The IMF's Unhelpful Retreat on Capital Controls

 Something I've been meaning to get to, that was brought to my attention the other day via Scott Sumner. It seems the IMF has "rethought" its position on capital controls in the wake of the financial crisis and lackluster global recovery. So what's this about? Here's a link to an article that lauds the decision, but nevertheless provides some good background http://www.guardian.co.uk/commentisfree/cifamerica/2011/apr/06/imf-capital-controls

My understanding is that the IMF is working off two justificaitons for capital controls: 

1. The financial crisis was contagious via the international mobility of financial assets. American mortgage securities were bought and sold by institutions and funds around the world, some of which are located in developing nations. The revaluation of these assets therefore caused disruption to economies beyond those that originated them. 

2. Many advanced economies remain depressed, with the result that both real and nominal interest rates remain low. With domestic returns to capital low, savings are increasingly flowing out of advanced economies and into develping economies where the marginal product of capital is higher. The IMF sees these new capital flows as potentially destabilizing, an argument they used to dismiss until the capital flows of the 2000's proved destabilizing. 

These justifications seem reasonable on their face. Why shouldn't policy makers in developing markets have tools available to protect their economies from the demonstrated volatility of financial asset prices in global capital markets? Here's the caveat: CAPITAL THEN WAS FLOWING IN THE OPPOSITE DIRECTION! Savings from China and Russia were being routed into American and European finanical assets. Now American savings are being routed into financial assets and FDI projects in developing markets, a shift that standard economic theory would predict. Effectively, the global imbalances in merchandise trade and financial assets are beginning to reverse themselves. And the IMF wants to reverse that reversal. 

The Agony and the Ecstasy, And the Government Debt

Whoow boy. A big hubub in the blogosphere about whether government debt imposes a burden on "future generations." Lots of input from high places. Check it:
http://krugman.blogs.nytimes.com/2012/10/12/on-the-non-burden-of-debt/
http://delong.typepad.com/sdj/2012/10/the-intergenerational-burden-of-the-debt-nick-rowe-tempts-fate-weblogging.html
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/10/the-burden-of-the-bad-monetary-policy-on-future-generations.html 
http://noahpinionblog.blogspot.com/

And now for some input from a low place, featuring my hat in the ring.
I've basically made this argument before, in my post about the stance of fiscal policy. Noah Smith spells it out well by framing the situation in terms of the effect on the capital stock, or the K term in the Cobb Douglas Production function.

Y = A(t) Ka Nb

The budget deficit affects the economy by absorbing funds that would otherwise have been invested in private capital. To the extent that the budget deficit "crowds out" this private investment, it does it by raising the real interest rate faced by borrowers. It makes sense that a larger budget deficit would raise the interest rate more than a small one, so that as the deficit grows, it increases the "burden" of future generations. Here's an ad hoc rule of thumb I just invented. It's basically an interest rate elasticitiy of the budget deficit:

(% change interest rate / % change in budget deficit)  < 1 no net "burden" on future generations

(% change interest rate / % change in budget deficit) > 1 net "burden" on future generations

Maybe I'll develop this further later. Perhaps something about future taxes.

Interest Rates and Monetary Policy (part 1, of many)

With the Fed's resumption of the task of trying to do it's job, I figured I'd get around to a piece on interest rates and monetary policy I've been putting off for a while. Here goes.

The interest rate is a price like any other; it is the price of present consumption in terms of future consumption.  Say you start out with $200. You have the option of consuming the entire $200 today, or delaying consumption until a later date in order to consume more. The tradeoff is given by the equation:

Future Value of consumption  = Present Value of consumption * (1 + r) ^ t  where r is the real interest rate and t is the amount of time consumption is delayed. So $200 delayed at a real interest rate of 5% for 10 years would be: $200 * (1+0.05) ^ 10 = $325.78. The higher the interest rate and the longer the time defered, the greater the consumption to be had in the future. 

The point of this is that the real interest rate is an actual price, the kind settled by good ol' fashion supply-and demand, where supply and demand are the supply of deferred consumption and the demand for purchasing power immediately, as illuistrated by the following diagram to the right. 

The tradeoff  between consumption today and consumption tomorrow can be illustrated by the indifference curve to the left. Any point on the curve represents a combination of present and future consumption that maximizes utility for the individual, with the actual combination being point where the curve intersects the budget line.

The Borne-Out Identity: Savings and Investment

One of the most well-known and oft troted out identities in economics is the identity that says savings = investment. This identity can be derived in a simple manner as J.M. Keynes did in the second chapter of the General Theory:

Income = Consumption + Investment 

Savings = Income - Consumption 

Therefore Savings = Investment

For fun, I ran gross private savings in the US against gross private investment. 

Notice that at times private savings exceeds investment, and other times vice-versa. This is because there are other types of saving and investment other than "private." Government budget surpluses are public savings and deficits are public dissavings, while foreign capital inflows (or outflows) allow for private investment to exceed (or under-exceed) private savings. 

By looking at discerepencies between these two lines, we can see patterns in these trends for the US; notice how private savings exceeds investment in in the early 90's but falls below at the end of the 90's, when the budget surplus added public savings. 

IS-LM and the Price Level

One criticism that is sometimes made about the IS-LM model is that it neglects the price level. The determinates of the model are the real interest rate and GDP; but the price level IS present in the framework. In the LM function that represents the necessary levels of (r) and (Y) that clear the market for real money balances, the supply function in the market is the real, as opposed to the nominal, money supply.

What this means is that a change in the price level, that is to say deflation or inflation, will shift LM either up or down. The real money supply is defined as M/P, where M is the nominal money supply and P the price level. A fall in P, that is to say deflation, leads to a smaller denominator and hence a larger real money supply. Inflation, that is to say a rise in P, leads to a larger denominator and hence a smaller real money supply. Recall that an increase in the real money supply relative to money demand causes the LM curve to shift to the right; a decrease causes a leftward shift.

This mechanism, where changes in the price level change the real money supply and hence the position of the LM curve, is the mechanism that theoretically allows the LM to reach FE equilibrium without a change in the nominal money supply, that is to say monetary policy. If the IS-LM intersection is left of IS-FE (the interest rate compatible with full employment), a then there will be downward pressure on prices: workers will accept lower nominal wages, and firms will cut nominal prices to move pilled-up inventory. This decrease in P then causes M/P to expand and shift the LM curve to the right until FE is reached. If IS-LM is to the right of IS-FE, then nominal wages and prices will rise (i.e. inflation) and M/P will contract until LM is once again at FE. So the price level does factor into our IS-LM analysis; its just hidden in the LM curve.

But what are the implications for Eurozone policy?

Combining the Models: IS-LM

So now we have two seemingly unrelated markets that are both cleared by the same thing: the interest rate. The IS-LM model, developed by John Hicks in 1936, combines the two. The model relates the interest rate (r) to GDP (or income on a national level) (Y). The two functions are not supply and demand but a downward sloping function representing cominbations of Investment and Saving corresponding to each combination of (Y) and (r). It's downward sloping because as income increases, saving increases relative to investment leading to a lower interest rate. The upward-sloping function is the Liquidity-preference and Money supply function which is upward sloping with relation to income because as income grows, money-demand increases due to the fact that more money is required to carry out more transactions in a larger economy; this causes money demand to grow relative to money supply, causing rates to rise. Yes, this is potentially the most obtuse collection of concepts in macroeconomics and the most convuluted framework ever. It makes more sense to see it put together piece by piece, but I don't have the ability to make the graphs I need myself and Google has failed me yet again.

As you can see, IS and LM intersect at FE, or the Full Employment level of GDP. This graph represents an economy in equilbrium, where the central bank has set the money supply relative to money demand in such a way as to set the LM curve along the IS curve so as to reach full employment and stable prices. If the central bank were to contract the money supply, the LM curve would shift to the left along IS, resulting in a new Y below Y*; in other words, a recession. If the central bank expanded the money supply relative to money demand, LM would move to the right of the current IS-FE point; that would mean an equilibrium point on Y above the FE level, which is to say an inflationary gap.

This brings us to the price-level aspect of IS-LM, and then onto its implicaitons for Eurozone policy. I can hardly wait.

Why Monetary Policy Matters Anyway (part 1): Loanable Funds

As I've demonstrated earlier, I'm a euroskeptic (I didn't invent the term) primarily because of what I see as the disasterous experience of the ECB: the periphery countries of Europe have been saddled with a monetary policy that has been tailor-made for Germany and Germany alone; the result has been stable prices and full employment for Germany; unemployment and depressed incomes for Italy, Spain, Ireland, and others. Now I want to delve into why that is: why does the monetary policy of the ECB have an effect on the economic performance of European economies at all?

Monetary policy affects the economy by affecting interest rates: monetary easing lowers rates, while tightening raises them. Lower interest rates entice firms to borrow for investment projects and encourgae households to save less. Higher interest rates discourage borrowing for investment and encourage household saving. The market for loanable funds thus determines what the equilibrum rate of interest will be for the economy: the the graph below, savings is the upward-sloping function of the interest rate (r) and investment is the downward sloping function. This is known as the loanable-funds model.

The savings function is an upward-sloping function of the real interest rate because households want to save more when the reward for doing so it higher. The amount of saving, however, is determined by both the interest rate (r) AND the level of income (Y) so that we write S= f(r, Y). Investment is a downward sloping function of the real interest because more investment takes place when borrowing to do so is cheaper. Since S=I in equilbrium, holding (Y) constant, (r) adjusts until the quantity saved = quantity invested; the market for loanable funds clears like any other.