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Is Biden a worse protectionist than Trump? Prove it isn't so, Joe.I've been engaged with a lot of real-world work, so I haven't been able to post that much as of late (apologies). Still, here's my initial take on events of 2021 with Joe Biden assuming the US presidency. Although the rest of the world breathed a sigh of relief that the isolationist Donald Trump has literally departed the White House with little fanfare, the question remains: How much of an improvement will Biden be for international economic relations? A new article makes me question whether he will be much of an improvement since Biden is indicating more "Buy American" provisos for government procurement are in store to shore up US industry during these challenging times: President Joe Biden will
take steps Monday to encourage the federal government to buy more
American-made products, a move the new administration argues will
protect U.S. jobs and juice an economy severely hobbled by the deadly coronavirus pandemic.Biden, who pushed a $700 billion Buy American campaign as a candidate for president, is set to sign an executive order
that will advance several policies to boost the federal government's
purchase of U.S.-manufactured goods and services, administration
officials said Sunday.Federal law requires
government agencies to give preference to American firms when possible,
but critics say those requirements haven't always been implemented
consistently or effectively. Some have not been substantially updated
since the 1950s.The federal government spends
nearly $600 billion a year on contracts, which is money the
administration says can spur a revitalization of the nation's industrial
strength and create new markets for new technologies.To that end, Biden's order will increase the
domestic content threshold, which is the amount of a product that must
be made in the U.S. before it can be purchased by the federal
government.Right now, loopholes in federal law
allow products to be stamped "made in America" for purposes of federal
procurement even if barely 51% of the materials used to produce them are
domestically made. Administration officials did not say how much Biden
intends to increase that threshold.Actually, Trump has tried to implement something similar, although it had some loopholes still that Biden is currently trying to close:Shortly after taking office in 2017, President Donald Trump
issued a series of executive orders that were intended to strengthen
rules requiring federal agencies to buy U.S.-made goods when possible.
But critics argued that effort fell short, partly because of Trump's
failure to adequately enforce the rules.The
order that Biden will sign is expected to include a clear timeline for
updating domestic content requirements and a process for reducing
unnecessary waivers, which the administration argues would fundamentally
change how the program operates.Agencies will be required to report twice a year on their implementation of Made in America laws.Oof! Is Biden even more protectionist than Trump? That won't be such a good signal to open with in terms of repairing strained relationships with other countries. Remember also that the United States is a signatory to the WTO's Government Procurement Agreement (GPA) that was intended to limit these shenanigans encouraging the purchase of own-country goods and services, and would therefore be subject to litigation by other signatories. Indeed, the Trump administration considered pulling out of the GPA for the purpose of introducing more "Buy American" policies:The U.S. is mulling a plan to withdraw from a global pact worth $1.7
trillion in government contracts, a person familiar with the matter
said, in a move that may anger close allies during a delicate moment for
trade.



Officials in President Donald Trump's administration are
circulating a draft executive order that would trigger a U.S. exit from
the World Trade Organization's Government Procurement Agreement, or GPA,
if the pact isn't reformed in line with American views, according to
the person, who asked not to be identified because discussions are
ongoing. It remains to be seen how Biden will tiptoe around the United States' WTO GPA commitments without offending other member countries. Still, the question remains: Is Biden really going to be more internationalist in outlook than Trump? This episode gives us reasons to doubt whether Biden's actions will match his rhetoric (which is admittedly better to listen to).

Virtual Student Federal Service Internship EventThursday, May 27th, 2021 | 3:00 – 4:00 PM ESTAre you interested in making a difference in the world? Do you want to gain career experience and connections in government? The Virtual Student Federal Service … Continue reading →

Curt Magleby is Vice President, U.S. Government Relations, Ford Motor Company and spoke to our Public Affairs Career Lecture Series on Thursday, September 26, 2019. He spoke about his position engaging with policymakers on a wide range of legislative and regulatory issues and overseeing Ford's federal, state and local government affairs. Magleby previously was director, […]

Yesterday, I posted a reply to John Cochrane's Sept 4 post on the national debt. John alerted me to his Sept 6 update, which I somehow missed. Given this update (together with some personal correspondence), let me offer my own update. John begins with an equation describing the flow of government revenue and expenditure. With a debt/GDP ratio of one, the sustainable (primary) deficit/GDP ratio is given by g - r, where g = growth rate of NGDP and r = nominal interest rate on government debt (I include Federal Reserve liabilities and currency in this measure). John assumed g - r = 1% (so about $200B). In a post I published last year, I assumed g - r = 3% (so about $600B); see here: Is the U.S. Budget Deficit Sustainable? Two things to take away from these calculations. First, this arithmetic suggests that the U.S. federal government can easily run persistent primary budget deficits in the range of 1-3% of GDP. Not only does the debt not need to be paid off, but it can grow forever. Second, primary budget deficits are presently far in excess of this range. What does this imply?Let's step back and think about John's equation. The arithmetic of the government "budget constraint" basically says this:Deficit/GDP = [1 - (1+r)/(1+g)] x Debt/GDPNote that a sustainable primary deficit is only possible if r < g. If r > g, then a primary surplus is needed to service the interest expense of the debt. Students of monetary theory may recognize the expression above as a Laffer curve for inflation finance. That is, in the case of currency we have r = 0. Let g represent the growth rate of the supply of currency and assume a constant RGDP (so that g also measures the growth rate of NGDP). Finally, replace debt with currency, so that Seigniorage revenue = [1 - 1/(1+g)] x Money/GDP Again, this is just arithmetic. Economic theory comes in through the assumption that the demand for money is decreasing in the rate of inflation, g. If this is true, then an increase in g has two opposing effects: it increases seigniorage revenue by increasing the inflation tax rate, but it lowers seigniorage revenue because it decreases the inflation tax base. There is a maximum amount of seigniorage revenue the government can collect by printing money. That is, there are limits to inflation finance. (See also my post here.)Now, I know John is fond of saying that Federal Reserve liabilities and U.S. Treasury securities are essentially the same thing (especially if the former exist mainly as interest-bearing reserve accounts). I happen to agree with this view. But then we can use exactly the same logic to characterize the limits to bond finance, recognizing that U.S. Treasury securities are essentially money. To this end, assume that the Debt/GDP ratio is an increasing function of (r - g). To make things a little simpler, let me continue to assume zero RGDP growth, so that g represents both inflation and NGDP growth. Finally, let me assume that r is a monetary policy choice (just as setting r = 0 for currency is a policy choice). Next, we need a theory of inflation. In the models I work with, the rate of inflation in a steady state is determined by the growth rate of the nominal debt, g, which I also treat as a policy parameter. So, the magnitude r - g is policy-determined, at least, within some limits. By lowering r and increasing g, the government is making its securities less attractive for people to hold. But this just tells us that the demand for debt is lower than it otherwise might be--it does not tell us how large this demand is in the first place, or how it is likely to evolve over time owing to factors unrelated to r or g (e.g., regulatory demand, foreign demand, etc.).So, with this apparatus in place, my interpretation of what worries John is the question of what happens if [1] the federal government finds itself near the top of the bond-seigniorage Laffer curve; and [2] a shock occurs that requires a large fiscal stimulus. Barring alternative forms of securing resources (e.g., through direct command/conscription), the government will not have the fiscal capacity to lay claim against the resources it needs. Printing more money/bonds here is not going to help even with zero interest rates. The ensuing inflation would simply put us on the right-hand-side of the Laffer curve -- the government's ability to secure resources would only diminish. Assuming I have captured at least a part of John's concern accurately, let me go on to critique it. To begin, there's nothing wrong with the logic I spelled out (I don't think). But I want to make a couple of points nevertheless.First, the demand for U.S. government securities (D/Y) seems to be growing very rapidly and for a very long time now. We know, anecdotally, that the UST is used widely as collateral in credit derivatives markets and repo, that foreign countries view it as a safe asset, that investors value its safety, and that recent changes to Dodd-Frank and Basel III have contributed to the regulatory demand for USTs. The global demand for the U.S. dollar is, if anything, growing more rapidly than ever (re: the recent "dollar shortages" that resulted in the Fed opening its central bank swap lines). We don't know where this limit is, but judging by how low U.S. inflation is (together with low UST yields), it seems fair to day that there's still plenty of fiscal capacity. (And I want to stress that this has nothing to do with the ability of a country to pay back its debt -- I'm not sure why John keeps mentioning this while at the same time understanding that this debt is money). I suspect that John is likely to agree with what I just said. Sure, there may be more room now, but how much more? With bipartisan concern for debt absent in Congress, with no sign of inflation in sight, with interest rates so low, how can we not hit this limit at some point?My own view is that we are bound to hit this limit (though, economists like Simon Wren-Lewis have warned me not to discount the forces of austerity). The question is what happens once we hit that limit? I say we get USD depreciation and some inflation (not hyperinflation). John seems to be worried about hyperinflation after all, which he likens to a debt rollover crisis. I just don't see it. (Of course, if John is simply suggesting that the fiscal authority will continue to run persistently large deficits in the face of high inflation, then I agree with him. While I don't see this happening, who can say for sure?)Finally, what happens if we're near the debt limit and there's a shock. Well, what type of shock exactly? The type of shock that hit us in 2008 is likely to increase the demand for debt, expanding fiscal capacity. So, here too, I'm not sure what form the debt crisis is supposed to take. It would be great to appeal to a model (but please, not one of Greece). 

After Canada's Supreme Court ruled the federal government's carbon tax is constitutional, Premier Kenney made the astonishing admission that his government didn't prepare a fallback plan on implementing a consumer carbon tax because they were hoping to win in the country's top court. For the UCP, apparently hope springs eternal, even when the fiscal boat itself is springing leaks.

There are a lot of moving parts to the MMT program. I want to focus on one of these parts today: the relation between monetary and fiscal policy.
One thing I find appealing about MMT scholars is their attention to monetary history and
institutional details. I've learned a lot from them in this regard.
But as is often the case with details, one has to worry about whether they help
shed light on a specific question of interest, or whether they sometimes let us not see
the forest for the trees. And in terms of the broader picture, since I grew up
in that branch of macroeconomics that tries to take money, banking, and debt
seriously (i.e., not standard NK theory), I sometimes have a hard time understanding what all the fuss is
about. Much of standard monetary theory (SMT) seems perfectly consistent with
some of the ideas I seen discussed in MMT proponents; see, for example, The Failure to Inflate Japan. 

  

This post is devoted to better
understanding a contribution by Eric Tymoigne. Eric is one of the people I go
to whenever I want to learn more about MMT (if you're interested in MMT, you
should follow him on Twitter @tymoignee). In this post, I discuss his
article "Modern Monetary Theory, and Interrelations Between the Treasury
and Central Bank: The Case of the United States." (JEI 2014). Passages quoted from his paper are highlighted in blue. The working
paper version of the paper can be found here. Eric has kindly agreed to respond to my comments and let me post our conversation. We had to some editing, hopefully this did not disrupt the flow too much. In any case, I hope you find it interesting. And, as always, feel free to join in on the conversation in the comments section below. -- DA



============================================================================



DA: Eric, let's start with the opening paragraph:



One of the main contributions of modern money theory (MMT) has been
to explain why monetarily sovereign governments have a very flexible policy
space. Not only can they issue their own currency to spend and to service their
public debt denominated in their own unit of account, but also any self-imposed
constraint on budgetary operations can be easily bypassed. 



I'm
curious to know what the contribution is here relative to standard monetary
theory (SMT). In SMT, the government can also issue its own currency to spend
and to service the public debt denominated in its own unit of account. So this
degree of "flexibility" is already accounted for. As for
"self-imposed constraints on budgetary operations," SMT takes several
approaches to this issue, depending on the purpose of the analysis. One
approach is to take these constraints as given and then to study their
implications. But it is also common to consolidate the central bank, treasury
and government into a single authority, which implies no self-imposed
constraints on budgetary operations. 


Perhaps what is meant is that MMT shows how existing self-imposed constraints
on budgetary operations can be (or are) bypassed in reality.  This leads
us to question, however, concerning what those self-imposed constraints are doing there in
the first place. Are they there by design and, if so, why? Or are they there by
accident (and, if so, how in the world did this happen)?



ET: Yes
consolidation is not unique to MMT as we have said repeatedly. Not only is it
used quite commonly in the economic literature, but also it is a common
rhetorical tool in economic talks, discourse, etc.

























 

DA: Right, so everyone understands this (at least, they should)--it's perfectly consistent with standard monetary theory. So far, so good.



ET: Most
economists, politicians and the public don't understand this or its
implications. They will interpret the above as saying that it is obvious that
the government can create money but it is not a normal way to proceed and it is
inflationary. MMT just pushes consolidation to its logical conclusions and
shows that institutional details do back those conclusions. In a consolidated
framework, the federal government can only implement spending by creating
money, this is not abnormal and it is not inflationary by itself. There is no
other way to find the necessary dollars to spend. Here is what consolidation means in terms of balance sheets:



For the federal government, taxes destroy currency
(L1 falls) and claims on non-fed sectors falls (A1 falls) (an alternative
offsetting operation is net worth of government rises). When US spends, it
credits accounts (L1 rises). Similarly, bond issuance does not lead to a gain
of any asset for the government; all it does is replace a non-interest earning government
liability (monetary base) with an interest-earning government liability (Treasury
securities).



DA: I am not going to argue against your accounting. As for bond-issuance, in
SMT, an open-market operation is modeled as a swap of zero-interest reserves
for interest-bearing treasuries. The interest on treasuries is explained by
their relative illiquidity (another self-imposed constraint). The economic
consequences of such a swap depends on a host of factors, which I'm sure you're
familiar with. 



ET: Sure, in
addition, self-imposed financial constraints (e.g. debt ceiling, no direct
financing by the Fed, no monetary power for treasury) have been put in place at
various times with the argument that they impose discipline in public finances.
MMT argues, these financial constraints are not necessary and are bypassed
routinely through Treasury-Central Bank coordination.



DA: Sure, the standard view is that these
self-imposed constraints are designed to impose discipline in public finance.
The proposition that these financial constraints are or are not necessary, however, must be
based on a set of assumptions that may or may not be satisfied in reality. (The
fact that these constraints may be bypassed through Treasury-Central Bank
coordination does not seem relevant to me -- the conflict emphasized by SMT is
between an "independent" central bank and the legislative authority
(e.g., the Fed and Congress, not the Fed and Treasury). I'm not sure why a new
theory is needed here. We know, for example, that if the legislative branch of
government fully trusts itself (and future elected representatives) to behave
in a fiscally responsible manner, the notion of an "independent"
central bank (and other self-imposed constraints) makes little sense. 



ET: Remember
that MMT emphasizes the irrelevance of financial/nominal constraints for
monetarily sovereign governments (bond vigilantes, risk of insolvency of social
security, etc.). One can do that by using the consolidated government (taxes
don't finance, bonds don't finance, government spends by crediting accounts,
etc.) or by using the unconsolidated government (the central bank helps the Treasury,
the Treasury helps the central bank). The second method conforms to actual
federal government operations but it is much less easy to use rhetorically and it
waters down the core point: government finances are never a financial issue as
long as monetary sovereignty applies.

Given that point, as you note, financial constraints are not only
irrelevant, but also disruptive and used for political games. MMT wants to make
government financial operations as smooth and flexible as possible. Once
society has decided how, and to what degree, government should be involved in
solving socioeconomic problems, finding the money should not be an issue when
monetary sovereignty prevails. That means demystifying
and eliminating financial barriers to government operations so the political
debate can focus on solving real issues (environment issues, socio-economic
issues, etc.). Fearmongering about the public debt and fiscal deficits makes for
poor political debates and policy prescriptions.



There is a view, expressed by Paul Samuelson, that if
we tell policymakers and the public that there are no financial limits to
government spending, policymakers will spend like mad; therefore, economists
need to lie to policymakers and the public (and themselves). This is nonsense.
We ought to discuss policy choices not on the basis of Noble Lies but rather on
the basis of sound and informed premises. Economists needs to make sure that
policymakers focus on resource constraints.



In addition, political constraints on government should be geared
toward improving the transparency and participatory aspects of government (e.g.
limit role of big money in elections, limit wastes, etc.). We already have a
government that passes a budget (it needs to do so for transparency and
accountability purposes), we already have an auditing process, and we already
have some (limited) democratic process, so aim at improving these aspects. MMT
proponents are not naive, we know that some politicians are self-interested, we
know that policy implementation may lead to mistakes, we know people may try to
game the system ("free riders"); however we trust that a transparent and
democratic government can (and does) get through these issues. MMT does not see
financial constraints as helping in any ways, rather they inhibit the
democratic process.



Of course, MMT proponents also have a policy agenda (Job guarantee,
financial regulation based on Minsky, etc.) because we do not see market
mechanisms as self-promoting full employment, price stability and financial
stability. As such, as you said, MMT proponents favor alternative means to
achieve these goals through direct government intervention. We don't see the
central bank as an effective means to promote price stability. The central bank
should focus on financial stability through interest-rate stabilization and
financial regulation (an area where the Fed has not performed well).



Finally, yes independence
of the central bank is seen as a big deal but MMT disagrees for two reasons.
First, MMT emphasizes the lack of effectiveness of monetary policy in managing
the business cycle and, second, and probably more importantly, MMT notes that
central-bank independence in terms of interest-rate setting and goal settings
does not mean independence from the financial needs of the Treasury.



DA: I think it's fair to say most people want to see government
operations run smoothly, and would welcome a sober debate over the issues at
hand without the fear-mongering that some like to promote. The broad objective seems the same--the debate is more over implementation--how monetary and fiscal policy is to be coordinated--given human frailties. 



Having said this, I think you go too far by asserting that
"government finances are never an issue as long as monetary sovereignty
applies." Of course, technical default on nominal debt is not an issue (we
all understand this). But SMT also recognizes the importance of economic default
on nominal debt. True, a government can always print money to satisfy its
nominal debt obligation, but if money printing dilutes the purchasing power of
money, this is a de facto default. 



On a related issue, SMT asks "what are the limits to
seigniorage?" The fact that a government can print money does not give it
the power to command resources without constraint. People can (and do) find
substitutes for government money (they may also substitute out of taxed activities
into non-taxed activities). SMT treats the limits to seigniorage as a financial constraint.
Maybe MMT has a different label for this constraint? Perhaps it is related to
what I hear MMT proponents call an "inflation constraint." Maybe
one way to reconcile MMT with SMT on this score is by recognizing that SMT
usually assumes (sometimes incorrectly) that the inflation constraint is always
binding. If this is the case, a monetarily-sovereign government does have
a financial constraint, even according to MMT. 



ET: Yes, ability to create a
currency does not mean ability to command resources because there may not be a
demand for the currency. That is where tax liabilities and other dues owed to
the government become important (cf. the chartalist theory of money, a
component of MMT). That's also why taxes, monetary creation and bond issuance
are not conceptualized by MMT as alternative financing means but rather as
complementary. The government imposes a tax liability, spends by issuing the
currency necessary to pay the tax liability, then taxes and issues bonds. Spending may be inflationary
indeed and so there is an inflation constraint; but it is not a financial constraint,
it is a resource constraint.



About the "printing" of money
by government, inflation and economic default. Regarding the first two, there
is no evidence of an automatic relation between money and inflation. In a
consolidated view, government always spends by monetary creation but controls
the impact on inflation via taxes and the impact on interest rates via bond
issuance. In an unconsolidated view, the central bank routinely finances and
refinances the Treasury by helping some of the auction bidders and by
participating in the auction.

Finally, regarding economic
default, governments routinely "default" in that sense with no problems. I
don't see that as a relevant concept unless someone can show that economic
default raises interest rates or generates rising inflation (it does not); here
again, there is no automatic link between inflation and interest rates. That
link depends on how the central bank reacts; if it does not then market
participants don't either.



DA: Let me return to the manner in which the Fed/Treasury/Congress
are consolidated (or not) in SMT and why this matters, in your view. In some
SMT treatments, Congress decides spending and taxes, which implies a primary
deficit. It's up to the Treasury to finance that deficit, with the Fed playing
a supporting role (by determining interest rate and issuing reserves for
treasury debt). What's wrong with this approach?

   

ET: That goes in the
right direction with an understanding that the government really has no control
over its fiscal position. All this, which relates to the implementation of
monetary sovereignty, helps understand why the financial crowding out is not
operative, why monetary financing is not by definition inflationary, why i >
g is normal. It helps explain why the hysterical rhetoric surrounding the
public debt and deficits in nonsense. I recently wrote a piece for Challenge Magazine on that topic. Surpluses are celebrated, governments implement
austerity during a recession to "live within our means", Social Security needs
to be fixed to avoid bankrupting it, governments need to save more, etc. All of this is incorrect.



DA: I'm not sure why you claim SMT leads to the idea of i > g.
The case i < g is perfectly consistent with SMT (see Blanchard's 2019 AEA
Presidential address, and also my posts here and here). The
correct criticism (I think) is that mainstream economists have assumed i > g
as being the empirically relevant case (it is not).



ET: That is what I meant. MMT links that to monetary sovereignty.



DA: I think that's correct. I should like to add that mainstream economists (apart from a small set of
monetary theorists) have not appreciated the role of high-grade sovereign debt
as an exchange medium in wholesale financial markets and as a global store of value, which in my view likely explains a lot of the "missing inflation." But as for
"surpluses being celebrated," you are now talking about individual
viewpoints and not SMT per se. There were plenty of calls out there
for countercyclical fiscal policy based on standard macroeconomic principles.
But I do agree virtually all mainstream economists are (perhaps overly)
concerned about "long-run fiscal sustainability." The view is that at
the end of the day, stuff has to be paid for -- and that having the ability to
print money, while granting an extra degree of flexibility, does not get around
this basic fact. 



DA: I'd like to ask you about this statement you make:



In (the unconsolidated) case, the Treasury collects taxes and
issues securities before it can spend. However, federal taxes and bond
offerings also serve another highly important function that is overlooked in
standard monetary economics. Specifically, federal taxes and bond offerings
result in a drainage of funds from the banking system, and MMT carefully
analyzes the implication of this fact. From that analysis, MMT argues that
federal taxes and bond offerings are best conceptualized as devices that
maintain price and interest-rate stability, respectively (of course, the tax
structure also has some important role to play in terms of influencing
incentives and income distribution; something not disputed by MMT). 



DA: Well, yes, taxes serve both as a revenue device
(permitting the government to gain control over resources that would otherwise
be in control of the private sector) and as a way to control inflation. I'm not
sure about the idea of the Treasury offering bonds for the purpose of achieving
interest-rate stability (though this may happen to some extent when the
treasury determines which maturity to offer). I don't think this is the way
things work in the U.S. today.



ET: Taxes and issuance of
treasuries drain reserves and so raise the overnight rate. Hence, on a daily
basis, a fiscal surplus raises the overnight rate and a fiscal deficit lowers
it. There has been significant Treasury-Fed coordination to smooth the impact
of taxes (and treasury spending) on the money market.



DA: Fine, but so what? We all understand
"coordination" between Fed and Treasury exists at the operational
level. 



ET: I think you are too kind to other
economists and policymakers. On taxes as price-stabilizing factors, there is
indeed some similarities here. On the role of treasuries for interest-rate
stability, it does work like this today. It may not be obvious because of the
current emphasis on treasuries as Treasury's budgetary tools, but Treasury has issued securities for
other purposes than its budgetary needs. In the US, this occurred most recently during the 2008
crisis (SFP bills). In Australia, in the early 2000s, the Treasury issued
securities while running surpluses in order to promote financial stability.



DA: But even if this is not the way things actually work
(in my view, it's the Fed that stabilizes interest rates, possibly through OMOs
involving U.S. Treasuries), I'm not sure what point is being made. I think we
can all agree that monetary and fiscal policy can be thought of as being
consolidated in some manner. What would be good to know is how a specific MMT
consolidation matters (relative to other specifications) for a specific set of
questions being addressed. There is nothing in the abstract or introduction of
this paper that suggests an answer to this question.  

ET: The point being made is that in a consolidated
government, tax and bond issuance lose the financial purpose
they have for the Treasury but keep their price and interest-stability purposes.





DA: In standard monetary theory, tax and bond issuance keeps
its funding purposes for the government and at the same time can be used to
influence the price-level (inflation) and interest rates. Is this wrong? I
don't think so. At some level, taxes (a vacuum cleaner sucking up money from
the private sector) must have some implications for the ability of government
to exert command over real resources in the economy. What we label this ability
(whether "funding" or ''finance" or whatever, seems
inconsequential). 



ET: Ok here comes the crucial difference between financial
and real sides of the economy. In financial terms, taxes do not increase the
capacity of the government to spend, i.e. the government does not earn any
money from taxing; taxes destroy the currency. In financial terms, there is no
reason to fear a fiscal deficit; deficits are the norm, are sustainable and
help other sectors grow their financial net wealth. As such, it is not because a
government wants to spend more that it must tax more or lower spending
somewhere else. That is the PAYGO mentality. This mentality makes policymakers
think of spending and taxing in terms of how they impact the fiscal balance
instead of their impact on employment, inflation, incentives, etc. While
deficits may have negative consequences, they are not automatic. If
one takes a look at the evidence, deficits have no automatic negative impacts
on interest rates, tax rates, public-debt sustainability, or inflation.



In real terms, the necessity to increase tax rates to prevent
inflation, and so move more resources to the government, depends on the state
of the economy and the permanency of the increase in government spending relative to
the size of the economy. In an underemployed economy, the government
can spend more without raising tax rates. In a fully employed economy, shifting
resources to the government without generating inflation does require raising
tax rate and/or putting in place other measures such as rationing, price
controls, and delayed private-income payment. Here Keynes's "How to Pay for the
War" provides the roadmap. Standard economics is full-employment economics so
opportunity costs are always present. MMT follows Kalecki, Keynes and the work
of their followers (have a look at Lavoie's "Foundations of Post
Keynesian Economic Analysis") and note that capitalist
economies are usually underemployment and economic growth is demand driven. Put
in a picture, the economy is usually at point a.









Put succinctly, the real constraint is conditionally relevant, the
financial constraint is irrelevant if monetary sovereignty prevails. That is
the proper way to frame the policy debates and to advise policymakers; don't
worry about the money, worry about how spending impacts the economy.



ET: Moving to another topic, consolidation of the government brings to the forefront
forces that are operating in the current system but that are buried under
institutional complications. Namely that a fiscal deficit lowers interest rates
and treasuries issuance brings them back up, that spending must come before
taxing and treasuries issuance, that monetary financing of the government is
not intrinsically unsound and does not mean that tax and treasuries issuance
don't have to be implemented. 



DA: The statement that "deficit lower
interest rates" needs considerable qualification. Among other things, it
depends on the monetary policy reaction function. As for the claim that
spending *must* come before taxes, this is not a universally valid statement
(even if it may be true in some circumstances. But even more importantly, who
cares? Mainstream theory does not suggest that monetary financing is
intrinsically unsound (seigniorage is fine, if it respects inflation ceiling).
As for money, taxes and bonds not being alternative "funding"
sources, I worry that this semantics. You can call X a "funding"
source or not -- it's just a label. The real question is: what are the
macroeconomic implications of X? 



ET: Let me emphasize where I agree. Yes, evidence
shows the central role of monetary policy for the direction of interest rates,
fiscal policy is at best a very small driver. And yes, one ought to focus on
the real implications of government spending and we ought to forget about the financial implications. A fiscal
deficit is not unsustainable nor abnormal; deficits are the stylized fact of
government finances and are financially sustainable if monetary sovereignty is
present. So don't try to frame the policy debate and set policy in terms of
household finances, bankruptcy, fixing the deficit, etc.

To conclude I see three reasons why the "taxes/bonds don't
finance the government" rhetoric is helpful:



1- It is strictly true for the federal government (i.e.
consolidation).



2- it brings to the forefront some lesser-known aspects of taxes
and treasuries issuance: impacts on money market, role of central bank in
fiscal policy, role of treasury in monetary policy.



3- It changes the narrative in terms of policy and political
economy: government does not rely on the rich to finance itself, taxes should
be set to remove the "bads" not to finance the government (e.g. one
should not set tax rates on pollution with the goal of balancing the budget but
with the goal of curbing pollution to whatever is considered appropriate, that
may lead to much higher tax rates than what is needed to balance the budget),
PAYGO is insane, one should focus on the real outcomes of government policies
not the budgetary outcomes.



DA:

1. I think this is semantics.

2. Not sure how it helps in this regard.

3. I think all of these positions are defensible without the
statement "taxes/bonds don't finance the government", so
if this is the ultimate goal (and I think it should be), perhaps we should set
aside semantic debates and focus on the real issues at hand. 



ET: 1 is not semantic. I know you have in mind taxes as a
means to leave resources to the government. MMT makes a clear difference
between financial (ability to find the money) and resources constraint (ability
to get the goods and services) as explained above. The financial
constraint is highly relevant for non-monetarily sovereign governments so it
should be noted and clearly separated from the real constraint. Too many
policy discussions and decisions by policymakers operating under monetary
sovereignty are based on an inexistent inability to find money and the imagined dear financial
consequences of budgeting fiscal deficits. 2 helps to understand how monetary
sovereignty is implemented in practice. On 3, yes focus on the real issues.



DA: We agree on 3! Thank you for an interesting discussion,
Eric. There's so much more to talk about, but let's leave that for another day. 



ET: You are welcome and thank you too!

The U.S. federal budget deficit for 2018 came in just shy of $800 billion, or about 4% of the gross domestic product (the primary deficit, which excludes the interest expense of the debt, was about 3% of GDP).


As the figure above shows, the present level of deficit spending (as a ratio of GDP) is not too far off from where has been in the 1970s and 1980s. It's also not too far off from where it was in the early 2000s (although, the peaks back then were associated with recessions).

Of course, the question people are asking is whether deficits of this magnitude can be sustained into the foreseeable future without economic consequences (like higher inflation). In this post, I suggest that the answer to this question is yes, but just barely. If I am correct, then any new government expenditure program will have to come at the expense of some other program, or be funded through higher taxes. Let me explain my reasoning.

The Arithmetic of Government Spending and Finance

I begin with some basic arithmetic (I describe here where theory comes in). Let G denote government expenditures and let T denote government tax revenue. Then the primary deficit is defined as S = G - T  ( if S  <  0, then we have a primary surplus ). The absolute magnitudes involved have little meaning--it turns out to be more useful to measure a growing deficit relative to the size of a growing economy. Let Y denote the gross domestic product (the total income generated in the economy). The deficit-to-GDP ratio is then given by (S/Y).  In what follows, I will assume that this ratio is expected to remain constant over the indefinite future (this is what a "sustainable" budget deficit means.)

Let D denote the outstanding stock of government "debt." For countries that issue debt representing claims to their own currency and permit their currency to float in foreign exchange markets, attaching the label "debt" to these objects--like U.S. Treasury securities--is somewhat misleading. The better analog in this case is equity. Companies that finance acquisitions or expenditure through equity do not have to worry about bankruptcy. They may have to worry about diluting the value of existing shareholders if they over-issue equity, or use it to finance negative NPV projects. The same is true of the U.S. federal government (but not state or local governments). The risk of over-issuing treasury debt is not default--it is share dilution (i.e., inflation).

Let R denote the gross yield on debt (so that R - 1 is the net interest rate). If we interpret D as currency, then R = 1 (currency has a zero net yield). If we interpret D as U.S. Treasury debt, then R = 1.025 (UST debt has an average net yield of around 2.5%). Note that in some jurisdictions today, government debt has a negative yield (so, R < 1 ) -- that is, government "debt" is in this case an income-generating asset!

Alright, back to the arithmetic. Let D' denote the stock of debt inherited from the previous period that is due interest today. The interest expense of this debt is given by (R - 1)D' (the interest expense of currency is zero). The primary deficit plus interest expense must be financed with new debt D - D', where D represents the stock of debt today and D' represents the stock of debt yesterday. Our simple arithmetic tells us that the following must be true:

[1]  S + (R - 1)D' = D - D'

Let me rewrite [1] as:

[2] S = D - RD'

Now, let's divide through by Y in [2] to get:

[3] (S/Y)  = (D/Y) - R(D'/Y)

We're almost there. Notice that (D'/Y) = (D'/Y')(Y'/Y). [I want to say that this is just high school math...except that my son came to me the other night with a homework question I could not answer. If you're not good at math, I understand your pain. But if you need some help, don't be afraid to ask someone. Like my son, for example.]

Define n = (Y/Y'), the (gross) rate at which the nominal GDP grows over time. In my calculations below, I'm going to assume n = 1.05, that is 5% growth. Implicitly, I'm assuming 2-3% real growth and 2-3% inflation, but I don't think what I have to say below depends on what is driving NGDP growth. In any case, let's combine (D'/Y) = (D'/Y')(Y'/Y) and n = (Y/Y') with [3] to form:

[4] (S/Y)  = (D/Y) - (R/n)(D'/Y')

One last step: assume that the debt-to-GDP ratio remains constant over time; i.e., (D'/Y') = (D/Y). Again, I impose this condition to characterize what is "sustainable." Combining this stationarity condition with [4] yields:

[*] (S/Y)  = [1 - R/n ](D/Y)

Condition [*] says that the deficit-to-GDP ratio is proportional to the the debt-to-GDP ratio, with the factor of proportionality given by [1 - R/n ]. This latter object is positive if R < n and negative if R > n.

The Mainstream View

There is no such thing as "the" mainstream view, of course. But I think it's fair to say that in thinking about the sustainability of government budget deficits, many economists implicitly assume that R > n. In this case, condition [*] says that if the outstanding stock of government debt is positive (D > 0), then sustainable deficits are impossible. Indeed, what is needed is a sustainable primary budget surplus to service the interest expense of the debt.

The condition R > n is a perfectly reasonable assumption for any entity that does not control or influence the money supply: state and local governments, emerging economies that issue dollar-denominated debt, EMU countries that issue debt in euros, federal governments that abide by the gold standard or delegate control of the money supply to an independent central bank with a preference for tight monetary policy.

The only exception to this that a mainstream economist might make is for the case of "debt" in the form of currency. The seigniorage revenue generated by currency (zero-interest debt), however, is typically considered to be small potatoes. Consider the United States, for example. Let's interpret D as currency. Currency in circulation is presently around $1.7 trillion, almost 10% of GDP. So let's set (D/Y) = 0.10, R = 1, and n = 1.05 in equation [*]. If I've done my math correctly, I get (S/Y) = 0.0025, or (1/4)% of GDP. That's about $100 billion. This may not sound like "small potatoes" to you and me, but it is for a government whose expenditures in 2018 totaled about $4 trillion.

The New and Modern Monetarist View

I think of "monetarists" as those who view money and banking as critical factors in determining macroeconomic activity. I'm thinking, for example, of people like Friedman, Tobin, Wallace, Williamson and Wright (old and new monetarists) on the mainstream side and, for example, Godley, Minksy, Wray, Fullwiler on the MMT (and other heterodox) side. A common ground shared by new/modern monetarists is the view of treasury debt as a form of money; i.e., the difference between (say) U.S. Treasury debt and Federal Reserve money is more of degree than in kind. Consider, for example, the following two objects:


Can you spot the difference?  The first one was issued by the U.S. Treasury and the second one by the Federal Reserve (the promised redemption for silver has long since been suspended). The Fed is said to "monetize the debt" when it replaces the top bill with the bottom bill. Is it any wonder why the BoJ cannot create inflation by swapping zero-interest BoJ reserves for zero-interest JGBs? (In case you're interested, see my piece here.)

In any case, rightly or wrongly, U.S. government policy presently renders the treasury bill illiquid (in the sense that it cannot easily be used to make payments). Of course, while the treasury bill no longer exists in physical form, every U.S. person can acquire the electronic version of (interest-bearing) T-bills at www.treasurydirect.gov. Just don't expect to be able to pay your rent or groceries with your treasury accounts any time soon. (Though, as I have argued elsewhere, it would be a simple matter to integrate treasury direct accounts with a real-time gross settlement payment system.)

But even if treasury securities cannot be used to make everyday payments, they are still liquid in the sense of being readily convertible into money on secondary markets (and maybe one day, on a Fed standing repo facility, as Jane Ihrig and I suggest here and here). USTs are used widely as collateral in credit derivative and repo markets -- they constitute a form of wholesale money. Because they are safe and liquid securities, they can trade at a premium. A high price means a low yield and, in particular, R < n is a distinct possibility for these types of securities.

In fact, R < n seems to be the typical case for the United States.


The only exception in this sample is in the early 1980s -- the consequence of Volcker's attempt to reign in inflation.

But if this is the case, then the mainstream view has long neglected a source of seigniorage revenue beyond that generated by currency. Low-yielding debt can also serve as a revenue device, as made clear by condition [*] above. How much is this added seigniorage revenue worth to the U.S. government?

Let's do the arithmetic. For the United States, the (gross) debt-to-GDP ratio is now about 105%, so let's set (D/Y) = 1.0.  Let's be optimistic here and assume that the average yield on USTs going forward will average around 2%, so R = 1.02. As before, assume NGDP growth of 5%, or n = 1.05. Condition [*] then yields (S/Y) = 0.03, or 3% of GDP. That's about $600 billion.

$600 billion is considerably more than $100 billion, but it's still small relative to an expenditure of $4 trillion. And, indeed, since the budget deficit is presently running at around $800 billion, there seems little scope to increase it without inducing inflationary pressure. (Note: by "increase it" I mean increase it relative to GDP. In the examples above, the debt and deficit all grow with GDP at 5% per year).

Conclusion

What does this mean for fiscal policy going forward? The main conclusion is that the present rate of deficit spending and high level of debt-to-GDP is not something to be alarmed about (especially with inflation running below 2%). The national debt can, will, and probably should continue to grow indefinitely along with the economy. What matters more is how expenditures are directed and how taxes are collected. Of course, this should be done with an eye to keeping long-term inflation in check.

What deserves our immediate attention, in my view, is a re-examination of the mechanisms through which government spending (when, where and how much) is determined. This is not the place to get into details, but suffice it to say that one should hope that our elected representatives have a capacity to reason effectively, have a broad understanding of history, are willing to listen, and do not view humility and compromise as four-letter words or signs of personal weakness. If we don't have this, then we have much deeper problems to deal with than the national debt or deficits.

Once the spending priorities have been established, the question of finance needs to be addressed. If the level of spending is less than 2% of GDP, then explicit taxes can be set to zero--seigniorage revenue should suffice. However, if we're talking 20% of GDP then tax revenue is necessary (at least, if the desired inflation target is to remain at 2%). If the tax system is inefficient and cannot be changed, this may mean cutting back on desired programs. Ideally, of course, the tax system could be redesigned to minimize inefficiencies and distortions. But tax considerations are likely always to remain in some form and, because this is the case, they should be taken into consideration when evaluating the net social payoff to any new expenditure program.

1. USA Today published my Op-Ed titled "Fighting the Coronavirus Pandemic: The Economic Front." In it, I make the case that the large relief package from the White House and Congress and the Fed's interventions are best seen as mobilizing for war: 

The proposed government outlays can be best thought of as part of a mass mobilization for war, just like the country did for World War II. Back then, the war was against foreign powers, and we mobilized factories, machines and troops to fight a physical foe. Today, the war is against a virus or an "invisible enemy," as President Donald Trump has described. We're mobilizing our health care industry and the ability for people to stay home in order to fight.


This fight against the novel coronavirus, like World War II, is also a two-front war. The first front is the public health battle against the virus. The second front is saving the economy from a debilitating wave of bankruptcies and liquidations as businesses are shut down and workers are sent home. This lockdown amounts to an economically induced coma, and most of new government funding is a form of life support to make it through this ordeal.


Mobilizing for war is very different than responding to a garden-variety recession. Consequently, this government relief should not be viewed as 'stimulus' but as life support for an economy temporarily put into an induced coma. 




2. The Mercatus Center published a new policy brief of mine where I call for Congress to grant the Federal Reserve the ability to do helicopter drops in very special circumstances. Specifically, the Fed should be allowed to do helicopter drops when interest rates hit their effective lower bound and the cash disbursements should be tied to a NGDP level target. 



3. We have increased the number of podcasts to two a week as the COVID-19 pandemic has taken off in the United States. The shows have focused on what policymakers can do and there have been a number of excellent guests. Below is a screenshot of some recent shows. Check out these episodes here.  

I want to say a few things about Chicago Booth's recent survey questions posed to a set of economists; see here. The survey asked how strongly one believes in the following two statements:


Question A: Countries that borrow in their own currency should not worry about government deficits because they can always create money to finance their debt.

Question B: Countries that borrow in their own currency can finance as much real government spending as they want by creating money.

Not surprisingly, most economists surveyed disagreed with both statements. Fine. But, not fine, actually. Because the survey prefaced the two questions with 


Modern Monetary Theory


as if the the two statements constitute some core belief of MMT.  



Was any MMT proponent included in the survey? Don't be ridiculous, of course not (there were a couple from MIT though--perhaps they thought this was close enough). How would a typical MMT proponent have answered these two questions? I am sure that most would have answered in the exact same way as other economists. If this is the case, then why does Chicago Booth preface the survey with MMT? There are many possibilities, none of which are attractive for Chicago Booth.




Let's consider Question B first. Or, better yet, let's not. This question is so ridiculous it hardly merits a response. Nobody believes that governments face no resource constraints.




O.K., so let's consider Question A, where some legitimate confusion may be present. Before I start though, I want to make clear that I don't purport to know the entire MMT academic literature very well. But I have done some reading and I have corresponded with some very smart, very thoughtful MMT proponents. I don't agree with many of their views, but I think I see how some of what they say is both valid and contrary to conventional thinking. At the very least, it seems worth exploring. What I am about to say is my own interpretation -- I am not speaking on behalf of MMTers.




Alright, so on to the question of whether deficits "matter." The more precise MMT statement reads more like this "A country that issues debt denominated in its own currency operating in a flexible exchange rate regime need not worry about defaulting in technical terms on its outstanding debt." That is, the U.S. government can always print money to pay for its maturing debt. That's because U.S. Treasury securities represent claims for U.S. dollars, and the government can (if it wants) print all the dollars it needs. 



Nobody disagrees with this statement. MMTers like to make it explicit because, first, much of the general public does not understand this basic fact, and second, this misunderstanding is sometimes (perhaps often) used to promote particular ideological views on the "proper" role of government.




Mainstream economists, like myself, like to point out what matters is not technical default but economic "default." An unexpected inflation whittles away the purchasing power of those caught holding old money as new money is printed to pay for whatever. I think it's clear that MMTers understand this too. This can be seen in their constant reference to an "inflation constraint" as defining the economic limits to government spending. I tried to formalize this idea in my previous blog post; see here: Sustainable Deficits.




But it's more complicated than this -- and in interesting ways, I think. Consider a large corporation, like General Motors. GM issues both debt and equity. The debt GM issues is denominated in dollars, so it can go bankrupt. But GM also issues a form of "money"--that is, is can use newly created equity to pay its employees or to make acquisitions.




Issuing more equity does not expose GM to greater default risk. Indeed, it may very well reduce it if the equity is used to buy back GM debt. If GM is thinking about financing an acquisition through new equity issuance, the discussion is not going to about whether GM can afford to print the new shares. Of course it can print all the shares it wants. The question is whether the acquisition is accretive or dilutive. If the former, then issuing new money will make the value of GM money go up. If the latter, then the new share issue will be inflationary (the purchasing power of GM shares will go down). In other words, "deficits don't matter" in the sense that the outstanding GM liabilities do not matter per se -- what matters is something more fundamental. Equity "over-issue" may not be desirable, but the phenomenon is symptomatic, not causal.




The U.S. government and Federal Reserve in effect issue equity. The government need not default on its debt. This is because U.S. Treasury debt is convertible into money (equity) and the Fed can do so if it so chooses. The question for the government, as with GM, is whether any new spending program is accretive or dilutive. If the economy is operating at less than full capacity, then this is like GM being presented with a positive NPV investment opportunity. The government can issue new money that, if used wisely, need not be inflationary.




There are limits to how far this can go, of course. And there was the all important qualifier "if used wisely." But this is exactly where the debate should be: how should our institutions be designed to promote the "best" allocation of resources?




I often hear that MMTers don't have a good theory of inflation. As if there is a good theory of inflation out there already. But I see in MMT a theory of inflation that overlaps (not entirely) with my own views expressed, say, here: The Failure to Inflate Japan. The MMT view seems to take a broader view over the set of instruments that monetary policy may employ to control inflation. We can have a debate about the merits of their views, but there's no reason to dismiss them outright or to pretend they don't have a theory of inflation.




Another complaint I hear: the MMTers don't want to produce a model. You know, it's true, there are not many mathematical models out there. So what? 



First, the lingua franca of policy making is English -- math is a part of a trade language. Economic ideas can be understood when expressed in the vernacular. It's also been helpful to me and others to attempt to "formalize" our thoughts in our trade language. But it seems to me that some of my colleagues can only understand an argument if it's posed in their trade language. This is a rather sad state of affairs, if true. 



Second, MMT, like any school of thought, is evolving over time and comes from a different tradition. Instead of demanding a model (now!), why not reach out and try to help formalize some of their ideas. You never know -- you may actually learn something in the process.



I could go on, but will stop here for now. 

Peter Stella joined me on the podcast this week. He was back by popular demand and we touched on two important and related questions: how should the government finance its relief efforts and who should ultimately manage the public debt? The U.S. Treasury may seem like the obvious answer to both questions, but it is not the whole story. The Federal Reserve can also finance the relief efforts and, in so doing, affect the structure of public debt. But is this a good thing? Peter Stella says no, at least in the longrun. He makes the case that it is economically and politically cheaper to return the financing and management of the public debt back to the U.S. Treasury once the COVID-19 recession is over. In other words, the Fed's expansion of its balance sheet, an understandable response to the crisis, needs to be unwound as the economy improves. Otherwise, we might end up with two government agencies with very different objectives trying to manage the public debt. This is an interesting argument and one I want to flesh out in this post by taking a closer look at the two questions of financing the budget deficits and managing the public debt.Financing the Budget DeficitsThe first issue is financing the budget deficit. The question here is whether the government should fund the deficit through (1) overnight debt with a variable interest rate or (2) long-term debt with a fixed interest rate. The former option is what happens when Federal Reserve liabilities--the monetary base--finance the deficit, while the latter option arises when it is funded by treasury securities. The Fed financing of deficits, in other words, is not risk free. It could lead to higher financing costs as the economy recovers. In such a scenario, financing with long-term treasury securities with fixed interest rates would be ultimately cheaper. But is this even possible in the current crisis with the Fed buying up so much public debt? That is, even if Treasury Secretary Steve Mnuchin issued more long-term treasury bonds, the Fed's asset purchases have been so large they would effectively convert most of the long-term bonds into overnight reserves. That, in fact, is what has happened over the past three months. The chart above shows that for  March, April, and May, the Fed purchased about $1.67 trillion of treasury securities compared to $2.31 in new issuance. The Fed, in other words, bought up about 72 percent of the treasury securities supplied during this time.Not only was the Fed buying up most of the new issuance, but it was buying up treasury securities with a maturity far longer than overnight reserves. This can be seen in the chart below. The Fed, then, has been acting as the final financier for most of the deficit during the COVID-19 crisis and, in so doing, has transformed the structure of $1.67 trillion of U.S. public debt into overnight government liabilities.  Managing the Public DebtSo are we stuck with these short-term government liabilities forever? As Peter Stella explained in the show, the answer is no. The U.S. government could convert those overnight reserves back into longer-term treasury securities once the crisis is over.  To illustrate how, imagine that by the end of 2020 the Fed has bought up $2 trillion in treasury securities. The purchase of these treasuries were used to indirectly fund the cash transfers to households, the PPP program, extended unemployment benefits, and other economic relief efforts. The figure below shows this development in terms of the respective balance sheets of the Treasury and Fed. The treasury securities are liabilities for the U.S. Treasury and assets for the Fed and vice-versa for Fed-issued reserves. The Treasury takes the reserves on its balance sheet and sends them to the private sector as part of the economic relief efforts.If we now combine the Treasury and Fed balance sheets into a consolidated government account and also look at the private sector balance sheet, we see the following two t-accounts: The net government liabilities are now $2 trillion in overnight reserves which are assets on the private sector's balance sheet. Again, during a crisis this is not a surprising outcome as the Fed rapidly expands its balance sheet. But left unchanged, it would imply rising interest rate costs once the economy starts recovering and the Fed is forced to raised the IOER to keep inflation in check.To avoid this problem, Peter Stella recommends that after the crisis the Treasury issues additional long-term treasury bonds that lock in low interest rates. Selling these treasuries to the private sector means taking reserves off their balance sheets. The Treasury, in other words, is swapping long-term treasury securities for the overnight Fed liabilities. This is what the consolidated balance sheet would like after this activity: Peter Stella outlines this process more thoroughly in his paper titled "Exiting Well". Again, this would not happen right away, but after the crisis has ended. Historically, the Fed has financed about 20 percent of the consolidated public debt (CPD) based on data back through 1945. I define CPD as the sum of marketable treasury securities not held by the Fed and the monetary base. Using data from the Financial Accounts of the United States, I constructed the chart below that shows the share of CPD attributable to the Fed and the U.S. Treasury. Unsurprisingly, the Fed's share of CPD during the Great Inflation rose to an average of almost 30 percent and hit almost 40 percent in 1974. During the Great Moderation it fell to about 14 percent. As of May, the Fed's share of CPD is approximately 24 percent, just above the historical average. The reason it is not higher is because of large budget deficits coming into the crisis. If 'exiting well' means returning to the historical average, it might occur naturally with regular budget deficits after the crisis. If 'exiting well' means returning to something closer to the Great Moderation levels, then this will be a more ambitious project and require a vast reduction in the stock of reserves.Other ConsiderationsThe argument so far for reducing the Fed's management of the public debt is that it is likely to be economically cheaper. As noted by folks like George Selgin, Charles Plosser, Paul Tucker, and others, a second argument is that it is also politically cheaper for the Fed to avoid playing the role of public debt manager. The management of U.S. public debt is normally under the purview of the U.S. Treasury because this process is inherently politically and therefore overseen by representatives of the taxpayers. The Fed can avoid these political entanglements by minimizing its influence on public debt management. This, of course, requires a smaller Fed balance sheet.

A post-crisis journey to a smaller balance sheet, however, faces two big roadblocks. First, the Fed has chosen an 'ample reserve' or floor operating system. This keeps the stock of excess reserves large in normal times and therefore keeps elevated the Fed's influence over public debt management. A number of post-2008 bank regulations also has increased the demand for bank reserves. Some of these regulations have been tweaked in the crisis, but both they and the Fed's floor system would have to be reconsidered if we wanted to return to a world of scarce reserves and less political entanglement for the Fed. Finally, it is worth noting that maintaining large central bank balance sheets do not guarantee robust growth. The charts below show the 2009-2019 averages of central bank balance sheets sizes against several measures of nominal economic activity. They, ironically, show bigger balance sheets are tied to slower nominal growth. Now, it could be the case that the countries with the weakest nominal growth responded with the most aggressive use of the LSAP programs. This is probably true, but the data span an entire decade so one would expect to see inflation, domestic demand, and credit growth respond to the use of LSAPs over this long of a period if QE worked as advertised. If nothing else, these figures should give us pause in considering the benefits of maintaining large central bank balance sheets over long periods. Further analysis of this data supports this interpretation. So between the higher financing cost for the public debt, the greater political entanglement for the Fed, and the unclear benefits from maintaining a large central bank balance sheet over a long period, we should take seriously Peter Stella's suggestions for 'exiting well' once the crisis is over. Here's hoping we do.

The so-called zero-lower-bound (ZLB) plays a prominent role in modern (and even older) macroeconomic theories. It is often introduced in a paper or at conference as a fact of life -- an unavoidable property of the physical environment, like gravity. But is it correct to view it in this way? Or is the ZLB better thought of as legal constraint--something that can potentially be circumvented by policy?

The Financial Services Regulatory Relief Act of 2006 allows the U.S. Federal Reserve (the Fed) to pay interest on reserve accounts that private banks hold at the Fed. Specifically, the Act states that:

Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.
The effective date of this authority was advanced to October 1, 2008, by the Emergency Economic Stabilization Act of 2008.

It is not clear (to me, at least) whether the Act grants the Fed the authority to pay a negative interest rate on reserves. Note that if the interest-on-reserves (IOR) rate is set to a negative number, then banks would in effect be paying the Fed a "service fee" for the privilege of holding reserve balances with the Fed. But if the Fed is not legally permitted to use negative interest rate policy (NIRP), then the ZLB is obviously a legal constraint.

This legal constraint, however, may not be binding if the ZLB is also an economic constraint. In fact, the traditional explanation for the ZLB is the existence of physical currency bearing zero interest. The idea that arbitrage will effectively keep interest rates from falling below zero is deeply ingrained in the minds of economists. For example, Corriea, et. al. (2012) write:

Arbitrage between money and bonds requires nominal interest to be positive. This "zero bound" constraint gives rise to a macroeconomic situation known as a liquidity trap. It presents a difficult challenge for stabilization policy.
However, we know from recent experience that the ZLB appears not to be an economic constraint.  Several central banks today have set their deposit rates into negative territory:




There is currently over $10 trillion of government debt in the world yielding a negative nominal interest rate; see here. As of this writing, even long bonds like the German 10-year Bund are in negative territory.

Well, alright, so the ZLB is evidently not an economic constraint. But surely there is some limit to how low nominal interest rates can fall? This lower limit is called the effective lower bound (ELB). And economic theory is clear: if we're at the ELB in a recession, then monetary policy has done about as much as it can be expected to do.

But what exactly is the ELB? Is it -1%, -2%, -5%, or perhaps even lower? Economists like Miles Kimball believe it to sufficiently negative to warrant NIRP as an effective policy tool; see here (see also the discussion by Ken Rogoff in chapter 10 of his book). These arguments, however, did not seem to gain much traction. For example, in the present discussions concerning the Fed's new long-run monetary policy framework, the possibility of NIRP is not even mentioned. But perhaps it should be if the ELB is in fact significantly below zero. In what follows, I want to make my own (related) argument for why the ELB is probably a lot lower than most people think.

Suppose the Fed was to set the IOR to -10% (in a deep demand-driven recession, this would presumably be accompanied with a promise to raise the IOR at some point in the future). The traditional economic argument suggests that any security dominated in rate of return by cash would in this case be driven out of circulation.

The first thing we could imagine happening is banks attempting to convert their digital reserves into vault cash. Banks are presently holding over $1.6 trillion in reserves with the Fed. The largest denomination Federal Reserve note is $100. This is what $1 trillion in $100 bills apparently looks like:




That's about the size of a football field. Banks would not convert all of their reserves into cash--even if it was costless to do so--because they'd need about $20-30 billion or so to make interbank payments. Of course, managing all that cash would be far from costless. But there is a simpler reason for why banks would not make the conversion. The Fed could simply charge banks a 10% service fee on their vault cash.

Alright, well what effect is the -10% IOR rate going to have on the deposit rate (or fees) that banks offer (or charge) their depositors? Banks are not likely to pass the full cost on to their depositors, especially if they view the NIRP to be temporary, because they'll want to maintain their customer relationships.

But let us take the extreme case and suppose that NIRP is perceived to be permanent. Then surely deposit rates will decline (or bank fees will rise) significantly. Deposit rates may even decline to the point where depositors start withdrawing their money from the banking system. Banks may well let this source of funding go if they could borrow more cheaply from the Fed (banks would need to borrow reserves to honor the withdrawal requests of their customers). Of course, the Fed lending rate is also a policy variable and could, in principle, be lowered to negative territory as well.

But how realistic is it to imagine all or most bank deposits converted to cash? While this might be the case for small value accounts, it seems unlikely that the business sector would be able to manage its payments needs without the aid of the banking system. Even money market funds need to work through the banking system. I suppose one could imagine a new product created by (say) Vanguard in which they create a cash fund with equity shares redeemable for cash that is collected and stored in rented Las Vegas vault. But the moment the activity is intermediated, it becomes taxable. If the Fed is not permitted to tax (oops, charge a service fee) such entities, the fiscal authority could, in principle, implement a surcharge that is set automatically off the IOR rate in some manner.

I think in this way one can see how the ELB might easily be well below -5% (or more). This is probably low enough to allow us to disregard the ELB as a binding economic constraint. The relevant constraint is always a legal one. And laws can be changed if it is deemed to serve the public interest.

Keep in mind that in a large class of economic models, ranging from Keynes (1936) to New Keynesian, there is potentially much to be gained by eliminating the ZLB. If these models are wrong, then let's get rid of them. But if they're roughly correct, why don't we take their policy prescriptions seriously? Let's stop talking about the ZLB as if it's a force of nature. It is a policy choice. And if it's a bad policy choice, it should be changed.

Michal Kalecki 1899 - 1970

Sam Levey reminded me of Kalecki's 1943 article on the political aspects of full employment. This a very interesting and thought-provoking paper. I enjoyed it enough to offer my critique of it.

The paper starts by taking as given what Kalecki calls the doctrine of full employment. The basic idea is that the private sector, left to its own devices, is prone to Keynesian aggregate demand failures (see here for game-theoretic interpretation). The remedy for these spontaneously-occurring "coordination failures," is a government spending program that acts, or stands ready to act, as private demand begins to falter.

Kalecki starts his paper off by asserting that by 1943, the doctrine was widely accepted by most economists. It seems clear that Kalecki views the doctrine to be self-evidently true.

But if this is the case, then this poses a problem. If the doctrine is so obviously true, why then are there still economists who oppose it? And if the idea is so self-evident, why are so many "captains of industry" reluctant to accept it? As Kalecki admits (pg. 324), this attitude is not easy to explain. After all, depressions are bad for business and businesses collectively should welcome any intervention that restores the economy to full employment.

The problem, as he sees it, is a political one. While the "economic experts" that disavow the doctrine may believe in their own theories, however poor they may be, he notes that "obstinate ignorance is usually a manifestation of underlying political motives." He doesn't say exactly what these political motives are, but he notes that these "economic experts" are, or have been, closely connected with banking and industry. But if this is the case, then the question turns to what motivates industry leaders to block interventions that they know will be good for industry?

He lists the following three reasons.

[1] Absent full employment policy the "state of confidence" will produce business cycles. Under laisser-faire then, industry leaders can credibly use this fact to exert a powerful indirect control over government policy.

[2] Supporting obviously beneficial public sector investments leads to a slippery slope. The government may wish to encroach in other areas in competition with private enterprise.

[3] In a perpetually full employment economy, the threat of unemployment vanishes as a discipline device for employers (see also here). As well, the social position of the boss would be undermined and the self assurance and class consciousness of the working class would grow, leading to political instability.

What to make of this? Well, I'm not sure. The first reason asserts that "business leaders" are willing to plumb the depths of economic depression every once in a while in exchange for political power. He doesn't actually say what this political power buys them. But whatever it buys them, I wonder whether it might not be purchased more cheaply through more conventional means?

The second reason doesn't seem plausible to me. Why wouldn't the private sector be willing to support infrastructure projects that benefit their interests directly? Was there any serious industry opposition, say, to the Federal Highway Act of 1956? And if there was, was it because of a fear that the project might succeed too well, an outcome that would encourage the government to become more adventurous in other arenas?

The third reason also seems weak to me. It is true, Kalecki writes, that profits would be higher under full employment, "but 'discipline in the factories' and 'political stability' are more appreciated by the business leaders than profits." First, the idea of unemployment as a discipline device only needs a constant low level of unemployment to work (Shapiro and Stiglitz, AER 1984 "Equilibrium Unemployment as a Worker Discipline Device;" see their reply here to a critique.) A decade-long Great Depression seems like an awfully high price to pay for "worker discipline." And as for promoting political stability, I think it is understood that events like the Great Depression, or even the Great Recession for that matter, promote political instability (which even Kalecki mentions in the article).

To sum up, Kalecki asks a great question. Collectively, we are all better off materially in the absence of economic depressions. We know--in principle, at least--how to prevent major economic depressions (I'm not talking about regular "small time" business cycles here.) But if so, why are interventions like the Obama stimulus program met with such bitter opposition in some quarters? For that matter, the TARP intervention--a "bailout" program aimed at stabilizing the financial sector--was also met with vocal opposition, especially from Main Street. Is this really all just a concern over "moral hazard?"

Maybe there's just a suspicion that these interventions, however good they may sound on paper, work out in practice simply as ways to redistribute income to undeserving, but squeaky wheels. I overheard a political commentator on NPR the other day remark that in economic and political negotiations, "if you're not at the table, then you're likely on the menu."  I suppose it's easy to say what we need in this case is better representation at the table. How to do this? I'm all ears.

The 10-year treasury yield reached an historic low this week, crossing the 1% barrier. For many observers, this was a troubling development that confirms the U.S. economy is being sucked into the mire of secular stagnation. For others, it was an unsurprising outcome given the long-run trajectory of interest rates and the ongoing safe asset shortage problem.
Both views have some merit. The decline of the 10-year treasury yield does create problems for the U.S. economy, but it has been happening for some time. There is nothing magical about crossing the 1% barrier, though it does brings closer the day of reckoning for the Fed's operating framework.


The decline of the 10-year treasury yield, if sustained, means the entire yield curve may soon run into its effective lower bound. This will render useless much of the Fed's toolbox. Fortunately, there is a fix for the Fed's operating framework that makes it robust to any interest rate environment. This fix, ironically, ties the Fed more closely to fiscal policy while making it more Monetarist in practice. 

This post outlines the proposed fix, but first motivates it by explaining how the decline in the 10-year treasury yield creates problems for the U.S. economy.

Why The 10-Year Treasury Yield Decline Matters 

The are three reasons why the fall in the 10-year treasury yield matters. First, it implies there is an excess demand for safe assets. These are securities that are expected to maintain their value in a financial crisis and, as a result, are highly liquid. The biggest sources of safe assets are government bonds from advanced economies, especially U.S. Treasuries. The global demand for them has far outstripped their supply and this has led to the global safe asset shortage problem. The 10-year treasury yield falling below 1% is the latest manifestation of this phenomenon.



The safe asset shortage is problematic because it amounts to a broad money demand shock that slows down aggregate demand growth. One solution is for safe asset prices (interest rates) to adjust up (down) to the point that safe asset demand is satiated. The effective lower bound (ELB) on interest rates prevents this adjustment from happening and causes investors to search for safe assets elsewhere in the world. Other economies, as a result, are also affected by the safe asset shortage problem and experience lower aggregate demand growth.1



The demand for safe assets, as noted above, is closely tied to the demand for liquidity. This can be seen in the figure below which shows that the use of money assets (i.e. money velocity) closely tracks the 10-year treasury yield. Over the past decade, this has meant the public's desired money holdings have increased as the 10-year treasury yield has fallen. All else equal, this implies slower growth in aggregate spending.






Below is a chart from an upcoming policy brief of mine that illustrates this point from a global perspective. It shows the average 10-year government bond yield between 2009 and 2019 plotted against the average growth rate of domestic demand over the same period. The government bond yield can be viewed as the safe asset interest rate in these advanced economies. The figure reveals a strong positive relationship between the safe asset yield and the domestic demand growth rate.









One has to be careful interpreting the causality here, but I do further analysis in the policy brief and find shocks to the bond yields do influence domestic demand growth. The safe asset shortage, therefore, appears to be a drag on global aggregate demand growth. The first reason, then, why the decline in the 10-year treasury yield matters is that it portends weaker aggregate demand growth. 



The second reason the decline matters is that it leads to a flattening of the yield curve. Financial firms that fund short term and invest long term rely heavily on a positive slopping yield curve to make this business model work. A flattening yield curve undermines it and may lead to less financial intermediation. This is one reason an inverted yield helps predict recessions. In this case, however, the  effect may be longer lasting than the business cycle as the decline in treasury yields appears to be on a sustained path.


The third reason the decline matters is that it impairs the Fed's current tool box. The Fed's target interest rate is now down to a 1-1.25% range, a small margin for a central bank that normally cuts around 5% during a recession. The Fed could turn to large scale asset purchases once it hits the ELB, but with the 10-year treasury now near 1%, there is not much space here either. Consequently, the Fed's toolbox is shrinking and soon could be rendered useless. 

Now the Fed can add to its toolbox and indeed the Fed is exploring new tools--such as negative interest rates and yield curve control--under its big review of monetary policy. Even these tools, however, are limited since the declining 10-year treasury yield is compressing the yield curve. 

The Fed's current toolbox, in short, is premised on a positive interest rate world that is slowing fading. The Fed, therefore, may soon face a day of reckoning for its current operating framework. That possibility and what the Fed could do in response is considered next.


Revamping the Fed's Operating Framework

The Fed's operating framework--defined here as the instruments, tools, and targets the Fed uses in its conduct of monetary policy--has been geared toward a positive interest rate environment. This framework has been increasingly strained by the downward march of interest rates. The 10-year treasury yield dropping below 1% underscores this challenge.

The Fed needs, consequently, an operating framework that is robust to any interest rate environment and one that is capable of stabilizing aggregate demand growth. I have proposed a fix to the Fed's operating system that addresses these challenges in a forthcoming journal article. Here I want to briefly outline that proposal. It has three parts: (1) the Fed adopts a dual reaction function, (2) the Fed adopts a NGDP level target, and (3) the Fed is empowered with a standing fiscal facility for use at the ZLB.  The three parts are explained below. 






Part I: A Dual Reaction Function. To make the Fed's operating framework robust to both positive and negative interest rate environments, I call for a two-rule approach to monetary policy. Specifically, the Fed would follow a version of the Taylor rule when interest rate are above zero percent and follow the McCallum rule when interest rate are at zero percent or below. The former rule uses an interest rate as the instrument of monetary policy while the latter rule uses the monetary base as the instrument.  Consequently, the Fed would have effective instruments to use no matter what happens to interest rates. 


Part II: A NGDP Level Target. A level target provides powerful forward guidance since it forces the central bank to make up for past misses in its target. For reasons laid out here, I prefer a nominal NGDP level target (NGDPLT) and specifically, one that targets the forecast. This combined with the first feature implies the following dual reaction function system for the Fed:









Here, in is the neutral interest rate, the NGDPGap is the percent difference between the forecasted level of NGDP and the NGDPLT for the period of t to t+h, Δb is the growth rate of the monetary base, Δx* is the target NGDP growth rate, and Δv is the expected growth rate in the velocity of the monetary base for the period of t to t+h.




Part III: A Standing Fiscal Facility. The final part of the proposal establishes a standing fiscal facility for the Federal Reserve to use when implementing the McCallum rule. That is, when the Fed starts adjusting the the growth of the monetary base according to the McCallum rule, it will do so by sending money directly to the public. My proposal, then, incorporates 'helicopter drops' into the Fed's toolkit in rule-like manner. 


I provide more details in the paper, but here are the advantages of this proposed operating framework. First, it keeps countercyclical macroeconomic policy at the Federal Reserve. This provides continuity with the existing division of labor between the U.S. Treasury Department and the Federal Reserve.  Second, it enables the Fed to provide meaningful countercyclical monetary policy no matter what happens to interest rates. Third, it provides credible forward guidance since it combines a NGDPLT with helicopter drops. Finally, since this operating framework would require the Fed to be much more intentional about the rules it follows, it would make the Fed more rules-based and predictable. 



This proposal would require approval from Congress. Given the Fed's shrinking toolbox and the ongoing expectation that it deliver countercyclical policy, this may not be as big an ask as some imagine. Moreover, it could easily be seen as return to a more Monetarist Federal Reserve since it would be relying more explicitly on the monetary base to implement monetary policy. 

Conclusion 
Some commentators have speculated that the corona virus might be a shock that forces us out of our complacency and spawns many unintended innovations. To the extent this shock leads to ongoing declines in the treasury yields and exhausts the Fed current toolbox, it might also lead to innovations in U.S. monetary policy. Here's hoping it does along the lines suggested above. 






1 The safe asset shortge can also become self-perpetuating and lead to what Caballero et al (2017) call a 'safety trap'. This problem emerges when the excess demand for safe assets pushes down safe asset yields to the effective lower bound (ELB) on interest rates. If the excess demand for safe assets is not satiated at that point (i.e. the equilibrium real safe asset interest rate is below the ELB), then aggregate demand will contract and push down inflation. Via the Fisher relationship, the lower inflation will drive up the real safe asset interest rate and increase the spread between it and the equilibrium real safe asset interest rate. As a result, aggregated demand will further contract and the cycle will repeat.  This is the safety trap.

Loet Leydesdorff on the Triple Helix: How Synergies in University-Industry-Government Relations can Shape Innovation Systems





This is the sixth and last in a series of Talks dedicated to the technopolitics of International Relations, linked to the forthcoming double volume 'The Global Politics of Science and Technology' edited by Maximilian Mayer, Mariana Carpes, and Ruth Knoblich 







The relationship between technological innovation
processes and the nation state remains a challenge for the discipline of
International Relations. Non-linear and multi-directional
characteristics of knowledge production, and the diffusive nature of knowledge
itself, limit the general ability of governments to influence and steer
innovation processes. Loet Leydesdorff advances the framework of the "Triple
Helix" that disaggregates national innovation systems into
evolving university-industry-government eco-systems. In this Talk, amongst others, he shows that these eco-systems can be
expected to generate niches with synergy at all scales, and emphasizes that, though
politics are always involved, synergies develop unintentionally.




Print version of this Talk (pdf)




What is the most relevant aspect
of the dynamics of innovation for the discipline of International Relations?



The
main challenge is to endogenize the notions of technological progress and
technological development into theorizing about political economies and nation states.
The endogenization of technological innovation and technological development
was first placed on the research agenda of economics by evolutionary economists
like Nelson and Winter in the late 1970s and early 1980s. In this context, the
question was how to endogenize the dynamics of knowledge, organized knowledge,
science and technology into economic theorizing. However, one can equally well
formulate the problem of how to reflect on the global (sub)dynamics of
organized knowledge production in political theory and International Relations.



From
a longer-term perspective, one can consider that the nation states – the
national or political economies in Europe – were shaped in the 19th
century, somewhat later for Germany (after 1871), but for most countries it was
during the first half of the 19th century. This was after the French
and American Revolutions and in relation to industrialization. These nation
states were able to develop an institutional framework for organizing the
market as a wealth-generating mechanism, while the institutional framework
permitted them to retain wealth, to regulate market forces, and also to steer
them to a certain extent. However, the market is not only a local dynamics; it
is also a global phenomenon.



Nowadays,
another global dynamics is involved: science and technology add a dynamics different
from that of the market. The market is an equilibrium-seeking mechanism at each
moment of time. The evolutionary dynamics of science and technology nowadays
adds a non-equilibrium-seeking dynamics over time on top of that, and this puts
the nation state in a very different position. Combining an equilibrium-seeking
dynamics at each moment of time with a non-equilibrium seeking one over time
results in a complex adaptive dynamics, or an eco-dynamics, or however you want
to call it – these are different words for approximately the same thing.



For
the nation state, the question arises of how it relates to the global market
dynamics on the one side, and the global dynamics of knowledge and innovation on
the other. Thus, the nation state has to combine two tasks. I illustrated this
model of three subdynamics with a figure in my 2006 book entitled The Knowledge-Based Economy: Modeled,
measured, simulated (see image). The figure shows that first-order interactions
generate a knowledge-based economy as a next-order or global regime on top of
the localized trajectories of nation states and innovative firms. These complex
dynamics have first to be specified and then to be analyzed empirically.



For
example, the knowledge-based dynamics change the relation between government
and the economy; and they consequently change the position of the state in
relation to wealth-retaining mechanisms. How can the nation state be organized
in such a way as to retain wealth from knowledge locally, while knowledge (like
capital) tends to travel beyond boundaries? One can envisage the complex system
dynamics as a kind of cloud – a cloud
that touches the ground at certain places, as Harald Bathelt, for example,
formulated.



How
can national governments shape conditions for the cloud to touch and to remain
on the ground? The Triple Helix of University-Industry-Government Relations can
be considered as an eco-system of bi- and tri-lateral relations. The three
institutions and their interrelations can be expected to form a system carrying
the three functions of (i) novelty production, (ii) wealth generation, and
(iii) normative control. One tends to think of university-industry-government
relations first as neo-corporatist arrangements between these institutional
partners. However, I am interested in the ecosystem shaped through the tri- and
bilateral relationships.



This
ecosystem can be shaped at different levels. It can be a regional ecosystem or
a national ecosystem, for instance. One can ask whether there is a surplus of synergy
between the three (sub-)dynamics of university-industry-government relations
and where that synergy can generate wealth, knowledge, and control; in which
places, and along trajectories for which periods of time – that is, the same
synergy as meant by "a cloud touching the ground".



For
example, when studying Piedmont as a region in Northern Italy, it is
questionable whether the synergy in university-industry-government relations is
optimal at this regional level or should better be examined from a larger perspective
that includes Lombardy. On the one
hand, the administrative borders of nations and regions result from the
construction of political economies in the 19th century; but on the
other hand, the niches of synergy that can be expected in a knowledge-based
economy are bordered also; for example, in terms of metropolitan regions (e.g.,
Milan–Turin–Genoa).



Since
political dynamics are always involved, this has implications for International
Relations as a field of study. But the dynamic analysis is different from
comparative statics (that is, measurement at different moments of time). The
knowledge dynamics can travel and be "footloose" to use the words of Raymond
Vernon, although it leaves footprints behind. Grasping "wealth from knowledge"
(locally or regionally) requires taking a systems perspective. However, the
system is not "given"; the system remains under reconstruction and can thus be
articulated only as a theoretically informed hypothesis.



In
the social sciences, one can use the concept of a hypothesized system
heuristically. For example, when
analyzing the knowledge-based economy in Germany, one can ask whether more synergy
can be explained when looking at the level of the whole country (e.g., in terms
of the East-West or North-South divide) or at the level of Germany's Federal
States? What is the surplus of the nation or at the European level? How can one
provide political decision-making with the required variety to operate as a
control mechanism on the complex dynamics of these eco-systems?



A
complex system can be expected to generate niches with synergy at all scales,
but as unintended consequences. To what extent and for which time span can
these effects be anticipated and then perhaps be facilitated? At this point,
Luhmann's theory comes in because he has this notion of different codifications
of communication, which then, at a next-order level, begin to self-organize
when symbolically generalized.



Codes
are constructed bottom-up, but what is constructed bottom-up may thereafter
begin to control top-down. Thus, one should articulate reflexively the
selection mechanisms that are constructed from the bottom-up variation by
specifying the why as an hypothesis.
What are the selection mechanisms? Observable relations (such as
university-industry relations) are not neutral, but mean different things for
the economy and for the state; and this meaning of the observable relations can
be evaluated in terms of the codes of communication.



Against
Niklas Luhmann's model, I would argue that codes of communication can be
translated into one another since interhuman communications are not
operationally closed, as in the biological model of autopoiesis. One also needs a social-scientific perspective on the
fluidities ("overflows") and translations among functions, as emphasized, for
example, by French scholars such as Michel Callon and Bruno Latour. In
evolutionary economics, one distinguishes between market and non-market
selection environments, but not among selection environments that are
differently codified. Here, Luhmann's theory offers us a heuristic: The complex
system of communications tends to differentiate in terms of the symbolic
generalizations of codes of communication because this differentiation is
functional in allowing the system to process more complexity and thus to be
more innovative. The more orthogonal the codes, the more options for
translations among them. The synergy indicator measures these options as
redundancy. The selection environments, however, have to be specified historically
because these redundancies—other possibilities—are not given but rather constructed
over long periods of time.





How did you arrive where
you currently work on?


I
became interested in the relations between science, technology, and society as
an undergraduate (in biochemistry) which coincided with the time of the student
movement of the late 1960s. We began to study Jürgen Habermas in the framework
of the "critical university," and I decided to continue with a second degree in
philosophy. After the discussions between Luhmann and Habermas (1971), I
recognized the advantages of Luhmann's more empirically oriented systems approach
and I pursued my Ph.D. in the sociology of organization and labour.



In
the meantime, we got the opportunity to organize an interfaculty department for
Science and Technology Dynamics at the University of Amsterdam after a
competition for a large government grant. In the context of this department, I
became interested in methodology: how can one compare across case studies and
make inferences? Actually, my 1995 book The
Challenge of Scientometrics
had a kind of Triple-Helix model on the cover: How do cognitions, texts, and
authors exhibit different dynamics that influence one another?



For
example, when an author publishes a paper in a scholarly journal, this may add
to his reputation as an author, but the knowledge claimed in the text enters a
process of validation which can be much more global and anonymous. These
processes are mediated since they are based on communication. Thus, one can add
to the context of discovery (of authors) and the context of justification (of
knowledge contents) a context of mediation (in texts). The status of a journal,
for example, matters for the communication of the knowledge content in the article.
The contexts operate as selection environments upon one another.



In
evolutionary economics, one is used to distinguishing between market and
non-market selection environments, but not among more selection environments
that are differently codified. At this point, Luhmann's theory offers a new
perspective: The complex system of communications tends to differentiate in
terms of the symbolic generalization of codes of communication because this differentiation
among the codes of communication allows the system to process more complexity
and to be more innovative in terms of possible translations. The different
selection environments for communications, however, are not given but constructed
historically over long periods of time. The modern (standardized) format of the
citation, for example, was constructed at the end of the 19th
century, but it took until the 1950s before the idea of a citation index was
formulated (by Eugene Garfield). The use of citations in evaluative
bibliometrics is even more recent.



In
evolutionary economics, one distinguishes furthermore between (technological)
trajectories and regimes. Trajectories can result from "mutual shaping" between
two selection environments, for example, markets and technologies. Nations and
firms follow trajectories in a landscape. Regimes are global and require the
specification of three (or more) selection environments. When three (or more)
dynamics interact, symmetry can be broken and one can expect feed-forward and
feedback loops. Such a system can begin to flourish auto-catalytically when the
configuration is optimal.



From
such considerations, that is, a confluence of the neo-institutional program of
Henry Etzkowitz and my neo-evolutionary view, our Triple Helix model emerged in
1994: how do institutions and functions interrelate and change one another or,
in other words, provide options for innovation? Under what conditions
can university-industry-government relations lead to wealth generation and
organized knowledge production? The starting point was a workshop about Evolutionary Economics and Chaos Theory: New
directions for technology studies held in Amsterdam in 1993. Henry
suggested thereafter that we could collaborate further on university-industry
relations. I answered that I needed at least three (sub)dynamics from the
perspective of my research program, and then we agreed about "A Triple Helix of
University-Industry-Government Relations". Years later, however, we took our
two lines of research apart again, and in 2002 I began developing a
Triple-Helix indicator of synergy in a series of studies of national systems of
innovation.





What would you give as
advice to students who would like to get into the field of innovation and
global politics?



In
general, I would advise them to be both a specialist and broader than that.
Innovation involves crossing established borders. Learn at least two languages.
If your background is political science, then take a minor in science &
technology studies or in economics. One needs both the specialist profile and
the potential to reach out to other audiences by being aware of the need to
make translations between different frameworks. Learn to be reflexive about the
status of what one can say in one or the other framework.



For
example, I learned to avoid the formulation of grandiose statements such as
"modern economies are knowledge-based economies," and to say instead: "modern
economies can increasingly be considered as knowledge-based economies." The
latter formulation provides room for asking "to what extent," and thus one can
ask for further information, indicators, and results of the measurement.



In
the sociology of science, specialisms and paradigms are sometimes considered as
belief systems. It seems to me that by considering scholarly discourses as
systems of rationalized expectations one can make the distinction between
normative and cognitive learning. Normative learning (that is, in belief
systems) is slower than cognitive learning (in terms of theorized expectations)
because the cognitive mode provides us with more room for experimentation: One
can afford to make mistakes, since one's communication and knowledge claims
remain under discussion, and not one's status as a communicator. The cognitive
mode has advantages; it can be considered as the surplus that is further
developed during higher education. Normative learning is slower; it dominates
in the political sphere.





What
does the "Triple Helix" reveal about the fragmentation of "national innovation
systems"?



In
2003, colleagues from the Department of Economics and Management Studies at the
Erasmus University in Rotterdam offered me firm data from the Netherlands containing
these three dimensions: the economic, the geographical, and the technological dimensions
in data of more than a million Dutch firms. I presented the results at the
Schumpeter Society in Turin in 2004, and asked whether someone in the audience
had similar data for other countries. I expected Swedish or Israeli colleagues
to have this type of statistics, but someone from Germany stepped in, Michael
Fritsch, and so we did the analysis for Germany. These studies were first
published in Research Policy.
Thereafter, we did studies on Hungary, Norway, Sweden, and recently also China
and Russia.



Several
conclusions arise from these studies. Using entropy statistics, the data can be
decomposed along the three different dimensions. One can decompose national
systems geographically into regions, but one can also decompose them in terms
of the technologies involved (e.g., high-tech versus medium-tech). We were
mainly relying on national data. And of course, there are limitations to the
data collections. Actually, we now have international data, but this is
commercial data and therefore more difficult to use reliably than governmental
statistics.



For
the Netherlands, we obtained the picture that would more or less be expected:
Amsterdam, Rotterdam, and Eindhoven are the most knowledge-intensive and
knowledge-based regions. This is not surprising, although there was one surprise:
We know that in terms of knowledge bases, Amsterdam is connected to Utrecht and
then the geography goes a bit to the east in the direction of Wageningen. What
we did not know was that the niche also spreads to the north in the direction
of Zwolle. The highways to Amsterdam Airport (Schiphol) are probably the most
important.



In
the case of Germany, when we first analyzed the data at the level of the
"Laender" (Federal States), we could see the East-West divide still prevailing,
but when we repeated the analysis at the lower level of the "Regierungsbezirke"
we no longer found the East-West divide as dominant (using 2004 data). So, the
environment of Dresden for example was more synergetic in Triple-Helix terms
than that of Saarbruecken. And this was nice to see considering my idea that
the knowledge-based economy increasingly prevails since the fall of the Berlin
Wall and the demise of the Soviet Union. The discussion about two different
models for organizing the political economy—communism or liberal democracy—had
become obsolete after 1990.



After
studying Germany, I worked with Balázs Lengyel on Hungarian data. Originally,
we could not find any regularity in the Hungarian data, but then the idea arose
to analyze the Hungarian data as three different innovation systems: one around
Budapest, which is a metropolitan innovation system; one in the west of the
country, which has been incorporated into Western Europe; and one in the east
of the country, which has remained the old innovation system that is state-led
and dependent on subsidies. For the western part, one could say that Hungary
has been "europeanized" by Austria and Germany; it has become part of a
European system.



When
Hungary came into the position to create a national
innovation system, free from Russia and the Comecon, it was too late, as
Europeanization had already stepped in and national boundaries were no longer
as dominant. Accordingly, and this was a very nice result, assessing this
synergy indicator on Hungary as a nation, we did not find additional synergy at
the national (that is, above-regional) level. While we clearly found synergy at
the national level for the Netherlands and also found it in Germany, but at the
level of the Federal States, we could not find synergy at a national level for
Hungary. Hungary has probably developed too late to develop a nationally
controlled system of innovations.



A
similar phenomenon appeared when we studied Norway: my Norwegian colleague
(Øivind Strand) did most of our analysis there. To our surprise, the
knowledge-based economy was not generated where the universities are located (Oslo
and Trondheim), but on the West Coast, where the off-shore, marine and maritime
industries are most dominant. FDI (foreign direct investment) in the marine and
maritime industries leads to knowledge-based synergy in the regions on the West
Shore of Norway. Norway is still a national system, but the Norwegian
universities like Trondheim or Oslo are not so much involved in entrepreneurial
networks. These are traditional universities, which tend to keep their hands
off the economy.



Actually,
when we had discussions about these two cases, Norway and Hungary, which both
show that internationalization had become a major factor, either in the form of
Europeanization in the Hungarian case, or in the form of foreign-driven
investments (off-shore industry and oil companies) in the Norwegian case, I
became uncertain and asked myself whether we did not believe too much in our
indicators? Therefore, I proposed to Øivind to study Sweden, given the availability
of well-organized data of this national system.



We
expected to find synergy concentrated in the three regional systems of
Stockholm, Gothenburg, and Malmö/Lund. Indeed, 48.5 percent of the Swedish
synergy is created in these three regions. This is more than one would expect
on the basis of the literature. Some colleagues were upset, because they had
already started trying to work on new developments of the Triple Helix, for
example, in Linköping. But the Swedish economy is organized and centralized in
this geographical dimension. Perhaps that is why one talks so much about
"regionalization" in policy documents. Sweden is very much a national
innovation system, with additional synergy between the regions.





Can governments alter
historical trajectories of national, regional or local innovation systems?



Let
me mention the empirical results for China in order to illustrate the
implications of empirical conclusions for policy options. We had no Chinese
data set, but we obtained access to the database Orbis of the Bureau van Dijk
(an international company, which is Wall Street oriented, assembling data about
companies) that contains industry indicators such as names, addresses,
NACE-codes, types of technology, the sizes of each enterprise, etc. However,
this data can be very incomplete. Using this incomplete data for China, we said
that we were just going to show how one could do the analysis  if one had full data. We guess that the
National Bureau of Statistics of China has complete data.
I did the analysis with Ping Zhou, Professor at Zhejiang University.



We
analyzed China first at the provincial level, and as expected, the East Coast
emerged as much more knowledge intense than the rest of the country. After
that, we also looked at the next-lower level of the 339 prefectures of China.
From this analysis, four of them popped up as far more synergetic than the
others. These four municipalities were: Beijing, Shanghai, Tianjin, and
Chongqing.



These
four municipalities became clearly visible as an order of magnitude more
synergetic than other regions. The special characteristic about them is that –as
against the others – these four municipalities are administered by the central
government. Actually, it came out of my data and I did not understand it; but
my Chinese colleague said that this result was very nice and specified this
relationship.



The
Chinese case thus illustrates that government control can make a difference. It
shows – and that is not surprising, as China runs on a different model – that
the government is able to organize the four municipalities in such a way as to
increase synergy. Of course, I do not know what is happening on the ground. We
know that the Chinese system is more complex than these three dimensions
suggest. I guess the government agencies may wish to consider the option of
extending the success of this development model, to Guangdong for example or to
other parts of China. Isn't it worrisome that all the other and less controlled
districts have not been as successful in generating synergy?



Referring
more generally to innovation policies, I would advise as a heuristics that
political discourse is able to signal a problem, but policy questions do not
enable us to analyze the issues. Regional development, for example, is an issue
in Sweden because the system is very centralized, more than in Norway, for
example. But there is nothing in our data that supports the claim that the
Swedish government is successful in decentralizing the knowledge-based economy
beyond the three metropolitan regions. We may be able to reach conclusions like
these serving as policy advice. One develops policies on the basis of intuitive
assumptions which a researcher is sometimes able to test.



As
noted, one can expect a complex system continuously to produce unintended
consequences, and thus it needs monitoring. The dynamics of the system are
different from the sum of the sub-dynamics because of the interaction effects
and feedback loops. Metaphors such as a Triple Helix, Mode-2, or the Risk
Society can be stimulating for the discourse, but these metaphors tend to develop
their own dynamics of proliferating discourses.



The
Triple Helix, for example, can first be considered as a call for collaboration
in networks of institutions. However, in an ecosystem of bi-lateral and
tri-lateral relations, one has a trade-off between local integration
(collaboration) and global differentiation (competition). The markets and the
sciences develop at the global level, above the level of specific relations. A
principal agent such as government may be locked into a suboptimum. Institutional
reform that frees the other two dynamics (markets and sciences) requires
translation of political legitimation into other codes of communication. Translations
among codes of communication provide the innovation engine.





Is there a connection
between infrastructures and the success of innovation processes?



One
of the conclusions, which pervades throughout all advanced economies, is that
knowledge intensive services (KIS) are
not synergetic locally because they can be disconnected – uncoupled – from the
location. For example, if one offers a knowledge-intensive service in Munich
and receives a phone call from Hamburg, the next step is to take a plane to
Hamburg, or to catch a train inside Germany perhaps. Thus, it does not matter
whether one is located in Munich or Hamburg as knowledge-intensive services
uncouple from the local economy. The main point is proximity to an airport or
train station.



This
is also the case for high-tech knowledge-based manufacturing. But it is
different for medium-tech manufacturing, because in this case the dynamics are
more embedded in the other parts of the economy. If one looks at Russia, the
knowledge-intensive services operate differently from the Western European
model, where the phenomenon of uncoupling takes place. In Russia, KIS
contribute to coupling, as knowledge-intensive services are related to state
apparatuses.



In
the Russian case, the knowledge-based economy is heavily concentrated in Moscow
and St. Petersburg. So, if one aims –as the Russian government proclaims – to create
not "wealth from knowledge" but "knowledge from wealth" – that is, oil revenues
–it might be wise to uncouple the knowledge-intensive services from the state
apparatuses. Of course, this is not easy to do in the Russian model because
traditionally, the center (Moscow) has never done this. Uncoupling
knowledge-intensive services, however, might give them a degree of freedom to
move around, from Tomsk to Minsk or vice
versa, steered by economic forces more than they currently are (via institutions
in Moscow).





Final question. What does path-dependency mean in the context of
innovation dynamics?



In
The Challenge of Scientometrics. The development, measurement, and
self-organization of scientific communications (1995), I used Shannon-type information theory to study
scientometric problems, as this methodology combines both static and dynamic
analyses. Connected to this theory I developed a measurement method for
path-dependency and critical transitions.



In
the case of a radio transmission, for example, you have a sender and a
receiver, and in between you may have an auxiliary station. For instance, the
sender is in New York and the receiver is in Bonn and the auxiliary station is
in Iceland. The signal emerges in New York and travels to Bonn, but it may be possible
to improve the reception by assuming the signal is from Iceland instead of
listening to New York. When Iceland provides a better signal, it is possible to
forget the history of the signal before it arrived in Island. It no longer
matters whether Iceland obtained the signal originally from New York or Boston.
One takes the signal from Iceland and the pre-history of the signal does not
matter anymore for a receiver.



Such
a configuration provides a path-dependency (on Iceland) in
information-theoretical terms, measurable in terms of bits of information. In a
certain sense you get negative bits of information, since the shortest path in
the normal triangle would be from New York to Bonn, and in this case the
shortest path is from New York via Iceland to Bonn. I called this at the time a
critical transition. In a scientific text for instance, a new terminology can
come up and if it overwrites the old terminology to the extent that one does
not have to listen to the old terminology anymore, one has a critical
transition that frees one from the path-dependencies at a previous moment of
time.



Thus,
my example is about radical and knowledge-based changes. As long as one has to
listen to the past, one does not make a critical transition. The knowledge-based
approach is always about creative destruction and about moving ahead,
incorporating possible new options in the future. The hypothesized future
states become more important than the past. The challenge, in my opinion, is to
make the notion of options operational and to bring these ideas into
measurement. The Triple-Helix indicator measures the number of possible options
as additional redundancy. This measurement has the additional advantage that one
becomes sensitive to uncertainty in the prediction.





Loet Leydesdorff is Professor Emeritus at the Amsterdam School of Communications Research (ASCoR) of the University of Amsterdam. He is Honorary Professor of the Science and Technology Policy Research Unit (SPRU) of the University of Sussex, Visiting Professor at the School of Management, Birkbeck, University of London, Visiting Professor of the Institute of Scientific and Technical Information of China (ISTIC) in Beijing, and Guest Professor at Zhejiang University in Hangzhou. He has published extensively in systems theory, social network analysis, scientometrics, and the sociology of innovation (see at http://www.leydesdorff.net/list.htm). With Henry Etzkowitz, he initiated a series of workshops, conferences, and special issues about the Triple Helix of University-Industry-Government Relations. He received the Derek de Solla Price Award for Scientometrics and Informetrics in 2003 and held "The City of Lausanne" Honor Chair at the School of Economics, Université de Lausanne, in 2005. In 2007, he was Vice-President of the 8th International Conference on Computing Anticipatory Systems (CASYS'07, Liège). In 2014, he was listed as a highly-cited author by Thomson Reuters. 





Literature and Related
links:



Science & Technology Dynamics,
University of Amsterdam / Amsterdam School of Communications
Research (ASCoR) 


Leydesdorff,
L. (2006). The Knowledge-Based Economy: Modeled, Measured, Simulated. Universal Publishers, Boca Raton, FL.


Leydesdorff, L. (2001). A Sociological Theory of Communication: The Self-Organization of the
Knowledge-Based Society. Universal Publishers, Boca Raton, FL.


Leydesdorff,
L. (1995). The Challenge of Scientometrics . The development, measurement, and
self-organization of scientific communications. Leiden, DSWO Press, Leiden University.


http://www.leydesdorff.net/





Print version of this Talk (pdf)



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