Intervention. European Journal of Economics and Economic Policies, 5: 331–56. Lazonick, W. and O’Sullivan, M. (2000), Maximizing shareholder value: a new ideology for corporate governance, Economy and Society, 29: 13–35. Manne, H.G. (1965), Mergers and the market for corporate-control, Journal of Political Economy, 73: 110–20. Naastepad, C.W.M. (2006), Technology, demand and distribution: a cumulative growth model with an application to the Dutch productivity growth slowdown, Cambridge Journal of Economics, 30: 403–34. Orhangazi, Ö. (2008), Financialization and capital accumulation in the nonfinancial corporate sector: A theoretical and empirical investigation on the US economy: 1973–2003, Cambridge Journal of Economics, 32: 863–86. Palley, T. (2008), Financialization: What it is and why it matters, in: Hein, E., Niechoj, T., Spahn, P., Truger, A. (eds), Finance-led Capitalism? Macroeconomic Effects of Changes in the Financial Sector, Marburg: Metropolis. Rappaport, A. (2005), The economics of short-term performance obsession, Financial Analysts Journal, 61(3), 65–79. Rowthorn, R. (1981), Demand, real wages and economic growth, Thames Papers in Political Economy, Autumn. Setterfield, M. and Cornwall, J. (2002), A neo-Kaldorian perspective on the rise and the decline of the Golden Age, in: Setterfield, M. (ed.), The Economics of Demand-led Growth. Challenging the Supply-side Vision of the Long Run, Cheltenham: Edward Elgar. Skott, P. and Ryoo, S. (2008a), Macroeconomic implications of financialization, Cambridge Journal of Economics, 32: 827–62. Skott. P. and Ryoo, S. (2008b), Financialization in Kaleckian economics with and without labor constraints, Intervention. European Journal of Economics and Economic Policies, 5: 357–86.

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Eckhard Hein 265 Steindl, J. (1952), Maturity and Stagnation in American Capitalism, 2nd edition, 1976, New York, London: Monthly Review Press. Stockhammer, E. (2004), Financialization and the slowdown of accumulation, Cambridge Journal of Economics, 28: 719–41. Stockhammer, E. (2005–6), Shareholder value orientation and the investmentprofit puzzle, Journal of Post Keynesian Economics, 28: 193–215. Stockhammer, E. (2008), Some stylized facts on the finance-dominated accumulation regime, Competition and Change, 12: 189–207. Van Treeck, Hein, E. and Duenhaupt, P. (2007), Finanzsystem und wirtschaftliche Entwicklung: neuere Tendenzen in den USA und in Deutschland, IMK Studies, 5/2007, Duesseldorf: Macroeconomic Policy Institute (IMK) at Hans Boeckler Foundation. Van Treeck, T. (2008), Reconsidering the investment-profit nexus in finance-led economies: an ARDL-based approach, Metroeconomica, 59: 371–404. Van Treeck, T. (2009a), The political economy debate on ‘Financialization’ – a macroeconomic perspective, Review of International Political Economy, forthcoming. Van Treeck, T. (2009b), A synthetic stock-flow consistent macroeconomic model of Financialization , Cambridge Journal of Economics, forthcoming. Verdoorn, P.J. (1949), Factors that determine the growth of labour productivity, in: McCombie, J., Pugno, M., Soro, B. (eds), Productivity Growth and Economic Performance. Essays on Verdoorn’s Law, 2002, Basingstoke: Palgrave Macmillan.

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Part 4 Financial Markets and Governance in Developing Economies

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18 Instantiating Neo-Liberal Reform via Economic Theory and Small Group Agreements Ilene Grabel

1. Introduction Much work in finance, money and macroeconomics is dominated by neo-classical theoretical models and by empirical tests that are built on assumptions that yield formal tractability but that do little to illuminate the complexities of the economy. This work also tells us little about the political economy effects of the phenomena under consideration. Philip Arestis’s prodigious and multi-faceted oeuvre stands as a welcome departure from work in this sterile tradition. He has contributed enormously to the development of a counter-hegemonic body of research in macroeconomics, finance, development, and heterodox economic policy. These contributions have been brought about both through his own published research and through his generous efforts to bring heterodox economists into dialogue with one another and with the mainstream of the profession via the numerous projects, journals and conferences he has organized over an extraordinarily dynamic career. Philip Arestis’s work (often in collaboration with colleagues and friends, most frequently with Malcolm Sawyer) has strands too numerous to delineate here. The facets of his work that have proven most germane to this volume span the following five areas. First, he has written widely on the relationship between financial structure, financial policy, speculative behavior and macroeconomic performance in the developing country context (Arestis, 2008, Arestis and Glickman, 2002). In this realm, he has contributed importantly to our theoretical and empirical understanding of the consequences of financial liberalization (Arestis, 2007). Second, he has examined the macroeconomic and political effects of central bank structure and inflation targeting by independent central banks in developing and developed countries (Arestis and Angeriz, 2006; 269

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Arestis, 1997). Third, he has critically examined the political economy of the European Central Bank and the European Monetary Union with particular emphasis on the distributional and recessionary biases built into this institutional structure (Arestis and Sawyer, 2006). Fourth, he has written widely on the political economy of neo-liberal economic theory and policy (Arestis, 2004). Fifth and finally, he has been a central player in the development of post-Keynesian macroeconomics that stands as a persuasive and well-articulated challenge to neo-classical thought (Arestis, 1996). This work has positioned post-Keynesianism at this critical historical juncture as a paradigm that provides a persuasive narrative about the roots of and pathways out of the current global economic malaise. This chapter very much reflects the influence of these various strands of research. I examine here the critical linkages between certain aspects of neo-classical macroeconomic theory, central bank structure, and policy in the developing world. I argue that together they play an important role in instantiating neo-liberal reform in the developing world, a reform agenda about which Philip Arestis has written widely and critically. Specifically, in this chapter I examine recent and continuing intellectual and policy initiatives that have been advanced by the economics profession and by policy-makers to lock in neo-liberal reform in developing countries by restricting severely the policy autonomy or policy space that is available to these countries. The profession has been wildly successful in achieving this objective. This is because, in part, the profession has advanced a two-pronged front in pursuit of neo-liberalism. The first operates on the level of ideology, and involves the recent theoretical advances that purport to show that neo-liberal reform is the only viable avenue forward for developing countries. In this context I will examine the rise of the theory of ‘policy credibility’ during the 1980s and 1990s, and its more recent incarnation in the more aggressive form of the concept of ‘policy coherence.’ The second front operates on the level of institutional reform, and involves new means by which neo-liberalism can not only be achieved but also secured against reversal in the (likely) case of opposition from those who suffer its harms, and even the rise to power of parties and leaders who seek alternative development paths. And in this context, I will examine several institutional means by which neo-liberalism is being cemented. These include creation of independent central banks and inflation targeting regimes that remove from elected governments the opportunity to use financial flows and policy in the service of developmental and social goals, and small-group trade and investment agreements

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(of which the North American Free Trade Agreement (NAFTA) is an exemplar) that not only augment the power of international investors but also mobilize this power to punish governments that waiver from the neo-liberal path. Obviously, there are other institutional means by which neo-liberalism is being cemented in developing countries, such as creditrating agencies and standards and codes (and the surveillance thereof). For reasons of space, we will not discuss these latter two channels. I will contend that the institutional reforms discussed in this chapter draw their power not from a demonstrated record of developmental success, but from the intellectual developments surveyed in section 2. The net result of these two fronts is a substantial and dangerous loss of developmental policy space, which entails not only a higher likelihood of failure, but also a much greater degree of risk for those in developing countries that are least able to survive it. This loss of policy space increases the challenges faced by those seeking to create new opportunities for economic policies that promote stable, sustainable and vibrant economic growth in the developing world.

2. Theoretical constraints on policy space: From policy credibility to policy coherence The preoccupation of neo-classical development economists with the idea of policy credibility emerged on the heels of two developments – one empirical and one theoretical. On the empirical level, the failure of the ambitious neo-liberal economic reconstruction of South America in the late 1970s and early 1980s prompted an anxious search for explanations. By the mid-1980s, a consensus had emerged among new-classical development economists that despite the inherent correctness of the neoliberal prescription for South America, the reform agenda nevertheless failed to achieve its intended results because its architects had not taken into account the overall ‘policy environment’ in which these programs were implemented. 2.1 Credibility theory: Paving the way for neo-liberalism by protecting the economy from the state On the theoretical level, the current preoccupation with policy credibility stems directly from the precepts of new classical economic theory. The seminal work of Kydland and Prescott (1977) was particularly important to the development of the theory of policy credibility. In this approach, rational agents use the uniquely correct economic model and take into account all available information when forming expectations

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about the future. Among other things, agents must assess the credibility of an announced policy when forming expectations and making judgments about what actions to take. Unfortunately, however, assessing policy credibility is no simple matter. At issue are the perceptions of economic actors concerning the viability and effectiveness of announced policies, policy-makers’ commitment to sustain them and, hence, the likelihood of policy reversal or collapse. In light of the recognition of the importance of policy credibility, economists now faced a challenging question: How could economic policy be developed in this complex environment, in which the success of policy depends critically on agents’ perceptions of its viability? Two choices presented themselves: one could shade policy toward existing popular sentiments; or one could implement ‘correct’ policy, policy that respects the fundamentals of new-classical economic theory. The former option is ruled out of court on the simple grounds that ‘incorrect’ policy (no matter how popular) could not possibly retain credibility in the wake of the disruptions that would inevitably attend it. In the context of open capital markets, for instance, incorrect policy would precipitate capital flight. In contrast, correct policy (no matter how unpopular) would induce credibility over time as it proved itself uniquely capable of promoting development and growth. A correctly specified policy would therefore impel rational agents to act ‘properly,’ at once attracting international private capital inflows, achieving growth and stability, and inducing the credibility necessary to sustain the policy regime. In particular, the new classical theory of policy credibility has come to cement the intellectual case for the desirability and indeed inevitability of economic reconstruction along neo-liberal lines. The concept of policy credibility is central to the broader tasks of elevating the market as the principal means of directing economic affairs, and the effort to place severe constraints on state manipulation of economic policy toward what are seen as particularist aims. In doing so, credibility theory has helped create an intellectual climate wherein (contra the lessons of history) the state is cast as the chief obstacle to development and neo-liberal reform represents the sole means to secure these objectives. The movement to insulate the market and the policy-making process from politics has had many powerful practical consequences in the developing world, among the most important of which is in the realm of central bank reform, as we will see below in section 3. For now, it will suffice to say that the effort to ‘depoliticize’ monetary policy is reflected in the creation of independent central banks (many of which utilize inflation targeting) that are beyond the reach of state representatives.1

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2.2 Coherence: Locking in the case for neo-liberalism These ideas about policy credibility have been carried forward and indeed amplified into the new concept of policy coherence. I argue that the concept of coherence today is code for another and altogether different goal, policy conformance. Policy coherence is commonly used to refer to the need to harmonize the liberal policies of the IMF, World Bank (WB) and World Trade Organization (WTO). On its face, the idea that policies of the world’s three most important multilateral institutions should be coherent with one another is unobjectionable. After all, the inverse strategy of ‘inconsistent,’ ‘incoherent’ policy seems simply absurd (as would the case for in-credible policies). But, in practice, coherence has come to mean something very particular, that is, IMF–WB support for the WTO’s efforts to promote trade liberalization in the developing world. The intuition behind the concept of policy coherence is simple: any individual economic policy – such as free trade – will only yield beneficial outcomes if it is nested in a broader policy environment conducive (that is, consistent or coherent) with its objectives. From this perspective, the justification for expanding the scope of trade reform and agreements to new areas over the last decade is that previous efforts to liberalize trade have failed to promote growth because of inconsistencies between trade and other economic and social policies. It is by now a commonplace that the IMF–WB have aggressively promoted trade liberalization for a quarter century. What is less well known is that these institutions intensified their promotion of an expansive view of trade liberalization by formalizing a policy of cooperation with the General Agreement on Tariffs and Trade in 1993 and with the WTO via a series of agreements on ‘Policy Coherence’ beginning in 1994. This goal of policy coherence was embodied in the 1994 agreement that established the WTO. These original coherence commitments have been reaffirmed and extended in different fora since the issue was first discussed. For example, at the 1999 Seattle WTO ministerial meeting, the WTO, WB and IMF issued a ‘Joint Declaration on Coherence,’ a statement that reflected a shared belief that trade liberalization was essential to the promotion of global growth and stability (BWP, 2001). In the hands of the IMF–WB–WTO, it is hardly surprising that coherence has come to mean the need for the simultaneous pursuit of complementary policies that further the neo-liberal agenda, and which therefore preclude the use of development strategies that involve the state in important ways. Today, the drive toward policy coherence has been entirely subsumed under this agenda.

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One of the most visible manifestations of this drive has been the emphasis on trade liberalization and integration of developing countries into the WTO as critical components of WB–IMF work over the last decade. Indeed, UNCTAD notes that ‘the principle vehicle for trade liberalization are conditions attached to IMF–WB loans’ (UNCTAD, 1999: 87 in Rowden, 2001). Recent empirical studies trace the diverse channels by which IMF–WB work has promoted trade liberalization in the developing world and provided support to the WTO. For instance, a 1997 review of IMF programs by the non-governmental organization Oxfam finds that half of these programs targeted quantifiable reduction of trade restrictions as part of loan conditionality (Oxfam in Caliari, 2002: fn.3). A study by Rowden (2001: 11) shows that between 1997 and 2001, 36 countries agreed to bring their trade regimes in line with WTO accession requirements or committed to accelerate the implementation of WTO rules in official IMF documents. Rowden (2001) reports that between 1995 and 1999, 65% of all WB adjustment operations have supported trade policy and exchange rate reforms (IBRD in Rowden, 2001). The same study also describes the case of Azerbaijan where, in 1997, conformity with WTO rules was an actual condition of IMF lending. Khan (2007) demonstrates that the IMF has actually extended the reach of the WTO by demanding of developing countries a degree of trade liberalization that far exceeds the level promoted by the WTO. Many factors explain IMF–WB decisions to promote trade liberalization and to cooperate with the WTO. Free trade ideology and the power of the US, the WTO and the interest groups that benefit from liberal trade reform must figure prominently in any account of WB–IMF trade advocacy. However, we must also consider that an intellectual foundation for the Bank’s trade advocacy is provided by its own research that argues for the central role of trade in the promotion of growth and the reduction of poverty. Though it is outside the scope of this chapter, it warrants mention here that a large body of research calls into question the neo-liberal case for trade liberalization (especially of the ‘one-sizefits all’ variety) in the developing world (Rodrik, 2007).

3. Institutional constraints on policy space: Independent central banks and small group trade and investment agreements The neo-liberal agenda has not only been instantiated in the developing world through ideational means. A variety of complementary institutional constraints also cemented this regime. These institutional

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constraints restrict the ability of developing country governments to pursue financial policies that support development. They also prevent them from taking steps to respond to financial instability, while increasing the cost of policy experimentation through the establishment of mechanisms that internally and externally ‘lock-in’ neo-liberal policies. In what follows, I consider two examples of these institutional constraints. 3.1 Credibility theory and central bank independence The theory of policy credibility has proven to be influential in the design and operation of the institutions that govern monetary policy in developing economies. From the perspective of new classical economic theory, the logic of extending the theory of policy credibility to the design of financial policy-making institutions is rather straightforward: To be credible, financial policy must be insulated from the vagaries of the political process, where shortsighted political goals often predominate. In the absence of this insulation, financial policy can be manipulated instrumentally by governments seeking to garner political support. Aware of this possibility, the (rational) public will know that announced financial policies ‘may lack credibility because they are economically inconsistent or politically unsustainable’ (Schmieding, 1992: 45–6). Problems of financial policy credibility may also arise if policy-makers have a history of reneging strategically on established policies in order to achieve a short-term political or economic objective. This is the problem of ‘time inconsistency’ (Kydland and Prescott, 1977). In this context, rational economic actors are likely to expect policy reversals, and will act accordingly (such as by hedging against reversal). At best, the policy will therefore fail to induce the intended results; at worst, it will be sabotaged. The case for independent central banks in new classical economic theory follows rather directly. Central bank independence is seen to impart a degree of credibility to monetary policy that cannot be achieved when policy is developed by elected politicians. This credibility stems from the political insulation of the institution. Armed with respect for the precepts of new-classical economic theory, and protected by institutional barriers from political contamination, the non-partisan technocrats who staff independent central banks are able to pursue credible (and time consistent) monetary policy in pursuit of an antiinflationary course for the national economy. A vast empirical literature seeks to substantiate the theoretical claims for the anti-inflationary performance of independent central banks.

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Initial studies focused on central banks in wealthy countries; these tended to confirm the hypothesis. But this is simply not the case for developing economies. Indeed, Grabel (2003) argues that the purported economic benefits of independent central banks are not borne out by a substantial body of empirical evidence; that there are economic and social costs to the inflation obsession that drives these institutions; and that their justification derives from ideology that masquerades as economic theory and from the exercise of political power by the financial community. Despite the ambiguous empirical basis for the case for central bank independence in developing economies, independence is nevertheless taken as a necessary (though not sufficient) step for achieving monetary policy credibility. Where central banks are new institutions (as in the former communist countries) or where the public has little confidence in these institutions, it may also be necessary to import central bank credibility by adopting the actual operating guidelines of credible Western central banks or even by importing central bank staff directly. Credibility can also be created via externally imposed constraints on central bank operations. Such constraints are often embodied in IMF structural adjustment programs that tie financial and/or technical assistance to the central bank’s adherence to certain operating practices, such as the refusal to finance government debt (Schmieding, 1992). The replacement of discretionary with rule-based monetary policy may also enhance central bank credibility. Increasingly, these rules are taking the form of quantitative inflation targets, about which there exists a gathering international consensus among new-classical and other mainstream economists. The IMF is also increasingly pressuring the (independent) central banks of developing countries to adopt inflation targeting as part of their stabilization and/or technical assistance packages (Epstein and Yeldan, 2008). As of 2006, 18 developing countries were committed to some form of inflation targeting (Epstein and Yeldan, 2008) despite econometric results that indicate that there is no justification (in regards to economic growth benefits) for inflation targeting as it is currently being practiced throughout low- and middle-income countries (with targets set in a 3–5% band) (Pollin and Zhu, 2006).2 The maintenance of central bank independence and inflation targeting means that central bank operations cannot support multiple economic and social goals, as they have in so many countries throughout their history. Historically, central banks have played critically important developmental roles. Their operations have promoted growth,

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employment creation, poverty reduction, investment, and financial stability. Central bank operations have also supported programs of industrial policy, credit allocation to economically or socially important sectors, and export promotion through the maintenance of a competitive exchange rate and a variety of capital management techniques. (See Epstein, 2006 for a discussion of the historically important role of central banks as agents of development; Epstein et al. (2004) for a discussion of the role of central banks in supporting capital management techniques; and Epstein and Grabel, 2006 for a discussion of pro-poor central banking.)

3.2 Policy coherence through small group agreements that lock-in neo-liberalism Although the language of policy coherence does not appear as regularly in bi- or multi-lateral trade negotiations and agreements, a parallel movement is afoot in this domain to construct what is taken to be a coherent package of policies in developing countries. Most notably, we find here an embedding of complementary financial and investment policies nested into what are, ostensibly, bi- and multi-lateral trade agreements. This is particularly true of the trade agreements signed between the USA and individual or small groups of developing countries. In this context, what is most important about these agreements is the range of matters that they engage. In 1994 NAFTA broke new ground insofar as it was as much – if not more – of an investment than it was a traditional trade agreement. It includes the controversial Chapter 11 provision that grants unprecedented rights to foreign investors vis-à-vis the state. Under Chapter 11, foreign investors have the right to seek damages for a range of governmental actions or policies that they can claim – even preemptively – are ‘tantamount to expropriation.’ These claims of loss (even potential loss) are adjudicated in unaccountable external arbitration bodies, such as the International Center for the Settlement of Investment Disputes (ICSID). NAFTA also de-legitimizes the right of governments to grant favored treatment to national investors, firms or banks. The US has used NAFTA, especially its Chapter 11 provision, as a prototype for the large number of bi- and multi-lateral trade and/or investment agreements that it has been negotiating with developing countries over the last 15 years. Indeed, some recent agreements, such as the US–Chile and the US–Singapore trade agreements, go much further in granting foreign investors the right to sue governments for losses

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associated with even the temporary imposition of capital controls during financial crises (Anderson, 2009). The Central American–Dominican Free Trade agreement also includes these provisions on capital controls, as does the pending US–Colombia free trade agreement, along with 52 bilateral trade or investment agreements that the US has signed (Anderson, 2009). These and other recent trade and investment agreements increase the cost of departing from neo-liberal policies by placing governments under the threat of lawsuits by foreign investors. The latter can bring legal action whenever certain state policies – those that target particular development, industrialization, social or environmental goals or that protect an economy temporarily from financial instability – have interfered with their right to earn profits. Anderson (2009) rightly identifies these strictures in trade and investment agreements as ‘policy handcuffs.’ The justification for expanding the scope of trade agreements to these new areas is that previous efforts to liberalize trade have failed to promote growth because of inconsistencies between trade and other financial and social policies. What all of these agreements have in common is that they reinforce – and in many cases, actually go much further than the IMF–WB–WTO commitments to promote free trade and capital flows. As with IMF–WB–WTO policy, these agreements also redefine the appropriate role of the state, constrain state policy autonomy and promote homogeneous policies across developing countries. Thus, the US bi- and multi-lateral agreements support the drive toward what the WB–IMF–WTO views as coherence, but which we can more adequately describe as enforced conformance to the neo-liberal model.

4. Conclusions The concept of policy coherence has been invoked exclusively to legitimize ambitious and comprehensive liberalization schemes. This points to perhaps the greatest concern about the abuse of the concept of coherence. The emphasis on policy coherence by the WB–IMF–WTO constrains the national policy space available to developing countries, creates a ‘locking in’ of neo-liberal policies, and validates neo-liberal arguments about the limited (and perverse) role of the state in the development process. It is becoming far more difficult to pursue diverse types of national policies and for policy-makers to engage in any type of policy experimentation because of the interlocking power of the IMF–WB–WTO and because of the formidable dispute settlement mechanisms in bi- and multi-lateral trade and investment agreements that threaten severe sanctions for any

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departures from the neo-liberal regime. The concept of coherence is used to validate the common, dangerous and incorrect view that neo-liberal policies represent the only viable path to development for all countries. Like credibility theory, then, it serves to close off consideration of any and all other paths to development. At present, there is a pressing need to separate the new emphasis on policy coherence from conformance with neo-liberal policies. This is necessary in order to protect developing countries’ right to development and their right to policy experimentation. That policy coherence (and hence, success) must entail liberalization has been contradicted by historical and cross-country experience. Chang and Grabel (2004) and Rodrik (2007) (among others) demonstrate that there exist multiple paths to development, and that economic growth that is robust, sustainable and stable can be achieved via an array of heterogeneous strategies. While any one country’s policies must exhibit a degree of internal coherence in order to succeed, the evidence is clear that the alternative policy regimes need not cohere around liberalization. Coherence can mean many different things. It can mean that economic policies within and across nations are consistent with development goals, as the OECD (2003) has suggested in its discussion of ‘policy coherence for development.’ Coherence may alternatively involve consideration of the dynamic consistency between a nation’s economic policies and its history, institutional structure, capacities, and prior policy choices. This implies that each country will have to discover its own set of available development schemes – schemes that are coherent in light of its own unique path. It may well be that the current global financial crisis and the significant shifts in national power that will likely follow this crisis create space for the kinds of policy diversity and policy experimentation that Philip Arestis and other critics of policy conformance have long advocated. As of this writing, the IMF is being pressed by member countries to increase the representation and voice of countries such as China that have long rejected the idea that enforcing conformance to neoliberal policy is a legitimate goal of the Fund. Moreover, the momentum behind the movement to enforce neo-liberal conformance may have been dealt a fatal blow by the failures of this regime in its home, especially because one consequence of the crisis may be a diminution in US hubris about economic policy. Finally, we may take heart from the fact that some developing countries (such as Bolivia, Ecuador, Venezuela and Argentina) are pushing back against the constraints on policy space associated with bilateral trade and investment agreements and ICSID.

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While such sentiments in the developing world are not new, the current conjuncture may weaken the case for neo-liberalism to the point that they finally can be heard. This takes us back to the work of Philip Arestis, whose many contributions to our profession have created intellectual space for heterodox theoretical and empirical research on finance, macroeconomics and policy that is critically important to understanding the economic challenges of our time.

Notes 1. However, these institutional reforms fail on their own terms. Stated plainly, the effort to depoliticize financial policy via the creation of independent central banks is ineluctably political (Grabel, 2003). 2. Angeriz and Arestis (2006) find that the adoption of inflation targeting by central banks has not resulted in lowering inflation rates. In a wide-ranging review of international experiences with inflation targeting, Roger and Stone (2005) find that inflation targets are missed 40% of the time.

References Anderson, S. (2009) Policy Handcuffs in the Financial Crisis. Institute for Policy Studies. Arestis, P. (1996) ‘Post-Keynesian Economics: Towards Coherence’, Cambridge Journal of Economics, 20(1). Arestis, P. (2007) ‘Financial Liberalization and the Relationship between Finance and Growth’, in P. Arestis and M.C. Sawyer (eds), A Handbook of Alternative Monetary Economics, Edward Elgar Publishing. Arestis, P. (2008) ‘Financial Structure and Economic Growth’ (with K.L. Luintel, M. Khan and K. Theodoridis), Journal of Development Economics, 86(1). Arestis, P. and A. Angeriz (2006) ‘Has Inflation Targeting Had Any Impact on Inflation?’, Journal of Post Keynesian Economics, 28(4). Arestis, P. and M. Glickman (2002) ‘Financial Crisis in South East Asia: Dispelling Illusion the Minskyan Way’, Cambridge Journal of Economics, 26(2), pp. 237–60. Arestis, P. and M. Sawyer (1997) ‘The Problematic Nature of Independent Central Banks’, in A.J. Cohen, H. Hagemann and J. Smithin (eds), Money, Financial Institutions and Macroeconomics, Kluwer Academic Publishers. Arestis, P. and M. Sawyer (2004) Neo-Liberal Economic Policy: Critical Essays, Edward Elgar Publishing. Arestis, P. and M. Sawyer (2006) ‘What Type of European Monetary Union?’, in P. Whyman, M. Baimbridge and B. Birkitt (eds), Implications of the Euro: A Critical Perspective From the Left, Routledge. Bretton Woods Project (BWP) (2001) More WTO–WB–IMF cooperation on trade, Bretton Woods Update, No. 25, October/November, p. 3. Caliari, A. (2002) Coherence between trade and financial policies: Summary of current issues, Center of Concern. Washington, DC, September. www.coc.org. Chang, H.-J. and I. Grabel (2004) Reclaiming development: An alternative economic policy manual. London: Zed Books.

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Ilene Grabel 281 Epstein, G. (2006) ‘Central banks as agents of economic development.’ WIDER working paper, no 2006–54. Epstein, G. and I. Grabel (2006) Financial Policies for Pro-Poor Growth, UNDP, International Poverty Centre, Global Training Programme on Economic Policies for Growth, Employment and Poverty Reduction. Epstein, G. and E. Yeldan (2008) ‘Inflation Targeting, Employment Creation and Economic Development: Assessing the Impacts and Policy Alternatives’, International Review of Applied Economics, 22(2), pp. 131–45. Epstein, G., I. Grabel, and K.S. Jomo (2004) ‘Capital management techniques in developing countries: An assessment of experiences from the 1990s and lessons for the future.’ G24 Discussion Paper No.27, NY and Geneva. Grabel, I. (2003) Ideology, power and the rise of independent monetary institutions in emerging economies. In Monetary orders: Ambiguous economics, ubiquitous politics. Ithaca: Cornell University Press, pp. 25–52. Khan, S.R. (2007) ‘WTO, IMF and the closing of development policy space for low-income countries: A call for new-developmentalism,’ Third World Quarterly, 28(6), pp. 1073–90. Kydland, F. and E. Prescott (1977) ‘Rules Rather than Discretion: The Inconsistency of Optimal Plans,’ Journal of Political Economy 85(3), 473–91. OECD (2003) Policy coherence: Vital for global development. OECD Observer: Policy Brief. Pollin, R. and A. Zhu (2006) ‘Inflation and economic growth: A cross-country nonlinear analysis.’ Journal of Post Keynesian Economics, 28(4), pp. 593–614. Rodrik, D. (2007) One Economics Many Recipes, Princeton: Princeton University Press. Roger, S. and M. Stone (2005) On target? The international experience with achieving inflation targets. IMF working paper WP/05/163. Washington DC: IMF. Rowden, R. (2001) IMF–WB–WTO synthesis report. Working Paper, RESULTS Educational Fund, Washington, DC, October. Schmieding, H. (1992) Lending Stability to Europe’s Emerging Market Economies. Tubingen, Germany: J.C.B. Mohr. UNCTAD (1999) Trade and Development Report 1999. Geneva and NY: UNCTAD.

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19 Financial Liberalization, Growth and Financial Crisis Marisol Esteban, Jesús Ferreiro and Felipe Serrano

1. Introduction One of the most relevant contributions made by Philip Arestis to the economics literature is his study on the relationship between finance and growth. The extent of his work and the limited size of this chapter makes possible only to mention a small sample of his contributions. Philip Arestis has helped to recognize the existence of a deep relationship between finance and development and growth and to understand the channels through which the financial market affects economic activity (Arestis and Demetriades, 1997; Arestis, Demetriades and Luintel, 2001). But he has also contributed, and today perhaps this is what makes, if possible, Philip’s work even more attractive, to the explanation of the inherent risks arising from untrammelled domestic and international financial liberalization. What makes Philip Arestis different from most authors on these topics is that his Post Keynesian background gives him the needed tools to explain the inherent problems of financial markets, their inefficient working due to the existence of uncertainty, and, consequently, their potential negative consequences in the form of financial crises and the influence that a right institutional framework has on its working (Arestis et al., 2005; Arestis and Stein, 2005). Actually, the current crisis is a good example of the lessons to be drawn from Philip Arestis’s work. The Economic Report of the President 2009 sets the origin of the current crisis in the following terms: The roots of the current global financial crisis began in the late 1990s. A rapid increase in saving by developing countries (sometimes called the ‘global saving glut’) resulted in a large influx of capital to 282

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the United States and other industrialized countries, driving down the return on safe assets. The relatively low yield on safe assets likely encouraged investors to look for higher yields from riskier assets, whose yields also went down. (US Government, 2009, p. 61) It is paradoxical that this Report puts the origin of the crisis in some financial flows that are in contradiction with the main conclusions that the neoclassical theory had argued to justify the positive impacts of capital markets liberalization. For neoclassical theory, capital account liberalization generates a more efficient international resources allocation, with capital flowing from developed (capital abundant) to developing countries, capital scarce and with higher profitability. These capital inflows would complement the domestic savings in these countries, allowing a higher capital stock and GDP per capita. Recent experience, however, shows that capital flows in an opposite direction to that prescribed by neoclassical theory. The high surpluses in the balance of payments of emerging markets (in the form of a rise in foreign reserves) have flowed to the financial markets of developed economies, mainly to the US economy. However, the foreseen crisis resulting in the imbalance in the US balance of payments and the mass withdrawal of those capitals invested by emerging economies has not happened. The current financial, in the first stage, and real, in the later stage, crises have been created by the incapacity of the American financial system to recycle the mass liquidity it was receiving. If in the 1990s, in the East Asian and the Russian crises, the weakness of the financial institutions of the emerging markets was blamed as the main reason of the crisis, now it is the weakness of the assumed most efficient financial system which is blamed as the responsible for the crisis. It is obvious that the US financial market has structural weaknesses, but one can wonder if the relationship between financial crises and the capital account liberalization have other components different to those related to the institutional quality of the economies that concentrate most international capital flows. Financial globalization is not generating the expected outcomes. The empirical research carried out during the years of trade and financial liberalization has shown the reasons of this failure. In the next sections we will show the state of the art of these two key elements of the international economics, the relationship between liberalization and economic growth, and between liberalization and financial crises. First, we will show the main conclusions reached by the empirical research about

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the relationship between capital account liberalization and economic growth argued by the neoclassical economics. Institutional variables, and not the size of capital inflows, are presented as the cornerstone of economic growth. This opens the door to the possibility of using foreign capital inflows to accelerate economic growth. This will be the focus of the second section. Next, we briefly analyse the relationship between financial crises and capital account liberalization. Finally, we show the main conclusions of these researches. These conclusions lead us to reject the neoclassical argument according to which markets, with a minimum external control, generate efficient resources allocations.

2. Financial flows and economic growth: The empirical evidence According to the neoclassical theory, the capital account liberalization (regardless of its composition) in a country i leads to a movement in its interest rates to bring them into equality with the international interest rates. A fall in the interest rates leads to higher investment, thus leading to a permanent change in the stationary state. However, the model does not include a channel through which liberalization can affect the rate of growth of total factor productivity (TFP), a variable that is the main determinant of long-run economic growth in neoclassical theory. Henry, basing his argument on the lack of this channel, argues that the empirical studies that have tried to test the consequences of neoclassical theory are not valid, because these researches have focused on the impact of financial liberalization on long-term growth, while this is not the prediction of neoclassical theory: ‘What the neoclassical model does predict is that liberalizing the capital account of a capital-poor country will temporarily increase the growth rate of its GDP per capita’ (Henry, 2007, p. 888, emphasis in original). Henry’s argument is right in that what the theory does not predict cannot be contradicted. However, it does not make invalid the conclusions reached in empirical studies that have analysed the relationships between long-term economic growth and the capital markets liberalization. Even if we accept that these researches are not useful to accept or reject the conclusions of neoclassical theory, they provide relevant information that cannot be ignored. Empirical studies (for a survey, see Obstfeld, 2009 and Kose et al., 2006) do not allow a single answer to be given to the question of the impact of financial liberalization of economic growth in the long-run, although most empirical evidence shows the lack of a clear relationship.

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Empirical evidence shows that the effects depend on the level of development of the economies included in the sample analysed. While for some authors developing countries would benefit more from the removal of capital controls (Edison et al., 2002), for others only developed countries benefit from financial liberalization (Klein and Olivei, 2000; DeLong, 2004; Dell’Ariccia et al., 2005). In the case of developing economies, some studies pose the existence of differences among them depending on the relative degree of development: emerging countries would benefit from capital account liberalization but the less developed economies would be damaged (Edwards, 2001; Chinn and Ito, 2002). For other authors, the conclusion is even more mixed: only intermediate countries would benefit from capital account liberalization, and neither the less developed countries nor the most advanced economies would benefit from that process (Edison et al., 2002; Klein, 2005). Moreover, a number of studies argue that the consequences of financial liberalization in developing and emerging countries are contingent on the region where they are located: Thus, while East Asian countries would have benefited from capital account liberalization, in Latin American economies domestic and external financial liberalization would have generated the assumed growth effect (Asiedu and Lien, 2004; Bekaert et al., 2005; Edison et al., 2002; Ferreiro et al., 2008–09; International Monetary Fund, 2002; Stiglitz, 2004). Papers based on the neoclassical economics, i.e., those trying to show the existence of a one-off effect, focus on the estimation of the liberalization of equity markets in the rate of growth. However, the positive outcomes vary in intensity depending on the quality of institutions in the analysed countries: ‘Countries with better legal systems, good institutions, favorable conditions for foreign investment, and investor protection generate larger growth effects’ (Bekaert et al., 2005, p. 41). The relevance of the institutional variable in empirical analyses about the relationship between economic growth and liberalization of capital markets is also evident in the analyses about the impact of capital inflows in developing countries on total factor productivity. Kose et al., (2006, 2008) name these effects as ‘indirect collateral benefits’. These effects would complement the traditional effects described by neoclassical economics. ‘These indirect collateral benefits could include development of the domestic financial sector, improvements in institutions (defined broadly to include governance, the rule of law, etc.), better macroeconomic policies etc., all of which could result in higher growth through gains in allocative efficiency’ (Kose et al., 2008, p. 1). The outcomes reached by these authors are quite obvious, mainly if we compare them

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with the proposed notion of collateral benefits. The positive relationship argued between capital flows and a higher TFP is limited to certain capital flows, that is, FDI and equity inflows, with debt inflows having the opposite effect. They also find that the negative effect of stocks of external debt liabilities on TFP is partially attenuated in economics with betterdeveloped financial markets and better institutional quality. At best, these authors show that there exists a microeconomic dimension that allows the generation of positive effects. However, it is more complicated to show how these micro-effects are translated to the whole economy in the form of a sustained higher economic growth in the long-term.1 In any case, the outcomes reached by these neoclassical studies reinforce the conclusions obtained in other papers that had stressed the analytical relevance of the institutional quality of the host countries, and those that stressed the need to make a distinction among the different kinds of capital flows. The distinction among FDI, equity and debt flows and bank flows is relevant to grasp the impact of capital account liberalization of economic growth, on the stability of growth and of the relationship between liberalization and financial crisis (Federici and Caprioli, 2009; Fernandez-Arias and Hausmann, 2000; Lipsey, 2001; Williamson, 2005).

3.

Institutional quality, capital flows and economic growth

Modern economic growth theories give special attention to the role of institutions in the process of economic growth (Acemoglu and Robinson, 2001; Acemoglu, 2009; Rodrik, 2007). To a large extent, this is the result of the poor performance of economic growth of developing countries induced by the recent experiences of trade and financial liberalization. This performance would be related to the failure of these countries to create ‘an environment that supports productive activities and encourages capital accumulation, skill acquisition, invention and technology transfer’ (Hall and Jones, 1999, p. 84). This incapacity to create a high-quality institutional environment would help to explain also the ‘Lucas paradox’2: ‘protection of property rights, reducing corruption, increasing government stability, bureaucratic quality and law and order should be at the top of the list of policy makers seeking to increase capital inflows to poor countries’ (Alfaro et al., 2005, p. 21). The relevance of the institutional environment involves that the timing of the financial liberalization processes is also a key determinant of their economic impact (Arestis and Sawyer, 2005; Eichengreen, 2001; Eichengreen and Leblang, 2003; Eichengreen and Voth, 2003; Forbes, 2004; Mishkin, 2001; Prasad et al., 2003, 2004; Prasad and Rajan, 2008;

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Tressel and Detragiache, 2008; Wyplosz, 2001). Capital account liberalization should be the final step in the more general liberalization processes, once product markets have been liberalized, the domestic financial and banking system has been successfully transformed and, in general, when the macroeconomic and institutional reforms needed to reap the benefits of the capital account liberalization have been implemented. From a theoretical perspective, to recognize the relevance of the institutional dimension in the development process of developing countries involves changing the relation causality defended by neoclassical authors. Economic growth is not the automatic result of capital account liberalization. On the contrary, financial liberalization can only be effective once certain institutional shortcomings are resolved. Even authors defending the existence of collateral benefits of financial liberalization accept that these benefits are only possible if countries open to international capital flows have previously reached some institutional thresholds, mainly in their domestic financial systems (Mishkin, 2007; Kose et al., 2006). Although empirical studies conclude that institutional quality is a driver of long-term economic performance, it is impossible to establish a strong causal link between any particular design of institutions and economic growth. Therefore, there does not exist a unique institutional design valid for any economy at any time. The efficient institutions depend on local constraints and opportunities (Rodrik, 2007). As the theories show, the impact of finance liberalization on growth does not depend on the financial structure arising from the liberalization process but on its capacity to generate a right legal system and better functioning banks and markets. Consequently, there is not one universally optimal financial structure (Demirguc-Kunt and Levine, 2001). The ‘optimal’ financial structure will be contingent, depending on the particular economic features prevailing in a country at a specific time (Luintel et al., 2008). Therefore, policy-makers should adopt a pragmatic strategy (Prasad and Rajan, 2008) to liberalize both domestic and external financial markets, deciding the timing, the speed and the scope of financial liberalization, but always under the constraint that any strategy of financial liberalization will succeed if it comes with the design of a proper institutional environment.3

4. Composition of capital flows, economic growth and financial stability One criticism of the financial liberalization process of the 1980s is that it has been responsible for the recurrent financial crises that have

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happened since that date: the Latin American debt crisis, the Mexican crisis in the 1990s, and the later crises of Russia and East Asian countries. The current crisis, despite its USA origin, is quite similar to past episodes, mainly because it has its origin in an inefficient design and working of the financial system. Therefore, it is reasonable to link it with the financial globalization process. The relationship between financial crises and capital flows liberalization is not a direct cause and effect relationship. The link between both phenomena is through the role played by domestic financial systems, mainly the banking system of host countries. If these systems are weak, that is, if they lack a sufficient degree of developments and supervision, the reason for the crisis would be in the working of bank system rather than in the capital account liberalization. However, the recent financial crisis has originated in the US whose financial system is seemingly that of the highest quality.4 Although the quality of financial institutions is a key element in understanding financial crises, it is not the only reason. The composition of financial flows and the management by the central banks of that liquidity are variables that cannot be ignored. Regarding the composition of financial flows, financial stability seems to be linked with the timing and the nature of these flows. In this sense, it is necessary to distinguish between equity and debt flows and between short term and long term. Equity forms of investment serve to transfer risk to suppliers of funds and away from the users of funds. Debt has to be serviced irrespective of the returns earned on the investment financed by borrowing. Borrowers reliant on long-term debt to finance long-term projects are less vulnerable to interest rate and refinancing risks. A decline in the market value of long-term debt paper will be borne by the lender. The foreign direct investment is a ‘good’ capital flow because it represents equity rather than debt, is long-term rather short-term, and is associated with increased domestic capital formation (BIS, 2009). The more stable inflows, besides having a positive impact on economic growth, at least from a micro perspective, are a source of low financial instability. On the opposite side, we would find the crossborder banking credits. If we analyse the composition of capital inflows in developing countries since the beginning of the financial liberalization process, one can see, except in the last phase (2000–2007), an excessive share of short-term capital flows, mainly of short-term bank loans (BIS, 2009). These flows are the more volatile ones, and, therefore, those that can provoke a higher financial instability. The combination of this kind of

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capital inflow and a poorly developed banking system with supervision deficits is at the origin of all financial crises, including the current one. In the financial crisis of East Asian economies (Furman and Stiglitz, 1998), domestic banks borrow on a shot-term basis in international banking markets while lending long-term loans in their countries, thereby creating a liability mismatch. Domestic banks can hold these sheet positions provided that they can always refinance their initial credits. If this is not possible, because of a loss of confidence of international capital markets or because of domestic or external shocks, the banking crisis is unavoidable. The global liquidity excess has recently generated behaviour in the American commercial and investment banks similar to that registered in the East Asian financial crisis. American banks borrowed short-term in international markets to lend long-term, thereby creating a liability mismatch: the fall in housing prices leading to the collapse in the value of mortgage-related assets, thus leading to non-renewal of short-term credits. Those institutions (financial) were vulnerable … because they were highly levered and, in particular, were highly dependent on shortterm funding. In other words, those institutions had borrowed extensively against their long-term assets, and a large part of their debt was short-term, so that their existing debt needed to be paid off and replaced with new short-term debt with some frequency. (US Government, 2009, p. 61) One positive consequence of the financial crisis of the late 1990s was the strengthening of the financial systems of developing countries and a renewed interest in fostering safer behaviours in credit-giving by international banks. In the emerging markets economies the domestic financial systems became more resilient: long-term local currency debt markets developed, equity markets deepened, derivatives markets developed and domestic financial firms became stronger (BIS, 2009). The recent crisis appears at a moment when, seemingly, there were stronger national financial systems, both in developed and emerging countries that should be better prepared to avoid new episodes of financial crises. The question we must ask is: what has failed? The answer given is similar to that during the East Asian countries in the late 1990s: regulation has failed; that is, the problems of asymmetric information were not solved. The notion that financial markets can work efficiently with

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the right supervision that removes the adverse selection and moral hazard is still dominating most of the analysis about the reasons for the current crisis (Blanchard, 2009). Recurrent financial crises should lead us to argue that capital markets are not efficient in the neoclassical sense because of the problems of information they suffer. As Keynes argued, the existence of uncertainty makes it impossible that they can be efficient. If the future value of assets cannot be estimated with precision we cannot make an efficient allocation of resources. When we link financial crises and weakness of domestic financial systems, the relevant information problem is the asymmetric distribution of information rather than uncertainty. A solid financial system, with the right banking supervision, can help to solve the problems of adverse selection and moral hazard, but cannot avoid the existence of financial cycles. An alternative analysis to the theory of efficient financial markets involves considering these markets as liquidity providers (Davidson, 2006). This view does not mean that supervision is not needed to avoid problems of asymmetric information. What we want to stress is that the key role of the regulator is to manage the liquidity volume, guaranteeing a stable price in the long-term. The current financial crisis, like the past financial crisis in East Asia, has taken place in some capital markets with high liquidity.5 The liberalization of financial flows has not come with the setting of mechanisms to regulate international liquidity, thus leading to increasingly speculative decisions: ‘Market liquidity can turn sharply during episodes of stress, highlighting the importance of managing this source of risk in the financial system’ (Bank of England, 2007, p. 18, emphasis added).

5. Conclusions Recent empirical research shows that the outcomes from capital markets liberalization expected by neo-classical theory have not happened. Economic growth in developing countries depend more on institutional variables than on foreign capital inflows. The lack of mechanisms to regulate the world liquidity increases the probability of suffering financial crises. In sum, the current model of financial globalization is not working. Therefore, what is needed is to start the change to a new model not based on the notion of neoclassical efficiency. As Philip Arestis’s work has shown us, financial markets are a key determinant of growth and development. However, this does not involve these markets being fully liberalized. Only under proper institutional

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design, involving a more intense and efficient public intervention (in terms of regulation and supervision), can financial markets fulfil the objective of encouraging growth and development.

Notes 1. This reasoning is very similar to the notion of ‘industrializing industries’ that inspired some planning experiences in the 1960s in some Asian and African countries. The objective was to develop some basic industries with a high potential to generate spillovers, thus giving rise to a generalized process of industrialization and development along the whole country. For Kose et al., firms participated by foreign capital would be the modern version of state-owned industrializing companies. A similar criticism can be made of researches focusing on the equity markets liberalization. The impact on the economic growth estimated by these papers could be overestimating the impact of the liberalization, since we do not know the channels through which a small set of firms (the foreign-owned companies) can generate spillovers to the whole economy. 2. Lucas (1990) posed this paradox by showing that, according to the conclusions of neoclassical theory, capitals should flow from developed to developing economies with an intensity higher than that existing in the real world. 3. Despite the above mentioned, we should avoid an institutional dogmatism similar to that generated by the capital markets liberalization (Rodrik, 2006). Institutions are needed, but poverty is not solved with only good institutions. Geographical constraints faced by some African and Latin American countries, with natural problems in building communication infrastructures, and, thus, enlarge their markets, involve huge investments that can only happen with higher income transfers from developed countries. 4. ‘Foreign investors may choose to purchase U.S. portfolio investments in order to benefit from the highly developed, liquid, and efficient U.S. financial markets, from the strong corporate governance and institutions in the United States’ (Forbes, 2008, p. 32). 5. Bank of England (2007) elaborates a synthetic index of the evolution of international liquidity since early 1990s. The index shows that the previous financial crisis came with a rise of international liquidity, although this rise was lower than that registered before the current crisis: in 2007 the value of the index was 0.8, almost double that of 1997.

References Acemoglu, D. and Robinson, J.A. (2001), ‘A theory of political transitions’, American Economic Review, 91(4), September, 938–63. Acemoglu, D. (2009), Introduction to Modern Economic Growth, Princeton: Princeton University Press. Alfaro, L., Kalemli-Ozcan, S. and Volosovych, V. (2005), ‘Why doesn’t capital flow from rich to poor countries? An empirical investigation’, National Bureau of Economic Research Working Paper, no. 11901.

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Arestis, P. and Demetriades, P.O. (1997), ‘Financial development and economic growth: assessing the evidence’, Economic Journal, 107(442), 783–99. Arestis, P., Demetriades, P.O. and Luintel, K. (2001), ‘Financial Development and Economic Growth: The Role of Stock Markets’, Journal of Money, Credit and Banking, 33(1) (February), pp. 16–41. Arestis, P. and Sawyer, M. (2005), ‘Financial liberalization and the finance–growth nexus: what have we learned?’, in Arestis, P. and Sawyer, M. (eds) Financial Liberalization. Beyond Orthodox Concerns, Basingstoke: Palgrave Macmillan, pp. 1–42. Arestis, P. and Stein, H. (2005), ‘An Institutional Perspective to Finance and Development as an Alternative to Financial Liberalisation’, International Review of Applied Economics, 19(4), pp. 381–98. Arestis, P., Nissanke, M. and Stein, H. (2005), ‘Finance and Development: Institutional and Policy Alternatives to Financial Liberalisation Theory’, Eastern Economic Journal, 31(2) (Spring), pp. 245–63. Asiedu, E. and Lien, D. (2004), ‘Capital controls and foreign direct investment’, World Development, 32(3), 479–90. Bank of England (2007), Financial Stability Report, April. Bank of International Settlements (2009), ‘Capital flows and emerging market economies’, CGFS Papers, No. 33. Bekaert, G., Harvey, C.R. and Lundblad, C. (2005), ‘Does financial liberalization spur growth?’, Journal of Financial Economics, 77(1), 3–55. Blanchard, O. (2009), ‘The crisis: basic mechanisms, and appropriate policies’, IMF Working Paper, WP/09/80. Chinn, M.D. and Ito, H. (2002), ‘Capital account liberalization, institutions and financial development: cross-country evidence’, National Bureau of Economic Research Working Paper, no. 8967. Davidson, P. (2006), ‘Mercados financieros e incertidumbre en el mundo real’, in Esteban, M. and Serrano, F. (eds) La Política Económica en Tiempos de Incertidumbre, pp. 71–95, La Coruña: Netbiblo. Dell’Ariccia, G., Detragiache, E. and Rajan, R. (2005), ‘The real effect of banking crises’, IMF Working Paper, WP/05/63. DeLong, J.B. (2004), ‘Should we support untrammeled international capital mobility? Or are capital controls less evil than we once believed?’, Economists’ Voice, 1(1), article 1, available at http://www.bepress.com/ev/vol1/iss1/art1. Demirguc-Kunt, A. and Levine, R. (2001), Financial Structures and Economic Growth: A Cross-Country Comparison of Banks, Markets and Development, Cambridge, MA: MIT Press. Edison, H.J., Klein, M., Ricci, L. and Sløk, T. (2002), ‘Capital account liberalization and economic performance: survey and synthesis’, International Monetary Fund Working Paper, WP/02/120. Edwards, S. (2001), ‘Capital mobility and economic performance: are emerging economies different?’, National Bureau of Economic Research Working Paper, no. 8076. Eichengreen, B. (2001), ‘Capital account liberalization: what do cross-country studies tell us?’, The World Bank Economic Review, 15 (3), 341–65. Eichengreen, B. and Leblang, D. (2003), ‘Capital account liberalization and growth: was Mr. Mahathir right?’, International Journal of Finance and Economics, 8(3), 205–24.

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Eichengreen, B. and Voth, H.J. (2003), ‘Symposium on capital controls’, International Journal of Finance and Economics, 8(3), 185–287. Federici, D. and Caprioli, F. (2009), ‘Financial development and growth: an empirical analysis’, Economic Modelling, 26, 285–94. Fernandez-Arias, E. and Hausmann, R. (2000), ‘Is FDI a safer form of financing?’, Inter-American Development Bank Working Paper, 416. Ferreiro, J., Correa, E. and Gómez, C. (2008–9), ‘Has capital account liberalization in Latin American countries led to higher and more stable capital inflows?’, International Journal of Political Economy, 37(4), 31–63. Forbes, K.J. (2004), ‘Capital controls: mud in the wheels of market discipline’, National Bureau of Economic Research Working Paper, no. 10284. Forbes, K.J. (2008), ‘Why do foreigners invest in the United States’, National Bureau of Economic Research Working Paper, no. 13908. Furman, J. and Stiglitz, J.E. (1998), ‘Economic crises: evidence and insight from East Asia’, Brooking Papers on Economic Activity, 2, 1–114. Hall, R.E. and Jones, C.I. (1999), ‘Why do some countries produce so much more output per worker than others?’, Quarterly Journal of Economics, 114(1), pp. 83–116. Henry, P.B. (2007), ‘Capital Account Liberalization: Theory, Evidence, and Speculation’ Journal of Economic Literature, 45 (December): 887–935. International Monetary Fund (2002), World Economic Outlook. Washington, DC: International Monetary Fund (April). Klein, M.W. (2005), ‘Capital account liberalization, institutional quality and economic growth: theory and evidence’, National Bureau of Economic Research Working Paper, no. 11112. Klein, M.W. and Olivei, G. (2000), ‘Capital account liberalization, financial depth and economic growth’, Boston: Fletcher School of Law and Diplomacy, Tufts University, unpublished. Kose, M.A., Prasad, E.S. and Terrones, M.E. (2008), ‘Does openness to international financial flows raise productivity growth?’, NBER Working Paper Series, 14558. Kose, M.A., Prasad, E., Rogoff, K. and Wei, S.J. (2006), ‘Financial globalization: a reappraisal’, IMF Working Paper, WP/06/189. Lipsey, R.E. (2001), ‘Foreign direct investors in three financial crises’, NBER Working Paper Series, 8084. Lucas, R.E. (1990), ‘Why doesn’t capital flow from rich to poor countries?’, American Economic Review, 80, 92–6. Luintel, K.B., Khan, M., Arestis, P. and Theodoridis, K. (2008), ‘Financial structure and economic growth’, Journal of Development Economics, 86, 181–200. Mishkin, F.S. (2001), ‘Financial policies and the prevention of financial crises in emerging market economies’, World Bank Policy Research Working Paper, no. 2683. Mishkin, F.E. (2007), ‘Is financial liberalization beneficial?’, Journal of Money, Credit and Banking, 39 (2–3), March–April, pp. 259–94. Obstfeld, M. (2009), ‘International finance and growth in developing countries: what have we learned?’, NBER Working Paper Series, 14691. Prasad, E.S. and Rajan, R.G. (2008), ‘A pragmatic approach to capital account liberalization’, Journal of Economic Perspectives, 22(3), 149–72. Prasad, E.S., K. Rogoff, S.-J. Wei and M.A. Kose (2003), ‘Effects of financial globalization on developing countries: some empirical evidence’, International Monetary Fund Occasional Paper, no. 220.

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Prasad, E.S., K. Rogoff, S.-J. Wei and M.A. Kose (2004), ‘Financial globalization, growth and volatility in developing countries’, National Bureau of Economic Research Working Paper, no. 10942. Rodrik, D. (2006), ‘Goodbye Washington Consensus, hello Washington confusion? A review of the World Bank’s Economic Growth in the 1990s: Learning from a Decade of Reform’, Journal of Economic Literature, 43, December, 973–87. Rodrik, D. (2007), One Economics Many Recipes. Globalization, Institutions and Economic Growth, Princeton: Princeton University Press. Stiglitz, J.E. (2004), ‘Capital-market liberalization, globalization and the IMF’ Oxford Review of Economic Policy, 20(1), 57–71. Tressel, T. and Detragiache, E. (2008), ‘Do financial sector reforms lead to financial development? Evidence from a new dataset’ IMF Working Paper, WP/08/265. US Government (2009), Economic Report of the President, Washington, DC: US Government Printing Office. Williamson, J. (2005), Curbing the Boom–Bust Cycle: Stabilizing Capital Flows to Emerging Markets. Policy Analyses in International Economics 75, Washington: Institute for International Economics. Wyplosz, C. (2004), ‘How risky is financial liberalization in the developing countries?’, G-24 Discussion Paper Series, UNCTAD, Center for International Development, Harvard University

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20 Institutions and Finance in Developing Countries: Challenges to Orthodoxy Howard Stein

Introduction The influence of theory on policy reached its apotheosis over the past few decades when power and money backed a series of misconceived ideas about how financial systems best operate and in turn how they must be transformed to reach a hypothetical world arising from a false set of deductive principles. The result of these exercises has led to a series of unintended consequences including frequent and costly financial crises and disintermediation with a growing disconnect between the world of finance and more productive sectors of the economy. While neo-classical writers have often searched for extraneous explanations for these crises (not enough financial liberalization, wrong order of liberalization, political influence, etc.), post-Keynesian and institutional economists understand the problem as fundamentally theoretical and therefore entirely predictable. They have ventured forwarded an alternative body of theory and with it a different set of guiding principles to ensure the finance serves the rest of the economy rather than the perverse inversion we have witnessed with terrible consequences in recent years. Philip Arestis has been one of the most prolific contributors to a body of theory that has predicted the fallout from these ill-conceived exercises in financial liberalization, provided incisive empirical and theoretical insights into our understanding of these failures and provided well-grounded alternatives for transforming financial systems to support economic activities that generate investment, employment and poverty reduction. Drawing partly on Philip’s work and experiences from Africa and Asia, this essay will explore theoretical and policy issues in finance and development. 295

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Orthodox position In the orthodox world of finance of McKinnon (1973, 1993) and Shaw(1973), the low savings and investment that is characteristic of developing economies is assumed to be the result of government intervention in the financial sector. The theory argues that investment and savings have been repressed by a combination of controlled and negative interest rates, insufficient competition, high reserve requirements, and government allocation of credit. Pursuing economic development therefore means that countries need to deregulate interest rates, privatize, and liberalize bank licensing in order to increase competition, lower reserve requirements, and dismantle any credit allocation schemes. The rise in interest rates increases the incentive to save and the level of financial savings. Higher interest rates should also weed out less productive investment, thereby leading to an increase in the quality of investment. Discerning private bankers, without the constraints of credit controls, will allocate funds to the most productive users. Increased competition will lower the spread between savings and loan rates, thereby increasing the efficiency of the financial system. Overall, higher savings ensue, which generate more investment, thereby stimulating economic growth, which in turn augments savings – thus creating a virtuous circle. The key is to ensure that interest rates are market-determined and that banks are privately owned and operated so that bankers can make decisions without political constraints. A sufficient number of bank licenses must be made available to enhance competition while avoiding too much deposit insurance and its associated problems of moral hazard (encouraging risky behavior) and adverse selection (leading to too many poorly run banks).

Critique There are a number of problems with the theory. Among other things, the theory of financial liberalization relies on the textbook world of pure competition. Although the notion of competitive goods markets in the non-financial world is sufficiently suspect, the divergence between the world of finance and that of McKinnon–Shaw is even more profound. As the imperfect market theorists have argued, finance is even more replete with the asymmetries of risk and information than are goods. Stiglitz (1989, 1994), for example, lists a plethora of ‘imperfections’ in financial markets that transcend the better-known

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issues of moral hazard and adverse selection. First, finance is replete with externalities which affect deposits, lending, and monitoring. One or two bad banks can make it difficult for better banks to attract depositors or capital. Second, there tends to be a large divergence between the social and private costs of bank failures. Third, on the benefit side, there is likely to be a divergence between the social value of lending and the private benefits. For example, projects with longer turnover, higher working capital, and greater risk (such as manufacturing with higher social value) are likely to be underfinanced compared to projects with short turnover, lower working capital, and lower risk (such as financing speculative imports). Fourth, information on the solvency of institutions is a public good, and is therefore likely to be undersupplied due to free riding. Fifth, financial markets generally will not be Pareto efficient. Prices in standard theory measure the marginal benefit of a commodity to a buyer and the marginal cost to the seller. However, in finance, those who are willing to pay the most for a loan may not be those who are expected to provide the greatest return to the lender. When interest rates are too high, the expected return may actually decline, since the probability of default increases. More recent contributions by the imperfect market school, have argued that competition can actually erode bank value, reduce incentives for prudential behavior, and increase systemic risk substantially (Hellman et al., 2000). Stiglitz (1989, 1994) recognizes that unfettered financial markets of the type suggested by orthodox financial liberalization are incapable of providing correct signals. Moderate state intervention, such as the subsidization of interest rates to worthy projects, can produce more socially desirable outcomes. The problem is that given the poorly developed nature of financial markets in developing countries, even adjusted signaling may not produce the desired results and may lead to unintended consequences. For instance, in countries such as Nigeria, where regulation has been weak, norms such as trust are poorly developed, and military regimes have used liberalization to hand bank licenses to individuals with personal contacts in the army. In this context, subsidizing interest rates alone would do little to alter the chaos created by the 1986 liberalization of the financial system (Lewis and Stein, 2002).

Financial liberalization in practice The period of the 1980s saw a rapid increase in financial liberalization policies, with enormous consequences for banking stability. Between 1981 and 1992, there were at least 15 major financial crises, which

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cost countries’ treasuries between 5% and 40% of the Gross Domestic Product (GDP) to rescue the banking system (Honohan and Klingebiel, 2000; Caprio and Klingebiel, 1999: see also Laeven and Valencia, 2009 for comprehensive list of banking and financial crises since 1970 and estimates of their costs).1 How did McKinnon respond to the crises that invariably followed his recommended policies? He argued that the key is not in the content, but in the sequence of policies. How fiscal, monetary, and foreign exchange policies are sequenced is of critical importance. Government cannot, and perhaps should not, undertake all liberalizing measures simultaneously. Instead, there is an ‘optimal’ order of economic liberalization, which may vary for different liberalizing economies depending on their initial conditions. (McKinnon, 1993, p. 4) This optimal order would begin with getting inflation under control, followed by interest rate deregulation, privatization, commercialization of banks, unification of foreign exchange rates from multi-tiered regimes, the liberalization of international trade, and, only finally, liberalizing restrictions on capital flows. The McKinnon argument on the order of financial reform has influenced a growing literature analyzing these crises, including many World Bank writers.2 Caprio et al. (1994), for example, review financial reforms in a number of developing countries. They emphasize the importance of carefully managing the sequence of reform. Macrostability and adequate bank supervision are important prerequisites. Earlier literature had also raised the issue of the pace of reform, with a gradual process preferred over rapid financial liberalization (Cho and Khatkhate, 1989; McKinnon, 1988). However, arguments that financial crises can be avoided with proper sequencing or the correct pace have been increasingly challenged. More recent literature has examined experiences in a variety of countries and indicated that variations in the sequence have not altered the outcome. In places such as Chile and Uruguay, where opposite sequences were used, the results were the same: banking crises followed financial liberalization. Irrespective of the order of sequencing, there was a marked increase in the intensity and frequency of financial crises in the 1980s and 1990s arising from financial liberalization (Grabel, 1995; DemirgucKunt and Detragiache, 1998; Arestis and Demetriades, 1999). More generally, Arestis et al. (2003) survey the literature and undertake their own empirical investigation, and find no evidence that

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varying the sequence of financial liberalization, along the lines of McKinnon’s (1993) ‘optimal’ order, has any effect on the results. Even some World Bank econometric studies have revealed the same relationship. Demirguc-Kunt and Detragiache (1999) test a series of factors to explain financial crises and find them to be highly correlated with financial liberalization policies, even when controlling for McKinnontype sequencing. Weller (2001), surveys 26 developing countries around the world to try to explain the relationship between financial liberalization and crisis, again with many variations in the sequencing of policies.3 He tests a number of hypotheses based on the work of Minsky (1984). In Minsky’s view, internal and external deregulation creates financial fragility by encouraging loans to speculative enterprises. Asset inflation raises the borrower collateral and associated euphoria. Speculation becomes self-fulfilling, as the increase of flows into speculative activities in turn perpetuates the speculative boom. Short-term capital inflows following capital account liberalization can raise the exchange rates, leading to deterioration in the current account, with implications for the growth of certain sectors, such as manufacturing. This effect is worsened by the shift away from financing investment and toward lending for speculation. Eventually the asset bubble bursts, defaults rise, and maturity risk increases, as short-term capital outflows rise with the banks’ deteriorating balance sheet. Ultimately, the economy is left with higher interest rates, a contraction of credit, a rise in import prices, and depleted domestic demand. Weller (2001) tests these hypotheses, and of particular interest in Weller’s findings is the duration of the impact of financial liberalization. It has been frequently argued that financial liberalization could create some dislocation in the short term, but that it would have a positive impact in the long term. Contrary to these expectations, Weller finds that the likelihood of a banking crisis actually increases over time. Arestis and Glickman (2002) reach similar conclusions in the case of the Southeast Asian crisis. The concept of optimal sequencing can be challenged for other reasons. Financial liberalization is not simply an economic issue, it also carries profound political implications. Any shift in existing financial arrangements generates new winners and new losers, which has significant consequences in the political realm. Underhill (1997) sees three possible changes in financial systems. The first is ‘desegmentation,’ whereby various branches of finance are unified into a single branch. The second is ‘marketization,’ which focuses on liberalization

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of domestic financial market, and the third is ‘transnationalization,’ which integrates financial markets across national boundaries. The actual product of transforming the system will vary according to the relative strength of the constituent members of the financial community. Key players include central bankers and regulators, national and multinational banks, members of international financial institutions, and private players involved in privatization. There is no guarantee of any economic improvement in the final outcome, and there is a considerable downside risk. To suggest that there is some optimal sequence that will ensure a positive outcome seems simply implausible. Indeed, financial transformation in the image of McKinnon-Shaw has engendered widespread banking crises precisely because of such weak theoretical foundations, which – as has been demonstrated – cannot be rescued by altering the sequence or the pace of liberalization. Empirical results have also left the theory in question. Ndung’u (1997) surveys nine English-speaking African countries introducing orthodox financial liberalization and finds declining investment, few examples of a rise of savings, reduced efficiency of intermediation as measured by the rising spread between deposit and lending rates and falling GDP growth rates. Other authors have documented rising interest rate spreads in places like Venezuela (Vera, 2002). The chaos caused by financial liberalization led to growing inefficiency of intermediation. There is also little evidence of the direction of causality between savings and growth assumed in McKinnon–Shaw. Sahoo et al., (2001) examine the case of India in the 1970s and show that higher levels of savings did not lead to higher levels of growth. Later periods of growth seemed to occur without an appreciable rise in savings. To examine this more systematically, they apply causality testing of real savings and real GDP data from 1950 to 1999. They manage to establish a strong oneway linkage from growth to savings and thereby refute the proposition that savings was the engine of growth in the case of India. The World Bank (1993) found the causation from growth to savings in five countries (Indonesia, Japan, Korea, Thailand and Taiwan), ambiguity in two (Hong Kong and Malaysia) and in one it was due to other factors (in Singapore, the state provident fund was salient). In addition, the elasticity of the savings relationship is either insignificant or when significant, it is rather small. Surveys of the literature indicate little or no evidence of a positive relationship between interest rates and savings (Dornbusch and Reynoso, 1993). Various econometric studies from Asia, Latin America and Africa also confirm the lack of correspondence

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between interest and savings (for example, Fry, 1988, Giovannini, 1985De Melo and Tybout, 1986; Warman and Thirwall, 1994; Oshikoya, 1992). The overwhelming evidence has even encouraged McKinnon (1993) to abandon the higher interest to prior savings argument in favor of a rise in the ‘quality’ of investment after liberalization.

Banks and post-Keynesian theory Arestis (1992) following post-Keynesian and institutional traditions emphasizes the importance of understanding that the ‘institutions of money and banking are inextricably related.’ Money is endogenous and foremost a product of credit-creation: Money necessarily comes into existence at the same time as debt. In a dynamic monetary production economy credit is generated to facilitate production and other activities such as purchase of durables. Thus ‘credit granting’ institutions, especially the banking ones are of paramount importance and therefore the way they operate must be carefully analyzed. (p. 180) In contrast, financial reform in the image of McKinnon–Shaw has been largely a-institutional. In the McKinnon–Shaw world, there are three types of actors in two markets (deposit and lending) brought into balance through interest rates changes. Privatization and competition will reduce the cost of intermediation (difference in interest rates in the rates between the markets). Financial liberalization is aimed at removing government-imposed barriers to atomistic self-seeking, individuals so they can make unfettered Pareto-efficient decisions. Finance is simply the sum of all these actors making individual utility-, profit-, and investmentmaximizing decisions. Governments need only generate sufficient money supply to accommodate economic activity to avoid seigniorage and inflation. In a world seen through the lens of post-Keynesian theory, the nature of the institutions demanding and supplying credit are salient to the process of accumulation, employment generation and growth that is developmentally enhancing. Government policy should be aimed at generating homology between the financial and productive sectors of the economy. In contrast, as Arestis and Glickman (2002) argue, one of the reasons that financial liberalization has led to so many crises is precisely because it breaks down the rules and conventions that previously

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governed relationships between banks and customers, fuels speculation in assets and foreign exchange and speeds up the financial fragility leading to Minsky type meltdowns.

Models of bank systems One can use seven categories to classify banking systems to help understand the merit of each approach and to get a sense of how financial systems have transformed over time. These include state monobanking, state commercial banking, private group banks, main banks, universal banks, arm’s length banks and laissez faire banking. The main attributes of the different bank systems are summarized in Table 20.1. The state mono-banking system dominated the Soviet Bloc countries up to 1989. Credit plays a rather passive role and follows the priorities set down by the central planning agencies. Since the credit follows rather than leads, it is often referred to a ‘soft budgeting system’. Monitoring functions are limited or non-existent. Interest charges, which are seldom applied, are of little consequence and have no influence on savings and investment. In addition to the Soviet Bloc, countries like China also had a mono-banking system. However the contrast between the Chinese experience with reforming their banking systems and the Russian approach could not be more dramatic. In Russia, following a McKinnon–Shaw inspired process of change, the number of banks went from 4 in 1989 to 2600 in 1996 (Stein et al., 2002). By 1998, the state’s share of banking fell to 30% (Vermikov, 2007). Most of the new banks (which were set up by oligarchs) were not involved in lending to productive sectors like industry but in shortterm loans to finance commodities trade, foreign exchange speculation, Mafia business, exportation of resources and the importation of luxury goods, and the asset-seizing operations of domestic tycoons. Long-term lending, the backbone of industrial expansion, was merely 1.3 per cent of total lending. Governments supported the operations of these elites by paying lucrative above the competitive interest rates on the loans from the banks to cover deficits. Arguably there was little interest in developing industries which could compete with the import trade of the oligarchs (Rosefielde, 2002). The manufacturing contribution to GDP declined from 35.5% in 1992 to only 16.7% in 2003. In addition, the manufacturing portion of exports fell from 26% in 1995 to a mere 16% in 2006 (UNCTAD, 2009). The Russian system had moved toward an almost laissez faire system with poor regulatory authority and banks able to undertake lending

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Table 20.1 Bank models Bank system Relationship to Ownership securities market and control of banks

State influence Monitoring of Governance Degree of Country on credit corporations of corporations interest examples allocation by banks by banks rate control

State mono bank

no markets

state

extremely high little or none

none

State commercial banks

weak or nonexistent markets

mostly state

high

little

little or none

private

little or none

little

little or none

mixed; autonomous management; hands on regulation private and hands off regulation

significant directly ⫹ indirectly

strong ex ante; strong interim; and ex post

none

private and hands off regulation private

none

strong ex ante; strong but interim; and ex some sharing post with stake holders limited none

Private group high equity holdbanks ings of related companies Main banks no underwriting; equity holdings of corporations permitted strictly separated Universal underwriting perbanks mitted; significant equity holdings strictly separated

Laissez faire banking

open

Source: Derived from Stein, 2002.

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none

limited capacity

none

Soviet block before 1989. China high African countries before liberalization. China today little or none zaibatsu during 1930s. Mexico pre-1982 high Japan in postSecond World War

limited

Germany

indirect USA mechanisms none

Japan 1890– 1927. Russia post 1989.

303

Arm’s length banking

high

304


with few guidelines or priorities. By 1998, the banking system was in full crisis following the devaluation of the ruble and defaulting of government debt and Russian banks were left with billions in foreign loans and forward foreign exchange contract obligations (Stein et al., 2002). Still the number of registered banks stood at 1350 in 2006, which was greater than the total in all of Europe and well above the 180–200 really needed. As a Russian newspaper noted ‘There are so many banks in Russia because they are not transparent, which hampers mergers and acquisition on the market, experts note’ (Kommersant, 2006).4 China took a very different approach, which was reforming the state banks and their operating basis rather than handing out banking licenses like lottery tickets to the highest bidder. In 1995, China passed a new commercial bank law aimed at moving its four large state banks to operate on a commercial basis. The four banks were organized for specific economic purposes. The Bank of China focused on foreign exchange activity and financing imports and exports, the Industrial and Commercial Bank lent to the industrial sector, China Construction Bank provided loans for infrastructure and the Agricultural Bank of China gave credit for agricultural and rural development. While there were 80 or so smaller commercial banks these were very tiny and covered only 4% of domestic banking business. In contrast, at the end of 2001, the big four had 62% of the deposits and lending and 80% of the payments business. Loans are overwhelmingly the main source of financing in China and account for nearly 80% of funding for Chinese companies. To facilitate the movement toward lending on a commercial basis, the government set up three new state policy banks, the State Development Bank, the Agricultural Development Bank and the Export and Import Bank of China, to finance less commercially viable but developmentally important investments. In addition, a number of measures were undertaken in 1999–2000 to clean up the books of the four largest banks, including the organization of four asset management companies to take over some of the non-performing loans of the commercial banks, the writing off of loans with their own reserves and profits and the recaptilization of the Bank of China and the China Construction Bank with $45 billion of state funds. Along with these changes China has been slowly moving toward more indirect monetary control through the formation of an interbank market and open market operations. Even within the system China has continued to have low interest rates to encourage higher levels of investment. The impact of the Chinese financial system on the Chinese financial and economic development has been profound particularly compared

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to Russia. In 1990 M2/GDP was 71% in China and 70% in Russia. By 1993 the Chinese figure rose to 103% in 1995 and 182% by 2004. In contrast, Russian banking transformation has largely created financial underdevelopment with the ratio falling to 21% in 1995 with a slight increase to 29% in 2004 (Maswana, 2005). Not only has China experienced much higher growth and poverty reduction than Russia, it has also heavily emphasized manufacturing expansion for both the domestic economy and exports. In contrast to the declining and very tiny manufacturing exports from Russia, in 1995 83% of China’s exports were in manufacturing goods. In 2006 the figure rose to an astounding 93%. In China, in contrast to Russia, the portion of GDP in manufacturing has largely risen and was 40.5% in 2003 (UNCTAD, 2009). A second type of state-owned financial system is one dominated by state commercial banks. In a number of developing countries private commercial banks were nationalized after independence. While banks are state-owned, there also tends to be a significant private sector. In China state banks were transformed into commercial banks as part of the financial reform process. They, however, are generally used to support government priorities through the required purchase of government bonds, or direct loans or lines of credit to government organizations. While banks in theory are to operate strictly on commercial lines, in practice this can lead to soft budgeting and problems in maintaining profitability as bad loans accrue. Interest rates are often tightly controlled, other markets for corporate finance are poorly developed (only 6% of corporate financing was from equities in 19985) and indirect means of money supply influence, such as open market operations, are nonexistent or slowly being put in place. Ex ante monitoring (project evaluation), interim monitoring (operations) and ex post monitoring (success of projects) functions of banks tend to vary. South Korea, offered a somewhat different variation on state-owned commercial banks. First, credit is primarily channeled to private enterprise not state enterprises as in China. Second, banks were assigned to the largest 50 companies not only to service the needs of the companies, but to act as an agent of information gathering for the state to ensure that companies receiving credit are in compliance with the conditions of allocation. Credit to the private sector was frequently allocated in line with the priorities of industrial policy (policy loans). Thus there is some interim and ex post monitoring although little or no role in governance. The demobilization of the mechanisms of monitoring and coordination as part of financial liberalization in the 1990s led to a proliferation of loans that created excess capacity and a temporal

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mismatch where short-term international debt financed long-term investments (Chang et al., 2002). A third type of system is the private group banks. The best example of this is the zaibatsu banks in pre-Second World War Japan or the Mexican banking system before the nationalizations of 1982. Banks are organized and owned by a conglomerate or group of companies as a means of raising funds for investment purposes. Since they are largely instruments of these groups, these banks typically have rather weak monitoring and governance attributes. Some examples of these types of banks can be found in Russia where oligarchs have organized banks as part of their accumulation strategies. The fourth approach to banking is the main bank system formulated in postwar Japan. Although companies are lent money by many banks one bank takes responsibility as a main bank and takes the lead in arranging financing. The main bank also owns a significant equity. However, the banks have widely dispersed equity providing considerable managerial autonomy. As the main bank they take responsibility for ex ante, interim and ex post information gathering. The main bank has contingent governance responsibility and, in times of distress, it takes the responsibility for reorganization, liquidation or new management appointments. The government works closely with the banks. It sets sectoral priorities and provides subsidized credit through the central bank. Along with the main banks are a number of public and quasi public long-term banks. The most important was the Industrial Bank of Japan. The long-term banks extended the time horizons of loans and were heavily involved in investments in plant and equipment as industry expanded. For instance, in 1956 they provided 64.7% of the investment funds in machinery production, 63.7% in steel and iron, 56.2% in chemicals and 47.8% in textiles. The best technical experts were concentrated in the long-term banks. They financed their operations not through deposits but through debentures purchased by the ministry of finance using postal savings funds, thereby reducing the risk and uncertainty of being typically embedded in private bond markets. Interest rates are carefully regulated with spreads sufficient to guarantee profits to the banks. Securities and bond markets were poorly developed. Banks are prohibited from involvement in underwriting functions (Stein, 2002). A fifth model in banking is the universal system. Germany provides the best historical example, although the US began to bring in universal features after the repeal of the Glass–Steagall Act in 1999. Banks can provide a full complement of financial instruments to their customers

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including underwriting bonds and equities. Banks own many companies and play an extensive role in their monitoring and governance. Bank power is counterbalanced by stake holder influence. The system is bank centered rather than market or state focused. A sixth is the US type system or arm’s length approach which relies on a careful separation of ownership between banks and non-financial institutions. The state mostly uses indirect influences on monetary variables through open market operations and discount rates. Bank loans provide a comparatively minor role as an external financial source for companies which rely on a variety of private sources of capital including equity and bonds. Monitoring functions are divided by different types of institutions including private rating companies. Credit allocation is driven by corporate needs and priorities. Regulatory systems and an independent central bank are central aspects of this system. Given the lack of mechanisms of constraint, arm’s length banking seems particularly prone to fueling asset bubbles, financial fragility and Minsky-type crises. A final model is laissez faire banking. Japan, between 1890 and 1927 provides a good example and Russia after 1989 tended in this direction. Banks entered and exited freely from the market. Interest rates were driven by the market. The central bank was quite weak and the regulatory system was poorly developed. There tended to be a large number of banks. In a manner consistent with McKinnon–Shaw, the laissez faire approach relied entirely on the discerning prowess of private bankers and the conditioning impact of competitive markets. At the core of finance for development is the ability to generate banking institutions which will place a priority on facilitating flows to enterprises engaged in productive activities. As private or state enterprises generate the demand for credit, what is needed is organizational structures that can facilitate a supply response and that can ensure investment priorities are in line with a country’s development priorities. What is clear from the above description is that three financial systems would be best suited for this singular purpose. However, shy of North Korea and a few other places, only the state commercial and main bank systems would provide the most viable options for developing countries. Along with suitable banking organizations developing countries choosing either of these approaches require a clear statement of priorities mapped out through an industrial policy mechanism. Suitable private sector industrial entrepreneurs (as in the case of Korea) or state enterprises must also be created and/or identified and supported.

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Conclusions Philip Arestis has been one of the most important contributors to our understanding of the reform of financial systems and the frequent pitfalls of orthodox strategies. In line with Philip’s work, the paper has critically reviewed the history, theory and problems of financial change in the image of McKinnon and Shaw. The latter part of the chapter examines alternative models of banking. Countries such as China, Japan and Korea have had enormous success in designing banking systems that have served the development needs of their countries. In many ways their experiences confirm the insights of a post-Keynesian view of credit and how to embed it in a system that will best facilitate the development process.

Notes 1. The 15 countries experiencing financial crises includes Uruguay and Chile, 1981; Columbia, 1982; Philippines, 1983; Norway, 1987; Senegal and Cote D’Ivoire, 1988; Sri Lanka and the Czech Republic, 1989; Finland, Hungary, Malaysia, and Sweden, 1991; Japan and the Slovak Republic, 1992. 2. For a detailed review of influence of financial liberalization theory on the World Bank research and policies see Stein, 2008, ch. 7. 3. In addition to the list in the footnote above, Weller adds Thailand, 1983; Argentina, Brazil, and Malaysia, 1985; Bolivia, 1987; Jordan and Peru, 1989; and Turkey, 1991. All these financial crises followed financial liberalization. 4. As of April 2009, there were still 1152 registered banks according to the Central Bank of Russia (CBR, 2009) 5. The same year 70% of all financing came from bank loans (Maswana, 2005).

References Arestis, Philip (1992) The Post-Keynesian Approach to Economics: An Alternative Analysis of Economic Theory and Policy. London: Edward Elgar. Arestis, Philip and P.O. Demetriades (1999) ‘Financial Liberalization: The Experience of Developing Countries.’ Eastern Economic Journal 25, no 4: 441–57. Arestis, P. and M. Glickman (2002) ‘Financial Crisis in South East Asia: Dispelling Illusion the Minskyan Way.’ Cambridge Journal of Economics 26, no 2: 237–60 Arestis, P., P. Demetriades, and B. Fattouh (2003) ‘Financial Policies and the Aggregate Productivity of the Capital Stock: Evidence from Developed and Developing Countries.’ Eastern Economic Journal 29, no 2: 219–44. Caprio, Gerald and Daniella Klingebiel (1999) ‘Episodes of Systemic and Borderline Financial Crises.’ World Bank Working Paper. Caprio, Gerlan, Izak Atiya and James Hanson (eds) (1994) Financial Reform: Theory and Experience. Cambridge, UK: Cambridge University Press, 1994.

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Howard Stein 309 Central Bank of Russia (2009) ‘Banking Statistics’ www.cbr.ru. Chang, Ha-Joon, Park, Hong-Jae and Yoo, Chulo Gyue (2002) ‘Interpreting the Korean Crisis: Financial Liberalization, Industrial Policy and Corporate Governance’ in H. Stein, O. Ajakaiye and P. Lewis (eds). Deregulation and the Banking Crisis in Nigeria: A Comparative Study. Basingstoke: Palgrave. Cho, Yoon J. and Deena Khatkhate (1989) ‘Financial Liberalization: Issues and Evidence’ Economic and Political Weekly. 20 May. De Melo, Jaime and James Tybout (1986) ‘The Effects of Financial Liberalization on Savings and Investment in Uruguay.’ Economic Development and Cultural Change 34, April. Demirguc-Kunt, Asli and Enrica Detragiache (1998) ‘The Determinants of Banking Crises in Developing and Developed Countries.’ IMF Staff Papers 45: 81–109. Demirguc-Kunt, Asli and Enrica Detragiache (1999) ‘Financial Liberalization and Financial Fragility.’ In Proceedings of the 1998 World Bank Conference on Development Economics, (eds) B. Pleskovic and J.E. Stiglitz. Washington, DC: World Bank. Dornbusch, R. and A. Reynoso (eds) (1993) Financial Factors in Economic Development. Edited by R. Dornbusch, Policy Making in the Open Economy: Concepts and Case Studies in Economic Performance. Oxford: Oxford University Press. Fry, Maxwell (1988) Money Interest and Banking in Economic Development. Baltimore: Johns Hopkins Press. Giovanni, Alberto (1985) ‘Savings and Real Interest in LDCs.’ Journal of Development Economics. Vol. 18, No 2–3. Grabel, I. (1995) ‘Speculation-Led Economic Development: A Post-Keynesian Interpretation of Financial Liberalization Programs.’ International Review of Applied Economics 9, no 2: 127–49. Hellman, K., K. Murdock, and J. Stiglitz (2000) ‘Liberalization, Moral Hazard in Banking and Prudential Regulation: Are Capital Requirements Enough?’ American Economic Review 90, no 1: 147–65. Honohan, Patrick and Daniela Klingebiel (2000) ‘Controlling the Fiscal Costs of Banking Crises.’ Policy Research Working Paper Series No 2441. Komersant (2006) ‘Russia Has More Banks than the Whole Europe’ 28 September, 2006 http://www.kommersant.com/page.asp?idr=528&id=708252 Laeven, L. and F. Valencia (2009) ‘Systemic Banking Crises: A New Database’, IMF Working Paper WP/08/224, Washington: IMF. Lewis, P. and H. Stein (2002) ‘The Political Economy of Financial Liberalization in Nigeria.’ in H. Stein, O. Ajakaiye and P. Lewis (eds). Deregulation and the Banking Crisis in Nigeria: A Comparative Study. Basingstoke: Palgrave, 2002. Maswana, Jean-Claude (2005) ‘Reconciling the Chinese Financial Development with its Economic Growth: A Discursive Essay’ Graduate School of Economics, Kyoto University, Japan Working Paper 70, March. McKinnon, Ronald (1973) Money and Capital in Economic Development. Washington, DC: Brookings Institution. McKinnon, Ronald (1988) ‘Financial Liberalization and Economic Development: A Reassessment of Interest Rate Policies in Asia and Latin America’. Occasional Papers International Center for Economic Growth 6. McKinnon, Ronald. (1993) The Order of Financial Liberalization Baltimore: Johns Hopkins University Press.

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Minsky, Hyman (1984) Can ‘It’ Happen Again? Essays on Instability and Finance. Armonk, NY: M.E. Sharpe. Ndung’u, Njuuna (1997) ‘The Impact of Financial Sector Liberalization on Savings, Investment Growth and Financial Development in Anglophone Africa.’ African Development Review 9, no1. Oshikoya, T.W. (1992) ‘Interest Rate Liberalization, Savings, Investment and Growth: The Case of Kenya.’ Savings and Development 16: 305–21. Rosefielde, Steven (2002) ‘Klepto-Banking: Systemic Sources of Russia’s Failed Industrial Recovery’ in H. Stein, O. Ajakaiye and P. Lewis (eds). Deregulation and the Banking Crisis in Nigeria: A Comparative Study. Basingstoke: Palgrave. Sahoo, P. et al. (2001) ‘Savings and Economic Growth in India: The Long-Run Nexus’ Savings and Development 25, no 1: 66–80. Stein, Howard (2002) ‘The Nigerian Banking Crisis and Japanese Financial Development: In Search of Lessons’ in H. Stein, O. Ajakaiye and P. Lewis (eds). Deregulation and the Banking Crisis in Nigeria: A Comparative Study. Basingstoke: Palgrave. Stein, Howard (2008) Beyond the World Bank Agenda: An Institutional Approach to Development. Chicago and London: University of Chicago Press. Stein, Howard, Ajakaiye, O. and Lewis, P. (eds) (2002) ‘Financial Deregulation and Banking Crises: An Introduction to Theoretical, Institutional and Policy Issues’ in H. Stein, O. Ajakaiye and P. Lewis (eds). Deregulation and the Banking Crisis in Nigeria: A Comparative Study. Basingstoke: Palgrave. Shaw, Edward (1973) Financial Deepening in Economic Development. New York: Oxford University Press. Stiglitz, J. (1989) ‘Financial Markets and Development.’ Oxford Review of Economic Policy 5, no 4: 55–68. Stiglitz, J. (1993) ‘The Role of the State in Financial Markets.’ In Proceedings of the World Bank Annual Conference on Development Economics. Washington, DC: World Bank. UNCTAD (2009) Handbook of Statistics 2008 On-Line. stats.unctad.org/ handbook/ Underhill, G. (ed.) (1997) The New World Order in International Finance. Basingstoke: Macmillan. Vera, L. (2002) ‘A Chronicle of a Latin America Country Financial Crash: The Case of Venezuela’ in H. Stein, O. Ajakaiye and P. Lewis (eds). Deregulation and the Banking Crisis in Nigeria: A Comparative Study. Basingstoke: Palgrave. Vermikov, Andrei (2007) ‘Russia’s Banking Sector Transition: Where To?’ BOFIT Discussion Papers, 5. Warman, Fanny and A.P. Thirwall (1994) ‘Interest Rates, Savings Investment and Growth in Mexico 1960–90: Test of the Financial Liberalization Hypothesis.’ Journal of Development Studies. Vol. 3, no 3, April. Weller, C. (2001) ‘Financial Crises and Financial Liberalization: Exceptional Circumstances or Structural Weaknesses.’ Journal of Development Studies 38, no 1: 98–126. World Bank (1993) The East Asian Miracle: Economic Growth and Public Policy. Washington, DC: World Bank.

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21 Are the Institutions of the Stock Market and the Market for Corporate Control Evolutionary Advances for Developing Countries? Ajit Singh1

I. Introduction This chapter explores the question to what extent, if any, the institution of the stock market is likely to benefit the real economy in developing countries and aid their industrialization. This question is examined here by focusing on the following aspects that are salient to the assessment of the stock market from a developmental perspective: a the role of the stock market in promoting technological development; b the implications of the stock market for corporate finance and corporate governance; and c the efficiency of the pricing process and the take-over mechanism observed in the real world stock markets. Contrary to most literature, the present contributes by its negative overall assessment of the institution of the stock market in relation to economic development. Although orthodox economics extols the virtues of the stock market and the international financial institutions (IFIs) encourage developing countries (DCs) to establish or to expand such markets there is an important literature which suggests that this institutional innovation may not be helpful for economic development in many poor countries. Following the Great Depression and noting the role of the stock market in propagating rather than preventing it, John Maynard Keynes (1936) 311

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famously provided an intellectually robust attack on the institution. He termed the stock market a gambling house and suggested that a society’s investment decisions should not be left to the vagaries of a casino. The Keynesian criticisms were echoed 60 years later in a blue ribbon report by 25 leading US finance specialists under the Chairmanship of Professor Michael Porter of Harvard University. The Commission was appointed in order to find out to what extent, if any, the stock market based US financial system was responsible for poor US economic performance relative to European countries during 1980–95. Porter (1992) summarized the Commission’s conclusions as follows: The change in nature of competition and the increasing pressure of globalisation make investment the most critical determinant of competitive advantage. Yet the US system of allocating investment capital both within and across companies is failing. This puts America at a serious disadvantage in global competition and ultimately threatens the long term growth of the US economy. As with all strong statements in economics this powerful critique of the stock market did not stand the test of time. The significance of this criticism came in part from the fact that it emanated from a country that was a citadel of the stock market itself. Over the next 10 years, 1995–2005, the US economic performance improved immeasurably and the country experienced spectacular expansion, outdoing its industrial competitors in GDP and productivity growth. It is suggested that it is the stock market that has enabled the US to adopt information technology and achieve other technological breakthroughs much more quickly than other advanced countries (ACs) (see further Summers, 1999). If the stock market can help with achieving similar technical progress in DCs, this would be an important argument for its encouragement in such countries.

II. The stock market: New technology and short-termism Notwithstanding Keynes, a surprisingly large constituency favours the establishment of the stock markets to promote economic development in emerging economies. As mentioned above, the IMF and the World Bank have, of course, fully supported the institution of the stock market and helped developing countries in various ways to either establish them or to encourage their growth (Singh, 1993, Sudweeks, 1990). This constituency includes not only the IFIs but also Central Left think tanks such as the World Institute of Development Economics Research

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(WIDER) and surprisingly the Chinese Communist party, which has established stock markets in seven Chinese cities.2 Significant intellectual support for the ability of the stock market to promote technical change has come from Professor Larry Summers, an erstwhile critic, who has now become a firm supporter of the market. He argued that the US stock market was, in large measure, responsible for the structural change experienced in the US economy in the 1990s. This had enabled it to recover from low productivity growth of the period 1980 to 1995, and achieve higher productivity growth between 1995 and 2005. This transformation, according to Summers, was brought about by the take-over mechanism on the stock market, which led to a huge reallocation of resources in the US economy leading to faster productivity growth. Similarly, Summers suggested that through the system of stock options the US stock market is better able to align the interests of managers with those of shareholders (Summers, 1999). It was also pointed out that the US stock market promotes technological progress through the venture capital route. Through the latter, it ensures that the US is able to provide much greater incentives for technological innovation than the institutional arrangements in other countries. One reason for the higher pay-off for inventors and innovators in the Anglo-Saxon system is precisely the exit mechanism through take-overs, which the US system allows, normally permitting the target company to be sold on the stock market with a sizable capital gain. It has been noted that other countries such as Germany, which have tried to emulate the US system in this respect, have not succeeded because traditional attitudes to involuntary take-overs still prevail (Black and Gilson, 1998). On the critical side, however, there still persist the arguments of Michael Porter and his colleagues regarding the shortcomings of the US financial system, and these remain unanswered. Specifically, the critics suggest that the stock market engenders short-termism and quick financial gains rather than long-term investment. The short time horizon is thought to be inimical both to competitiveness and fostering economic development. The bursting of the technology share prices bubble in 2000 – the so-called ‘dot com boom and bust’ – has provided further support for the critics of the stock market.

III. Stock markets and economic development Apart from the issue of encouraging technological development by the stock market, there are other ways in which the market can contribute to development through a variety of channels. It could raise savings

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and investment by making it possible for individuals and households to purchase a fraction of a shipyard or a steel mill, thereby spreading the risk, without which such investment may not occur at all. Similarly the monitoring function performed automatically and from the perspective of an entrepreneur, costlessly, by the stock market also helps raise investment. Moreover, a well-functioning stock market purportedly allocates resources more efficiently through its normal pricing process, which, other things being equal, would accord higher share prices to efficient firms and lower prices to inefficient ones. Furthermore, the take-over mechanism ostensibly ensures that not just the new investment resources but also the existing capital stock is efficiently utilized. Inefficient use of existing resources is punished by the market for corporate control through disciplinary take-overs. How effectively the stock market can perform the above tasks depends on the efficiency of two critical market mechanisms, namely (a) the pricing mechanism and (b) the take-over mechanism. These are central issues of debate on which the literature is briefly reviewed below. Determination of share prices3 The orthodox paradigm of share price determination postulates that share prices are efficient because they emanate from perfect markets involving large numbers of well-informed buyers and sellers in which no single buyer or seller can influence the price and where there is a homogeneous product, namely shares. There is, however, an alternative paradigm indicated by Keynes’s comment characterizing stock markets essentially as gambling casinos dominated by speculators. Stiglitz (1994); Allen and Gale (2000); Shiller, (2000), Shleifer (2000), Baker and Wurgler (2007), Hong and Stein (2007) and not least students of behavioural finance (see for example Barberis and Thaler, 2003; Hong and Stein, 2007), formalize the various elements of this paradigm. In brief, this literature suggests that, in the face of a highly uncertain future, share prices are likely to be influenced by the so-called ‘noise traders’, and by whims, fads and contagion. For similar reasons of psychology, investors may attribute much greater weight to near-term price forecasts rather than historical long-term performance. This line of reasoning is taken further in the growing literature on behavioural finance (referred to above). Until recently, the empirical literature on share prices has been dominated by the so-called ‘efficient markets hypothesis’ (EMH), which argues that real world share prices are efficient in the sense that they incorporate all available information (Fama, 1970). In the 1980s and

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1990s, with (a) the 1987 US stock market crash, (b) the meltdown in the Asian stock markets in the 1990s, and (c) the bursting of the technology stocks bubble in 2000, the EMH has suffered fundamental setbacks. Alan Greenspan (1998) has commented as follows on the reasons for (a) and (b): At one point the economic system appears stable, the next it behaves as though a dam has reached a breaking point, and water (read, confidence) evacuates the reservoir. The United States experienced such a sudden change with the decline in stock prices of more than 20 percent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a change in the fundamentals of long-term valuations on that one day. Kindleberger (1989) similarly documented about 30 cases of unwarranted euphoria and excessive pessimism on the stock markets since the South-Sea bubble of 1720. He termed these episodes as manias, panics and crashes. Tobin (1984) made an analytically useful distinction between two kinds of efficiency of stock markets: (a) the information arbitrage efficiency that ensures that all information concerning a firm’s shares immediately percolates to all stock market participants, ensuring that no participant can make a profit on such public information; (b) fundamental valuation efficiency, that is, share prices accurately reflect a firm’s fundamentals, namely the long-term expected profitability. The growing consensus view is that, in these terms, stock markets may at best be regarded as being efficient in the sense of (a) but far from being efficient in the economically more important sense (b). Thus EMH, as identified in (a), is compatible with share prices not reflecting fundamental values. A detailed discussion as well as examples of share prices evidently departing from their fundamentals are provided in Singh et al. (2005). It is generally accepted that such mis-pricing of shares is a common occurrence on the stock market and it may persist for a considerable period, some would say for as much as 10–20 years. The Nikkei stock market index in Japan reached a value of approximately 38000 in the mid-1980s. Twenty-five years later, it has not recovered to even half the 1980s value. Evidence suggests a share price bubble on the Tokyo stock market in the mid-1980s. Similarly, UK and US stock markets did not recover to their pre-Great Depression index values until the mid1950s.

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IV. The take-over mechanism and the market for corporate control In orthodox economics, the market for corporate control is thought to be the evolutionary endpoint of stock market development. The market may advance economic efficiency through two distinct channels: a) the threat of take-overs, which can discipline inefficient firms, and b) even if the firms were operating efficiently the actual take-overs may lead to a restructuring of an economy’s resources leading to enhanced social values. Research over the last two decades has indicated that there are significant theoretical and practical reasons why the market for corporate control may not work in the idealized way outlined above. This research has been discussed in detail in Singh (2008) and will not be reviewed here for reasons of space. This helps to explain that although there exists a very active market for corporate control in the major Anglo-Saxon countries, it is seriously inefficient. Two kinds of evidence support this conclusion. First, studies of the take-over selection process indicate that selection in the market for corporate control takes place only to a limited extent on the basis of the target firm’s performance and much more so on the basis of its size. A large relatively unprofitable firm has a much smaller chance of being acquired than a small profitable firm. Secondly, controlling for other relevant variables, studies of post-merger profitability of amalgamating firms indicate that there is at best no improvement on average in postmerger profits but most likely a decline (Ravenscraft and Scherer, 1987; Scherer, 2006; Singh, 1992; Tichy, 2002). To the extent that an increase in market power is associated with mergers, the lack of such an increase suggests a micro-economic inefficiency in resource utilization, certainly not an improvement. A related set of financial studies – the so-called ‘events studies’ – suggest, however, that in US take-overs the acquiring firms suffer a sizeable decline in share prices in the period of six months to three years following the merger. The gainers are mainly the acquired firms whose share prices may rise by up to 20 per cent on average (Jensen, 1988). This poses serious incentive problems as potential acquiring firms stand to lose rather than to gain. Equally importantly, in order to classify these gains to the shareholders of acquired firms as being social gains, the analysis has to assume that share prices are always efficient in the fundamental valuation sense, which, as indicated above, is far from being the case. The rise in the share price of the acquired firm may reflect

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simply the price for control which empire builders are willing to pay even to the detriment of their own shareholders (Singh, 2000). In addition to the inefficiencies of the take-over mechanisms in the real world, in a closely related but more general sense, the dominance of stock markets can also result in the unhealthy ascendancy of finance over production, and that of financial engineering (through the takeover process) over the normal long-term entrepreneurial tasks of introducing technical change, reducing costs and improving products.

V. Corporate finance, the stock market and corporate governance A central function of the stock market is to finance corporate growth. The nature of finance in turn affects corporate governance. Although the manner in which corporations are governed is affected by many factors, the ownership and control of a company’s shares are bound to be affected by the manner in which companies are financed. For example, if they are primarily financed by creditors, say bank debt, the managers’ first concern will be to earn at least the level of profit required to finance the debt. If, on the other hand, the principal financing is provided by equity shareholders, managers may earn any rate of profit to finance dividends, which rise and fall with the profits, but with the risk of take-over by another company, if share prices are too low. This, of course, also describes the nature of the agency problem in the normal US/UK corporation. Managers are supposed to look after the interests of the shareholders, but the latter, for various reasons, may not be able to motivate the managers to act in their interest rather than those of the management itself. The corporate governance question will be discussed analytically and empirically below in two stages. First, we will enquire, how do emerging firms finance their growth, i.e., to what extent do firms use retained profits or long-term debt or new equity to pay for the expansion of their net assets? At the second stage the implications of the observed financing patterns for corporate governance will be examined. Singh and Hamid (1992) and Singh (1995), were among the first large scale studies of financing corporate growth in emerging markets. These studies arrived at theoretically quite unexpected conclusions: developing country corporations rely far more on external than on internal finance, and within external finance, they use equity finance to a surprisingly large degree.

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It is not surprising in itself that there should be differences between AC and DC corporations in relation to how they would meet their financing requirements. However, what is observed is totally opposite to what economic analysis would predict to be the nature of the differences between the two groups. It may be noted that the pattern of finance reported for AC corporations themselves is fully compatible with the so-called ‘pecking order’ theory of finance. The latter suggests that firms will choose sources of external finance for their investment needs in the following order. First, they will rely on internal sources (i.e., retentions) as much as they can; if they require more finance, they will borrow from the banks, and will go to the stock market only as a last resort. Myers and Majluf (1984) showed long ago that this pattern of finance can arise from the existence of asymmetric information between managers and the world outside the corporation. Singh (2003) suggested that these considerations apply with even greater force to developing countries. This is because with imperfect capital markets developing country corporations may be expected to be obliged to rely largely on self-financing for their expansion; in addition, they will be reluctant to issue equity capital for fear of losing control of the corporation. Thus, economic analysis predicts that developing country corporations should depend more on internal finance and less on equity than corporations of advanced countries. The empirical results are not compatible with this proposition. How does one explain these theoretically anomalous results on the financing of corporate growth observed for the 1980s? Do the 1990s yield similar results? Table 21.1 provides information on this subject for firms in 22 DCs and 22 ACs for the period 1995–2000. This is a more comprehensive data set than that which was available to researchers for the 1980s. Exactly the same methodology is used to measure financing of corporate growth for the two periods. The results show that for the 1990s, the pecking order pattern of finance is decisively rejected for both rich and poor countries. Also, what stands out is the high recourse to equity finance by developing country corporations. (For a full discussion and explanation of these anomalous results, termed the ‘Singh paradox’ by Dennis Muller, see Singh, 1995, 2003; Gugler et al., 2003 and Glen and Singh, 2005.) Next we take up the implications of these observed patterns of financing corporate growth for corporate governance. There are in principle three channels through which corporate governance may be affected by the stock market: a) the regulatory framework of the stock market itself concerning standards for corporate accounts, disclosure of information

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Table 21.1 Financing of corporate growth in 19 developing countries and 22 advanced countries for 1995–2000* Developed markets

Liabilities

External finance

Internal finance

58% 52% 56% 41% 56% 90% 72% 53% 61% 62% 52% 76% 68% 62% 65% 50% 66% 68% 57% 54% 52% 47% 53% 49%

32% 3% 6% 23% 8% 6% 26% 7% 5% 34% 5% 5% 6% 9% 23% 15% ⫺9% 4% 4% 7% 21% 21% 17% 22%

11% 45% 38% 36% 12% 2% 23% 22% 31% 33% 14% 18% 27% 32% 26% 27% 19% 40% 39% 39% 27% 32% 30% 29%

Australia Austria Belgium Bermuda Canada Cayman Islands Denmark Finland France Germany Greece Ireland Italy Japan Netherlands Norway Singapore Spain Sweden Switzerland United Kingdom United States Group average Global average

Emerging markets Argentina Brazil Chile Columbia Czech Republic Hong Kong Hungary India Indonesia Israel Korea Malaysia Mexico Philippines South Africa Taiwan Thailand Turkey Venezuela

Liabilities

External finance

Internal finance

46% 74% 44% 73% 33% 44% 28% 53% 110% 54% 27% 40% 61% 34% 49% 59% 74% 61% 27%

16% 11% 33% 16% 21% 20% 1% 5% 12% 6% 48% 18% 30% 17% 10% 40% 11% 18% 54%

38% 15% 23% 11% 46% 35% 71% 43% ⫺23% 40% 25% 42% 10% 49% 41% 1% 15% 21% 19%

35%

39%

27%

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Note: * The basic accounting identity in this table is: the total finance for corporate growth consists of the growth of liabilities, growth of equity capital (Ext F) and the growth of internal finance. Source: Glen and Singh (2005).

320


about major changes in corporate activities, transparency, etc., b) the pricing process on the stock market, and c) the take-over process. It is worth noting that although AC corporations do not use stock markets as much as the DC corporations to raise equity capital, the former are paradoxically subject to greater discipline of the stock market than are the latter. This is because of the existence of a highly active market for corporate control in the US and the UK so that even firms which never go to the stock market to raise funds, nevertheless, become subject to take-over discipline. The nature of discipline imposed by the stock market through the take-over mechanism has been discussed in detail in the last section. It falls far short of what is required and indeed creates major distortions of its own particularly for developing countries. The stock market pricing process and the take-over mechanism are not in general very helpful in improving economic performance in advanced countries and there are good reasons to suggest that they are even less likely to do so in developing countries. To illustrate, consider the Indian case. India, like many other developing countries, has large, potentially predatory conglomerate groups (Singh, 1995). As suggested earlier, if there was a market for corporate control these groups could take over smaller, more efficient firms and thereby reduce potential competition to the detriment of the real economy. Also as noted above, the development of an active market for corporate control may encourage managers to ‘empire-build’ not only to increase their monopoly power but also progressively to shield themselves from take-over by becoming larger. However, the market for corporate control in developing countries remains rudimentary because shareholdings are not widely dispersed and standards of disclosure are not conducive to take-overs. It is therefore not surprising that hostile take-overs are rare in developing countries. However, this situation may change if large international MNCs are allowed to engage in take-overs in developing countries. Domestic firms, with their limited funds and relatively restricted access to international capital markets, would not be able either to compete with or resist the MNCs. There are also other potential factors that could lead financial liberalization and stock markets to have a negative effect on corporate governance. Financial liberalization establishes a strong link between two potentially volatile markets, the stock market and the foreign exchange market. The Asian crisis of 1997–98 demonstrated that there could be a strong negative feedback relationship between a falling stock market and a depreciating currency. As the stock market declines, investors

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pull out of the market and move their funds into foreign currency. The depreciating currency, in turn, lowers real returns on the stock market which in turn propels the cycle. Such a collapse in currency and equity values of course, ultimately may encourage ‘fire-sale-type FDI’ in the form of take-overs (suggesting that the expected rate of return measured in foreign currency has increased sufficiently due to the steep decline in domestic share prices). This may overturn quite successful corporate governance structures and replace them with ones that are less suited. To sum up, the above considerations together suggest that the greater influence of the stock market on developing country corporations is unlikely to improve corporate governance in these countries but may on the contrary make it worse.

VI. Natural progression and econometric studies One hypothesis that can certainly be refuted, even by broad-brush data, is that of natural progression. This theory suggests that as countries develop they establish stock markets and stock market development is therefore an emblem of economic development. Two kinds of evidence are relevant for assessing the validity of this claim. The first is the observation that the economic miracles that occurred in the second half of the twentieth century can hardly be ascribed to stock market development. Thus, in post-Second World War Europe – the Italian Miracle, the German miracle, the Austrian miracle and in Asia, the justly famous miracles of Korea or Taiwan – did not depend conspicuously on the equity or bond markets in these countries. Similarly, the second kind of evidence relevant here consists of an examination of comparative growth rates over a hundred year time span. Such an examination reveals that the bank-based countries (e.g. Germany and France) have as good if not a better long-term record of economic growth as do US and UK. Pagano (1993) notes that the Italian stock market was bigger a hundred years ago, than it was until a decade ago. The Italian economy evidently grew during these hundred years without any expansion of the stock market. Turning from the crude historical evidence above to more precise quantitative and econometric studies, the pioneering contribution of Goldsmith (1969), on the relationship between finance and growth has been followed by econometric exercises. An important issue in this research has been the causal question whether finance causes growth or economic growth leads to the development of the financial system. Another issue that has received attention is whether the banks and

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stock markets complement each other in causing economic growth or whether they are substitutes. Levine (1997; 1998) found a positive relationship between banks and economic growth, but he did not control for stock market development. Levine and Zervos (1998) found that stock market and bank development complement each other in assisting economic growth. This finding is confirmed by Beck and Levine (2004) which improves upon earlier studies in terms of both methodology and for being able to control for many other relevant variables. On the other hand, Atje and Jonanovic concluded in an earlier 1993 study that, while stock markets positively affect growth, raising it by a huge 2.5 percentage points per annum, banks had little influence. Sarkar (2009) examined the long-term relationship between stock market development and rate of investment in India over a 50-year period from 1950 to 2000. Using time-series analysis, he found no long-term relationship between the two variables. Apart from their mixed results, there are important methodological limitations of these econometric exercises. First, as Arestis and Demetriades (1997) noted, most of the studies are based on reducedform analysis and are therefore difficult to interpret in causal terms. Secondly, they ignore altogether the evidence presented in the earlier sections on the observed inefficiencies of the pricing and take-over mechanism on the stock markets. These methodological limitations are serious and detract from the value of this research.

VII. Stock market regulation and developing countries There was an enormous expansion of DC stock markets in the 1980s and 1990s in the wake of financial liberalization in many of these countries. Compared with the highly organized and extensively regulated stock market activity in the US and the UK, most DCs do not have such well-functioning markets. Not only is there inadequate government regulation, but private information gathering and disseminating firms are also often absent in DCs. These markets continue to suffer from significant regulatory and informational deficits: most DC markets remain ‘immature’ (i.e., riddled with insider trading and lack of transparency) and relatively illiquid. Most trading takes place in a few blue-chip shares (Singh, 1995; 1997). DCs have found it difficult to regulate stock markets, as is indicated by frequent scams on DC stock markets. This should not be surprising as even highly regulated and well-functioning markets, such as those of the US, from time to time experience episodes, such as those of Enron

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and WorldCom. Nevertheless, Singh (1998) has argued that one regulatory reform, which would be particularly useful for DCs, is to stop the emergence of a market for corporate control. Such a market, as indicated above, exacerbates the negative effects of stock markets (e.g. shorttermism) from the perspective of economic development. This reform may however involve major changes in company law, reducing the role of shareholders and enhancing that of stakeholders or the government in take-over situations. DC governments need to find cheaper and more efficient ways of changing corporate managements than the lottery and the huge expense of the market for corporate control. They should also encourage product market competition to discipline corporations rather than rely on the stock market alone for this purpose. As seen earlier, there are good theoretical reasons as well as evidence for the volatility of DC share prices. Volatility is, however, further accentuated if DCs allow external portfolio capital inflows. This greatly increases the vulnerability of the economy not only to international shocks, but also to domestic shocks, substantially magnifying their effects. The main reason for this is that capital inflows lead to an interaction between two inherently unstable markets – the stock market and the currency market. In the event of a large shock (domestic or external) these interactions generate a negative feedback that may lead to, or greatly worsen, a financial crisis.

VIII. Conclusion This chapter has provided a comprehensive review of the role of the stock markets in economic development, taking up topics such as corporate finance, corporate governance and technological change. It has surveyed analyses and evidence from both developed and developing countries in order to assess how best, if at all, stock markets can contribute to economic development. A main message of the chapter is that developing countries with stock markets must regulate these so that they do not become a source of instability or short-termism in the economy. For this reason, DCs should discourage the emergence of a market for corporate control. These countries should find other institutional ways of replacing inefficient managements that are reliable and cheap compared with the take-over device on the stock market. The latter, as we have seen, carries with it serious dangers for economic efficiency and social stability. If Germany and Japan can do without the corporate take-over mechanism and live happily, why not India and China?

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Notes 1. It is a pleasure to present this chapter to Philip Arestis whose friendship over the years I have greatly cherished and from whom I am continuing to learn evermore about the functioning of the financial markets. It was originally presented at the Workshop on Debt, Finance and Emerging Issues in Financial Integration, 8–9 April 2008, United Nations Headquarters, New York. The author is grateful to the Workshop participants and to Ann Zammit for helpful comments. The usual caveat applies. 2. For a detailed analysis of reasons for favouring the stock market by these diverse institutions, see Singh and Weisse (1998). 3. This section and the next rely heavily on and updates the discussion of Singh et al. (2003) and Singh (2008).

References Allen, F. and Gale, D. (2000) Comparing Financial Systems, MIT Press, Massachusetts. Arestis, P., Demetriades, P. and Luintel, K. (2001) ‘Financial Development and Economic Growth: The Role of Stock Markets’, Journal of Money, Credit and Banking, 33(1), 16–41. Atje, R. and Jovanovic, B. (1993) ‘Stock markets development’, European Economic Review, Vol. 37, 632–40. Baker, Malcolm and Wurgler, Jeffrey (2007) ‘Investor Sentiment in the Stock Market’, Journal of Economic Perspectives, 21(2), 129–52. Barberis, Nicholas and Thaler, Richard H. (2003) ‘A Survey of Behavioral Finance’, In Handbook of the Economics of Finance. George M. Constantinides, Milton Harris, and Rene’ Stultz (eds), Elsevier Science, North Holland, Amsterdam. Beck, T.H.L. and Levine, R. (2004) ‘Stock markets, banks and growth: Panel evidence’, Journal of Banking and Finance, 28(3), 423–42. Black, B. and Gilson, R. (1998) ‘Venture capital and the structure of capital markets: banks versus stock markets’, Journal of Financial Economics, 47(8), 243–77. Fama, E. (1970) ‘Efficient capital markets: A review of theory and empirical work’, Journal of Finance, vol. 25, 383–417. Glen, J. and Singh, A. (2005) ‘Corporate governance, competition and finance: rethinking lessons from the Asian crisis’, Eastern Economic Journal, vol. 31, 219–243. Goldsmith, Raymond W. (1969) Financial Structure and Development: Study in Comparative Economics, Yale University Press. Greenspan, A. (1998) ‘Testimony before the Committee on Banking and Financial Services, US House of Representatives, 30 January 1998. Gugler, K., Mueller, D.C. and Yortoglu, B. (2003) ‘The Impact of Corporate Governance on Investment Returns in Developed and Developing Countries’, Economic Journal, 113(491), November, F511–39. Gugler, K., Mueller, D. and Yurtoglu, B. (2004) ‘Corporate Governance and Globalization’, Oxford Review of Economic Policy, Special Issue on Globalization, 20(1), 129–56.

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Ajit Singh 325 Hong, H. and Stein, J.C. (2007) ‘Disagreement and the Stock Market’, Journal of Economic Perspectives, Spring 2007, 21(2), 109–28. Hoshi, T. and Kashyap, A. (2001) Corporate Financing and Governance in Japan: The Road to the Future, MIT Press, Massachusetts. Jensen, M. (1986) ‘The Agency Costs of Free Cash Flow, Corporate Finance and Takeovers’, American Economic Review, Vol. 76, 323–9. Keynes, J.M. (1936) The General Theory of Money, Interest and Employment, Macmillan, London. Kindleberger, Charles P. and Aliber, Robert (2005) Panics, Manias, and Crashes: A History of Financial Crises, 5th edn, London, Wiley. King, R.G. and Levine, R. (1993) ‘Financial Intermediation and Economic Development’, In Capital Markets and Financial Intermediation (eds), Colin Mayer and Xavier Vives, Cambridge University Press, Cambridge. Levine, R. (1997) ‘Financial Development and Economic Growth: Views and Agenda’, Journal of Economic Literature, June, 35(2), 688–726. Levine, R. and Zervos, S. (1998) ‘Stock Markets, Banks, and Economic Growth’, American Economic Review, 88(3), 537–58. Myers, S.C. and Majluf, N.S. (1984) ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, 187–221. Pagano, M., (1993) ‘Financial Markets & Growth: An Overview’. American Economic Review, 37, 613–22. Porter, M.E. (1992) ‘Capital Disadvantage: America’s Failing Capital Investment System’. Harvard Business Review, Vol. 46, 65–82. Ravenscraft, D.J. and. Scherer, F.M. (1987) Mergers, Sell Offs and Economic Efficiency, Brookings Institution. Sarkar, Prabirjit (2008) ‘Do the English Legal Origin Countries have more Dispersed Share Ownership and More Developed Financial Systems?,’ ESRC Centre for Business Research - Working Papers wp375, ESRC Centre for Business Research. Scherer, F.M. (2006) ‘A New Retrospective on Mergers’, Review of Industrial Organization, 28(4), June, 327–41. Shiller, R.J. (2000) ‘Irrational Exuberance’, Princeton University Press, New Jersey. Shleifer, A. (2000) ‘Inefficient Markets: An Introduction to Behavioural Finance’, Oxford, Oxford University Press. Singh, A. (1992) ‘Corporate Take-Overs’. In J. Eatwell, M. Milgate and P. Newman (eds) The New Palgrave Dictionary of Money and Finance, London, Macmillan, pp.480–86. Singh, A. (1993) ‘The Stock Market and Economic Development: Should Developing Countries Encourage Stock Markets?’, UNCTAD Review, 4, 1–28. Singh, A. (1995) ‘Corporate Financial Patterns in Industrialising Economies. A Comparative International Study’, IFC Technical Paper No.2, Washington DC, World Bank. Singh, A. (1997) ‘Financial Liberalisation, Stock Markets and Economic Development’, Economic Journal, vol.107, 771–82. Singh, A. (1998) ‘Liberalisation, the Stock Market and the Market for Corporate Control: A Bridge Too Far for the Indian Economy?’, In Ishar Judge Ahluwalia and IMD Little (eds), India’s Economic Reforms and Development: Essays for Manmohan Singh, Oxford, Oxford University Press, pp. 169–96.

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Singh, A. (2000) ‘The Anglo-Saxon Market for Corporate Control: The Financial System and International Competitiveness’, In C. Howes and A. Singh (eds), Competitiveness Matters: Industry and Economic Performance in the US, University of Michigan Press, pp. 89–105. Singh, A. (2003) ‘Capital Account Liberalization, Free Long-term Capital Flows, Financial Crises and Economic Development’, Eastern Economic Journal, 29(2), Spring. Singh, A. (2008) ‘Stock Markets in Low and Middle Income Countries’, Cambridge University CBR Working Paper No. 377, December. Singh, A. and J. Hamid (1992) Corporate Financial Structures in Developing Countries. Technical Paper 1, International Finance Corporation, Washington DC. Singh, A. and Weisse, B. (1998) ‘Emerging stock markets, portfolio capital flows and long term economic growth: micro and macroeconomic perspectives’, World Development, 26(4), 607–22, April. Singh, Ajit, Singh, Alaka and Weisse, Bruce (2003) ‘Corporate Governance, Competition, the New International Financial Architecture and Large Corporations in Emerging Markets’ Working Paper No. 250, Working Paper Series, Centre for Business Research, University of Cambridge. A revised version of this paper has been published in the Journal of Corporate Law Studies, 3(1), April, 41–72. Singh, A., Glen, J., Zammit, A., De Hoyos, R., Singh, A. and B. (2005) ‘Shareholder Value Maximisation, Stock Market, and New Technology: Should the US Corporate Model be the Universal Standard?’, International Review of Applied Economics, 19(4), 419–37. Stiglitz, J. (1994) ‘The Role of the State in Financial Markets’, Proceedings of the World Bank Annual Conference on Development Economics, Washington DC, World Bank. Sudweeks, L.B. (1990) Equity Market Development in Developing Countries, New York, Westport, Connecticut, London. Summers, L.H. (1999) Quoted in article ‘Winning ways: ready bucks and a flair of risk’, Financial Times, 14 December 1999. Tichy, G. (2002) ‘What do we know about the success and failure of mergers?’, Journal of Industry, Competition and Trade, 1(4). Tobin, J. (1984) ‘On the efficiency of the financial system’, Lloyds Bank Review, July, 1–15. World Bank (1989) World Development Report, World Bank, Oxford University Press. World Bank (1993) The East Asian Miracle, World Bank, Oxford University Press, New York.

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22 Financial Globalization and Innovation: Lessons of a Lost Decade for the OECD Economies Pascal Petit

1. Introduction When the thirty ‘golden years of capitalism’ came to an end with the crisis of the early 1970s (end of the gold exchange standard, important confrontation between capital and labour) the anti interventionist theses of the Hayekians received special attention. The publication of Milton and Rose Friedman’s book ‘Free to choose’ in 1980 is emblematic of this change of direction. This counter reform developed especially in countries like the US and the UK where the ‘golden years’ were those of slow growth in comparison with countries of continental Europe or with Japan which remained relatively more interventionist, each in their own way. This counter reform led effectively to some changes in the regulations of the forms of competition in various sectors. The deeper internationalisation of the economies in itself called for adjustments. The financial sector was prone to claim for such deregulation. The pre- and postwar regulations of these activities had wanted to minimize the risks of speculative bubbles and other financial vagaries in segmenting activities, setting controls and ceilings, etc. If the financial sector was not the only one to push for liberalization, it was certainly the quickest to call for it and the one where it led to a drastic change in the forms of competition and in turn to the emergence of global finance. In contrast with most sectors this deregulation was not accompanied by some standardization of the new financial products, a prerequisite to have a freer and more transparent market. There was little protest that such neglect was paving the way for global financial instability. Warnings, such as Minsky (1986), found little echo at the time. Not only has the financial sector been pro-active in this counter reform but it also could claim that its liberalization was consistent with 327

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a general change in the forms of competition more driven by innovation in most product markets. In other words the claim was that a liberalized finance could help to set free all the potential for innovation. This is precisely the issue that this chapter seeks to investigate. Section 2 will directly look at finance as a key promoter of deregulation. Section 3 will then see to what extent the association between finance and innovation is or is not linked with an archetype popularized by Schumpeter, whereby entrepreneurs’ capacity to innovate is highly conditioned by their ability to access finance. Section 4 will come back to whatever happened in terms of finance and innovation in the transition period of the 2000s. Changes in the overall patterns of innovation lead to question the effectiveness of finance. Has it been boosting innovation or, on the contrary, has it been hampering the dynamics of innovation? Section 5 follows the main traits of the herding speculative behaviours in the financial sector that led to the various international financial crises of the last decade, just to position the successive drives that led to these repeated crises and the lessons drawn by the financial sector.

2. Finance as the main promoter of deregulation The financial sector has been a major and early promoter of the wave of deregulation that took off in the early 1980s, under the ‘reigns’ of Thatcher and Reagan. Many reasons were given at the time to support plans in all countries to liberalize financial activities. In the first place came the difficulties met by cross-border transactions at a time of increasing internationalization of developed economies. Increases in international trade flows had led to large increases in cross-border financial transactions. The end of the Bretton Woods agreements on a fixed exchange rate system led to the development of large currency markets and large international transactions. In a highly regulated financial system banks and other financial institutions were highly tempted to develop off shore activities. They presented deregulation as an ultimate possibility to avoid delocalization. A second argument in favour of the deregulation of the financial sector was that the structures of production had changed. Large firms mainly based in one country and therefore attached to one nationality were losing ground in favour of truly multinational firms, producing in different places all over the world. Such international deployment of the productive structures required foreign outwards investments, all of which increased the pressure in favour of liberalization of the financial industry.

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Clearly giving finance more leeway was going to contribute directly to a process of creative destruction whereby a more proactive flexible finance would facilitate a fruitful reallocation of productive capital. There was also a third reason backing the campaign for deregulation. Namely after three decades of a postwar expansion, largely fuelled by process of catching up in continental Europe, there was a general feeling that developed economies were entering a new phase where competitiveness was going to be much less based on price competitiveness and more on qualitative factors (such as design, innovative technological characteristics, after sales service). A deregulated finance did seem from this perspective a natural co-evolution, matching on many grounds the transformation of the structures of production. In a decade or so major steps in liberalization were taken in the financial sectors in most of the OECD countries. By the early 2000s the financial sectors were fully opened to entries from abroad. By contrast with what was experienced in other product markets the deregulation of the constraints set on the modes of production was not accompanied by sets of rules (norms and standards on products) applying to standardization of financial products. It was a fully-fledged liberalization that occurred much in advance on other domains and without the constraints that kept developing on the very products (see Arestis and Basu, 2003, 2004). Figure 22.1 shows that by 2003 financial institutions were open to threat of entry with all barriers to entry having been suppressed. By contrast the ratio of countries having at least one state-controlled company remains relatively high (70% for financial institutions and 50% for insurance), recalling that the sector was largely under public tutelage in the previous period (much like transport, communication and health). This overall view on levels of product market regulations by sector should not mask the fact that countries differ on this issue. If one grades the levels of liberalization on a scale from 6 (highly regulated) down to 0 (totally deregulated), Figure 22.2 shows that a bunch of Anglo Saxon countries turn out as relatively liberal while an eclectic set of Mediterranean and eastern countries appear as relatively still more regulated than others by 2003.1 Overall one can see in Figure 22.2 that the average indicators of product market regulation (PMR) still declined significantly between 1998 and 2003, while reforms have been passed for most of them in the 1980s. The question is now to check whether this liberalized finance has been more strongly conducive of innovation than in the past.

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Percentage of countries with legal barriers to entry in the industry

90 80

Electricity

Correlation coefficient = 0.83 t-statistic = 6.96 Gas

70

Support services to air transport Water works

60

Railways

Urban, interurban passenger transport

50 40

Support services to water transport Support services to land transport Communication Health services Other passenger land transport

30 20

Air transport

Petroleum Water transport Insurance Road freight Wholesale tradeBusiness servicesBasic metals industries Tobacco

10 0

Financial institutions

Hotels and restaurants Fabricated metal products Motion picture

0

10

20

30

40

50

60

70

80

90

100

Percentage of countries having at least one state-controlled company in the industry

Figure 22.1 Barriers to entry and state controlled companies 4.5

Product market regulation

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5

U

ni

te

d

Au st Ki rali ng a d U Ic om ni el te an d St d at Ire es la D N en nd ew m Ze ark al a C nd an a Lu Swe da xe de m n bo u Ja rg p Fi an nl B an N elg d et he ium rla Sl n ov A ds ak us R tria ep ub lic G E er U m a N ny or wa Ko y Po rea rtu ga Sw Sp l itz ain er la C ze n ch Fra d R nce ep ub G lic re ec e H Ital un y ga M ry ex ic Tu o rk e Po y la nd

0.0

1998

2003

1998 average

2003 average

Figure 22.2 Regulation in 1998 and 2003

3. Is Schumpeter to be blamed? Schumpeter (1910) is a key pioneering reference on the subject of finance and innovation. Schumpeter first praised the role of entrepreneurs in the process of development. In his view the competitive process of capitalist economies was bound to lead to efficient use of existing resources. Still the major factor of economic growth obviously relied on innovations in both processes and products. But innovation in turn required investment that entrepreneurs, or more precisely the type

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of individual entrepreneurs praised by Schumpeter, could not finance themselves. Access to finance was thus central in his view to the dynamics of innovation that entrepreneurs could launch. Systems of finance that duly opened credit to entrepreneurs were definitely factors of economic growth. The question was then to know which projects were to be supported and which were not. Schumpeter first held a restrictive and rather tautological view on this link between finance and innovation. Finance was to support innovations that required both sizeable new investments and were operated by new entrepreneurs setting up new firms.2 The project in itself stemmed directly from the entrepreneurs’ own ideas. But experience led Schumpeter to change his view and to adopt a broader and more realistic conception of innovation. The major change in that regard was the development in the interwar period of a new organization of large firms. The period was marked by the diffusion of the M-form firm (multi-divisonal), a new mode of organization of firms by means of divisions specialized by product and overviewed by the R&D department. This multi-division structure facilitated the emergence of new products as well as major updating or delocalization of production processes. This evolution occurred first in the US just before the Second World War, then in Europe after the war (see Figure 22.3). It led to the development of R&D divisions in large firms especially in charge of designing and planning innovations, be they process innovations or products innovations. This diffusion was completed during the ‘golden years’ of capitalism (see Figure 22.3). Schumpeter adjusted his views on finance and innovation to this new reality (Schumpeter, 1950). The role of finance became in this postwar period somehow more complex. Large firms had various possibilities from self financing to borrowing or issuing stocks. The oligopolistic structure of the competitive process allowed large firms to mark up their current costs of production in order to be able to finance most of their R&D. Existing firms remained the main actors in R&D activities, and new incumbent firms were only a small minority. Considering this change in the views of Schumpeter on finance and innovation, it became common to distinguish a Schumpeter mark I from a Schumpeter mark II, which partly simply reflected an historical change in organizational pattern of innovation management by industrialized economies. Looking at the technology of industries also led to differences between sectors. The importance of R&D divisions differed, leading to a categorization between hi tech industries where R&D spending represented more than 5% of the overall value of production, medium tech where

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90 80

Britain

70

Japan Germany

60 50

France

40 30 20 10 87

85

19

83

19

81

19

79

19

77

19

75

19

73

19

71

19

69

19

67

19

65

19

63

19

61

19

59

19

57

19

55

19

53

19

51

19

48

19

47

19

19

19

32

0

Figure 22.3 Diffusion of the multidivisional structure in some European countries and in Japan Source: Kogut (2000).

it ranges between 3% and 5% and low tech industries where it is less than 3% of value of production. Even so Schumpeter mark II remained a largely outdated view to characterize the link between finance and innovation in the aftermath of the mid-1970s and the crisis of the ‘golden age of capitalism’. A relative endogenization of the financing of innovation has been a major trait of the ‘modern capitalism’ à la Schonfield (1965) that prevailed during the first three postwar decades. Financing innovation was either part of the normal growth process of large firms, cared for by the mark-up applied to current production costs or an issue that required some arrangements with public authorities, either for regulatory reasons or because the projects had large externalities. Some of these concerns appeared in intermediation industries (in transportation, communication but also in distribution and in banking where regulations were effectively binding). This state of affairs changed in the 1970s with the crisis of the ‘Fordist’ model, the liberalization of the economies in the 1980s and their growing internationalization. It all brought back to the forefront the issue of finance and innovation that had become relatively neglected (as noticed by O’Sullivan, 2006). Meanwhile the perspective on finance and innovation given by Schumpeter mark II had become irrelevant. No Schumpeter

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mark III was available to update it. Two streams of thoughts developed to fill this void. On one side studies on innovation developed, outlining new patterns of innovations more interactive, combining various actors, taking into account various learning processes. These studies were concerned by innovations schemes developed by large and small firms as well. In a way they could be seen as developing some Schumpeter mark III, featuring elements of a new historical configuration of the links between finance and innovation. The other stream of thought, that praised the concern of Schumpeter for the dynamics of finance and innovation, took a more general and ideological view. It stated that, in a competitive process that is increasingly based on non-price competition, innovation plays a key role that liberalization of all product markets can efficiently boost. The Schumpeterian dynamics of finance and innovation is there strongly used in support of liberalization policies. Somehow in this last perspective the issue of finance and innovation gets back to Schumpeter mark I with an idealized entrepreneur. Much of the discourse on venture capital in the 1990s has been emblematic of such vision. This combined idealized views of finance, taking directly risks on highly innovative projects, and of innovation, where blueprints came directly out of the heads of smart, young graduates just exiting from universities. The diffusion of the technological system centred around information and communication technologies (ICTs) played a specific role in this feature, with the emblematic figures of young successful entrepreneurs such as Bill Gates and rapidly growing firms that had started from zero (the so called ‘gazelles’), such as Microsoft. Still the configuration of the links between finance and innovation that developed in the 1990s had little to do with Schumpeter mark I and brought no support to liberalization policies.

4. Whatever happened to the links between finance and innovation in the 1990s? The age of information and telecommunications, starting around the 1970s, represents the fifth technological revolution since the industrial revolution of the late eighteenth century and it is associated, according to Perez (2002, p.18), with a techno economic paradigm gathering most of the organizational traits mentioned above. Still the association of the diffusion of ICTs with an increased internationalization of large firms and a development of a globalized financial system does allow us to conclude on the nature of a) the new link established between finance and innovation and b) the society that will come out of such proto-form

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techno economic paradigm. Liberalization of finance and internationalization of the economies may well have somehow crowded out financing of innovation. There are good grounds to think that such has been the case. The new financial and liberalized capitalism that emerged in the 1990s has indeed led to new rules of governance at odds with the kind of long term investment that financing of innovation requires. Shareholder value has become the main criteria of governance of firms listed on stock markets (see Aglietta and Rébérioux, 2005). At the same time the number of stock markets has increased significantly so that most of the large firms around the world have been submitted to similar rules of governance. Short-term results that increase the value of the stocks and/or the dividends became a must. Mergers and acquisitions helped to meet such short-term targets when product markets were not sufficiently buoyant. Clearly in this perspective innovations of importance that required rather long-term investment were not welcome. One could conversely defend the opposite and see the increased internationalization and liberalization of the economies as a factor enhancing innovations at least in the developed economies. A competitive process is always more driven by innovation in a world economy, where emerging countries and those with low wage costs are taking most of the product markets driven by prices, and should effectively give a new impetus to innovation. Internationalization also contributes in helping to pool many sources of research and development. Moreover, the creation of new stock markets specialized in hi tech stocks (of which the NASDAQ stock market in New York has been a major example) has clearly facilitated strategies of innovation by new firms. It was thus a real issue in the 1990s to see whether the short-term logic of shareholder value would overtake, or not, the dynamics of innovation spurred in developed economies by the competition on internationalized product markets. Part of the answer laid in the configuration taken by the innovation systems in the present phase of internationalization. The old configuration, where R&D departments of large firms played a crucial role in the dynamics of innovation, both in terms of product and process innovations, was bound to be transformed by the possibility of pooling knowledge resources at a world-wide level. This potential was all the more important where liberalization policies had facilitated market relations with university research laboratories. A good example of this liberalization was given by the Bay Dole Act (1980) in the US, whereby research in public laboratories that had been financed by public money, could now patent and diffuse their results.

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This was an important change that helped spread a more mercantile view of research activities. At the same time waves of mergers and acquisitions contributed to the change in the fabric of the innovation systems. Externalization in a broad sense, by means of selling and buying patents, subcontracting all kinds of tasks, setting up joint ventures, and cooperation all added to the transformation of the old linear model of R&D. It was accompanied by specific institutional settings (such as fiscal advantages for R&D expenditures, new stock markets for hi tech firms, etc.) completing the liberalization of product market and production (see Table 22.1) This transformation in the world of research and innovation led to patterns of innovation that have been qualified in the mid-1990s of ‘open innovation’ by contrast with the rather linear and closed model, where knowledge and inventions produced in public laboratories were turned by in-house R&D departments of large national firms into projects of product and process innovations to be implemented by in-house departments of production (see Christensen et al., 2005). By contrast in contemporary patterns of open innovation one could observe a diversity of external sources of knowledge and inventions, turned into innovations by R&D departments as well as by specialized business services that could then either be used by firms or outsold to other firms. The chain going from invention to innovation could thus, Table 22.1 The widening range of innovation strategies in the 1990s Firms R&D activities

Markets emerging and maturing

Relevant institutions upstream and downstream

– new phase of organization: enlargements to other services & interfaces – recognition importance of design (down to market innovations), radical incrementalism – technological alliances at all levels

– financial markets for innovating firms (second markets) – development of complex bussiness services

– raising the rent on innovation (IPR and patents)

– development of venture capital

– mergers and acquisitions

– development of business angels

– supporting public research and facilitating transfers – infrastructures supporting research and innovation (technological centres, incubators, etc.) – public procurements in hi tech fields

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– allowing special fiscal advantages to small firms and/or innovative firms

336


in this more internationalised and liberalized environment, follow a large diversity of paths. The flows of exchanges in these various paths from inventions to innovations did not remain as unidirectional, from inventors to users, as it seems in the above description of innovation patterns. The division of paths went altogether with more interactive processes where lessons and demands of users could be channelled back along the chain at any stage and influence supply. Such increased interactivity in patterns of innovation has been outlined from the mid-1980s (see Kline and Rosenberg, 1986, for instance). In the more recent phase of the 1990s, the characterization of ‘open innovation pattern’ just stresses a further step in the segmentation or modularization of the process of invention-innovation. Firms opted for specific strategies more or less dependent on the specificities of their sector. The whole system of innovation patterns was not though totally transformed in the process. By the end of the 1990s large firms were still key actors in conducting innovation (see Phelps, 2006). Indeed new paths in innovation financing developed. The most emblematic was venture capital which appeared like a financial instrument, especially dedicated to support new innovative projects at a very early stage where financial support is crucial. Even if the first venture capital operations appeared in the US in the 1950s (see Gompers and Lerner, 2002) it gained a new momentum in the 1980s and 1990s, following first the authorization given to research laboratories benefiting from public money to patent their inventions (see Bay Dole Act 1980 above) and, second, the creation of secondary stock markets at the turn of the 1990s more dedicated to hi tech stocks. Still, it channelled only a minor part of the investment linked to innovation (see figures in Phelps, 2006), and early phase investment is also a minor part of VC funds which tend to concentrate more on deals of more mature hi tech firms. A qualitative assessment of the change in R&D practices indicates that looking for radical innovation appeared undesirable, in the context of short termism of the financialized liberalized capitalism, and led firms to look for ‘radical’ incremental innovation, that is, innovation that may not be intrinsically radical but is so attuned with what the market expects in terms of design and uses that it wins the competition and comes to dominate the market (see Le Masson et al. 2006). This specific shift towards more market driven innovation is in accordance with all the claims that the conditions of diffusion have become a key issue (Bhide 2006).

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This multidimensional transformation of the space of innovation strategies of the firms is moreover bound to be idiosyncratic, that is to say, to depend on some national characteristics of the educational systems, of the public research systems as well as of the financial systems and of the labour markets of the economies under view. It thus strongly grounds systemic perspectives such as developed around the notion of national systems of innovation (see Nelson 2003). The question is now to see whether all these changes (even if potential) have fuelled or hampered the dynamics of innovation. One can make a preliminary assessment of this by looking at the performances in terms of productivity gains. As the technological revolution occurring at the time is centred around ICTs, we have selected data that distinguished sectors producing and using ICTs and we have given the share of ICT in equipment. Tables 22.2 and 22.3 help to compare Europe 15 with the US, where production and diffusion of ICT goods are more advanced. The period under view is 1995–2004, which corresponds to R&D strategies developed in the 1990s considering it takes on average four to five years for them to have an impact. Tables 22.2 and 22.3 also show rather low productivity gains in all sectors, be they manufacturing or services, using ICTs or not, with the only noticeable exception of the industrial sector producing ICT goods. But this ICT sector represents only a small share of the productive activities (some 3.4% of hours worked in Europe and some 7% in the US). This Table 22.2 Growth and productivity in Europe 15 (by sector, 1995–2004) EU15 1995–2004 (Less GR, IR, LU, Pl, SW)

VA

L

VA/L

Market economy (79) Electrical machinery, post and communication (3.4) Other manufacturing (16.4) Other goods producing industries (14.5) Distribution services (20.3) Finance and business services (13.5) Personal and social services (10.8)

2.2 6.0

0.7 ⫺0.4

1.5 6.4

1.0 1.2

⫺0.3 0.0

2.3 3.5 1.7

H

K

Kit

Mfp

0.4 ⫺0.6

1.2 1.7

0.6 1.2

0.3 4.7

1.3 1.2

6.0 ⫺0.2

0.7 0.7

0.3 0.1

0.6 0.5

0.7 2.1

1.6 1.4

0.6 1.9

1.2 2.3

0.5 1.3

0.4 ⫺1.3

1.5

0.2

1.4

0.9

0.3

⫺0.9

Notes: Average growth rates of VA: gross value added; L: labour input; VA/L: productivity gains; H: hours worked; K: capital input; Kit: ICT capital; Mfp: multifactor productivity. In parenthesis, under the name of the sectors, is the average share in the total hours worked. Source: Timmer et al. (2007).

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Table 22.3 Growth and productivity in the US (by sector, 1995–2004) US 1995–2004

VA

L

VA/L

H

K

Kit

Mfp

Market economy Electrical machinery, post and communication Other manufacturing Other goods producing industries Distribution services Finance and business services Personal and social services

3.7 8.9

0.7 ⫺0.3

3.0 9.2

0.3 ⫺0.9

1.4 2.5

0.8 1.5

1.6 6.8

0.7 1.6 4.7 4.9 2.6

⫺1.1 1.0 0.5 2.0 1.7

1.8 0.6 4.2 2.9 0.9

⫺1.5 0.9 0.2 1.6 1.4

0.7 0.9 1.4 2.0 1.0

0.4 0.2 1.0 1.2 0.4

1.1 0.3 2.8 0.9 0.0

Notes: Average growth rates of VA: gross value added; L: labour input; VA/L: productivity gains; H: hours worked; K: capital input; Kit: ICT capital; Mfp: multifactor productivity. Source: Van Ark et al. (2007).

average result is mediocre and does not support the notion of a renewed dynamics of innovation spurred by new R&D strategies in developed economies. A second look at the tables shows that, comparatively, the sector of distribution and the sector of finance have been faring better in the US than in Europe. This extra growth in productivity in the US in distribution and financial services cannot be explained by standard R&D activities that do not exist in these activities. Their results stem from other innovation strategies. The dominant role of the US financial sector, at an international level, certainly helped. Conversely one can link the relative performance in distribution services in the US with a modernization, largely based and steered by the firm Wal Mart. Before drawing conclusions on the impact of financial liberalization on the dynamics of innovations, let us notice that the two services under view, namely distribution and financial services, are also those where measurement of productivity is the more problematic (see Griliches, 1994).

5. The lost decade of a financialized capitalism, 1997–2008 It is tempting to conclude from the above that financial liberalization and globalization had no sizeable impact on the dynamics of innovations as measured in terms of productivity gains. But one should not forget in this overview that the period of the 1990s and the turn of the 2000s has not been a period of quietness for globalized finance. It has been marked by large financial crises which certainly impacted the strategies of innovation of the large international firms. First there

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was the Asian crisis which showed the global instability of the system. Some lack of confidence of traders in New York on the trustworthiness of the Thai currency, fear of overinvestment in housing, initiated some US capital flights and launched a world-wide crisis, deeply affecting East Asian countries in the first place, then Latin America and Russia. At the same time the collapse of a major hedge fund LTCM3 showed that even at the core of globalized finance dangerous hazards could persist. All this happened in the midst of speculative runs in stock markets on dotcom firms, e.g., firms dealing one way or another with ICTs, and most of the time linked with the development and use of the internet. Stocks of firms that had never made any profit were thus rapidly propelled ahead of stocks of old mature industries. This speculative bubble burst in 2000 leading stocks on secondary markets to fall heavily. This crash showed that many so-called financial innovations had led to or simply consisted of fraudulent actions. A lot of financial transactions, kept off the books, created a very uncertain situation many of the previously successful dotcom firms. The most emblematic case has been Enron, often praised4 in the previous decade for its innovations in financing. In the aftermath of 2001 it became also clear that rating agencies had vested interest, being paid by the very enterprises they were rating. So did auditing services. The lack of transparency it implied could and did lead to all kinds of frauds and provoked a wave of mistrust that affected all stock markets. Still, the lessons of 2001 seemed to have been soon forgotten with little changes in the degree of (de)regulation. The changes that were made, such as the diffusion of new accounting norms, valuing firms assets at current stock market values and not at investment prices, increased the instability of the system. New controls on banking such as Basel II, implemented in the aftermath of the 2001, did not take much notice of the problems of vested interest of private controllers. Trust somehow resumed if one looks at the steady rise of the stock markets prices from 2002 till 2007. Although the whole system became even more shortterm oriented and thus even less inclined to take long-term risks on innovative projects. It showed in fact that second markets recovered much less rapidly while venture capital nearly became an endangered species, to quote Phelps (2006). Indeed the fraction of support to early stage financing which was small became negligible. Robb (2006) stresses that venture capital in early stages projects represents only 0.02% of GDP in the US in the mid-2000s. It amounts to 0.2% of GDP if one includes all the deals done by venture capital which concern much less risky and more mature innovative projects.

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Furthermore these VC deals are respectively for 42% and 41% in ICT and life sciences industries, sectors which represent around 20% of GDP. VC had always been investing in projects that had already showed their viability: in the mid-1990s 77% of the deals concerned three years old projects. Table 22.4 shows to what extent VC risk taking towards innovative projects decreased after the 2001 stock market prices crisis. This occurred on top of a strong reduction in the overall volume of deals in VC after 2001, clearly showing that financial capitalism was by no mean speculating on innovation. What has occurred in the late 1990s was moreover mainly centred on the ICT industries. Ventures in life sciences turned out to be much more difficult and long-term oriented. All of which is part of the story that explained why financial capitalism concentrated on housing ventures. It looked beneficial for both national construction industries and for financial industries which by means of intensive securitization created instruments to fuel the whole process, still at a rather mid- or short-term horizon. The disastrous effects of such inflexion were clear from the start. Housing was extended with little care for environment and urban planning and Spain gave the worst example of these damages. Financial industries deployed their techniques of securitization, segmenting deals to extremes, especially in the US, allowing stillborn commitments where defaults were obviously a matter of days. The so-called sub-prime crisis that emerged in 2007 was truly no surprise. One has only to see the rise in ‘no documents loan’ in the US (from the usual 5% up to 20%

Table 22.4 Venture capital deals less prone to support seed and early stage projects after 2001

Seed-startup Early Expansion Later

1996–98

1999–2001

2002–04

2005–06

9.2 25.3 50.2 15.2

3.5 23.2 56.6 16.7

1.6 18.0 49.8 30.5

4.0 15.7 41.4 38.9

Notes: Seed-startup includes proof of concept (seed), research, product development, or initial marketing. Early includes financing for activities such as initial expansion, commericial manufacturing, and marketing. Expansion includes major expansion of activities, or to prepare a company expecting to go public within 6–12 months. Later includes acquisition financing and management and leveraged buyout. Source: Thomson Financial, National Venture Capital Association Yearbook 2007 (2007). See appendix table 6-56.

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in the early 2007) or the initial excessive levels of indebtedness of those who finally defaulted in 2007 and 2008. 1997–2007 was indeed a lost decade as the drawbacks of global finance capitalism were clearly exposed (Arestis and Basu, 2003, 2004). First the East Asian crisis of 1997 confirmed the structural instability of the system. International lending to East Asian countries which had shown such extraordinary successful growth from the mid 1980s onwards was a first speculative run of the freshly globalized finance (see Mayer 1998, Arestis and Glickman 2002). The economic crisis that followed a reversal of this speculation seriously harmed the economies of the East Asia region. Second, this warning did not slow down the speculative run on ICT ventures which had started in the early 1990s in most OECD countries leading to a sharp fall in stock market crisis in 2001. Few lessons were drawn from these examples of Minskian financial instability, although the dominance of finance seemed unsustainable, not only to critical economists like Strange (1998) or Toporowski (2000) among others, but also to businessmen like Soros (1998, 2000). The speculative run that developed in the 2000s through the securitization of housing loans gave a dramatic illustration of this un-reconstruction. A supersized financial sector has turned all its innovation ability inwards in order to force to unprecedented heights the levy of financial intermediation. The share of finance in US total corporate profits, for instance, rose from 10% in 1980 to 40% in 2007, while at the same time the sector represented 5% of employment and 15% of value added. Conversely the share of the stocks of financial firms rose from 6% of total to some 20% in 2007 while its debts rose from 10% of GDP to some 60% of GDP.5 Two major financial crises, namely those of 1997 and 2001, touching different important aspects of globalized finance, did not lead to any deep reform of the system (see Arestis and Sawyer, 2005). Will the system to do any better after the 2008 crisis? The massive intervention of the states to avoid a full systemic crisis seems to imply that a big reform should follow. But the bankruptcies of some major financial establishments have left many survivors in monopolistic positions, with sizeable perspectives of profit on a still globalized market.

Notes 1. Figures 22.1 and 22.2 are drawn from an OECD working paper by Conway et al. (2006). 2. See O’Sullivan (2006) for an exposé in an historical perspective of the various stands of Schumpeter on finance-innovation.

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3. The Long Term Capital Management was a very exclusive hedge fund, reserved for high investors, which had to be rescued in 1998 having borrowed over $120 billions with as ‘little’ as $4.7 billions of initial fund. 4. If only in the Harvard Business Review. 5. Another sign of this extravagance was the extremely high wages of financial CEOs and of little groups of traders, leading an unprecedented rise in wage inequality across the board of all sectors while median wages stagnated.

References Aglietta, M. and Rébérioux, A. (2005) Corporate Governance Adrift: A Critique of Shareholder Value. Cheltenham: Edward Elgar. Arestis P. and Basu S. (2003) ‘Financial Globalization: Some Conceptual Problems’, Eastern Economic Journal. Vol. 29, No 2, May. Arestis P. and Basu S. (2004) ‘Financial Globalization and Regulation’, Research in International Business and finance. Vol. 12, No 1, July. Arestis P. and Glickman M. (2002) ‘Financial crisis in South East Asia: Dispelling illusion the Minskyan way’ Cambridge Journal of Economics, Vol. 26, No 2, March. Arestis P. and Sawyer M. (2005) ‘Financial Liberalization and the Finance–Growth Nexus: What have we learned’ in P. Arestis and M. Sawyer (eds), Financial Liberalization: Beyond Orthodox Concerns, International Papers in Political Economy, Basingstoke: Palgrave Macmillan. Bhide A. (2006) ‘How Novelty Aversion Affects Financing Options’, Capitalism and Society Vol. 1, No 1, article 1. Christensen, J.F., Olesen M.H. and Kjær, J.S. (2005) ‘The industrial dynamics of Open Innovation – Evidence from the transformation of consumer electronics’, Research Policy Vol. 34, pp. 1533–49. Conway P. Janod V. Nicoletti G. (2006) Product market regulation in OECD countries: 1998 to 2003. OECD, Paris, Economics department working paper No 419. Friedman, M. and Friedman, R. (1980) Free to choose. A Personal Statement. New York, Harcourt Brace Jovanovitch. Gompers P. and Lerner J. (2002) ‘The venture capital revolution’, Journal of Economic Perspectives, 15(2), pp. 145–68. Griliches Z. (1994) ‘Productivity, R&D, and the Data Constraint’, American Economic Review, Vol. 84, No 1, pp. 1–23. Kindleberger C. and Laffargue J.P. (eds) (1982) Manias, panics and crashes, a History of Financial Crises. New York, John Wiley & Sons, Inc. Kline, S.J. and Rosenberg N. (1986) ‘An Overview of Innovation’ in R. Landau and N. Rosenberg (eds) The positive sum game: harnessing technology for economic growth. Washington, DC: National Academy Press. Kogut B. (2000) ‘The transatlantic exchange of ideas and practices: national institutions and diffusion’ Les notes de l’IFRI, No 26 Paris. Le Masson P., Weil B. and Hatchuel A. (2006) Les processus d’innovation, conception innovante et croissance des entreprises. Paris, Hermés Lavoisier, 471 pp. Mayer M. (1998) ‘The Asian Disease: Plausible Diagnosis, Possible Remedies’, The Jerome Levy Economics Institute. Working Paper No 232.

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Pascal Petit 343 Minsky H. (1982) ‘The Financial-Instability Hypothesis: Capitalist Processes and the Behaviour of the Economy’, in Kindleberger and Laffargue (eds), pp. 13–39. Minsky H. (1986) Stabilizing an Unstable Economy. New Haven: Yale University Press. Minsky H. (1995) ‘Longer waves in financial relations; financial factors in more severe depressions’, Journal of Economic Issues 29, March, 83–95. Nelson R. (ed.) (2003) National Innovation Systems: A Comparative Analysis. Oxford University Press. O’Sullivan, M. (2006) ‘Innovation and finance’, Handbook on Innovation, Oxford University Press. Perez C. (2002) Technological Revolutions and Financial Capital: The dynamics of bubbles and golden ages. Edward Elgar. Phelps E. (2006) ‘Capitalism Theory’. The Center on Capitalism and Society. Columbia University, New York. Robb D. (2006) ‘Europe’s venture capital institutions are good enough’, Paper presented at a joint conference of CESIFO and the Center on Capitalism and Society (Columbia University), Venice, July. Schonfield, A. (1965) Modern Capitalism: The Changing Balance Between Public and Private Power. Oxford: Oxford University Press Schumpeter J. (1910) Theory of Economic Development. Cambridge, Mass.: Harvard University Press. Schumpeter J. (1950) Capitalism, Socialism and Democracy. New York: Harper. Soros G. (1998) The Crisis of Global Capitalism: Open Society Endangered. London: Little, Brown & Company. Soros G. (2000) Open Society: Reforming Global Capitalism. New York: Public Affairs. Strange S. (1998) Mad Money. Manchester, Manchester University Press. Timmer M.P., O’Mahony M. and Van Ark B. (2007) ‘EU KLEMS Growth and productivity accounting: an overview’, International Productivity Monitor, Spring. Toporowski J. (2000) The End of Finance: Capital Market Inflation, Financial derivatives and Pension Fund Capitalism. London: Routledge. Van Ark et al. (2007) EU KLEMS Growth and productivity accounting: an overview. International Productivity Monitor, Spring.

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Index access to credit 229–33 aggregate demand 5–8, 24–6, 28, 57, 80, 115, 120–2, 133–4, 139–40, 144–7, 186, 189, 200, 217, 244 Arestis, Philip xii–xx, 3, 5, 7, 17, 19, 20, 21, 23, 24, 25, 26, 32, 35, 37, 50, 73, 75, 76, 112, 120, 121, 126, 128, 131, 134, 136, 147, 148, 180, 186, 193, 194, 205, 207, 209, 211, 226, 227, 228, 229, 230, 234, 238, 247, 248, 250, 262, 269, 270, 279, 280, 282, 286, 290, 295, 298, 299, 301, 308, 322, 324, 329, 341 asset prices 135, 184, 197, 198, 199, 210, 211–8, 250 Bank of Canada 36–9, 41, 44–7 Bank of Canada economic models 12–13 base money 112, 115, 116 capital account liberalization 27, 227, 283, 284–8, 289 capital accumulation 187, 224, 250–62, 286 capital flows 24, 278, 283, 286–7, 288–9, 298 central bank 3–8, 19, 29–30, 36–40, 42, 46, 54, 70, 77–86, 91–106, 115–16, 120, 121, 153, 154, 164–6, 169, 171–2, 179, 180–9, 193, 199, 200, 210, 218, 245–7, 267–70, 272, 288, 306 central bank independence 22–3, 61, 76, 112, 126, 133–6, 272, 274, 277, 307 contractive demand regime 257, 259, 260–1 contractive regime 259 corporate control 258, 314, 316, 320, 323 corporate governance 317, 320, 321, 323

cost-determined prices 139–40 cost-push inflation 29, 118, 133 credibility 5, 21, 22, 38, 67, 73, 78, 270, 271–9 credit crunch 119, 122, 156, 203 crises 27, 155, 157, 164, 181, 196, 198–200, 203–5, 225–6, 228–9, 238, 278, 282–4, 287–90, 295, 297–301, 307, 328, 338, 341 debt deflation 180, 182, 189, 193, 196, 199, 200, 203, 207, 209 demand regime 252, 254, 256–62 demand-determined prices 139, 140, 145 de-regulation 117, 153, 167, 200, 201, 203, 205, 209, 210, 218, 225, 298, 299, 327, 328–9 distributed profits 252–5 East Asian financial crisis 228, 283, 285, 288, 299, 339, 341 economic growth 28, 30–1, 75, 94–5, 137, 142, 153, 204, 224–6, 228, 231, 251, 271, 276, 279, 296, 283–4, 286–8, 321–2 efficient markets hypothesis 122, 164, 172, 173, 213, 214, 290, 314 emerging markets 26, 27, 283, 289, 317 ERM (exchange rate mechanism) 37, 61, 114 European Central Bank (ECB) 3, 7, 54–5, 62, 70, 72–3, 120, 270 expansive demand regime 257, 259, 260, 261 Federal Reserve Board 4, 7–8, 17, 36, 44, 46, 92–4, 164, 166, 167 Federal Reserve Board macro model 7–8 finance-led growth regime 251 financial crisis 6, 31, 50, 71, 154, 155, 157, 159, 171, 172, 196–7, 344

Sawyer

Index 345 198, 199, 209–10, 218, 229, 233, 279, 282, 286, 288–90, 323 financial fragility 196, 198, 203, 206, 299, 302, 307 financial instability 271, 225, 275, 278, 288, 327, 341 financial instability hypothesis 196–200, 203, 204, 210 financial liberalization 210, 211, 217, 224–34, 250, 269, 282–8, 295–301, 305, 320, 322, 338 financial robustness 198, 200, 206 financial services 229, 231–3, 338 financialization 250–2, 254, 261–2 fiscal policy 21–3, 25, 52, 66, 73, 80, 112, 114, 115, 120, 122, 123, 128, 146, 229 Glass–Steagall Act 154, 175, 180, 200, 201, 306 globalization 44, 121, 232, 247, 283, 288, 290, 327, 338 great moderation 76, 196, 203 Greenspan, Alan 146, 157, 161, 167, 168, 170, 182, 200, 218, 315 import prices 118, 119, 121, 135, 299 income shares 80, 134, 226, 232 inequality 228, 232–3 inflation 5–17, 20–34, 35–52, 54, 56, 58, 60–5, 67, 72, 79–80, 83–6, 94, 111, 112, 113, 115–23, 126–36, 139, 143–8, 166, 172, 179, 186–9, 191–2, 194, 198, 200, 210, 217, 230, 241, 269, 276, 298, 301 inflation targeting 17, 19, 20, 30, 31, 35–6, 38–9, 42, 75, 78–9, 114, 119, 121, 123, 126, 133–6, 269, 270, 272, 276 informal financial sector 230–1 institutional constraints 274–5 institutional design 77, 78, 290–1 institutional framework 23, 62, 64, 282 institutional quality 283, 286–7 institutional reforms 270 interest rate 4–9, 12–16, 21–2, 24, 26, 27–8, 36–7, 40, 42, 46, 49, 52, 54, 91–3, 98, 100, 111–15, 117, 120,

122, 146, 198, 241,

127, 133, 134, 135, 136, 141–3, 179–80, 182, 184–7, 188–93, 200, 212, 213, 224, 230, 232, 245, 284, 288, 296–307

Kalecki, Michał 238, 240, 241, 242, 245, 247–8, 253, 255 Kaleckian approach 139, 140, 141, 144, 146, 245, 252, 257, 261 Keynes, John Maynard 4, 19, 23–5, 112, 120–1, 163, 164–75, 197, 204–5, 214, 237–48, 290, 311, 312, 314 Keynesian economics 4, 15, 25, 74, 75, 77, 111, 115, 116–17, 127, 204–5, 238–48, 312 liquidity 24–5, 114, 164, 168, 169–74, 179–82, 184–5, 189, 191–3, 200, 283, 288–90 Medium Term Financial Strategy (MTFS) 111, 112, 113, 114, 117 microfinance 231 Minsky, Hyman 196–205, 209–18, 242–3, 246, 299, 302, 307, 327 Minsky credit bubble 196 Minsky meltdown 196, 203, 302 Minsky moment 196, 209 mixed economy 151, 151, 161, 248 monetarism 112, 115, 116, 117, 119, 120, 122, 241 monetary base control 115, 116, 123, 182 monetary policy 4–8, 12, 15, 17, 19, 21–4, 27–30, 35–9, 44, 50, 54, 62, 72–3, 75–82, 86–7, 91–3, 101, 104, 111, 112, 114, 119, 120–3, 132–5, 141, 144, 146–7, 180, 182, 185, 187, 192, 198, 199, 200, 202, 205, 229, 241, 272, 275–6 monetary union 58, 62, 64, 65, 67 money wages 24, 117, 140 money, (non) neutrality of 7, 17, 23–4, 25, 165–7 moral hazard 153, 158, 290, 296–7 NAIRU (non-accelerating rate of unemployment) 21, 117, 133–4

Sawyer

346

Index

nationalization 151–61, 306 natural rate of growth 146, 243, 258 natural rate of interest 121, 143 natural rate of unemployment 23, 119, 127–9, 133 neo-classical economics 39, 75, 76, 119, 147, 216, 283–7, 290 neo-liberal reform 269–70, 272 neo-liberalism 225, 269–80 new Classical economics 76, 112, 166, 271–2, 275–6 new consensus in macroeconomics (NCM) 3–4, 17, 19, 40, 75, 76, 112, 119, 120, 122, 128, 130, 147, 180 new Keynesian economics 19, 76, 77, 112, 120, 126, 130, 131–2, 147, 166, 238 non-inflationary continuous expansion (NICE) 112, 119, 121

productivity 94, 117, 121, 140–1, 145, 146, 147, 224, 226, 231, 245, 252, 284, 285, 337–8 productivity growth 250–5, 257–8, 259, 260, 262, 312–13 productivity regime 257–8, 259, 261 profit margins 24, 140 profit maximization 119, 130, 215, 231 profit rate 186, 187, 188, 191, 251, 253–5 profit share 127, 253–5 profitability 134, 156, 160, 185, 187, 189–91, 229, 283, 305, 315–17 profits 134, 139, 174, 182, 189, 197, 198–9, 203–4, 211, 214–16, 242, 251–5, 278 public sector borrowing requirement (PSBR) 111, 113, 114, 116 quantitative easing 7, 122, 182

oil prices 31, 39, 41, 71, 118, 121, 146 Phillips’ curve 4–5, 20, 37–8, 77, 111, 120, 126–36, 144–5 policy coherence 270, 271, 273, 278–9 policy conformance 273, 279 policy credibility 270, 271–3, 275, 276 policy space 270–1, 274, 278–9 Ponzi financing 198, 206, 212 Post Keynesian economics 19, 20, 23–5, 31, 35, 50, 114, 116, 117, 167, 197, 209, 237–48, 243–5, 248, 250–1, 255, 257, 270, 282, 295, 301, 308 poverty 224–9, 231–4, 274, 277, 295, 305 price level 10, 117–19, 130–1, 139–40, 166 price stability 5, 6, 21–3, 36, 55, 65, 69, 70, 72, 78, 92, 94, 95, 136, 143, 210 principal–agent 78–9, 81, 82, 83, 86, 251 privatization 151–3, 155, 157, 158, 160–1, 225, 295, 300, 301

rate of interest see interest rate real wages 117, 127, 128, 131, 132, 140, 146, 228 regulation 80, 122, 151–3, 156, 158–9, 160–1, 166, 167, 173, 171, 200–3, 205, 213, 229, 289, 291, 299, 322, 329, 332 rentiers 40, 242, 251, 253–7 Schumpeter, Joseph 142, 147, 239, 328, 330–3 securitization 171, 174–5, 181, 201, 340, 341 shareholders 250, 251, 252, 254, 261–2 speculative attacks 70, 114 speculative behaviour 328 speculative boom 199 speculative bubbles 327, 339 Sterling M3 (£M3) 111, 112, 114, 116, 117, 118 stock market 10, 28, 136, 200, 213, 218, 239, 311–23, 334–6, 339–41 subprime crisis 196, 200–3, 204 supply shocks 29, 30, 146 supply-side 5, 21, 23, 24, 42, 79, 80, 127, 134, 147, 243

Sawyer

Index 347 Sveriges Riksbank model 15–17 systemic failure 153, 154, 156, 158, 160 take overs 116, 304, 311, 313–14, 316–17, 320–3 Taylor rule 12, 19, 20, 44, 46, 47–9, 120, 143, 144, 146, 147 technical progress 252, 255, 257, 312 Thatcher, Margaret 111–12, 115, 123, 153, 238, 328

unemployment 9–10, 11, 12, 21, 23, 25, 26, 28, 30, 40, 111, 114, 117, 119, 120, 121, 122, 126–9, 131, 132, 133, 147, 164, 197, 225, 228, 242, 244, 254 Wicksell, Knut 4, 36, 127, 143, 186 Wicksellian approach 37, 39, 140, 180, 186

Sawyer

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