Paul McCulley does Modern Monetary Theory

This is just in from PIMCO’s Paul McCulley, who seems to have caught on to the Wynne Godley sectoral balances approach to viewing the macro economy (hat tip Scott).  He says:

Double-entry bookkeeping was a great invention. It is a shame that so many macroeconomists and political pundits – and therefore, politicians themselves – seem to have forgotten it. One who hasn’t is the Financial Times’ Martin Wolf. And to the delight of all friends of the Levy Economics Institute, Martin cited in a recent column the financial balances approach of the late Wynne Godley, who spent his last years as a Distinguished Scholar at Levy.

Godley’s analytical framework should be the workhorse of discussions of global rebalancing, in the context of a deficiency of global aggregate demand. So, it was wonderful to see Martin riding Godley’s horse. I’ll walk you through it, but first the punch line: Front-loaded fiscal austerity in countries with their own fiat currencies is unwarranted and is likely to have deleterious, deflationary effects on the global economy. How so?

Let’s start with a simple tautology for any individual country:

Household Financial Balance +
Business Financial Balance +
Government Financial Balance +
Foreign Financial Balance = 0

Again, double-entry bookkeeping: The only way that one of the four sectors can run a deficit or surplus is for one or more of the other three sectors to run the opposite. This assertion doesn’t, of course, tell us anything about causation. Nor does it tell us about the composition or the sustainability of the starting positions for global stocks of debt and assets. It’s simply the tyranny of arithmetic for the flow of funds.

Right now, the household and business sectors in the developed world are running huge financial surpluses, in contrast to the opposite three years ago. In contrast, developed country governments are running larger deficits. Meanwhile, the emerging world is running a still-large financial surplus with the developed world. The graph below tells the story for the United States.

Thus, any notion that fiscal austerity in the developed world will not be a cyclical drag on global aggregate demand growth, much less boost it, must rest on the presumption that (1) the household and business sectors in the developed world will reduce their surpluses and/or (2) that the emerging world will reduce its surpluses with the developed world.

This is exactly right. The private sector is deleveraging right now in countries like the US, the UK, Spain and Ireland. This deleveraging increases the private sector’s net savings position. All else equal, this increase in net savings reduces aggregate demand and trade deficits and increases budget deficits.

I have presented this outcome in a number of different contexts, most notably from the US domestic perspective , from the Japanese perspective and from the intra-Eurozone perspective. Here McCulley is presenting it as a low-growth developed economy, higher-growth emerging economy split. He is saying that austerity works only if the Chinese, Brazilians and Indians pick up the slack in aggregate demand or if the developed economies stop saving and allow their bloated balance sheets to stay bloated.

I see two problems here: the emerging economies are all trying to slow overheating economies. Moreover, maintaining excess consumption and leverage in the west is kicking the can down the road. In sum, austerity from all sides in the west leads the global economy to stall speed very quickly.

McCulley continues his essay challenging Ricardian equivalence, something that I don’t buy into either. Marshall will discuss his views on Ricardian equivalence and tax cuts in an upcoming post. But, here McCulley makes my point that government deficits are not the cause of private sector surpluses but rather the reverse – private sector debt distress is causing deleveraging and driving up net savings – which causes greater government deficits. Thinking about the aggregate private sector debt distress as being like any company bankruptcy or workout the way Ray Dalio does helps you understand the forces at work in the D-Process. Dalio uses GM as his model. I prefer RJR Nabisco post-KKR leveraged buyout.

Reverse-Ricardian Austerians
Why do so many implicitly make that presumption? With regard to reducing private sector surpluses in the developed world, it’s called reverse-Ricardian Equivalence. Recall, Ricardian Equivalence is the notion that governmental deficits cause the private sector to increase its surpluses, so as to save for the future increase in taxes that inevitably will be required to reduce the government deficits. Thus, current evangelists of front-loaded fiscal austerity preach that if only governments would reduce their deficits, the private sector, freed from the fear of future tax increases, will spontaneously reduce their surpluses. Put differently, it is argued, if only governments would put their fiscal houses in order, the private sector would immaculately regain confidence in their own financial affairs, pull down their savings and borrow more, boosting aggregate demand. Really, that is the argument, made with a straight face.

But it conveniently ignores why the private sector in the developed world is running a financial surplus: deflated asset prices, which have undermined the debt that had been applied to inflated asset prices. The private sector in the developed world wants to get its financial house in order! This is a profound structural change, running in parallel with a permanent downsizing of the shadow banking system and de-risking of the conventional banking system. Simply put, both the demand and supply curves for private sector credit creation have shifted inward.

And the only way that can happen without increasing the risk of a deflationary depression is either for the developed country governments to continue to run large financial deficits and/or for the emerging countries to reduce their financial surpluses. Again, the tyranny of arithmetic.

The bottom line, McCulley asserts, is that the developed world is facing a "cyclical deficiency of aggregate demand." I see this as a secular deficiency, but let’s not quibble. the reality is then that the private sector in the west is in a higher savings and slower growth mode. The only way that the government can net save at the same time is via an increase in net exports to the emerging economies. The FT’s Geoff Dyer is right when he writes the "G20 looks to Beijing to drive global growth." For the global economy, it’s China or bust.

Source: Facts on the Ground, Paul McCulley, PIMCO

austerityEconomicsEmerging MarketsfiscalinternationalModern Monetary TheoryPaul McCulleyRicardian equivalence