General Gluts, Secular Stagnation and the World Economy

The head of the International Monetary Fund warned today on her visit to Beijing that the global economy faces the risk of a "lost decade" with little or no growth and that without action, the world faces worsening financial instability and a possible collapse of demand.  This news item also coincided with my morning lecture in History of Economic Thought on the economics of Thomas Malthus.  Along with his theory of population, Malthus was also known for his ideas on the possibility of “general gluts” or long term under-consumption. What was old is new yet again.

The Classical School, using Say’s Law, argued that while there might be temporary imbalances between demand and supply of goods in an economy, the self-correcting market mechanism would eliminate them.  John Maynard Keynes popularized Malthus as an economic thinker who “refuted” Say’s Law but in reality he argued that oversupply or “general gluts” as they were termed then were not only possible, but could be persistent as a result of over-saving.  Too much saving resulted in less consumption, undermining the motive for production.  Thus a general glut was not self-correcting.  David Ricardo, on the other hand, in his debates with Malthus, took a more logical interpretation of Say’s Law that supply creates its own demand and argued there could not be a general glut.

According to Malthus, saving created investment spending which came into play faster than the growth of the population leading to surplus capital - hence, excess capacity and ultimately under-consumption, setting up a problem of secular stagnation.  The solution, according to Malthus was to encourage economic agents to consume more to slow down saving and put in place public investment projects to use up the surplus capital and investment.  In private correspondence, Malthus discussed with Ricardo the advisability of putting labour to work on public projects like road building.  The attractiveness of this type of thinking to Keynes is obvious though Keynes linked “under-consumption” to “animal spirits” severing the link between saving and investment, which reduced aggregate demand.

What insights do this classical work provide for the current world economy?  Good question.  We have a sovereign debt and financial crisis that is undermining the consumption side of the economy.  David Ricardo’s thinking on the English debt crisis of the early nineteenth century advocated going on the gold standard to stabilize the currency, pay as you go government financing - meaning no deficits, and a one time capital levy to pay off the debt.  However, pay as you go financing combined with more taxation would certainly not boost the demand side of the economy.  Malthus, on the other hand would suggest a program of government spending.  

Since I’m keeping things simple, I would suggest that on the financial side, there is a need for a global lender of last resort to stabilize financial markets, sovereign debt, and currencies and reduce the uncertainty of the current piecemeal approach to crisis management.   How this might be accomplished is beyond me.  Borrowing from Malthus, on the commodity side, there is a need for a global spender of last resort to buttress the demand side and reduce the risk of secular stagnation.  That used to be the American economy and its consumers.  I’m not certain I see a replacement for the American role anywhere on the horizon though perhaps the head of the IMF is in China to see if they might want to step up to the plate. 

Ultimately, I think resolving the current difficulties also comes down to a lack of economic institutions to deal with a more connected global economy.  When push comes to shove, the international efforts of summits and meetings to deal with the crisis of interconnected global financial and commodity markets seem more akin to the diplomacy of the slower moving 19^th century than the world of the 21^st century.  The framework to deal with the complexity of the world economic system consists of short term crisis management housed in an international institutional structure last revised in the aftermath of the Second World War.   What should replace it is a good question.

Comments

[Determinant]

We made a half-hearted effort to have a world lender of last resort in the form of the Classic IMF and the Bretton Woods Agreement. But that effort failed. In Canada we had a recurring currency crisis in 1950 due to our large trade with the United States. The Bank of Canada let the Canadian dollar float and it floated until 1962.

More generally, Bretton Woods punished payment deficit countries and did not punish or discourage the countervailing surpluses. Since Bretton Woods was a closed system it had unstable incentives.

The problem we had in 1944 remains: how to penalize surplus countries and deficit countries equally to encourage balance. This is linked the problem that balance assumes every country has or ought to have something exportable that the market wants; in reality that is hard to achieve.

[geerussell]

When you carve out monetary authority and remove it to a trans-national authority divorced from domestic fiscal and political authority as was done with the EMU, you create not a union but a chain gang. Semi-sovereigns shackled together by a common currency without the power to adapt monetary policy to their own circumstances and without the fiscal transfer support they would receive if they were sub units of a larger sovereign.

Downturns will tear apart the weaker members economically for lack of fiscal/monetary coordination and socially for lack of domestic political legitimacy for monetary policy imposed from the outside.

All of that was probably just a long winded way of saying one country, one floating currency.

[Min]

Livio di Matteo: "Borrowing from Malthus, on the commodity side, there is a need for a global spender of last resort to buttress the demand side and reduce the risk of secular stagnation."

Interesting idea. :) Especially when you think of Nick Rowe's central bank that owns everything. ;)

Livio di Matteo: "Ultimately, I think resolving the current difficulties also comes down to a lack of economic institutions to deal with a more connected global economy. When push comes to shove, the international efforts of summits and meetings to deal with the crisis of interconnected global financial and commodity markets seem more akin to the diplomacy of the slower moving 19th century than the world of the 21st century."

Yes, our gov'ts seem to be a couple of centuries behind, don't they? :(

[Min]

Determinant: "The problem we had in 1944 remains: how to penalize surplus countries and deficit countries equally to encourage balance."

As the SNL Frankenstein monster might say, "Deficit bad." We do seem to be caught in the mental trap of stigmatizing debts and deficits, don't we?

[K]

"there is a need for a global lender of last resort to stabilize financial markets, sovereign debt, and currencies"

So whenever the current lender of last resort isn't big enough we just need to go get a bigger one? Lord help us! Fundamentally the idea that there will always be someone there to catch us when we screw up, is the exact reason why we screw up. We need to get rid of agency problems, not compound them. The fact of the existence of lenders of last resort is why we find ourselves in this clusterf*** in the first place. What you are proposing is load up the charge even more before we blow it all up.

"there is a need for a global spender of last resort to buttress the demand side"

So you are proposing a global currency or global fiscal union? Why? There is no coordination failure in need of collective action here. The ECB, for example, is in no way constrained, except by their own dogmatic idiocy. Currency areas caught in a liquidity trap need to spend/inflate. For their own good. This might even cause global competitive devaluation which could also be good.

[Patrick]

I wonder if we sometimes over think the causes of our current malaise. Sure, peak oil and climate change are looking like they might well turn out to be the second coming of Malthus, but are the world's current financial woes a harbinger of this doom or a self-inflicted wound?

Would we be so glum today if, for example, the US had pulled a Sweden on it's banking system in 2008/9, Ireland had pulled and Iceland, and the ECB announced "we are prepared to buy unlimited amounts of member nation's bonds to maintain yields at [insert target here]". Heck, just that last sentence alone would probably put an end to the death spiral in Europe.

And yes, watching Italy tip into the abyss is terrifying. WTF is the ECB thinking?

[Determinant]

Sure, but the ECB would need to fire every German on its staff and Germany would collectively need to admit that it has to run the risk of a little inflation to make the Euro work.

Sure Germany may have bad memories of currency and price inflation and loves a "solid currency" but the rest of us have equal memories of being hamstrung by gold rules, deflation and money shortages.

Government deficits in one country can be managed and frankly in Canada the amount of a sustainable deficit is currently small and so near a nominal surplus that the difference doesn't matter.

It's current account deficits/surpluses that do the real damage. China and the US are but the latest iteration in the same show we have seen since 1945. Everyone loves a surplus but not everyone can have them. And China is going to get bit by its surplus through either default by inflation in the US or a drying-up of export markets. Chronic surpluses are not a panacea.

[Jacques René Giguère]

I wouldn't mind Germany having bad memory of hyperinflation. What is unforgivalble is not understanding the difference between now. and four empires dissolving after a WW.
What we will witnessing shortly will be the disnmantling of an empire. That's what causes hyperinflation. Even in Zimbabwe, the real shock preceded the monetry explosion.

[Determinant]

And a year and a half from now we will remember the 100th Anniversary of the Guns of August.

1914: the year that everything changed.

[Will]

I'd been hoping that Livio's History of Econ course would prompt some more posts of this sort. If they're just now on Malthus, though, how early did they start?

[Livio Di Matteo]

Hi Will:
I started with ancient economic thought- the Bible, the Greek and the Romans, followed by the medieval scholastics. If you go to my university web page and go under under teaching, you can download the course outline.

[anon]

"Borrowing from Malthus, on the commodity side, there is a need for a global spender of last resort to buttress the demand side and reduce the risk of secular stagnation. That used to be the American economy and its consumers. I’m not certain I see a replacement for the American role anywhere on the horizon though perhaps the head of the IMF is in China to see if they might want to step up to the plate."

I'm not getting this. Spending shortfalls are a monetary phenomenon, and the global economy is not dependent on a single currency standard anymore, as it was under the gold standard and the Bretton Woods system. So any underconsumption can be addressed locally by monetary easing, and exchange rates will adjust to a new equilibrium.

In practice, the effect of local monetary easing on exchange rates may be politically contentious during a global shortfall in spending. Even then, international coordination in monetary policy (e.g. through the BIS) could fix a demand shortfall at negligible cost, with little effect on relative exchange rates and no need for anything resembling a "spender of last resort".

[Min]

Determinant: "China and the US are but the latest iteration in the same show we have seen since 1945. Everyone loves a surplus but not everyone can have them."

But dammit, isn't the richest country in the world supposed to run a trade deficit?

[Min]

anon: "Spending shortfalls are a monetary phenomenon, and the global economy is not dependent on a single currency standard anymore, as it was under the gold standard and the Bretton Woods system. So any underconsumption can be addressed locally by monetary easing, and exchange rates will adjust to a new equilibrium."

Think Euro, the New Gold.

[Determinant]

Using the BIS in that way makes it look like a "World Government" and that is a deadly political proposition in many countries. Most of all the US which has maintained the notion of inviolability of the nation-state more than most countries.

Please, I know are a million rebuttals to that but that's the idea that circulates among American leadership.

Then we come to China which steadfastly refuses to let the Yuan float. If the US starts to inflate then China will see the downside of the peg in short order.

[reason]

http://www.monbiot.com/2008/11/18/clearing-up-this-mess/

[nemi]

"pay as you go financing combined with more taxation would certainly not boost the demand side of the economy."

I am certainly no fan of pay as you go financing (or the gold standard) – but why wouldn’t something equivalent to forcing people to buy instead of save increase AD?

[Steve Roth]

"Keynes linked “under-consumption” to “animal spirits” severing the link between saving and investment"

A wise man, that. Our economy has money, debt, and wealth, and financial assets that are valued according to animal spirits in addition to (arguably far more than) the largely imponderable fundamental values of underlying real assets -- a reality that the S=I identity and the S = Y - C definition both obfuscate and ignore.

[Livio Di Matteo]

Reason:
Re-http://www.monbiot.com/2008/11/18/clearing-up-this-mess/
Thanks for this. Was quite interesting to see the discussion of a Global Bank as laid out by Keynes.

[Determinant]

Blame Harry Dexter White. He, on behalf of the US Treasury, wanted to ensure Dollar Supremacy and got it. But then Britain had felt the sting of losing its global power and most of its money while the US had not.

Keynes at the time was dying. It was almost his last hurrah, his final act was the rolling over of Lend-Lease into a stable debt structure to be paid off over the next few decades.

By way of Canadian interest, Britain owed a similar debt to us as Mutual Aid, our counterpart to Lend-Lease. That too was rolled over into a bond series to be paid off over a few decades.

The last payments were discharged three years ago.

[Keystone garter]

What sectors in the USA have high construction unemployment? We could import temporary workers more cutting-edge sewers and water services always. Chindia may act to maintain growth in N.A. recessions, but we have higher health standards so it would be nice to give the multinationals a reason to R+D (okay only the D part) in recessions.
Gotta pick the cheaper housing cities to build housing stock, and desired-growing ones to get good social ROI. The workers can't build their own housing so need a housing buildup beforehand.