CAN THE EXPANSION BE SUSTAINED

CAN THE EXPANSION BE SUSTAINED? A MINSKIAN VIEW

L. RANDALL WRAY

In a series of important pieces, Wynne Godley has demonstrated the necessary implication of a public sector surplus—the private sector’s deficit. He has also, rightly, questioned Congressional Budget Office projections that presume that the federal government’s surplus will not only continue, but will grow over time. What I will focus on here is an analysis of the processes that brought us to this point as well as implications for the future. My discussion will be informed by the teachings of Hyman P. Minsky, who was a Distinguished Scholar at the Levy Institute until his death in fall of 1996. All who had the pleasure of knowing him recognize that his views on our economy at the beginning of the new millennium would have been uniquely insightful and are therefore missed. While the following cannot possibly substitute for the analysis that Minsky could have supplied, it is hoped that my analysis can contribute to a Minskian understanding of the dangers involved in the current expansion.

When I was a student of Minsky’s in the early 1980s, he introduced us to the Kalecki equation, which he, and we, later found to be similar to Jerome Levy’s profits equation. In the Kalecki version, aggregate profits are equal to the sum of the private sector’s investment, plus the government’s deficit, plus the trade surplus (or, for the relevant US case, minus the trade deficit), plus consumption out of profits (or, in short hand, capitalist consumption) and less saving out of wages (or, worker’s saving). In his exposition, Minsky quickly jumped to what is called the classical case, in which capitalists don’t consume and workers don’t save, so that aggregate profits would be equal to investment, plus the government deficit and minus the trade deficit.

The early 1980s was interesting, of course, because the US was struggling to break free from the Reagan recession, with almost no private investment and a growing trade deficit. Thus, the only source of profit was the burgeoning federal budget deficit. In his 1986 book, Minsky had noted that the deep recession of the early 1970s was the first recession in which personal income never fell—because the government’s transfers and deficits rose sufficiently to maintain private income. (Minsky 1986) I later adapted his analysis to the Reagan recession, showing that the Reagan deficits maintained personal income in a similar manner—so that it continued to grow in spite of the recession. (Wray 1989) In Minsky’s view, the importance of this lay in the floor to aggregate demand provided by maintenance of personal income. This is a key stabilizing feature of the post-war big government economy we have inherited, indeed, Minsky counted it along with Central Bank intervention as lender of last resort as one of the two main stabilizers.

As the Reagan deficit continued to climb through the 1980s, the economy recovered and indeed profits boomed—even though investment remained sluggish for most of the 1980s. This exansion thus provided a new wrinkle on the Keynesian macro model, in which investment is supposed to be the driving force of the cycle. In fact, neither the Reagan expansion nor the Clinton expansion can be attributed to investment. The early stages of the Reagan expansion could be almost entirely explained by the explosion of the government deficit; while the government deficit was similarly important in the early phase of the Clinton expansion, as I’ll explain below, continued growth occurred primarily on the basis of private sector spending.

I remember one day in 1984 as the economy was recovering and consumers were becoming sufficiently confident to increase debt, I discussed with Minsky a non-classical version of the Kalecki equation. Minsky had emphasized the role that government transfers play in fueling consumption, but what if consumers simply borrowed to keep consumption up? In other words, the Kalecki equation subtracted worker saving from aggregate profits, but what if worker saving were negative—that is, workers spent more than their income? In that case, even with a trade deficit and sluggish investment, aggregate profits could be positive without requiring government deficit spending.

We even considered a more extreme version of the Kalecki equation. What would happen if the government budget moved toward surplus? In the US case, with a trade deficit, profits would have to be generated by capitalist spending (both on investment and consumption) as well as by worker deficit spending. Theoretically, this could happen but Minsky was skeptical that it was sufficiently likely to warrant further investigation. Steve Fazzari and I did spend some time trying to get estimates of saving out of wages but it proved to be too difficult to allocate personal saving between profits and wages. In other words, worker saving may well have been negative in the mid-1980s, with all measured saving actually coming out of profits, but it was impossible to know for sure.

Fortunately two things happened over the next 15 years. First, Wynne Godley came up with a much more fruitful way of looking at the whole matter. In his approach, we simply consolidate all levels of government into a public sector, and similarly consolidate households and firms into a domestic, private sector. For completion, we must add a foreign sector. It is clear that if the public sector is spending more than its income—that is, is running a deficit—this must imply that at least one other sector is spending less than its income. In the case of the US, we have run a trade deficit over the past two decades, and one that has generally been rising. When our government sector is in deficit, this tends to generate a private sector surplus—some of which is drained off through a trade deficit. In theory, all of the government sector’s stimulus could be drained off that way, but in practice, our trade deficits were not generally large enough to do so. Using Godley’s approach, we don’t need to separate workers from capitalists; the relevant breakdown would be households and firms, and those data are readily available.

The second thing that happened, of course, is that the real world decided to cooperate by generating unprecedented private sector deficits. As Figure 1 shows, the private sector’s deficit is now approximately 5.5% of GDP. What had appeared to be unlikely to Minsky in 1984 became an empirical reality, albeit in a slightly altered form. However, I don’t want to imply that Minsky was mistaken in arguing that our real world outcome was highly improbable, because the current situation is virtually beyond the realm of the probable, and, indeed, almost inexplicable even with the vantage of hind sight.

If one compares the 1980s expansion with that of the 1990s, one can see that in both cases, large government deficits helped to initiate the expansion. Once the expansion was underway, the private sector balance dropped from very large, recession period, surpluses toward deficits. In the case of the 1980s expansion, the private sector balance fell from a surplus of about 4.5% of GDP to a deficit of about 1.5% of GDP—a swing of six percentage points. In the case of the 1990s expansion, the private sector balance fell from a surplus of 4% of GDP to a deficit of 5.5% (and still growing)—a swing of almost ten percentage points. This swing is entirely unprecedented in the postwar period. It was necessitated by the combination of a large trade deficit (although the 1980s expansion witnessed a similar deterioration of the balance of payments) and an unprecedented swing of the government budget toward large surpluses. How can our economy boom in the presence of large and growing government surpluses, and how can we explain the willingness of the private sector to spend in excess of its income to the tune of 5.5% of GDP, and rising?

For most analysts, our current situation is not difficult to explain. The government surplus is adding to our nation’s saving, fueling investment in productivity-enhancing technologies. Wall street is capitalizing future income streams, generating unprecedented private sector wealth. This is a type of saving that is not captured in income and product account figures. Households are devoting a portion of capital gains to consumption, but wealth is growing faster than consumption. Similarly, household debt-to-income ratios are high, but this is not the relevant measure because wealth is growing faster than debt. Government saving is keeping interest rates low so that the burden of servicing debt—even out of measured income flows—is not excessive. The only two black spots on our Goldilocks economy are the negative household savings rates (in large part explained away as a measurement problem) and the growing trade deficit. In any case, most analysts are confident that Chairman Greenspan will be able to keep Goldilocks on track in spite of depressionary influences caused by the government’s surplus and the trade deficit. Of course, most analysts are still more concerned with the possibility that Goldilocks will grow too fast, than with the likelihood that she will slow excessively.

How would Minsky explain the processes that brought us to this point, and what would he think about the prospects for continued Goldilocks growth?

First, I think he would argue that consumers became ready, willing, and able to borrow, probably to a relative degree not seen since the 1920s. Credit cards became much more available; lenders expanded credit to sub-prime borrowers; bad publicity about redlining provided the stick, and the Community Reinvestment Act provided the carrot to expand the supply of loans to lower income homeowners; deregulation of financial institutions enhanced competition. All of these things made it easier for consumers to borrow. Consumers were also more willing to borrow. As Minsky used to say, as memories of the Great Depression fade, people become more willing to commit future income flows to debt service. The last general debt deflation is beyond the experience of almost the whole population. Even the last recession was almost half a generation ago. And it isn’t hard to convince oneself that since we’ve really only had one recession in nearly a generation, downside risks are small. Add on top of that the stock market’s irrational exuberance and the wealth effect, and you can pretty easily explain consumer willingness to borrow.

I would add one more point, which is that until very recently, most Americans had not regained their real 1973 incomes. Even over the course of the Clinton expansion, real wage growth has been very low. Americans are not used to living through a quarter of a century without rising living standards. Of course, the first reaction was to increase the number of earners per family—but even that has allowed only a small increase of real income. Thus, I think it isn’t surprising that consumers ran out and borrowed as soon as they became reasonably confident that the expansion would last.

The result has been consistently high growth of consumer credit. In January, it grew at a rate of 15.7%, and at 10.2% in February. The debt service burden (see Table 1) has increased by about 2 percentage points since 1994 to above 13.5% of disposable income today—all of that growth is due to consumer debt service and none to servicing mortgages, which hasn’t grown at all. Still, thanks to relatively low interest rates, the burden is not at record highs—it was above 14% at some points during the late 1980s. Of course, interest rates are rising, and everyone expects the Fed to continue to tighten, so we might yet break the 1980s record debt service burdens. In addition, everyone is aware that margin debt has been growing rapidly and has become a concern with the turnaround on Wall Street. Not only do falling prices lead to margin calls and problems for investors, they also hurt brokers who’ve come to rely on interest paid on margin borrowing for as much as a quarter of their income.

The private sector’s balance is expected to continue to deteriorate. Looking to the public sector, the consolidated government balance is over 2% of GDP. The federal budget surplus was 1.4% of GDP in 1999, but on the CBO’s projections, that will increase to 2.8% by 2010. By then, government spending will equal only 16.9% of gdp while tax revenue will still equal nearly 20%. The federal debt held by the public will decline from 40% of GDP to little over 6% by 2010. It is important to note that this growth of the surplus is projected to occur as economic growth actually slows down—from about a 4% growth rate today to an average of 2.7%. In other words, fiscal policy is supposed to tighten substantially over the next 10 years—so that it will be heavily biased toward running government surpluses even when the economy grows far below its long-run average—which is closer to 3.5%. So we’ve gone from a budget that was biased toward huge deficits at moderate rates of growth during the peak of the 1980s expansion, to one that is biased toward huge surpluses at even lower growth rates.

I am sure Minsky would reject the notion that retirement of the outstanding debt stock is a worthy goal. Removing the most liquid asset from the economy (as the government destroys nearly $3 trillion of private sector wealth) cannot be a good thing. Further, I am sure he would argue that the budget is far too biased toward a restrictive stance, because it probably won’t move toward substantial deficit until we are far into a deep recession. At that point, it will be too late to perform its stabilizing function. Minsky would be skeptical of any claims that the Fed will be able to prevent a downturn. For Minsky, the primary role of the Fed in bad times is to prevent asset price deflation through intervention as lender of last resort. I cannot think of any inference by Minsky that lower interest rates, alone, can do any good when spending turns down. While he emphasized that rising interest rates can be a bad thing because they can cause present value reversals (that is, force discounted net revenue streams below zero), he never accepted the notion that there is a simple downward sloping credit demand schedule.

I am sure that Minsky would point to the case of Japan for support. The Japanese budget balance similarly became biased toward surplus by the end of the 1980s. (See Figure 2.) The government ran a surplus for 6 years after 1987; even after the economy turned down, the budget remained in surplus. And even with the easiest monetary policy the world has seen since WWII, that is, with zero interest rates for more than 4 years, the economy still has not recovered. Japan’s budget deficit returned in 1993, and it is now reaching to 8% of GDP. However, the earlier surpluses destroyed the private sector to such an extent that even with these huge budget surpluses and monetary ease, and with net exports running at 2% of GDP, the private sector just sucks it all up and saves to the tune of 10% of GDP. In some ways, our position might look even worse than that of Japan in 1989. Our households have never had much savings and are much more indebted. We also can’t export our way to growth, and any reduction of household income is going to make it difficult to service debt. Our stock market excesses are probably worse than Japan’s, however, it seems unlikely that our real estate sector is overvalued to the extent that Japan’s was at the end of the 1980s. Even if one doubts that our situation is as bad as Japan’s had been, the depths of the Japanese recession should raise alarm about the risks faced by our economy.

I believe Minsky would point to several additional danger signs:

*Charge-offs for consumer loans, especially for credit cards and leases, have been rising since 1996. Charge-offs on agricultural loans are rising. Delinquency rates have recently been rising for leases and construction and investment loans. I know that these rates are not yet inordinately high, and that they are to a large extent discretionary (for example, when delinquency rates are too low, that is taken to be evidence that management is too risk-averse, leading to purchases of riskier pools of customers). But it may give some indication of problems to come.

*It is somewhat ironic that bankruptcy law is just now being reformed in a way that will make it harder for debtors to default. While that will make it easier to collect on debts, it also means that indebted consumers will have to cut back spending elsewhere. This will make it harder to get out of recession.

*The Fed is pushing up interest rates. Private sector debt ratios are well above any previous record level, although debt service burdens have been moderated by low interest rates so far. Higher interest rates will eventually increase debt burdens sufficiently that households will begin to default.

*The stock market has probably already started on the way down. Note that if it is true that the wealth effect has been driving consumption, then it is not necessary to have a stock market crash in order to kill the expansion. As Godley has argued, stock market capital gains only provide a one-time boost to consumption levels; continued economic growth requires rising stock prices.

*While GDP growth rates remained above expectations, some areas of the economy slowed perceptibly in March—real earnings were down 0.4%, and business inventories were growing faster than sales. March retail sales were up by 0.4%, but they had grown by 1.8% in February.

*Since the middle of 1997, profits growth has consistently been below GDP growth and capital spending by firms, opening up a growing financing gap in the corporate sector. The financing gap is the difference between capital spending and available internal funds; it reached 19% in the third quarter of last year--highest since the mid 1980s.

*Business net interest expense is already rising, and will increase sharply as the Fed raises interest rates. A cut-back of consumer spending combined with rising interest rates will increase the financing gap and cause firms to reduce their own spending.

The expansion might not stall out in the coming months, but continued expansion in the face of a trade deficit and budget surplus requires that the private sector’s deficit and thus debt load continue to rise without limit. While Minsky cautioned us that government deficits cannot continue to rise relative to GDP without limit, I think he would be even more forceful in arguing against the belief that private sector deficits can rise without limit. It is particularly ironic that while many economists would agree with Minsky’s statements about government deficits, they do not recognize the dangers in private sector deficits. Minsky’s writings on the importance of debt load structures (and his tripartite classification of financial positions as hedge, speculative and Ponzi) should make us even more concerned about private deficits that are already well above 5% of GDP, and rising, than we were about the Reagan-Bush budget deficits that peaked in that range. I know of no reputable economic theory that concludes that growing private sector deficits are any more sustainable than are growing public sector deficits. Indeed, Minsky would have concluded that rising private sector deficits are far more risky!

What would Minsky recommend? So long as private sector spending continues at a robust pace, he would probably recommend that we do nothing today about the budget surplus. He would oppose any policies that would tie the hands of fiscal policy to maintenance of a surplus. Rather, he would push toward recognition that tax cuts and spending increases will be needed as soon as private sector spending falters. That means it is time to begin discussion of the types of tax cuts and spending programs that will be rushed through as the recession begins. For the longer run, he would recommend relaxation of the fiscal stance so that surpluses would be achieved only at high growth rates (in excess of the full employment rate of economic growth). For the shorter run, he would oppose monetary tightening, which would increase debt service ratios and push financial structures into speculative or Ponzi positions. He would support policies aimed at reducing “irrational exuberance” of financial markets; most importantly, increased margin requirements on stock markets would be far more effective and narrowly targeted than are general interest rate hikes that have been the sole instrument of Fed policy to this point. Most importantly, Minsky would try to shift the focus of policy formation away from the belief that monetary policy, alone, can be used to “fine-tune” the economy, and from the belief that fiscal policy should be geared toward running perpetual surpluses—in Minsky’s view, this would be high risk strategy without strong theoretical foundations.

Words 3493

References:

Godley, Wynne. “Seven Unsustainable Processes”

Minsky, Hyman. Stabilizing an Unstable Economy, New Haven: Yale University Press, 1986.

Wray, L. Randall. "A Keynesian Presentation of the Relations Among Government Deficits, Investment, Saving, and Growth", Journal of Economic Issues, Vol. 23, No. 4, 1989, pp. 977-1002.