I have blogged on this area before but thought it useful with the current discussion around macroeconomic policy. How does Modern Monetary Theory differ from more mainstream monetary policy – see table below.
The Economist ‘Briefing’ recently looked at what now for macroeconomic policy in the global economy. The GFC of 2008 and outbreak of COVID-19 has got policymakers scratching their head as what can be done to stimulate aggregate demand.
Keynes’ ideas of government involvement in managing the economy in the business cycle – spend in recessions and pay of debt in booms – was flavour of the month in the post-war period. However by the1970’s this policy was in trouble which the spectre of stagflation – high inflation accompanied by high unemployment. According to Keynes the two variables should move in opposite directions. In 1976 the UK Prime Minister James Callaghan in his speech at the Labour Party Conference said:
We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment.
The 1980’s saw monetarist ideas enter the scene with a focus on the control of inflation though constraining the money supply. University of Chicago economist Milton Friedman and US Federal Reserve Chairman Paul Volcker knew that in order the get inflation down that the economy would have to go through a recession and very higher unemployment in the short-run. However once inflation started to drop the Central Bank could relax monetary policy (interest rates) and then encourage more economic activity in the economy and thereby reducing unemployment. Previously policy had focused on equality of incomes which had a large impact of economic efficiency. Price stability was now the primary focus of a central bank and it was in New Zealand with the 1989 Reserve Bank Act that the first central bank became independent from government. Gone were the days where the Minister of Finance could get on the phone to the Reserve Bank Governor to change interest rates. Central banks had inflationary targets whilst fiscal policy was to keep government debts low and to redistribute income as the government saw fit.
This policy came unstuck after the GFC as central banks dropped interest rates to record levels and implemented a series of quantitative easing (QE) measures to no avail. Growth was stagnant for a long time but eventually demand for labour picked up. This would have normally been accompanied by higher inflation but it wasn’t the case. Just like in the 1970’s inflation and unemployment were not behaving according to the theory but at this time both were favourable – low inflation and low unemployment. However inequality was now gripping the attention of economists and there was concern about the monopoly position of some firms. The rich have a higher tendency to save rather than spend, so if their share of income rises then overall saving goes up and lower interest rates and QE were driving up inequality by increasing house and equity prices.
Once COVID-19 hit it was government’s fiscal policy which has been used to try and stabilise the economy and boost growth. Fiscal stimulus – government spending with running up large deficits might be required for a long period of time in order to support the economy. This is more acceptable amongst economists as low interest rates enable the government to service much larger debts and with such low inflation it is unlikely that rates will increase anytime soon. This resembles Modern Monetary Theory (MMT) – the situation where the government can create its own money therefore:
- Cannot default on debt denominated in its own currency;
- Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
- Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
- Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
- Does not need to compete with the private sector for scarce savings by issuing bonds. Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.
Negative interest rates
Some governments have gone the way of negative interest rates (see graphic) to try and stimulate more aggregate demand. This would discourage saving and see a potential withdrawal of cash from the banking system leaving less money to lend out. Avoiding this scenario might involve abolishing high-denomination bank notes and making the holding of large amount of cash expensive and unfeasible. However in order to keep money in the banks might renege on interest rate cuts as customers might move their money to rival banks therefore high negative interest rates would severely dent banks’ profits.
The current economic environment may make negative interest more plausible as:
- Cash is in decline.
- Banks are becoming less important to finance.
- Central bankers are looking at creating their own digital currencies
Greater government intervention is what the majority of economists want but it does carry with it risks of significant debt and high inflation. There is an opportunity to rethink the economics discipline and as stated in The Economist:
A level-headed reassessment of public debt could lead to the green public investment necessary to fight climate change. And governments could unleash a new era of finance, involving more innovation, cheaper financial intermediation and, perhaps, a monetary policy that is not constrained by the presence of physical cash. What is clear is that the old economic paradigm is looking tired. One way or another, change is coming
The Economist – A new era of economics – July 25th 2020
The ANZ Truckometer is a set of two economic indicators derived using traffic volume data from around the country. Traffic flows are a real-time and real-world proxy for economic activity –particularly for the New Zealand economy, where a large proportion of freight is moved by road. It represents an extremely timely barometer of economic momentum. The ANZ Heavy Traffic Index shows a strong contemporaneous relationship to GDP, while the ANZ Light Traffic Index has a six month lead on activity as measured by GDP. Notice the change around 2007/08 with the GFC. The index below does show some encouraging signs after the lockdown with heavy traffic bouncing back as restocking takes place. Although as stated by Sharon Zollner of ANZ it is early days.
A book published this year ‘Fully Grown: Why a Stagnant Economy Is a Sign of Success’ Dietrich Vollrath addresses the issue – is growth the best way to measure economic success — and does a slowdown indicate problems in an economy?
He discusses that the slowdown (Pre-Covid) is an indicator of economic prosperity. The economy has already provided much of what we need in life – comfort, security and luxury – that we have turned to new forms of production and consumption that enhance our well-being but do not contribute to growth in GDP. One chapter looks at the increase in imports from China and how it doesn’t necessarily have any connection with the level of GDP or growth rate. It is commonly portrayed in the media that imports from China have a negative effect on US GDP and you can say that they do impact on employment levels in certain sectors – e.g. manufacturing industry. This can lead to a slowdown in growth if workers didn’t find alternative employment. According to Vollrath the size of imports from China looks too small to account for the growth slowdown.
There is an assumption that imports lower GDP but most introductory economics courses refer to GDP with the following:
Y = C + I + G + (X-M)
Y = GDP, C = Consumption, I = Investment, G = Government spending, (X-M) = Exports – Imports
With this equation if imports are higher, it must be that GDP is lower. The right hand side of the equation is just a way of accounting for GDP; it does not determine the size of GDP. Vollrath now puts imports on the other side of the equation so you have:
Y + M = C + I + G + X
The above equation helps given the common way that people understand the relationship if they imagine that M goes up, they’ll jump to the conclusion that one of the items on the right (C + I + G + X) must have gone up as well.
Y + M is the total goods and services available in a given year which we can purchase. The other side of the equation represents the purchasing of these goods and services whether it is consumption goods, capital good, government purchases and foreign purchases. An increase in imports means that there are more goods and services to purchase. But there is no necessary mechanical effect of having more imports on the size of our own production, GDP.
Here is something that I use with my Year 12 & 13 Economics students when looking at the comparison between nominal GDP and PPP – NCEA Level 3 Growth external and CIE A2 Unit 4. I have found the worksheet that follows useful for students to workout the price of a Big Mac in US dollars in each country, the Big Mac exchange rate and compare it with the actual exchange. The table below gives the Nominal GDP in various countries expressed in US dollars. If you convert the value of GDP in local currency into one common currency (US$) it gives you a false idea of many countries’ economic status. The cost of different goods and services can vary widely – countries like China and India have much lower costs for most consumer items compared to more developed countries like the US and Germany. Therefore to make a more accurate comparison economists tend to use the purchasing power parity (PPP). This is a simple calculation where a base currency is chosen (usually US$) and a basket of goods and services is chosen. They are then compared to the value of the same items in another country using traditional exchange rates. However it is not as simple as that as countries use a wide variety of goods and services that are not the same or not as popular in certain countries.
Countries by Nominal GDP US$ – October 2019 (ranking is on Nominal GDP)
*New Zealand’s GDP in NZ$ is approximately – NZ$ 314 billion (March 2020)
The Economist came up with the Big Mac index in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries. Here is something that I put together using the the Big Mac index from The Economist website. Students have to complete the table below.
The Big Mac Index – July 2020
- Complete the table above. In which country was their actual exchange rate on July 2020 closest to their Big Mac exchange rate?
- Which country’s currency is suggested by your calculations above as being
a) the most undervalued against the dollar, and the most overvalued against the dollar?
- What factors could have an influence on exchange rate values on a given date as shown in the table above.
- In which country was their actual exchange rate on July 2020 closest to their Big Mac exchange rate?
You can check your answers and other countries Big Mac Index by going to The Economist’s website – click below:
I have blogged before about Modern Monetary Theory. Basically it says that you can print your own currency by having your own central bank, run large deficits, have full employment, have no inflationary pressure and do this year after year. However while large deficits and monetary stimulus make some sense during a short deflationary economic contraction, sustaining those policies for years, will lead to inflation and economic stagnation – stagflation. The video below is from BBC Reel where Stephanie Kelton, author of The Deficit Myth, argues that we need to rethink our attitudes towards government spending. Worth a look – great graphics.
New Zealand has been seen by many as a country which has so far done well to restrict the spread of Covid-19 and hopefully limit the longer term impact on the economy. Like many countries the economic consequences have been significant with the contraction of GDP and rising unemployment. New Zealand is now in a deep recession – negative GDP for two consecutive quarters – with GDP set decline by 17% through the six months of the year. By comparison NZ only fell by 2.7% during the GFC in 2008 and part of 2009.
The graph (from Westpac) below shows the importance of government spending in 2020 and continuing into 2021. But the reduction in household spending, residential construction and business investment are a major concern and invariable this will lead to a further loss of job. However the forecast for GDP in 2021 is more promising with household spending and government consumption being the engines of growth. Although some are saying that the recovery will be faster than after the GFC one has to remember that the GDP figures will be a lot higher as they coming from a very low base – even negative. So even a small increase in economic activity will give you a very large percentage change from the previous year. The government have spent approximately $22bn in support measure which is equivalent to around 7% of annual GDP and no doubt there is more to come.
Aggregate demand is crucial here and it is important for both Cambridge and NCEA students to understand its components and how it generates growth – see midmap below.
The impact of Covid-19 on countries like China, and other parts of Asia, has meant that firms in the large economies of Germany and France might not be keen to outsource work to Asia. Although the infrastructure and the resources are available in these countries the Covid-19 risks associated with them means some European companies are looking at options closer to home – also referred to as “nearshoring” (moves by China-wary western European manufacturers to bring production closer to home). CEE countries especially Czech Republic, Hungary, Poland, Slovakia and Romania are particularly strong in the manufacturing sector whilst Estonia, Latvia, and Lithuania (Baltic states) have a comparative advantage in services. Although outsourcing will help these economies it will take a bit of time before there is any significant change.
This is an optimistic view but for some Eastern European countries the GDP forecast has been worse than that experienced after the GFC.
With the fall of the Berlin Wall, the transition from command to market systems led to severe recessions within countries – accelerating inflation and very high levels of unemployment – GDP fell by over 40% in the old Soviet-bloc countries. The present recession is proving to be much worse and these Eastern European countries are particularly vulnerable. The Economist came up with three reasons:
- These economies are exported dependent – as a % of GDP exports are 96% in Slovakia, 85% in Hungary.
- Eastern European countries will find it hard to fund deficits as their credit rating tends to be a lot lower than other countries wishing to borrow money. Bulgaria’s rating is BBB compared to say Austria which is AA+
- A lot of these countries rely on tourism as part of GDP therefore with Covid-19 the tourist industry has all but disappeared. For Croatia that is about 25% of GDP.
The outlook looks especially bleak for economies that were in a poor economic condition before Covid-19. Even though there have been radical steps taken to nullify the economic impact of the virus it will take a strong and coordinated response at EU level to steer countries out of their economic hardship.
Source: The Economist – Eastern Europe’s covid-19 recession could match its post-communist one. 28th May 2020
Showed this to my IGCSE class today – great video which is well put together with good examples that explain a recession and its causes. Particularly apt for today’s economic environment. Makes good use of supply and demand graphs as well as supply side and demand side variables. Detailed explanation of the business cycle. Useful for NCEA Level 2 growth standard.
Paul Solman on PBS last week interviewed Nobel Prize winner Paul Romer about how the US should go about containing the virus and open up the economy. He is proposing mass testing the population every two weeks.
He states that each additional unit of testing frees up approximately 9 people who can go back to work. So how to does the cost of 1 test compare to 9 people being able to go back to work? He gives the example where the cost of 1 test each day of the year = $3,650 but the income generated by getting people back to work = $450,000 – these figures are approximate.
With this model he suggest that $100bn a year needs to be spent on testing which means 23 million tests per day or test the population every 14 days in the US. Worth a look.