[This post was co-written with Rafael Wildauer, Ph.D. Candidate at Kingston University, who is doing research on the links between income and wealth distribution, credit, growth and financial stability]
We are pleased to present our first report on the US economy using a model we have developed together over the last year. We will only provide here a brief summary with the main conclusions; interested readers can read the whole report for free here. Senator Sander’s economic program (and the discussion that has erupted in the last few weeks) has provided us with a nice example of why having a simple but holistic model of the US economy can help a lot in discussing economic policy issues and in dispelling ‘half-way’ economic reasoning. Because a copy-paste strategy from the report would be boring for the readers of the blog, we have decided to add a brief analysis of the Mr. Sander’s economic program as an example of the usefulness of the model advocated here. We think it is worth discussing what has been left out by Gerald Friedman as well as by his critics – notably Christina and David Romer. If you already read the original report, then you can skip the first section and go directly to the section dealing with Mr. Sanders’ economic program.
The Kingston Financial Balances model (KFBM)
First, a few words about the model. The Kingston Financial Balances Model (KFBM) is a stock-flow-consistent (SFC) model that tracks the evolution of the main variables of the US economy. A SFC model is, in a nutshell, a framework that ensures that all real and financial flows of an economy accumulate into stocks over time. For many people (e.g. engineers, physicists and accountants), we are sure this definition will not be very innovative. But in economic modelling, it is. Most of the economic modelling is carried out without any concern for the accounting consistency of real world economies. At the most basic level, such models simply estimate ‘sophisticated’ econometric equations for the GDP components (i.e. consumption, investment, etc.), and then they sum them up to come up with a (usually short-term) forecast for GDP, but without mentioning the implications of these expenditures for the financial positions of the different sectors of the economy. At a more advanced level, exemplified for instance by the Dynamic Stochastic General Equilibrium (DSGE) models, the sophistication falls on a rational description of the agents of the economy, but again, with little concern for the accounting consistency of the framework. In other words, economists have been in general very busy to come up with more sophisticated models, but accounting consistency is not among the top priorities.
Consistent accounting in a SFC model is achieved through the quadruple-entry bookkeeping principle, which says that at the macroeconomic level every transaction leads to four entries in different accounts across sectors: a debit and a credit entry for each sector involved in the transaction. Thus SFC modelling corresponds to the double-entry bookkeeping accounting frame used in the corporate world, but extended to all sectors involved in the recorded transaction, and not only the individual firm.
As we explain in the report, there have already been some people around doing financial balances models. The simplest models using a financial balances approach are the one developed by Jan Hatzius at Goldman Sachs and the one developed by the economists Casadio and Paradiso. A more sophisticated financial balances model has been developed by economists at the Levy Institute over the last decade, which has been publishing annual strategic reports with an excellent track-record in useful predictions. However, it is fair to say that the financial balances approach is still in its infancy, in the sense that neither governments nor economic institutions commonly use this framework when dealing with macroeconomic analysis.
Using the KFBM to project the path of the US Economy
Turning to the economic outlook (the base for our projections), we are not very optimistic. We think that the global economy faces a weak pattern of effective demand (something that we expect to persist this year). The Eurozone is still posting weak growth figures; ‘Abenomics’ has fallen short of expectations in Japan; commodity-exporting emerging economies have been suffering over the last year from a bearish commodity market and China will face, sooner or later, a disruptive rebalancing process. The poor performance of the world economy, if persists, will undoubtedly hit the performance of the US external sector. And because US private sector has still considerable leverage levels in its balance sheet, the prospect of a long-lasting private sector led expansion is close to zero.
In our simulations we explore this scenario of weak global demand, coupled with the Congressional Budget Office (CBO) projections for the fiscal stance. Interested readers should go to the report: here we will only show our projections for the trade balance under two different scenarios.
For the first scenario we take the growth rates used by the IMF in its world economic outlook for the growth rates of the US main trading partners and a constant real effective exchange for the dollar rate over the projection period. In this case, the trade balance would swell to 4.3% by the end of 2018, which in absolute terms amounts to roughly $900 billion. Historically the US trade deficit peaked in the third quarter of 2006 at 5.8% of GDP corresponding to $805 billion. Although obviously we are aware that an absolute amount of $800 billion is not the same in 2018 than in 2006 in terms of economic implications for the US (because of GDP growth), the rest of the world has still to finance such a deficit, and many developed economies have not enjoyed the US growth rates of the last decade. So $800 billion still would be a substantial amount to accommodate.
For the alternative scenario we assume a linear 7% appreciation of the real effective exchange rate from the fourth quarter of 2015 to the fourth quarter of 2016 and a reduction of 0.8 percentage points in main trading partners’ annualised GDP growth. The first assumption reflects: i) our belief that the divergence between the Fed and the ECB in terms of monetary policy will weigh on the short-term path of exchange rates and ii) that given the CBO projected path for interest rates, a 7% appreciation is conservative. On the other hand, we do not attempt to accurately forecast the exchange rate over the short-term. As we said, we rather assume a moderate increase based on the historical evolution of the dollar exchange rate. In this case, the trade balance worsens by almost 1% of GDP reaching a deficit of 5.1% (roughly corresponding to $1 trillion in absolute terms). Thus under the more realistic assumption of a dollar appreciation and a slowdown in global demand, the US economy will suffer from a major trade (and current account) deficit in the near future. Based on the assumption of a stable public deficit around 3% of GDP, this implies an even larger private sector deficit compared to the baseline scenario, which will lead to mass issues of doubtful private debt. Keeping in mind that a private sector deficit so large only occurred prior to the biggest financial crisis after the Second World War leaves a very pessimistic outlook. It is important however that this gloomy prediction rests on the assumption that the government sector will not increase its deficit over the forecasting period.
And the balance-of-payments consequences of Mr. Sanders
The last few weeks have given us a very timely example of why a holistic thinking when dealing with macroeconomic issues is usually lacking (even among leading economists) and of the importance of having a robust accounting structure – as the one provided by a financial balances framework.
Senator Bernie Sanders, one of the incumbents for the Democratic Party nomination, has presented as part of his political program a far-reaching economic agenda in case of being elected. Mr. Sanders’ program has (in our opinion) deservedly caught media and public attention, proposing measures as ‘Medicare for all’ and other badly needed actions for the US, notably a large infrastructure program. Some weeks ago, Gerald Friedman, Professor of Economics at the University of Massachusetts, Amherst, put some numbers to Mr. Sander’s economic program (available here). Prof. Friedman provides estimates of the economic impact of Mr. Sander’s plan on the US economy up to 2026. Although this is not the place to go into the details of Professor Friedman’s exercise, from our point of view the main conclusions of the document are:
- The growth rate of the real gross domestic product will rise from 2.1% per annum to 5.3% so that real GDP per capita will be over $20,000 higher in 2026 than is projected under the current policy.
- The unemployment rate will fall to 3.8% by the end of the first Sanders term in 2021, and remain at that full employment level through the end of his second term in 2025.
- There will be sustained increases in real wages for the first time since the 1960s, with real wages growing at a rate of nearly 2.5% per annum.
But that’s not all. In this economic nirvana of growth and of increasing prosperity and productivity, the federal government budget would be balanced by the end of 2025 – from the current deficit position. Despite the increase in government expenditures, higher tax revenues due to increased economic activity would fill that gap. The results can be seen in Figure 10 of Professor Friedman’s document:
Mr. Sanders’ economic program and Prof. Friedman’s exercise have not been gone unchallenged. A letter written by four former heads of the Council of Economic Advisors under Democratic presidents (Alan Krueger, Austan Goolsbee, Christina Romer and Laura D’Andrea Tyson) launched the first assault, warning that ‘no credible economic research supports economic impacts of these magnitudes.’ Last week, a detailed technical document by Christina and David Romer makes clear why they think Friedman’s projections are unrealistic. They provide basically two arguments. First, Friedman confuses absolute levels with growth rates when dealing with fiscal multipliers:
Thus, Friedman’s figures for the effect of additional government spending exceed conventional ones by at least a factor of four. He offers no evidence for such effects. Indeed, his estimates appear inconsistent with his own assumptions: he assumes that rise in government spending of $1 would typically raise real output by slightly less than a dollar.
We have a conjecture about how Friedman may have incorrectly found such large effects. Suppose one is considering a permanent increase in government spending of 1% of GDP, and suppose one assumes that government spending raises output one-for-one. Then one might be tempted to think that the program would raise output growth each year by a percentage point, and so raise the level of output after a decade by about 10%. In fact, however, in this scenario there is no additional stimulus after the first year. As a result, each year the spending would raise the level of output by 1% relative to what it would have been otherwise, and so the impact on the level of output after a decade would be only 1%.
And second, Friedman’s projections never take productive capacity constraints into account, and according to them that is unrealistic:
in assuming that demand stimulus can raise output 37% over the next 10 years relative to the Congressional Budget Office’s baseline forecast, Friedman is implicitly assuming that the U.S. economy is (and will continue to be for a long time) dramatically below its productive capacity. However, while some output gap likely still exists, the plausible range for the output gap is much too small to accommodate demand effects nearly as large as Friedman finds. As a result, capacity constraints would likely lead to inflation and the Federal Reserve raising interest rates long before such high growth rates were realized.
Summing up, even if you believe that Friedman’s fiscal multipliers are correct then you have to come up with an argument why GDP growth would not be limited by capacity constraints. Ever since (here, here, here and here), the debate has been centred around these two questions.
For us, this an example of how inward-looking the economic debate has become in the US, because there is no mentioning of the huge balance-of-payments problem the US would face under Mr. Sanders’ economic program. True, Friedman mentions by the end of his document that ‘in a world where other countries are undergoing austerity, rising growth in the United States risks driving up imports and creating a balance of payments crisis’, but he quickly reassures us saying that ‘[i]n the end, success or failure rests on the strength of the political forces behind a Sanders Administration.’ But the document does not even mention the word ‘exports’ – let alone economic policy measures to improve US export performance. The situation is even worse in Romer and Romer (and the same is true for the rest of the critics), because they do not address (explicitly or implicitly) the external sector problem either: they assume that what matters in the end are capacity constraints and that the existing slack is small, according to the CBO and Fed estimates (as an apart, estimates of full capacity coming from these models are, in our view, deeply flawed).
But of course, the real problem of the US in a world of ‘other countries undergoing austerity’ and lacklustre effective demand is the balance of payments constraint. As we explained above, the US has been able to navigate over the last business cycle with ‘reasonable’ growth rates (in comparison to Europe) and keeping at the same time a moderate (but increasing) deficit in the current account. Growth rates in real terms above 5% as implied in Mr. Sanders’ plan would blow up the current account deficit to astonishing levels. In other words, even if you believe that Friedman’s projections are not logically wrong and you also believe that supply-side constraints won’t be the decisive issue, the balance-of-payments constraint to US economic growth would be binding much sooner than any supply-side constraint. A bit of eyeballing would actually tell us that even growth rates of 3% would be unfeasible in a world stuck in second gear.
Using the KFBM to assess Prof. Friedman’s projections
But we do not have to eyeball to get a sense of what would happen to the US balance of payments. We can use instead the KFBM to project the economic implications for the external sector. A fiscal projection path as implied by Friedman’s document (reaching a balanced position in 2021 and a surplus in 2025) would, following the logic of the financial balances identity, squeeze the financial position of the private sector, which is already under pressure from the weak external sector performance. In other words, the economic plan would leave the private sector with a higher (and not a lower) level of indebtedness, even after the substantial wage increases envisioned by the plan are taken into account.
For our exercise, we started from our baseline scenario assumptions (exchange rates, US trading partners’ growth and price deflators). However, given the unavoidable aggregation of fiscal projections in Professor Friedman’s document (in contrast to the detailed item-by-item projections from the Translation of the Budget), we had to make some additional assumptions about some items. These are:
- We assume that Mr. Sanders’ economic measures would take place from 2017 onwards, which means that up to that point we use CBO projections for domestic demand. Beginning in the first quarter of 2017 we implement an annualized growth rate of 5% for domestic income along with a stable exchange rate and an annualized growth rate of 3.2% of the US’ most important trading partners.
- We assume (following Professor Friedman’s document) that the federal government will be balanced by 2022, based on a linear trend. Because nothing is said about the deficit of local governments, we keep that item constant at a deficit of 1% over the whole simulation period, following the most recent observation. From 2022 onwards, we assume that the federal deficit will have to reach a 1% surplus in 2026 (which would roughly correspond to the $1.4tn figure Friedman is giving as a target).
- For some items of the balance of payments (namely, rents and transfers) we follow the same strategy: we keep them constant relative to GDP based on the most recent values in 2015.
This is the setup for our simulation. The results are as follows, please fasten your seatbelt:
By 2026 the US would reach a current account deficit of more than 13% of GDP. It is hard to believe that the rest of the world would finance such a large-scale deficit. Due to the government sector running (almost) balanced budgets, it follows that the private sector (households and corporations) is forced in an equally drastic deficit position. A Sanders administration would be forced to stop its economic plan long before the end of Mr. Sanders’ first term.
Although the projection looks awfully flawed, it drives home a simple message: pushing domestic growth up to 5% while the rest of the world is stuck in second gear will end up in a balance of payment crisis. On the other hand, this thought experiment still bears some resemblance with the periods of 1991-2000 and 2002-2009: improvements in the overall fiscal position coupled with a strong deterioration in the balance of payments – which logically implies the private sector taking on debt. In other words, Mr. Sanders’ economic program would be a replay of the US’ recent economic past.
Summing up. We have not intended to bash Mr. Sanders’ economic program (actually, we are quite sympathetic with most of its measures) or Prof. Friedman’s economic exercise (which is useful to frame the economic discussion), but simply to highlight the incompleteness of economic analysis carried out in closed-economy frameworks – as the critics and Prof. Friedman’s exercise have exemplified.