New Directions in Monetary Economics, Marc Lavoie Part Deux

Here’s the second part of the Marc Lavoie interview with Phil Pilkington.  He doesn’t mention MR directly, but does hint at the recent debates in the blogosphere on S=I+(S-I) with a hint at his approval of JKH’s work on it.  The full interview can be read at Naked Capitalism:

Marc Lavoie is a professor in the Department of Economics at the University of Ottawa. He is the author of numerous books on post-Keynesian economics. His latest work ‘Monetary Economics’, written with the late Wynne Godley, is now available in paperback from Amazon.com.

Interview conducted by Philip Pilkington. Part I of this interview can be found here

Philip Pilkington: I think the first part of the interview provides a pretty good sketch of what you and Godley have built in the book – although, obviously, this barely scratches the surface and there is a great deal more than this in the book. Still though, I think readers should be able to grasp the broad aim of the book, at least.

If you don’t mind I’d like to move onto some more practical issues. The models set out in the book lead to some very different conclusions than the mainstream models as far as the effects of macroeconomic policy go. This has enormously important implications for both policymakers and people working in the financialmarkets. I’ll go into this a little bit more below, but first I’d like to draw attention to the fact that a simple model derived from your’s and Godley’s main work is already in use by both market practitioners and Keynesian-oriented economists, such as the Financial Times’ Martin Wolf. Aficionados of what has come to be known as Modern Monetary Theory (MMT) will also recognise the model which is, of course, called the ‘Sector Financial Balances Model of Aggregate Demand’ model. Could you outline briefly what it is that this model depicts and highlight its importance for economic analysis?

Marc Lavoie: First I should say that I learned all of this from Wynne. Yes, it is true that there is a great amount of interest now devoted to his analysis based on the sectoral financial balances, and which he used extensively for his conditional forecasts since the late 1990s. Even the Giant Squid, Goldman Sachs, provides analyses based on this equation, which says that financial lending by the domestic private sector (saving less investment) and the domestic public sector (overall tax revenue less overall government expenditures) has to equal the current account balance (CAB: net exports plus net foreign income), or with the standard notation: (S-I) + (T-G) = CAB.

This equation can be retrieved from our two-country models in the book. Wynne considered that it was a breakthrough when in the mid-1970s he discovered this accounting macroeconomic identity, an identity that was also put forward by Joseph Steindl (a student of Kalecki) when he was (already then in 1984) complaining about the poor state of macroeconomic theory. Interestingly, this identity, which I call the fundamental accounting identity, can also be found in the first-year textbook of Baumol and Blinder. So it is not as if mainstream authors were unaware of it.

What is the usefulness of this identity? Initially, Wynne saw the identity as a neat way to verify the consistency of the assumptions and forecasts that were imbedded in various parts of a model: forecasts on investment, saving rates, the government deficit, the external balance, and so on. Then he used the identity as a way to assess whether some imbalances were sustainable or not, looking at their implications for stocks. Finally, towards the end of his life, he tried to use it in the way that you defined it, as a ‘sector financial balances model of aggregate demand’. As much as I was comfortable with the first two uses, I was never much convinced by its ability to say much about aggregate demand. The identity is great in pointing out inconsistencies: for instance, when the UK government makes some forecasts about future net exports and government deficits, then, knowing about private saving, it is clear from the identity that the UK government is assuming a huge increase in private investment, something that just cannot happen in the current climate, whatever confidence austerity policies can generate among the business class.

But what about aggregate demand? GDP is made up of the four components of consumption, investment, government expenditures and net exports. It may be that the (S-I) balance is negative, meaning that the domestic private sector is borrowing, thus stimulating the economy, but this does not mean much for aggregate demand if investment is next to zero or if government expenditures are low.

I think there is also quite a controversy about this on the blogosphere. So the identity is useful and relevant, but there is a limit as to what it can tell us. I think that the practical contribution of our book is that we have rehabilitated the use and importance of flow-of-funds analysis and its associated balance sheets in national accounting. This is a point made very clearly by the Dutch economist Bezemer, when he claims that those that saw the crisis coming, and provided analytical reasons for the crisis, were mainly economists concerned with macroeconomic financial flows and balance sheets. Indeed, I have recently seen papers by economists working at the ECB and the Bank of England who refer to our analysis and argue that balance sheet linkages can help in spotting future financial fragility episodes. Despite the long-standing tradition in flow-of-funds analysis, most macroeconomists, especially the mainstream ones, had come to the conclusion that not much worthy of theorizing could be done with it. I was myself skeptical in the 1980s, after having supervised a Masters thesis on Canadian financial flows. But we all realize now that financial flows and stocks of debt are important to understand the evolution of the economy. Of course Minsky readers knew that a long time ago. I would say that Godley’s work, and hence our book, provides a framework to entertain and develop these ideas.