Flexible Exchange Rates, Fed Behavior,
and Demand Constrained Growth in the USA
by
L. Randall Wray
Abstract
This
paper examines Chairman Greenspan’s recent claim that central bankers around the
world have been operating “as if” monetary policy were constrained by gold that
backs up reserves. The paper argues, instead, that central banks in flexible
exchange rate regimes operate with an overnight interest rate target, which
eliminates the possibility of discretionary control over bank reserves. In other
words, central banks cannot behave as if reserves are constrained by
gold. The paper will argue that fiscal policy, on the other hand, has been
operated as if it faced financing constraints. For this reason, growth has been
demand-constrained by austere fiscal policy. However, the perceived constraints
on fiscal policy are not appropriate to a sovereign government operating with a
floating currency. The paper concludes by arguing that adoption of a floating
rate system from the mid 1970s (what Greenspan disparagingly calls a fiat money
standard) has made it possible to operate fiscal policy without these
constraints—that is, to take advantage of the possibilities offered to the
issuer of a floating currency. This would include maintenance of full employment
at home while enjoying the benefits of a trade deficit.
FLEXIBLE
EXCHANGE RATES, FED BEHAVIOR, AND DEMAND CONSTRAINED GROWTH IN THE USA
The following response from Alan
Greenspan’s final testimony before Congress to a question about why the Fed
holds gold is worth quoting at length:
Why do we hold
gold? [T]he answer is … that, over the generations, when fiat monies arose and,
indeed, created the type of problems … of the 1970s … central bankers began to
realize … how deleterious a factor the inflation was. And, indeed, since the
late '70s, central bankers generally have behaved as though we were on the gold
standard. And, indeed, the extent of liquidity contraction that has occurred as
a consequence of the various different efforts on the part of monetary
authorities is a clear indication that we recognize that excessive creation of
liquidity creates inflation which, in turn, undermines economic growth. … So I
think central banking, I believe, has learned the dangers of fiat money, and I
think, as a consequence of that, we've behaved as though there are, indeed, real
reserves underneath the system.
While his answer is rather
convoluted, the key point is that the fiat money system tended to lead to
“inadvertent” excessive liquidity creation by central banks, and so they have
been behaving as if they were constrained by a gold standard. A case could be
made that theories of “crowding out”, of “government budget constraints”, and of
current account constrained growth are all based on a presumption of fixed
exchange rates. However, this paper will focus a bit more narrowly on
Greenspan’s claim that with a “fiat money”, central banks create too much
liquidity, and on his claim that central banks have been fighting inflation by
“contracting liquidity” as if they were on a gold standard.
I will also provide an alternative
interpretation of the constraints that have been in operation in the US since
the 1970s. I will make two main points:
the US economy suffers from
chronic inadequate demand, and has rarely been subject to any significant
supply constraints—whether of productive capacity or of labor;
and leakages have been the
cause of the demand constraints.
In this light, Fed policy can be
seen as a string of mistakes guided by a fundamentally flawed view. Inflation in
the US does not result from excessive aggregate demand and, indeed, our worst
bouts with inflation have come during periods of above-normal slack. However,
Fed policy does not normally have a huge impact on the economy, and for that we
should be eternally grateful given how misguided it has been. This is the major
disagreement I have with many critics of the Fed. I could go even further and
argue that we really do not know whether restrictive policy by the Fed actually
reduces aggregate demand—and whether lower interest rates stimulate demand—but
that would take us too far afield. Hence, my argument is that while monetary
policy has been poorly formulated, it is fiscal policy that is primarily
responsible for chronically slack demand. I will conclude that fiscal policy has
been constrained “as if” it were operating in the context of fixed exchange
rates.
1. Growth Constraints
Very briefly, let us examine the
conventional wisdom regarding constraints on growth. There is a general
consensus among respectable economists that in the long run, only the supply
side matters. In the short run, both supply side and demand side variables
matter (there was of course a flirtation with new classical economics that
denied a role for demand even in the short run, but that view has lost favor).
Unlike the 1960s version of Keynesian economics, fiscal policy is given a small
role to play on the demand side (although government can influence the supply
side, for example through its tax policy) while monetary policy is the main
lever used to impact demand and hence growth. In the long run, money is neutral,
but a variety of transmission avenues have been posited to allow money to
influence demand in the short run. The new consensus rejects a simple monetarist
transmission mechanism (from reserves to monetary aggregates to spending).
Rather, it is recognized that central banks operate mostly with interest rate
targets, but these are supposed to affect demand directly and indirectly. Direct
effects would include most prominently supposed interest elasticity of
investment and some types of consumption spending (notably, on new housing).
Indirect effects would include complex portfolio effects; for example, interest
rate impacts on equity markets that could generate wealth effects on consumption
as well as affecting investment through revisions to Tobin’s “Q”. Further, the
central bank affects “liquidity” through purchases/sales of assets, including
foreign exchange, which also affects demand.
Together, this array of tools gives
the central bank a strong, albeit short run, impact on demand. When the economy
grows too fast, threatening to set off inflation, the central bank is to dampen
demand by raising interest rates; when it grows too slowly (causing unemployment
and raising the specter of deflation), the central bank lowers rates to
stimulate demand. Japan would seem to pose a conundrum for policy makers because
its interest rate was pushed essentially to zero many years ago—how can policy
provide further stimulus? Happily, theorists (including several Fed officials)
have argued that the Bank of Japan can still “pump liquidity” by refusing to
sterilize capital flows that result from its trade surplus, and by portfolio
transformations (the central bank could buy longer maturity bonds, or private
debt). (Meyer 2001; Bernanke 2005) While there is much more to policy formation
that follows the new monetary consensus—including Taylor Rules and Wickesellian
real rates—this is not essential to our analysis here.
In sum, when Greenspan says that
central bankers have been behaving as if they operated on a gold standard, and
when he refers to “liquidity contraction” to fight inflationary pressures, he
appears to mean that the central bank is operating to regulate demand so that it
grows at a pace consistent with growth of supply. Greenspan has openly rejected
both money growth rate rules and inflation targeting, opting for greater policy
flexibility. When productive capacity grows rapidly—as it supposedly did in the
Clinton boom—the chairman is willing to adopt “loose” policy, allowing
“liquidity” and demand to grow commensurately. However, when the Fed believes
that demand is outstripping supply, it raises rates to “reduce liquidity”. These
short run manipulations are supposed to maintain stable growth at capacity and
without inflation. Note that because monetary policy is supposed to have no
impact on the supply side, all attention is focused on demand management. That
the US and other countries generally have enjoyed disinflation over the past
quarter century is taken as evidence that the Fed and other central bankers have
successfully managed demand to keep it within more-or-less naturally given
supply constraints.
2. Empirical Evidence of US Demand
Constrained Growth
Let us move on to an alternative
argument that the US economy has suffered from chronic demand-constrained growth
that really never threatened to exceed supply constraints. Rather than taking
supply side capacity as given, it will be argued that both the supply of labor
as well as its productivity are variables that are highly responsive to demand.
To the extent that policy operates to constrain demand, it also operates to
maintain slack in labor markets and simultaneously limits productivity growth.
Further, slower economic growth also attenuates the incentive to invest and to
implement more productive operational procedures—although there can be
countervailing pressures, such as foreign competition. The notion of demand
constrained growth is certainly not novel for Post Keynesians. Verdoon’s Law
proposes a positive relation between the rate of growth of output and labor
productivity. (See Thirlwall 1983 and Verdoon 1980.) If demand constraints
reduce investment incentives, a cumulative causation process develops in which
low productivity growth affects growth, which generates continued low
productivity growth. What I will argue is that growth of demand in the US has
generally been too low to allow for adequate growth of both the labor force and
labor productivity. I will not pursue the more difficult cumulative causation
argument, nor offer direct evidence that investment in productivity-enhancing
equipment has been hindered. For my purposes, it will be sufficient to decompose
growth into constituent elements and examine their trends.
Per capita (inflation adjusted) GDP
growth can be attributed by identity to growth of the employment rate (workers
divided by population) plus growth of productivity per worker. Figure 1 shows
the allocation of per capita GDP growth in the US between these two variables.
In previous work, following the insights of Robert Gregory, I showed that while
per capita GDP growth was similar across OECD countries, the contributions of
each of these varied considerably. (Pigeon and Wray 2002) Only the US and Canada
had much growth of the employment rate—in large part due to more women coming
into the labor force. Employment rates actually fell in France on a long-term
trend, while they were more or less stable in all the other nations. By
contrast, and as is necessarily the case, productivity growth in all these
nations was very much higher than that experienced in the US and Canada from
1970 to 1995. I attributed the low growth of employment rates in the rest of the
OECD on the one hand, and slow productivity growth during those years in the US
and Canada on the other, to slow growth of aggregate demand. That is, if
aggregate demand does not grow at a clip sufficiently above productivity growth,
then employment rate growth must (identically) suffer; and vice versa.
**Insert Figure 1 Here**
As Figure 1 shows, productivity’s
contribution to US per capita GDP growth changed dramatically during the 1990s.
Suddenly, a “new economy” was created that supposedly removed supply constraints
and allowed GDP to grow more quickly. Even when that new economy crashed and
burned in the Bush recession, productivity growth still accounted for a
European-like majority of economic growth as employment rates stagnated and even
fell. Over the Bush recovery since 2001, job creation still has been far too
anemic to allow employment growth to recover to Clinton-era rates. In short,
between 1970 and 1995, growth of employment and growth of productivity each
contributed about equally to US economic growth, however, with the relatively
stagnant employment rate we’ve had in recent years all the growth of output has
been due to rising productivity.
**Insert Figure 2 Here**
Given a growth rate, there is a
tradeoff between employment growth and productivity growth: if the US grows at
only 3% and if our employment rate grows at 2% it is mathematically impossible
for productivity to grow at anything other than 1%. Figure 2 shows a
hypothetical trade-off for the US, Europe and Japan, based on historical data
from 1970-97. For the US to have productivity growth as high as that of Japan or
Europe—or as high as we had during the so-called new economy boom under
Clinton--we had to grow above 4 or 5% per year (in inflation-adjusted terms).
This is something we rarely achieved for very long—for reasons explored in the
remainder of this section. During the 1990s, it was argued that labor market
flexibility in the US contributes to higher employment rates (and lower
unemployment rates), and that is probably true to some degree. However, this
means that the US “suffered” from low productivity growth, except when aggregate
demand growth was very much more rapid than in the other OECD nations (excluding
Canada). By contrast, the other OECD nations “suffer” from low employment rates,
so they have come up with various schemes to increase vacations, lower
retirement ages, and share work (France’s experiment with mandated work week
reductions is the most glaring example). These schemes have not increased
employment, but rather have mostly raised productivity—evidence that the true
constraint has been insufficient demand. I interpret the US results since the
mid 1990s as further evidence that demand has constrained growth, and, indeed,
if demand were to begin to grow faster, our employment rate would resume
growth--the stagnation of employment in the Bush years is due to insufficient
growth of demand, not due to a sudden epidemic of laziness.
**Insert Figure 3
Here**
This brings us to the second main
point—that leakages constrain demand, resulting in chronic underperformance.
This follows from the usual Keynesian theory according to which spending
determines income. The autonomous components of spending determine and are equal
to the leakages—that is, the portion of income received but not consumed. In the
typical presentation, investment plus government spending plus exports are the
injections, equal to the sum of the leakages that are comprised of saving plus
taxes plus imports. (See also Powers 1996.) However, I prefer a more instructive
formulation that follows the work of Wynne Godley. We can think of the economy
as being composed of 3 sectors: a domestic private sector, a government sector,
and a foreign sector. If one of these spends more than its income, at least one
of the others must spend less than its income because for the economy as a
whole, total spending must equal total receipts or income. While there is no
reason why any one sector has to run a balanced budget, the system as a whole
must. Figure 3 shows the three sectoral financial balances as a percent of GDP
from 1960 through the second quarter of 2005. Note the sign on the government
balance is reversed, so that a deficit is shown as positive. As constructed, the
private sector balance equals the sum of the government balance plus the foreign
balance. In terms of the leakage/injection terminology, a sector that spends
less than its income represents a leakage, while a sector that spends more than
its income generates an injection. The following three points can be made:
*Historically,
the private sector usually runs a surplus—spending less than its income. This is
how it “saves” or accumulates net financial wealth. For the US this has averaged
about 2-3% of GDP, but it does vary considerably over the cycle. It is a leakage
that must be matched by an injection.
*Before
Reagan the foreign sector was essentially balanced—the US ran trade surpluses or
deficits, but they were small. After Reagan, the US ran growing current account
deficits, so that today they reach about 6% of GDP. That is another leakage.
*Finally,
the US government sector taken as a whole almost always runs a budget deficit.
This has reached to around 5% under Reagan and both Bushes. It is the injection
that usually offsets the private and foreign sector leakages.
With a traditional private sector
surplus that averaged about 2% and a more or less balanced trade account, the
“normal” budget deficit needed to be about 2% during the early Reagan years to
offset that leakage—with cyclical peaks and troughs that varied from about 3.5%
of GDP to nearly zero. In robust expansions, before the Clinton years, the
domestic private sector balance would fall close to zero, which allowed the
budget deficit to fall while a current account deficit would open. The budget
deficits were so large during the Reagan recession that the private sector
retained a surplus equal to 1% of GDP even as the current account deficit rose
above 3%. Still, what is important to note about this chart is that the private
sector always generated a leakage as it accumulated net financial assets.
However, since 1997 the private sector has been in deficit every year but one,
and that deficit climbed to more than 5.6% of GDP at the peak of the boom. This
actually drove the federal budget into surplus of about 2.5% of GDP (the overall
government balance reached 1.65% in the beginning of 2000) and the current
account deficit to about 4% of GDP. At that time nearly everyone thought the
Clinton budget surplus was a great achievement, never realizing that by identity
it meant that the private sector had to spend more than its income, so that
rather than accumulating financial wealth it was running up net debt.
What has been truly amazing is that
after a short-lived surplus during the Bush recession, the private sector
balance returned sharply to negative territory. In spite of a relatively
lack-luster recovery, there was no significant private sector retrenchment of
spending—while previous recessions had led the private sector to run surpluses
of about 6% of GDP (and nearly 9% of GDP after the 1974-75 recession) as balance
sheets were strengthened, the present “recovery” has occurred as balance sheets
have deteriorated.
Much more could be
said to document the growing private sector indebtedness and the financial
precariousness of the recovery, but let us return to the argument that leakages
constrain aggregate demand. The trade deficit represents a leakage of demand
from the US economy to foreign production. There is nothing necessarily bad
about this, so long as another source of demand exists for US output, such as a
federal budget that is biased to run an equal and offsetting deficit. Indeed, as
elementary trade theory teaches, in real terms, exports are a cost and imports
are a benefit for the nation as a whole. A trade deficit generates net real
benefits, with real costs resulting only if the nation refuses to put resources
made redundant by trade back to work. Private sector net saving (that is,
running a surplus) is also a leakage. As discussed above, the private sector
surplus was typically 2-3% of GDP in the past. Adding today’s current account
deficit (over 6% of GDP), that gives a total “normal” leakage of aggregate
demand of at least 8% of GDP. This leakage would have to be made up by an
injection from the third sector, the government. In other words, the only way to
sustain a combined domestic private sector and foreign sector leakage of 8% of
GDP is for the overall government to run a deficit of that size. Since state and
local governments have to balance their budgets, and on average actually run
surpluses, it is up to the federal government to run these deficits. (And,
indeed, only the federal government as issuer of the currency can run deficits
on a sustained basis—as will be discussed below.)
The federal budget deficit is largely non-discretionary over
a business cycle, and at least over the shorter run we can take the trade
balance as also largely outside the scope of policy. The driving force of the cycle,
then, is normally the private sector leakages. When the private sector has a
strong desire to save, it tries to reduce its spending below its income.
Domestic firms cut production, and imports might fall too. The economy cycles
downward into a recession as demand falls and unemployment rises (if imports do
fall, there are global knock-on effects). Tax revenues fall and some kinds of
social spending (such as unemployment compensation) rise, causing the budget
deficit to increase more-or-less automatically. That is what happened early in
this decade, with Bush budget deficits rising to 5% of GDP to cover the current
account leakage while the private sector retrenched slightly. Federal deficits
have fallen over the recovery as the private sector resumed its deficit
spending. However, federal budget deficits would almost certainly need to reach
above 6 or 7% before we obtain a sustained recovery that would push up
employment rates and create a positive private sector balance that would allow
balance sheets to strengthen.
It isn’t possible to state with
certainty what the long-term trend private sector balance ought to look like. As
we have seen, until 1997 it was always positive, averaging between 2 and 3
percent of GDP. A positive balance allows domestic households and firms to
accumulate net financial wealth. Over the years, the US has put in place
numerous policies, including most prominently favorable tax treatment, to try to
encourage private sector savings. Orthodox prescriptions for dealing with an
aging society in general, and for dealing with a supposed looming Social
Security crisis in particular, almost exclusively rely on encouraging more
saving. If these programs are to be successful, then one or more of the
following must simultaneously occur: a) the federal government budget must be
relaxed so as to run larger trend deficits; b) the rest of the world must
increase its spending so as to reduce the US current account; and/or c) domestic
firms must run larger deficits. Of these, the most feasible and the most
preferable from the point of view of Americans is for the federal government to
relax its budget. Reducing the US current account deficit means that Americans
would forego the real benefits of a trade deficit (obviously, the view is
different from the perspective of the rest of the world, however, this is mostly
because they view exports as a benefit and imports as a cost—what J.K. Galbraith
would call an innocent fraud). Increasing US business deficits carries with it
the risks of greater financial fragility and the possibility of financial
crises. We are left with the conclusion that if the US household sector is to
improve its balance sheet and increase its saving, the federal budget must be
biased toward larger deficits.
3.
Monetary Policy, Savings, and Portfolio Preferences on a Flexible Exchange Rate
Before we turn to Greenspan’s claim
that central banks have been behaving as if they were operating on a gold
standard, let us review how central banks actually operate. (See Bell 2000; Bell
and Wray 2003; and Wray 1998 for detailed treatments.) Central banks today
operate with an intermediate overnight interest rate target; it could be argued
that in practice they actually targeted interest rates even during the late
1970s experiment with monetary aggregates, but that is not necessary for our
analysis. To hit a non-zero overnight rate target, the central bank needs to add
or drain reserves to ensure that the banking system has just the amount of
reserves desired (or required in those nations with official reserve
requirements). Reserves are added through discount window loans, through open
market purchases of government bonds, and through purchases of gold, foreign
currencies, or even private sector financial assets. (Increasing float is also
possible.) The central bank reverses these actions in the case of excess
reserves. While a central bank employs a fairly large staff to estimate and
predict reserve supplies and demands, it is actually quite easy to determine
whether the banking system faces excess or deficient reserves: the overnight
rate will move away from target, triggering a nearly automatic offsetting
reserve add or drain by the central bank. Central banks also supervise banks and
other financial institutions, engage in lender of last resort activities (a bank
in financial difficulty may not be able to borrow reserves in the interbank
lending market even if excess reserves exist at the aggregate level), and
occasionally adopt credit controls, usually on a temporary basis. We will leave
all of these types of activities to the side as of secondary interest. The
primary tool used to implement monetary policy is the setting of the overnight
interest rate target.
When the fundamental operating
procedure is laid bare, it becomes obvious that conventional views about central
bank “pumping” of “excess liquidity” are incorrect. The quantity of reserves
left in the private banking system is never discretionary from the point of view
of the central bank if it wishes to hit a non-zero interest rate target.
Similarly, conventional views on discretionary sterilization or central bank
“financing” of treasury budget deficits by “printing money” have to be incorrect
for precisely the same reason. If international payments flows, or domestic
fiscal actions leave banks with excess reserves, the central bank has no choice
but to drain the excess unless it is willing to allow the overnight rate to fall
towards zero. Draining reserves is accomplished through open market bond sales,
unwinding discount window lending, or sales of foreign currency reserves. On the
other hand, if international payments flows or domestic fiscal actions leave
banks with insufficient reserves, overnight rates would rise above
target—triggering the opposite interventions.
For this reason, “sterilization” is
not a discretionary operation. For example, China currently runs a large trade
surplus with the US. Chinese importers want to convert their dollar-denominated
receipts to yuan, an operation that is facilitated by the central bank when it
buys dollars and creates yuan reserves. If this leads to excess reserves in the
Chinese banking system, the central bank then drains the excess through, for
example, a sale of Chinese government debt. It cannot choose, however, to leave
excess reserves in the banking system—unless it is prepared to see the overnight
interest rate fall toward zero. Any “sterilization” of yuan reserves is
automatic, a result of interest rate targeting procedure.
Likewise, the view that a central
bank might “choose” to “print money” to “finance a budget deficit” is flawed. In
practice, modern sovereign governments spend by crediting bank accounts and tax
by debiting them. Clearing with the government takes place using reserves, that
is, on the accounts of the central banks. Deficit spending then leads to net
credits of banking system reserves; again, if these are excessive, they are
drained by the central bank through bond sales in the open market. These
activities are coordinated with the Treasury, which will usually issue new bonds
more or less in step (whether before or after is not important) with its deficit
spending. This is because the central bank would run out of bonds to sell. (In
countries in which the central bank pays interest on reserves, bond sales are
unnecessary because interest-paying reserves can serve the same purpose—that is,
to ensure the overnight interest rate cannot fall below the target (support)
rate.) The important point, however, is that such central bank operations are
not discretionary, but rather are required to hit interest rate targets. The
quantity of “liquidity”, reserves, is not discretionary.
It is sometimes claimed that a
government’s deficit spending as well as a nation’s external position are
constrained by the portfolio preferences of savers. (Aspromourgos
2000) For example, many believe that government faces a “government budget
constraint”, according to which its spending must be financed by a combination
of tax revenues, bond sales (“borrowing”), or money creation. The form that
financing of budget deficits takes is thus supposed to depend on the portfolio
preferences of savers. Once they have accepted all the new money desired,
government must sell bonds—and the interest rate required to get the public to
hold the bonds will be determined by their preferences. This supposedly applies
even more forcefully to external constraints on US federal budget deficits: the
foreign sector is said to be financing the US budget deficit by lending dollars.
It is feared that once the ROW has all the US treasuries desired, the government
won’t be able to finance its deficit except at rising interest rates. Finally,
it is argued that the ROW might even turn against the dollar, refusing to hold
dollars or government debt—resulting in a financing crisis for the US and its
government.
This thinking reflects several
different types of confusion. First, it conflates saving with portfolio
allocation decisions; second, it inappropriately equates the position of the
issuer of the currency (the sovereign government) with the user of a currency;
and third it applies an analysis that might be appropriate for a nation on a
fixed exchange rate regime to a nation operating with a floating currency.
A sovereign government on a
floating rate regime spends by crediting bank accounts, so the “government
budget constraint” is nothing more than an ex post identity. If a deficit
results, government drains any excess reserves through bond sales as part of its
interest rate targeting procedure. (Again, a nation that pays interest on
reserves never needs to sell bonds—the interest earning reserves serve the same
purpose as interest-paying bonds.) The public makes its portfolio preferences
apparent as excess reserves drive the overnight interest rate below the target
rate, and will accept government bonds until all undesired reserves are drained.
The demand for reserves is highly interest inelastic, but even if it were not,
government can set the overnight rate at any positive level desired simply by
ensuring that the banking system has no more reserves than it wants. (Bell and
Wray 2003)
Whether the ex post budget
identity will record a budget deficit after government increases its spending
depends largely on the reaction of the other sectors. In other words, the
government can decide how much it will increase spending and after the fact we
will observe some combination of increased tax revenue, increased bonds held by
the non-government sector, and increased high powered money holdings (reserves
held by banks and cash held by the nonbanking private sector). The degree to
which taxes rise will depend on the responsiveness of tax revenue to rising
aggregate spending and income; the additions of bonds and high powered money to
nongovernment portfolios will equal (by identity) the budget deficit, and the
split between the two will depend on preferences for interest-earning assets,
given the overnight interest rate set by central bank policy.
The saving propensities of both the
domestic and external sector go into determining the financial balances of all
three sectors, as discussed above: the domestic private sector, the foreign
sector, and the government sector. Higher domestic private sector saving
represents a leakage that is matched by some combination of a bigger government
deficit and a smaller current account deficit. Higher ROW saving is matched by a
combination of a larger US government deficit and greater US current account
deficit. Of course, we do not observe propensities and our “three balances”
identity cannot tell us the complex causalities that lie behind the resulting
balances. However, current budgeting procedure ensures that the US federal
government budget deficit is mostly a residual, rising when private domestic and
foreign demand shrink and falling when demand is rising. By the same token, the
US current account deficit is largely a function of the ROW desire to spend.
Unfortunately, most analysts
incorrectly interpret the causal forces involved, adopting a loanable funds
approach according to which saving “finances” investment, budget deficits, and
current account deficits. Actually the causation is the reverse: it is the
investment spending, the government spending, and the export spending that
together create the domestic saving of the private sector and the foreign saving
in the form of dollars. A moment’s reflection about bank balance sheets will
confirm that this must be true. A saver cannot simply ask her bank to credit her
savings account with more dollars, but an investor can approach a bank for a
loan, in which case the investor’s deposit account is credited (offset on the
bank’s balance sheet by the loan, which is the bank’s asset). As the investor
purchases plant and equipment, that deposit account is drawn down and a saver’s
account is credited. Similarly, a foreigner cannot save more dollars until an
American importer has purchased foreign output (or purchased foreign assets,
including direct investment). Again, it is the importer’s willingness to take
out a loan to finance this purchase that results in a new dollar credit to the
account of the foreign saver. Hence, the notion that Americans are borrowing
dollars from abroad to finance government and trade deficits is erroneous.
Rather, it is more revealing to think of the US budget deficit and the current
account deficit as “financing” the ROW dollar saving.
The decision to save is a decision
to “not spend”. When the Japanese domestic sector taken as a whole produces more
than its government and nongovernment sectors wish to purchase, it can save in
financial form—but only if it can find external buyers. (Otherwise, saving takes
the form of undesired inventory accumulation—which would then probably depress
production, employment, and income.) Let us assume Japan sells the excess
production to Americans, in which case the savings are initially in dollars.
Portfolio decisions then come into play when savers decide how to hold the
savings. Most of the dollars will be exchanged for yen, used to purchase yen
assets. The Bank of Japan will usually facilitate this process as domestic banks
offer dollar reserves for yen reserves. As discussed above, if excess yen
reserves result, these can be drained so as to maintain a positive overnight
interest rate. (However, as Japan currently operates with a zero interest rate
target, it leaves some excess reserves in the banking system.)
The portfolio decisions of
foreigners (including, importantly, those decisions of ROW central banks) place
no direct pressure on the US overnight interest rate. However, they can affect
the exchange rate of the dollar. It is commonly believed that a US trade deficit
must (eventually?) place downward pressure on the dollar, although it is
well-recognized that empirical studies have not been able to systematically link
exchange rates to the usual set of variables thought to be important
determinants of exchange rates, including the trade balance. (As Greenspan 2004
laments, “forecasting exchange rates has a success rate no better than that of
forecasting the outcome of a coin toss”.) In any case, this is a separate issue
from the concerns with interest rate setting by the central bank or “financing”
of external and budget deficits. A country with a sovereign currency on a
floating exchange rate can set its policy interest rate at any level desired,
and can run budget deficits at any level desired, without worrying about impacts
of foreign saving propensities or portfolio preferences on “financing”. The
country might, if desired, adjust interest rates or fiscal policy in response to
actual or supposed pressure on exchange rates, but that is, again, a separate
issue from “financing”.
4. Greenspan’s “Gold Standard”
Revisited
Greenspan’s statement that central
banks have been, and should have been, acting “as if” they were operating on a
gold standard then reflects two important errors. First, as we have seen,
today’s central bank operates with an interest rate target, which means that it
has no discretion regarding the quantity of “liquidity” (reserves) it supplies,
in spite of Greenspan’s suggestion that it has been engaged in “liquidity
contraction”. Indeed, “liquidity contraction” has no operational meaning aside
from the recognition that central banks automatically remove excess reserves so
that they can hit overnight rate targets. This also means that a central bank
cannot behave as Greenspan put it “as though there are, indeed, real reserves
underneath the system”—for that would mean that the central bank would be
constrained in its ability to provide reserves as necessary to prevent the
overnight rate from rising above target. Second, his belief that “excess
liquidity” that is encouraged by “fiat money” systems leads to inflation is also
confused. Excess liquidity in the form of excess reserves causes the overnight
rate to fall below the target—it cannot directly cause inflation. Rather, it
leads to an automatic reserve drain (normally, an open market sale of
treasuries). It is conceivable that setting a lower overnight interest rate
might be inflationary (by stimulating demand through one of the conventional
transmission mechanisms), however, that is a different matter entirely (and one
with very little empirical support). If Greenspan’s claim is merely that central
banks had previously set interest rates too low, he should clearly state so
rather than obfuscating issues by speaking of excess liquidity.
We are left with only one possible
interpretation of Greenspan’s statement regarding gold standard behavior by the
central bank, and that is that they have been more willing to raise interest
rates in the face of inflationary pressures over the past three decades.
Ironically, however, they can set the overnight interest rate target with
discretion only in floating rate regimes—what he calls fiat money systems. On a
gold standard, the central bank’s interest rate target is substantially beyond
discretion, determined by international pressures on the value of the currency:
to stem an outflow of gold, the central bank raises interest rates. Whether this
works is, again, irrelevant to our analysis. The important point is that the
countercyclical interest rate adjustments that have been a common feature of the
major OECD nations since the 1970s require that central banks do not
behave as if they operated on a gold standard. The behavior that we observe is
possible only on a floating rate (fiat money) standard that does not act
as if there are gold reserves underlying the system.
We conclude that Greenspan is in
error: central banks have not been operating as if on a gold standard, but
rather their behavior requires that they recognize that they are operating with
a flexible exchange rate regime.
There has been much speculation
regarding the possibility that the incoming chairman, Ben Bernanke, will follow
in the footsteps of the outgoing chairman. We can be sure that the Fed will
continue to operate with an overnight interest rate target and that it will
remove or add reserves as necessary to hit its target. Whether Bernanke adopts
explicit inflation targets rather than Greenspan’s more “intuitive” approach
remains to be seen, but will not change operating procedure in any significant
way. It is fairly clear that the Fed realizes it has no direct control over
inflation, rather, hopes to influence price-setting behavior by firms and by
labor through development of consistent inflation expectations. (See Wray 2005
for an examination of Fed policy formation.) Some believe that explicit
inflation targets help to focus expectations around a specific inflation rate.
The downside is that an explicit inflation target reduces Fed flexibility in
choosing the set of expectations it wishes to form a consensus around: if actual
inflation exceeds the target inflation rate, it becomes more difficult for the
Fed to create expectations that inflation is falling. At this time, it is
difficult to provide a firm prediction, but I suspect that Bernanke will avoid
explicit inflation targets. Further, I suspect that the current fashionable
focus on expectations manipulation will lose favor in coming months because of
an inherent contradiction: if the Fed fears that inflation is heating up, and
believes that rising expectations of inflation will make matter worse, it should
try to develop a consensus that inflation will fall—an expectation that is
contrary to the Fed’s own fears.
5. What “Gold Standard”
Constraints Are Imposed?
While the central bank is not
operating on a gold standard, it could be argued that in some respects fiscal
policy is behaving as if spending were constrained by a gold standard or other
fixed exchange rate regime. We have already discussed the common belief that
federal spending is subject to a budget constraint imposed by the willingness of
domestic and foreign residents to lend to the government. On this view, there is
a limited amount of saving around the world (a position Greenspan has adopted
time and again) for which our government competes with alternative borrowers. If
the US were on a gold standard such that government had to have gold reserves to
back up its IOUs, such an analogy would hold some validity. The savings around
the world represented by stockpiles of gold would form the available reserves
for which our Treasury would compete to finance its deficits. On a fixed
exchange rate system (without gold backing), the constraint would be somewhat
relaxed, but the US would have to stockpile foreign currency reserves sufficient
to prevent dollar depreciation. Much as many Asian countries today use fiscal
policy to depress domestic demand in order to ensure a positive dollar flow, the
US would need to maintain slack demand to turn the current account deficit
around to surplus.
In fact, fiscal policy in the US
has indeed been used to keep demand slack—a policy that is required by a fixed
exchange rate system, but one that is counterproductive in a floating rate
regime. Given the fiscal stance that has been normal in the US since the 1970s,
robust growth relies increasingly on high domestic private sector demand. In the
context of a growing current account deficit (resulting, in part, from
deflationary fiscal policy around the globe), the domestic private sector must
deficit spend on a heretofore unprecedented scale in order to lower unemployment
rates to levels that were common in the early postwar era. Ironically, the
abandonment of the Bretton Woods fixed exchange rate system freed US fiscal
policy from international constraints (that had only begun to take hold at the
end of the 1960s) to pursue full employment. However, policy since the early
1970s has increasingly acted as if it faced the constraints that had been lifted
by the switch to a floating rate regime. If Greenspan’s statement about the gold
standard carries any validity, it is with respect to fiscal policy, and not
monetary policy.
6. Conclusion: Demand Constrained
Growth
In sum, we experienced something
highly unusual during the Clinton expansion because the private sector was
willing to spend far more than its income; the normal private sector leakages
turned into very large injections. The economy grew quickly and tax revenues
literally exploded. State governments and the federal government experienced
record surpluses. These surpluses represented a leakage that brought the
expansion to a relatively sudden halt. What we have now is a federal budget that
is designed (and mandated) to balance except when growth is far below potential,
in which case a budget deficit opens. This means that the “normal” private
sector balance now must be a large deficit in order for the economy to grow
robustly. Rather than the government sector being a source of injections that
allow the leakages that represent private sector savings, we now have the
private sector dissaving in order to allow a foreign sector leakage in the
context of fiscal restraint.
This sets up a highly unstable
situation because private debt ratios rise quickly and a greater percentage of
income goes to service those debts. While Fed policy normally doesn’t matter
much, in a highly indebted economy, rising interest rates can increase debt
problems very quickly—setting off bankruptcies that can snowball into a
1930s-style debt deflation. A far more sensible policy would be to reverse
course and lower interest rates, then keep them low. At the same time, the
federal government should take advantage of slack demand and abundant labor by
increasing its spending on domestic programs. Robust economic growth fueled by
federal deficits is the best way to reduce private sector over-indebtedness.
In conclusion, it appears that
growth in the postwar period has mostly been demand constrained, due to
leakages. If demand were to grow at 7%, I see no reason to believe that supply
could not keep pace. This is all the more true in today’s global economy with
massive quantities of underutilized resources all over the world, and with high
ROW desires to save and to accumulate dollar-denominated financial assets. This
requires that foreigners sell output to the US—which is just the counterpart to
the US trade deficit leakage. In real terms, a trade deficit means the US can
enjoy higher living standards without placing pressure on the nation’s
productive capacity. While it is hard to project maximum sustainable growth
rates, there can be little doubt that the US economy chronically operates far
below feasible rates. The best policy would be to push up demand, allow growth
rates to rise, and try to test those frontiers.
Greenspan’s analysis appears to be
precisely wrong, and in insightful ways. Monetary policy has not behaved as if
the US were on a gold standard, but fiscal policy has tried to impose
constraints that would be more appropriate to a fixed exchange rate system. The
adoption of a floating rate system from the mid 1970s (what Greenspan
disparagingly calls a fiat money standard) has made it possible to operate
fiscal policy without these constraints—that is, to take advantage of the
possibilities offered to the issuer of a floating currency. This would include
maintenance of full employment at home while enjoying the benefits of a trade
deficit.
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Figure 1: USA Growth Decomposition
Notes: Figure created by Marc-Andre
Pigeon and updated by Ergun Meric; see Pigeon and Wray 2002 for sources.
Figure 2: EPT Schedule
Note: Figure created by Marc-Andre
Pigeon; see Pigeon and Wray 2002 for sources.
Figure 3: The Three
Financial Balances
Notes:
BPR = Balance of Payments; GDEF= Government Deficit, Sign Reversed; NAFA=
Private Sector Balance (net acquisition of financial assets. Figure created and
supplied by Wynne Godley.
