The Contradictions of System Stability: One Asian View

At the 13th annual Seminar for Senior Bank Supervisors from Emerging Economies organised by the World Bank, the Board of Governors of the Federal Reserve System, and the International Monetary Fund in Washington, Institute for New Economic Thinking Advisory Board member Andrew Sheng argued that regulators should take an eclectic, rather than a one-size-fits-all approach, to governance.

 

Posted by The Institute for... at 4:05 pm

Fiscal implications of the ECB’s bond-buying program

Originally appeared on VoxEU

By Paul De Grauwe and Yuemei Ji

The monetary-fiscal policy connection is under scrutiny by the German Constitutional Court in the context of the ECB’s OMT bond-buying programme. This column argues that most analyses are deeply flawed by the misapplication of private-company default principles to the central bank. ECB bond-buying transforms public bonds into monetary base, and sovereign-default risk into inflation risk. The real question is: What is the non-inflationary limit to money-base expansion? This depends upon the economic situation and is much higher in the current liquidity-trap setting.

There is a lot of confusion about the fiscal implications of the government bond-buying programme – the OMT, or Outright Monetary Transactions – that the ECB announced last year.

  • This confusion arises mainly because the principles that guide the solvency of private companies (including banks) are applied to central banks.
  • The level of confusion is so high that the president of the Bundesbank turned to the German Constitutional Court arguing that the OMT programme of the ECB would make German citizens liable for paying taxes to cover potential losses made by the ECB.

In this column we argue that the fears that German taxpayers may have to cover losses made by the ECB are misplaced. They are based on a misunderstanding of solvency issues that central banks face.

Indeed, German taxpayers are the main beneficiaries of such a bond-buying programme.

Solvency central banks versus private agents: The key difference

Private companies are said to be solvent when their equity is positive, i.e. when the value of their assets exceeds the value of their outstanding debt. The solvency of a private company can also be formulated in terms of the maximum amount of losses that a company can bear at any given time. Thus, a private company is said to be solvent when its losses do not exceed the value of its equity. Since in efficient markets the latter is equal to the present value of future profits, we arrive at the solvency constraint that says that the losses today cannot exceed the present value of expected future profits.

The problem arises when these solvency constraints are applied to central banks.

  • This misapplication of private principles has led some to conclude that the loss the ECB (or any central bank) can bear should not exceed the present value of future expected seigniorage gains (see Corsetti and Delado 2013).
  • Similarly, it is sometimes concluded that a central bank needs positive equity to remain solvent (Stella, 1997, Bindseil et al. 2004).

These solvency constraints should not be applied to the central bank; central banks cannot default.

A central bank can issue any amount of money that will allow it to 'repay its creditors', i.e. the money holders.1 Such a 'repayment' would just amount in converting old money into new money.

Contrary to private companies, the liabilities of the central bank do not constitute a claim on the assets of the central bank. The latter was the case during gold standard when the central bank promised to convert its liabilities into gold at a fixed price. Similarly in a fixed exchange-rate system, the central banks promise to convert their liabilities into foreign exchange at a fixed price.

The ECB and other modern central banks that are on a floating exchange-rate system make no such promise. As a result, the value of the central bank’s assets has no bearing for its solvency. The only promise made by the central bank in a floating exchange-rate regime is that the money will be convertible into a basket of goods and services at a (more or less) fixed price. In other words the central bank makes a promise of price stability. That’s all.

Seigniorage is not a limit

Thus it makes no sense to state that the limit to the losses a central bank can make at any point in time is given by the present value of future profits (seigniorage). There is no such limit. The central bank can make any loss provided the loss does not endanger its promise to maintain price stability.

Also it is not correct to claim that the central bank needs to hold positive equity 'to remain solvent'. A central bank needs no equity. As a result the claim that is sometimes made that a central bank with negative equity needs to be recapitalised by the treasury is senseless. To be clear:

  • The central bank (that cannot default) needs no fiscal backing from the government (who can default).
  • The only backing the central bank needs from the government is that it can keep its monopoly power to issue money in the territory over which the sovereign has jurisdiction.

With that power granted by the sovereign the central bank is freed from any solvency constraint.

Let us now apply these first principles to the issue of how a bond-buying programme can have fiscal implications. We first discuss the situation of the central bank that faces only one sovereign. Then we discuss the problem of the central bank in a monetary union facing many sovereigns.

The central bank of a stand-alone country

We will consider the case of a central bank that buys government bonds in the secondary market.2 By buying government bonds the central bank transforms the nature of the public-sector debt.

When the central bank buys its government’s debt, the debt is transformed:

  • Government debt that carries an interest rate and a default risk becomes debt that is a monetary liability of the central bank (money base) that is default-free but subject to inflation-risk.

To understand the fiscal implications of this transformation, it is important to consolidate the central bank and the government (after all they are separate branches of the public sector).

After the transformation the government debt held by the central bank cancels out. It is an asset of one branch (the central bank) and a liability of another branch (the government). As a result, it disappears. The central bank may still keep it on its books, but it has no economic value anymore. In fact the central bank may do away with this fiction and eliminate it from its balance sheet and the government could then eliminate it from its debt figures. It has become worthless because it was replaced by a new type of debt, namely money, which carries an inflation risk instead of a default risk.

This is why It makes no sense to say central banks lose when the market price of the government bonds drops. If there were a loss for the central bank it would be matched by an equal gain of the government (whose market value of the debt has dropped in the same proportion). There is no loss for the public sector.

Public debt held by the public sector is different

We arrive at an important conclusion:

  • When the central bank has acquired government bonds, a decline in the market value of these bonds has no fiscal implications.

The loss in one branch of the public sector (the central bank) is offset by an equal gain in another part of the public sector (the government), leaving nothing to be paid by the taxpayer.

Another way to see this is to look at the interest-rate flows underlying bond holdings. Let’s take an example and suppose the central bank has bought €1 billion of government bonds. These have a coupon of, say, 4%. Thus the central bank that keeps these bonds on its balance sheet receives €40 million from the government every year. The bookkeeping practice is to count this as profits of the central bank. At the end of the year the same central bank will have to hand over its profits to the government. Assuming that the marginal cost of managing this bond portfolio is zero, the central bank will hand over €40 million to the government. This is the left hand paying the right hand, so to speak.

This bookkeeping practice has led to the perception that the interest revenue is to be considered as seignorage. It is not. There is no profit for the public sector. The profit of the central bank is exactly offset by a loss of the government. Both could do away with this bookkeeping convention because there is no economic substance to these losses and profits.

  • It is literally true that the central bank could put the government bonds 'into the shredding machine'; nothing would be lost.

In our example, the central bank would stop receiving €40 million a year, and would stop paying out €40 million to the government every year. 
What happens if the government defaults on its outstanding bonds?

  • Default leads to losses for private holders of these bonds.
  • But it is immaterial for central bank-held bonds.

These are now valued at zero, but they were also already worthless before the default. This is the right hand taking it back from the left hand.

Think about it in terms of the interest flows. After the default, the central bank stops receiving interest payments from the government, but by the same token it stops paying these back to the government. Nothing has happened in the public sector. Thus the loss that the central bank is making as a result of the default has no fiscal implications.

Price stability and public-sector default

There is an issue when it comes to price stability and its link to a government default. If the central bank keeps its liabilities (money base) under control, the default by itself will not lead to more inflation. The latter will arise only if the government were to force the central bank to issue more of these monetary liabilities, e.g. to finance current budget deficits that after the default the government cannot finance by issuing bonds anymore.

It is sometimes argued that if the central bank has no assets (because of a default by the government), then it no longer has instruments to reduce the money stock. This may sometimes be necessary to reduce inflationary pressures. This argument does not hold water. There are two ways a central bank that lacks assets can reduce the money stock.

  • First, the central bank can issue interest-bearing bonds and sell them in the market.

This has the effect of reducing liquidity (money base).

  • Second, the central bank can raise minimum reserve requirements.

As a result, the existing stock of liquidity is 'deactivated', which has the same effect of a decline in the money base.

The central bank of a monetary union

Things are more complicated in a monetary union that is not also a fiscal union. Here the fiscal implication of central-bank bond buying is more complicated. The crux is the presences of ‘n’ sovereigns. In the Eurozone, n = 17 (soon to be 18 with Latvia).

  • If we could consolidate the ECB and the 17 sovereigns into one public sector, the analysis would carry through unchanged.
  • But we cannot; the Eurozone is not a fiscal union.

As a result a bond-buying programme will lead to transfers among participating member countries.

To clarify thinking about this problem, assume that the ECB buys €1 billion of Spanish bonds with a 4% coupon. The fiscal implications are now as follows.

  • The ECB receives €40 million interest annually from the Spanish Treasury.
  • The ECB returns this €40 million every year to the EZ national central banks.

The distribution is pro rata with national equity shares in the ECB (see ECB 2012).

  • The national central banks transfer this to their national treasuries.

For example, the ECB will transfer back 11.9% of the €40 million to the Banco de España. The rest goes to the other member central banks. The largest receiver is the German Bundesbank; with its equity share of 27.1%, it would get €10.8 million.

Thus in a monetary union (and in the absence of a fiscal union) a bond-buying programme leads to fiscal transfers among countries – but not the one common in the public perception, especially in Germany.

  • An ECB bond-buying programme leads to a yearly transfer from the country whose bonds are bought to the countries whose bond are not bought.

It should be noted that the ECB could implement a bond-buying programme that avoids fiscal transfers by buying national government bonds in the same proportions to the equity shares of the participating NCBs. This has in fact been proposed sometimes. But this would not eliminate all transfers because the interest rates on the outstanding government bonds are not the same. In fact the countries with the highest interest rates would in this weighted bond-buying programme be net payers of interest to the countries with the lowest interest rates. Thus even a bond-buying programme weighted by the equity shares would involve fiscal transfers from the weaker (debtor) countries to the stronger (creditor) countries. 

What happens under a public-sector default?

One often hears in the creditor countries that these would be the losers if one of the governments whose bonds are on the balance sheet of the ECB were to default. This is an erroneous conclusion.

Returning to our example of an ECB purchase of €1 billion of Spanish government bonds, consider a Spanish defaults on these bonds.

  • The Spanish government would stop paying €40 million to the ECB.
  • The ECB would stop transferring this interest revenue back to the member central banks pro rata.
  • The German taxpayer, for example, would no longer receive the yearly windfall of €10.8 million.

In no way can one conclude that German taxpayers, or any EZ taxpayer, would pay the bill of the Spanish default – except in the narrow sense that they would no longer be able to count on the yearly interest revenues.

  • There is of course the possibility of an inflation tax.

We have noted before that at the moment of the bond buying programme interest bearing debt is transformed into monetary liabilities of the ECB (money base). This by itself could lead to inflation, and thus to an inflation tax that would be borne by all holders of euros. This leads to the issue of how large the ECB bond-buying programme can be without generating additional inflation.

From explicit taxation to inflation tax

Every open-market operation involving the purchase of government bonds creates the potential of inflation because it increases the money base. The key question we have to ask ourselves is how the increase in the money base is transmitted to the money stock. After all, it is the money stock not the money base per se that determines inflation.

In Figure 1 we show the evolution of money base and money stock (M3) in the Eurozone since 2004. We find a striking difference between the period before and after the banking crisis of October 2008.

  • Prior to the Global Crisis, the two monetary aggregates move in unison suggesting that the money multiplier (the ratio of money stock to money base) is constant.

A 1% increase in the money stock led to an increase of the money stock of approximately 1%. Things are very different during the crisis period.

Figure 1. Money base, money stock (M3) in Eurozone (2007 December=100)

Source: European Central Bank, Statistical Warehouse.
Over the period 2008 (Oct) to 2013 (April), the relation between the money base and the money stock breaks down. The money base increased by more than 50%; the money stock increased by only 7%. This suggests that the money multiplier has dropped dramatically.

This dramatic decline in the money multiplier has everything to do with the liquidity trap (Krugman 2010). Banks, which accumulate reserves as a result of the liquidity injections by the ECB, hoard these reserves. Their degree of risk aversion is such that they do not use their cash reserves to expand bank credit. As a result, the money stock (M3) does not increase.

Figure 2 is also instructive. It shows the average yearly inflation rate and the average yearly growth rates of money base and money stock before and after the banking crisis of 2008.

  • Prior to 2008 both monetary aggregates increased at practically the same rates; the yearly inflation was 2.3%.
  • Since 2008 the growth rate of the monetary aggregates diverges dramatically.

The money base grows at a yearly rate of 11% while the growth rate of the money stock collapses to less that 2% and inflation drops below 2%. 

  • Our interpretation is that the strong increase in the money base helped to reduce the deflationary forces in the economy, rather than being a source of inflation.3

Figure 2. Inflation, growth MB and M3 (average yearly growth rates)

 

Conclusions

The previous analysis suggests the following:

  • Limits to a bond-buying programme depend on the nature of the economic and financial situation, i.e. the existence of a liquidity trap.
  • In normal times when an increase of the money base leads to proportional increases in the money stock the limit to a bond-buying programme is tight.

If the target for the increase in the money stock is 4.5% (as is the case in the Eurozone where a 4.5% target is assumed to lead to at most 2% inflation) this also means that the money base should not increase by more than 4.5% per year. But then during normal times there is very little need for a bond-buying programme.

  • The situation has changed dramatically since the start of the banking crisis.

During the crisis period the limits to the amount of money base that can be created without triggering inflationary pressures is much higher because of the existence of a liquidity trap.

How much higher depends on the money multiplier. In De Grauwe and Ji (2013) we estimate the size of the multiplier during the crisis period and we conclude that it has collapsed to zero. As a result, there is no limit to the size of the bond-buying programme, i.e. the ECB can buy any amount of government bonds without endangering price stability, as long as the crisis lasts.

References

Bindseil U, A Manzanares and A Weller (2004), "The Role of Central Bank Capital Revisited", Working Paper Series, no. 392, European Central Bank, September.

Buiter, W (2008), "Can Central Banks Go Broke?", CEPR Policy Insight 24, 16 May.

Corsetti, G and L Dedola (2013), "Is the euro a foreign currency to member states?", VoxEU.org, 5 June.

De Grauwe, P, and Y Ji (2013), "Fiscal Implications of the ECB’s Bond Buying Program (OMT)", University of Leuven, mimeo.

European Central Bank (2012), "Capital subscription", ECB.int, 27 December.

Friedman, M and A Schwartz (1961), A Monetary History of the US, Princeton University Press, Princeton.

Krugman, P (2010), "Debt Deleveraging and the Liquidity Trap", VoxEU.org, 18 November.

Pringle, R (2003), "Why central banks need capital", Central Banking Journal, August.

Stella, P (1997), "Do Central Banks Need Capital?", IMF Working Paper, no 83, International Monetary Fund, Washington, DC.

1 We assume here that the central bank does not hold foreign currency liabilities. In that case the central bank can be pushed into defaulting on these foreign currency liabilities because it can only issue domestic currency liabilities (Buiter 2008).

2 Thus we do not discuss direct monetary financing of government budget deficits.

3 See Friedman and Schwartz(1961) for an analyis of the Great Depression in the US. These authors argued that the US Fed at the time failed to increase the money base sufficiently to counter the delflationary forces. As a result, the US money stock actually declined, reinforcing deflation.

Posted by Paul de Grauwe at 12:32 am

On the Link between Inequality, Credit, and Macroeconomic Crises

By Giovanni Dosi, Giorgio Fagiolo, Mauro Napoletano, Andrea Roventini

One of the most lively debates in macroeconomics nowadays focuses on the ability of standard macroeconomic models to forecast and explain the current economic crisis, and to provide ready- to-use policies which could restore growth, curb unemployment (see among many others Dosi, 2011; Krugman, 2011; Stiglitz, 2011) and stop policy makers navigating by sight (Blanchard et al., 2013). The debate has been raging not only among economic theorists and policy makers, but it has spilled over in newspapers and magazines (see e.g. the article on the state of economics appeared in The Economist, and the following reply of Robert Lucas). 

A key point in this discussion concerns the ability of existing (mainstream) models to properly address issues such as heterogeneity and interactions, which are considered central ingredients to understand economic crises as emergent, endogenous phenomena. In his opening address at the ECB Central Banking Conference 2010, Jean-Claude Trichet, the former president of the ECB, notes that “the atomistic, optimizing agents underlying existing models do not capture behavior during a crisis period. We need to deal better with heterogeneity across agents and the interaction among those heterogeneous agents.” Furthermore, he proposes a possible solution to this problem: “Agent-based modeling dispenses with the optimization assumption and allows for more complex interactions between agents” (Trichet, 2010).

An “empirically-grounded” approach to macroeconomic analysis

This post reports on recent research attempting to fill this gap and employing agent-based models (Tesfatsion, 2006) to explore the properties of macroeconomic dynamics during normal and crisis times (Dosi et al., 2010, 2013).

We develop a family of agent-based models that investigate two key issues in the current economic debate: i) the role of increasing income inequality as one of the triggering factors of the crisis (see e.g. Kumhof and Ranci`ere, 2011; Bordo and Meissner, 2012; Stiglitz, 2012); (ii) the short- and long-run impact of monetary and fiscal policies. Two key features of our agent- based approach are that agents are heterogeneous and that markets (e.g., the labor market) do not always clear at any point in time. In this framework, the statistical relationships exhibited by macroeconomic variables should therefore be considered as “emergent properties” stemming from microeconomic “disequilibrium” interactions. Moreover, agents’ behavior is rooted in micro empirical evidence, thus providing an explicit “behavioral” microfoundation of macro dynamics (Akerlof, 2002). The robustness of such empirically-grounded approach is then checked against its capability to statistical account, jointly, for a large set of empirical regularities both at the micro and macro levels.

The “Keynes+Schumpeter” (K+S) model 

The basic theoretical framework (Dosi et al., 2013) portrays an artificial economy composed of capital- and consumption-good firms, a population of workers, a bank, a Central Bank and a public sector. Capital-good firms perform R&D and produce heterogeneous machine tools.

Consumption-good firms invest in new machines and produce a homogeneous consumption good. Firms finance their production and investment choices employing internal funds as well as credit provided by the banking sector. The Central Bank fixes the interest rate and determines the credit multiplier. Finally, the public sector levies taxes on firm profits and worker wages, and pay unemployment benefits.

The model thus combines a traditional “Keynesian” mechanism of aggregate demand generation with a “Schumpeterian” innovation-fueled process of growth. These two dynamics are in turn nested into an endogenous credit dynamics. In the model, higher production and investment levels rise firms’ debt, eroding their net worths and consequently increasing their credit risk. Banks, in turn, tighten their credit standards. This increases the level of credit rationing in the economy and forces firms to curb production and investment, thus setting the premises for economic-activity slumps.

Using the model as a policy laboratory

In general agent-based models do not lend themselves to analytical solutions. Therefore, their properties must be analyzed via extensive computer simulations, which we perform via a three- step strategy. First, we empirically validate the model, i.e., we assess whether the statistical properties of artificially generated microeconomic and macroeconomic data are similar to the empirically observed ones for a large range of model parameters. Second, we explore the role of income inequality as a source of instability at the aggregate level. Third, we use the model as a sort of policy laboratory, exploring the short- and long-run effects of different fiscal and monetary policies under different income distribution scenarios.

We find that the model matches a long list of macro empirical regularities (e.g. persistent output growth, output volatility, co-movements between macro variables, etc.) as well as industry-level stylized facts (e.g. about firm size and growth-rate distributions, firm productivity dynamics, firm investment patterns, etc.). Furthermore, our results show that economies where the profits share is relatively high are more exposed to severe business cycles fluctuations, higher unemployment rates, and higher probability of crises (see Figures 1 and 2).

On the policy side, simulation exercises reveal the strong interactions between fiscal and monetary policies on the one side, and income distribution on the other. Fiscal policies do not only dampen business cycles, reduce unemployment and the likelihood of experiencing a crisis. In some circumstances, they are also able to affect long-term growth. The effectiveness of fiscal policy is strictly linked to income inequality: the more income distribution is skewed toward profits, the greater the effects of fiscal policies (see Figure 3). Conversely, on the monetary policy side, we find a strong non-linearity in the way interest rates affect macroeconomic dynamics. More specifically, there exists a threshold beyond which increasing the interest rate implies smaller output growth rates and larger output volatility, unemployment and likelihood of crises. Also the impact of interest rate policies is affected by income distribution: changes in interest rates have a mild impact in less equal economies, because higher profit rates allow firms to be relatively more independent from bank credit. Similarly, the sensitivity of real variables to policies affecting credit multipliers falls with higher profit margins.

Lessons and Conclusions

We draw two main lessons from our exercises. First, from a policy perspective, simulation results support the view that income inequality is a potential cause of economic instability: economies where income inequality is higher are also more prone to crises. In addition, they strongly sup- port the idea that counter-cyclical fiscal policies are a necessary condition to keep the economy on a “virtuous” high-growth path. Needless to say, if there is some truth in our conclusions they run exactly counter the current European recipes: the recent fiscal austerity programs pursued by EMU countries are likely to worsen the state of the economy, further lowering the rate of growth, and increasing the instability of European economies. Second, from a methodological perspective, the whole exercise suggests the very possibility of providing alternative theoretical tools to policy makers, which can endogenously account for crisis emergence within a general disequilibrium macroeconomic-dynamics rooted in an explicit empirically-grounded microfoundation of interactions and individual behaviors.

References

AA.VV., 2009.  The  Other-Worldly Philosophers. The  Economist. July,
16th, http://www.economist.com/node/14030288.

Akerlof, G. A., 2002. Behavioral Macroeconomics and Macroeconomic Behavior. American Economic Review. 92, 411–433.

Blanchard, O., Dell’Ariccia, G. and Mauro, P., 2013. Rethinking Macro Policy II: Getting Granular. IMF Staff Discussion Note SDN/13/03. IMF.

Bordo, M. and Meissner, C., 2012. Does inequality lead to a financial crisis?. VoxEU. 24 March.

Dosi, G., 2011. Economic Coordination and Dynamics: Some Elements of an Alternative “Evolutionary” Paradigm. Technical report. Institute for New Economic Thinking.

Dosi, G., Fagiolo, G., Napoletano, M. and Roventini, A., 2013. Income Distribution, Credit and Fiscal Policies in an Agent-Based Keynesian Model. Journal of Economic Dynamics & Control. http://dx.doi.org/10.1016/j.jedc.2012.11.008i.

Dosi, G., Fagiolo, G. and Roventini, A., 2010. Schumpeter Meeting Keynes: A Policy-Friendly Model of Endogenous Growth and Business Cycles. Journal of Economic Dynamics & Control. 34, 1748–1767.

Krugman, P., 2011. The Profession and the Crisis. Eastern Economic Journal. 37, 307–312.

Kumhof, M. and Ranci`ere, R., 2011. Inequality, leverage and crises. VoxEU. 4 February.

Lucas,  R.  E.  J.,  2009.  In  Defence  of the  Dismal  Science.  The  Economist. August,
6th, http://www.economist.com/node/14165405.

Stiglitz, J., 2011. Rethinking Macroeconomics: What Failed, and How to Repair It. Journal of the European Economic Association. 9, 591–645.

Stiglitz, J., 2012. The Price of Inequality: How Today’s Divided Society Endangers Our Future. WW Norton & Company.

Tesfatsion, L., 2006. ACE: A Constructive Approach to Economic Theory. In Handbook of Computational Eco- nomics II: Agent-Based Computational Economics, L. Tesfatsion and K. Judd (eds). Amsterdam, North Hol- land.

Trichet, J., 2010. Reflections on the nature of monetary policy non-standard measures and finance theory. In opening address at the 6th ECB Central Banking Conference, Frankfurt am Main. Vol. 18.

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The Entrepreneurial State: Debunking Public vs. Private Sector Myths

The public sector is often seen as sclerotic and conservative in contrast with a dynamic and innovative private sector. This assumption lies at the basis of much of the outsourcing of public services to the private sector. In this interview and in her new book, Institute for New Economic Thinking grantee Mariana Mazzucato argues against this assessment and in favour of state-led innovation and economic growth. She maintains that the public sector usually bears the highest risks of funding innovation without then reaping the rewards. 

What are the myths about the public sector and private sector that you say need to be debunked?

The myth is of a dynamic, creative, colourful, entrepreneurial private sector, that at most needs ‘unleashing’ from its constraints from the public sector. The latter is instead depicted as necessary for fixing ‘market failures’ (investing in ‘public goods’ like infrastructure or basic research) but inherently bureaucratic, slow, grey, and often too ‘meddling’. It is told to stick to the ‘basics’ but to avoid getting too directly involved in the economy.

Instead, if we look around the world, those countries that have grown or are growing through innovation-led growth are countries where the state did not limit itself to just solving ‘market failures’ but actually developed strategic missions, and was active in directing public investment in particular areas with scale and scope, changing the technological and market landscape in the process. And ironically one of the government’s that have been most active on this front is the US government, which is usually depicted in the media (and by politicians) as being more ‘market oriented’. From putting a man on the moon, to developing what later became the Internet, the US government, through a host of different public agencies, provided direct financing not only of basic research but also applied research and even early stage public venture capital (indeed Apple received $500,000 directly from public funds). In each case it provided funding for the most high risk/uncertain investments, while the private sector sat waiting behind.

What do you say to those who would argue that the government is not good at picking winners? That government spending crowds our private investment?

All this fear about the government trying and failing to pick winners is exaggerated. Both Apple and the technologies behind the iPhone were picked! But picking winners is more probable when the state is described as though it is relevant rather than irrelevant. When government is given a mission, proper funding, and organizes its agencies so they are dynamic and able to ‘welcome’ the exploratory trial and error process that accompanies innovation, it can attract top expertise and dynamism.

Today, we see countries that are growing thanks to a courageous public sector and through mission oriented policies. For example, China is spending $1.7 trillion on five key new broadly defined sectors, including ‘environmentally friendly’ technologies. Brazil’s active state investment bank is spending more than $60 billion just this year on green technology. The economics profession doesn’t adequately account for this kind of state-led activity, but only warns of governments ‘crowding out’ private business or failing at picking winners.

What governments are doing today with regards green technology is not crowding out but crowding in business investment by creating a vision around it, and funding the most capital intensive areas with high market and technological risk. But we must also change the language. To me, ‘crowding in’ still sounds negative, as it is being compared to a benchmark of useless government. In my new book I go into this further, and suggest some new language and images that can really change the way we talk about and imagine the space for the public sector.

Could you elaborate on your argument that modern capitalism is rewarding value extraction over value creation?

The problem is that by not admitting this entrepreneurial risk-taking role that the state provides, we have not confronted a key relationship in finance: the relationship between risk and return. Innovation is deeply uncertain, with most attempts failing. For every Internet there are many Concordes or Solyndras. Yet this is also true for private venture capital (VC). But while private VC is then able to use the profits from the 1 out of 10 successes to fund the 9 losses, the state has not been allowed to reap a return. Economists think this will happen via tax (from the jobs created, and from the profits of the companies), yet so many of the companies that receive such benefits from state funding, bring their jobs elsewhere, and of course we know they also pay very little tax. Thus the return generating mechanisms must be rethought. It could be done through retaining equity, a ‘golden share’ of the intellectual property rights, or through income contingent loans. But currently this is not even discussed. When Google received funding for its algorithm from the National Science Foundation (NSF), is it right that after it earned billions nothing went back to the NSF (which is today starved of funds), or that some of Apple’s profits go into a national innovation fund to fund the next wave of Apples?

What this means is that we have socialized the risk of innovation but privatised the rewards. This dynamic is one of the key drivers of increasing inequality. Because innovation today builds on innovation tomorrow, the ‘capture’ can be very large. This would not be the case if innovation were just a random walk. Policy makers must think very hard how to make value creation activities (done by all the collective actors in the innovation game) rewarded above value extraction activities (in this sense capital gains taxes are way too low). And since the booty from the latter can be very large, redirecting incentives and rewards towards the value creators is essential. The problem is that some of the ‘extractors’ like to sell themselves as the creators.

Are there areas of the economy for which the government needs to increase investment?

I believe the green economy merits much more funding than it is currently receiving by government. In the book, I look at global green investments, and conclude that few parts of the world are investing in the kind of scale and scope that will be necessary for a green revolution to happen. Part of this is due to governments being under extreme pressure to cut back spending. But another part is due to the lack of a proper risk-return relationship. Imagine how much more money there would be in state coffers today to fund green technology had even just .05% of the profits from the internet investments come back into something called the ‘public innovation fund’. Instead it is dry.

How can the UK get its economy going? What role does the public and private sector have in this?

And one of the key problems is that the way that the UK understands investments, is that somehow private business simply needs incentives, either via tax or regulation. Instead, what we know about private investment is that it is driven not by such tweaks, but by where the big new technological and market opportunities are. Indeed, Pfizer left Sandwich, Kent to go to Boston, not because of the lower tax or regulation there but due to the $32 billion a year (this figure is for 2012) that the National Institutes of Health spends in the knowledge base.

The UK economy is suffering from various problems:

  1. The Treasury and BIS must have similar growth models. The former is driven by a model in which the state is seen mainly as a barrier. The latter sees a role for the state but the policies remain very patchy, due to the lack of vision from the macro side. So no matter how many apprenticeships, or catapult centres we fund, if these investments are not seen as being key to economic growth they will remain patchy and largely incoherent.
  2. The government must be counter-cyclical. A government is not the same as a household, because it can roll over its debt (as long as it has a central bank and its own currency, which the UK does). What we have today in the UK is a pro-cyclical government, withdrawing funds precisely when both business and consumers are also withdrawing. But it is also key to understanding that stimulus is more effective when ‘directed’ towards broadly defined areas. Research from the NIST in Washington shows that the spending multiplier is almost three times as high when spending is directed, whether this be IT in the past or green in the future. Yet the fear in the UK of the government becoming too involved (picking winners and crowding out investment) has seen not only a lack of necessary investments, but also very inconsistent and confusing policy signals.
  3. Rebalancing the economy must include de-financialisation of real economy. Different policy areas that are trying to feed industrial policy need to be careful not to take a perspective where rebalancing means ‘away from finance towards the real economy’. Indeed, one of the problems in both the UK and the USA is that the real economy itself is over-financialised, with many companies spending more on share buybacks (to fuel share prices, stock options and executive pay) than on R&D or human capital investments. This is not just about short-termism. This is about the way that value extraction (of which share buybacks are only a proxy) have been rewarded over value creation activities. Making the UK less unequal will involve making sure that value creation is rewarded above value extraction, and that the state’s role in the former is better recognised (so we can fund both innovation and public services, such as health and education, which are increasingly skewed in each).
  4. Symbiotic rather than parasitic public-private partnerships. The problem is that the public aspect of these partnerships has not been adequately understood (even by the economists justifying them). The public part should not only be about ‘de-risking’ the private sector but also about guiding the way (through missions), and making sure that some of the returns from the partnership go back to the public sector, allowing growth to be not only ‘smart’ but also ‘inclusive’. When talking about the innovation ‘eco-system’, we should have better indicators to warn us when such eco-systems are symbiotic ones, rather than parasitic ones. Where are Xerox Park and Bell Labs today? Those companies were much more active investors in their partnership with the state then the equivalent companies of today, who are worried more about their stock price and lobby government for different types of investments and tax breaks, without necessarily pulling their weight in the partnership.

Originally published on the LSE’s British Politics and Policy blog

Posted by The Institute for... at 10:14 am

Nathan Tankus: Memo to Paul Krugman on the Euro Zone – Read Your Own Research!

Originally appeared on Naked Capitalism

Normally, I’m a harsh critic of neoclassical economics and neoclassical economists. However, sometimes the most frustrating things about neoclassical economists is their lack of familiarity with neoclassical models (especially older ones) and current neoclassical research. Monday provided a rather extraordinary example of this trend: Paul Krugman is apparently not familiar with Paul Krugman’s research! Before I explain why, I need to provide some context. Read more

Posted by Nathan Tankus at 9:14 am

Tiago Mata – Playing with the History of Economics

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How to become a historian of economic thought? Members of the profession gather just once a year at the annual conference of the History of Economic Society but otherwise are dispersed in universities and archives all around the world.

That’s why Tiago Mata and other young aspiring historians of economics decided to launch a group writing project to keep in touch and share ideas even when far apart. That project spawned the History of Economics Playground, a blog hosted on the Institute for New Economic Thinking’s website. Through their blog, Mata and his colleagues are bringing new perspectives and a wider audience to economic history. 

In this video: 
Tiago Mata
Posted by The Institute for... at 4:08 pm

Middle-Out Economics: A Truer Form of Capitalism

This article first appeared in the Summer 2013 issue of Democracy: A Journal of Ideas as part of a symposium on 'middle-out' economics. The symposium also features Neera Tanden, Bruce Bartlett, Mona Sutphen, Nick Hanauer and Eric Liu, among others.

“Four men sat at a table. Raised sixty floors above the city, they did not speak loudly as one speaks from a height in the freedom of air and space; they kept their voices low, as befitted a cellar.”

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Posted by Eric Beinhocker at 1:16 pm

Bigger Things to Worry About Than Ben Bernanke - Marshall Auerback

Watch the Institute for New Economic Thinking's Marshall Auerback talking on Fox Business News about what in the U.S. economy you should really be focused on.

Posted by The Institute for... at 10:29 am

Dirtying White: Harry Dexter White and the History of Bretton Woods

Why does Benn Steil’s history of Bretton Woods distort the ideas of Harry Dexter White?

Originally appeared in The Nation

By James M. Boughton  Read more

Posted by The Institute for... at 4:28 pm

What Money Can’t Buy

Harvard Professor Michael Sandel spoke over the weekend at the Festival of Economics in Trento, Italy on the moral limits of markets.  Read more

Posted by The Institute for... at 2:51 pm

The Dogmas of the Market Economy Under Critical Scrutiny

By Antoine Reverchon (translated from French), Le Monde

Roman Frydman and Michael Goldberg deconstruct the theory of rational expectations. 

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Posted by The Institute for... at 5:19 pm

The E.U.’s Feeble War on Unemployment

By NIALL FERGUSON and  Read more

Posted by Pierpaolo Barbieri at 10:23 am