MMT Macro Final (2/3)

Last semester I taught an MMT-based Macro course which attempted to re-integrate history into economics. The course was based on the premise that economic theories cannot be understood outside the historical context in which they were born. Standard graduate macro courses attempt to teach a body of theory which has been empirically falsified (see  Romer: Trouble With Macro ). My course had the goal of giving the student the ability to understand major economic events of the past century.  A previous post on  MMT Macro Final (1/3)  provided the first 4 question and answers for the Final Exam, as a sample of what was taught. This post provides questions 5 to 8, together with the answers.

  1. Atif Mian wrote that “Starting a major credit-fueled housing program in the middle of a Balance-of-Payments Crisis is not a good idea”. Explain why this statement is true when the PKR is overvalued, but false when undervaluation holds.

Answer: A credit fueled housing program will substantially increase the amount of money in the economy, as people borrow against future earnings to spend on purchase of current houses. The money will go into the firms of the construction sector, and into the pockets of their employees. Seeing the increased demand, the firms will seek to build capacity and expand, by increasing investment. The firms demand for imports required to build capacity, or imports used as raw materials in the construction process will increase. Employees aggregate demand for consumption will also increase and some of it will be directed towards imports. So overall, the demand for imports will increase.

As discussed in my note on “ Rupee Over-Valuation ”, increased imports under a regime of over-valuation means that the government subsidizes all imports. Increased demand for imports will lead to loss of foreign exchange reserves, and will exacerbate the BOP Crisis. On the other hand, with under-valuation, the government actually collects a tax, denominated in foreign exchange, for each unit imported. In this situation, an increased demand for imports will lead to increased foreign exchange reserves at the SBP, and will actually help to improve the BOP, instead of destabilizing the economy.

  1. Provide some empirical evidence which supports the view that the East Asian Miracle was based on free market policies. Provide some empirical evidence for the opposite view that East Asian Miracle was based on government led policies, which involved distorting free market incentives.

East Asian economy grew at an accelerated pace during the 1970s and 1980s. A major part of this miraculous growth was stimulated by increase in private investment, international trade especially exports and industrial development. The openness and market orientation gave the impression that free markets were responsible for this miracle.

However, the government had a significant role to play in the economy by instituting land reforms and rural development, investing in development of human capital the government makes sure that raw material was readily available and skilled labor force is in place. Also, government gave credit at lower rates than market which shows they did not acquire loan on basis of market determined rates. The government carried out a vast range of industrial policies, directing subsidies and credits towards export-oriented industries, leading the development of sectors like semiconductors, where there was no private sector present.  By following the policy of “produce what you can” the government controlled the sequence of industrial development. Also, the policy of import substitution provided domestic demand stimulus to the industrial sector. The government intervened in the foreign exchange market, using subsidized FX rates for critical imports, and prohibiting or making expensive unnecessary imports. Public spirit, generated by a variety of community-based programs, also played an important role.  The World Bank publication on the “East Asian Miracle” documents the vast range of government interventions in the markets which created this miracle.

  1. Explain why the Gold Standard broke down after World War 1 because Central Banks supported needs of domestic economy over international trade.

World War I depleted the treasuries of European economies, because of heavy war expenditures and borrowings.  After WW1, the amounts of money required by needs of the domestic economies were very large, and the amount of gold available to back them was very low. A solution which could have worked was to do a simultaneous increase in gold prices. A joint initiative by all countries to double the price of gold would have reduced the stock required for backing gold by 50%, and allowed countries sufficient flexibility in printing money so as to meet the needs of the domestic economy. This would also have maintained stable international trade prices. However, this could not be done one country at a time because depreciation of currency would make domestic goods more attractive to foreigners, reducing aggregate demand in foreign countries while increasing domestic aggregate demand. This was known as a beggar-thy-neighbor policy, and led to retaliations by other countries. The level of cooperation and trust required for a simultaneous one-time postwar devaluation did not exist. The option of competitive devaluations would have de-stabilized trade. So most countries chose to try to restore the pre-war gold standard at the same parity. This was a disastrous mistake.

To restore gold standard to pre-war parity required constricting the money supply, imposing heavy costs of unemployment and low output on the domestic economy, in order to maintain stable prices for foreign trade. With democratic governments, this was not possible – the people would not allow so much pain to be inflicted. Expanding the money supply to accommodate the needs of the domestic economy created enough leakage into imported goods that the Central Banks could not afford to honor foreign requests for conversion of notes into gold. This led Central Banks to suspend payments in gold, or convertibility, as a temporary measure. In the pre-war period, such suspensions would occur due to temporary BOP deficits, without any adverse consequences. This is because with strong domestic economies, the Central Banks ensured stable exchange rates and everyone assumed (correctly) that the Central Bank would undertaken policies to restore convertibility at regular standards. In the post war period, this was no longer assumed. Suspension of payments led to suspicions of weakness of the currency, and cause speculative attacks. Anticipation of possible devaluation led to selling off of currency creating further pressure to devalue. Massive efforts by Central Banks to restore pre-war gold standards failed because of these destabilizing effects of Central Bank policies, and the strong conflict between requirements of domestic economy, and needs of international trade. Breakdown of trade due to hyperinflation in Germany is said to be one of the causes of WW2. Hyperinflation destroyed trading links, and made war more profitable than trade.

  1. Explain how Krugman and Minsky have different views regarding “equilibrium”. Put this in context of Krugman’s explanation of the GFC versus Minsky’s explanation based on the Financial Instability Hypothesis.

Krugman’s view: Krugman shares the standard neoclassical view that the economy naturally tends towards equilibrium, in absence of constraints which prevent reaching equilibrium. Krugman is a Keynesian and believes that narrow money supply is one of these constraints. If we expand money supply removing constraints which prevent the achievement of equilibrium, then economy would automatically move towards full employment, with high levels of investment, output, and growth.

Minsky’s view: Minsky says that stability is destabilizing. This means that equilibrium itself is unstable, and generates forces towards disequilibrium. The general tendency of capitalism is towards unsustainable booms fueled by financial expansion. During stability, the returns are very high, aggregate demand is high; there is room for more money so people start borrowing and increase their spending. Investors invest in risky ventures, markets and financial institutions are deregulated. Investors and capitalists are backed by govt. and banks due to which they influence govt. to deregulate banks and financial institutions. Basically, stability leads to financial system instability because they make risky investments, extensive borrowing, shadow banking etc. rises which makes the financial system very fragile.

Krugman’s explanation of GFC: According to Krugman the conventional theory could not predict GFC because of the following reasons:

  1. It was a black swan event (which happens rarely) so financial markets miscalculated risks of collapse because it was out of line with past experience.
  2. FED kept interest rate too low (intervention) which enable large amounts debt accumulation.
  3. Shadow banks went unattended. A huge unregulated financial sector came into existence which generated near-substitutes for money, vastly increasing the money supply. This did not show up in standard macro statistics, leading it to be ignored by economists.

In contrast, Minsky predicted the pattern of the Global Financial Crisis almost perfectly. It corresponds exactly to his financial instability hypothesis. In quest for higher returns investors started taking risk because they think that this prosperity is forever and the macro models that they follow do not include a crisis in banking sector. Credit is readily given because asset prince inflation makes apparently good collateral available, and returns are high. Loans are readily taken because returns to investment are high. Loans move from being hedge financing to speculative financing to Ponzi financing. There are a number of different ways that this unstable financial bubble bursts.

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