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Krugman’s New Cross Confirms It: Job Guarantee Policies
Are Needed as Macroeconomic Stabilizers
Posted on July 19, 2009 by admin | 10 Comments
By Daniel Negreiros ConceiçãoKrugman’s new explanation of business cy cles in the form of a GSFB-
PSFB (government sector financial balances – private sector financial balances) model (see his post
entry here) has invoked a sort of call-to-arms by some dedicated Key nesian economists. Though
those of us who have acquired the habit of looking at both sides of every nominal flow in the
economy may see less novelty in Krugman’s new framework, the cross itself is still a very nice tool
for presenting our arguments. And, if Krugman’s cross actually succeeds in replacing the
unfortunate IS-LM interpretation of Key nes’ General Theory , it will have moved the New Key nesian
approach in a constructive new direction.
I will not rehash the details of the Krugman cross in this post, since other bloggers have already
explained the cross and some of its implications (see, e.g., Rob Parenteau’s, Scott Fullwiler’s, and Bill
Mitchell’s). Instead, I want to draw out a particular (and potentially revolutionary ) implication of
the model.I believe that what Krugman was able to finally see, with the help of his cross, is nothing
but the restatement of Key nes’s old paradox of thrift for a closed economy with a government sector
able to run a deficit (though one can also represent the original paradox of thrift taught in
intermediate macroeconomics if the GSFB – government sector financial balances – curve coincides
with the horizontal zero deficit/surplus line, i.e. if governments run a balanced budget). Much like
the simple exposition of the paradox of thrift for a closed economy without a government sector
where aggregate sav ings are unavoidably equal to the size of aggregate investments, in an economy
with a government sector the value of the private sector surplus is unavoidably determined by the
government deficit. This means that when the desired level of private sector surplus rises as a share
of each level of GDP, the tautological stubbornness of the accounting identity forces the adjustment
to take place in one of two way s (or a combination of both). Either:(1) The government deficit rises
so that the private sector is able to achieve its new desired level of surplus at the current level of GDP
or
(2) GDP must fall until the GS (government sector) deficit reaches the new desired level of PS (private
sector) surplus as a share of GDP
This is the exact equivalent to what Key nes argued with regard to an increase in the propensity to
save. When people decide that they want to save more as a share of their incomes (or alternatively ,
when capitalists decide to increase the mark up over wage costs), for a given level of aggregate
investment, aggregate incomes must fall so that the same aggregate sav ings becomes a greater share
of the reduced aggregate income. As Rob Parenteau argued, “If Paul [Krugman] recalls his reading of
Key nes’ General Theory (and he is to be applauded for being one of the few New Key nesians to
actually read Key nes in the original), this is one of the reasons Key nes argues incomes adjust to close
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gaps between intended investment and planned sav ing.”
It is time to play a little with the shapes of the curves. Here I believe that Krugman’s analy sis is
especially useful for explaining policy prescriptions advanced by Post Key nesian economists. First
of all, in the GSFB-PSFB model I see none of the interdependency problems and stock/flow
inconsistencies that exist in the IS-LM model (so far…). As many of the bloggers (Felipe Rezende
here) have demonstrated, under the current set of economic policies in the US, GS deficits tend to
rise substantially when GDP falls also substantially . In Krugman’s framework this is represented as a
relatively steep GSFB curve. The steeper the curve, the faster the deficit increases for a given
reduction of GDP bellow a given threshold (given by the level of GDP where the GSFB curve
intercepts the zero surplus/deficit horizontal axis). However, it is also true that the same
government who responds promptly to a fall in GDP by raising its deficit significantly also responds
aggressively to an increase in GDP above the threshold by raising its surplus since the curve is
equally steep going down below the intercept as it is going up above it. May be we should represent
the curve as hav ing different steepness below and above the threshold, but this is less important as it
depends on more sophisticated assumptions about government policies. While Prof. Krugman makes
the interesting and convincing argument that the fact that today ’s GSFB curve is much steeper than
that of the early 1930s (meaning that GS deficits in the 30s did not rise significantly despite a great
reduction in aggregate incomes) has kept us from experiencing another Great Depression, we have
just begun to experiment with the shapes of the curve.
First of all, let us look at extreme situations:
(1) In the absence of government deficits or surpluses in the economy (i.e. if governments were
blindly committed to hav ing balanced budgets), the horizontal GSFB curve would coincide with the
zero deficit/surplus line and changes in desired PS surplus out of sav ings would necessarily lead to
aggregate income adjustments so that new equilibrium would be reached at the new intercept where
PS surplus was zero. Income fluctuations would be the most v iolent under these conditions since
changes in spending preferences by the private sector would lead to full income adjustments. Note
that any horizontal GSFB curve would produce such effect. In other words, macroeconomic
instability is the result not of the unwillingness of governments to run a deficit (indeed a horizontal
GSFB curve above the horizontal axis could represent any size of GDP independent GS deficits), but
of governments not adjusting the size of their deficits to changes in spending propensities out of
given incomes.
(2) What if governments decided to determine the level of GDP for the economy (hopefully at full
employ ment)? Then governments could accommodate any change in the level of desired PS surplus
by raising and reducing its deficit accordingly so that GDP never needed to adjust. This would be
represented by a vertical (or, more realistically , almost vertical if some GDP adjustments still took
place) GSFB curve at full employ ment GDP. These are the kind of policies we should be looking for as
automatic stabilizers: policies that make the GDFB as close to vertical as possible at full employ ment
GDP. The most effective way to achieve it: an employ er of last resort policy where changes in desired
PS surplus at full employ ment GDP that lead to falling aggregate expenditures and employ ment in the
private sector would be largely compensated by increases in government transfers to the newly
hired workers in the form of wages. Even though it is not necessarily the case that the deficit brought
about by such policy will be exactly equal to the new desired PS surplus at full employ ment GDP so
that the GSFB is completely vertical, in addition to other stabilizers such policy will significantly
raise the steepness of the curve.
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Krugman has hit on something of great importance. I hope others will think through the implications
of his approachand not allow the momentum to wane.
[Tradutor]
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NEEDED AS MACROECONOMIC STABILIZERS
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JKH | July 20, 2009 at 2:01 am | Reply
I think the paradox of thrift connection is excellent, and absolutely fundamental.
Krugman should be salivating over this.It’s worthwhile not to forget the role of the
current account in this line of thinking. The domestic private sector can satisfy its net
sav ing objective with government deficits and/or current account surpluses (i.e. capital
account deficits) at the margin – i.e. reducing the current account deficit in today ’s
context. Both channels are currently operative.Indeed, the only slight hesitation I have
with the use of the government-centric paradigm is that it is really the most prominent of
what are two similar channels for the offset of desired domestic private sector net sav ing.
The model alway s has to be qualified in this way , somehow, notwithstanding the awkward
asy mmetries involved.
Scott Fullwiler | July 20, 2009 at 10:43 am | Reply
JKHI explicitly incorporated the current account into the graph in my post. Regardless,
the ELR policy would still make the govt line in Krugman's model or the Gov Def + Cur
Acct line in my post vertical, assuming y ou don't adhere first to some other constraint
prior to attaining full employ ment, like a fixed exchange rate or a balanced budget. Daniel
does a nice job of spelling out here the extreme cases that I alluded to at the end of that
post and in my subsequent comments there.Best,Scott
Daniel Conceicao | July 20, 2009 at 3:08 pm | Reply
Dear Scott and JKH,Thank y ou for the helpful comments. I think that the GSFB-PSFB
model has given us a nice tool to talk about economic policy . Both commentators are
absolutely correct that a more realistic and useful model must represent an open
economy . Hence, we must consider the current account balance as an additional source
of instability (not as a policy instrument, though). In an open economy income instability
may come from a reduction in the propensity to spend by agents out of each level of
income domestically and abroad. Scott has brilliantly shown us how to add the trade
balance to the GSFB-PSFB framework (making it a GSFB-PSFB-CAB – Current Account
Balance). In the expanded model, equilibrium is reached at the point where the PS surplus
(deficit) = [GS deficit (surplus) + trade surplus (deficit)]. We can find equilibrium at the
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level of GDP where our PSFB curve intercepts the GSFB+CAB curve. Naturally , it is also
true that the GS deficit must equal the sum of the PS surplus plus the trade deficit. Hence,
we can also find equilibrium GDP at the level where the combined curve (PSFB – CAB)
intercepts the GSFB curve. I personally like finding equilibrium GDP like this for policy
discussion purposes because it isolates the curve that can actually be controlled by policy
most efficiently – i.e. the GSFB curve. Therefore, the goal for governments try ing to
achieve full employ ment remains the same even in an open economy . Governments must
attempt to adjust spending so that the deficit compensates (as perfectly as possible) the
sum of desired private sector surplus and the trade deficit in order to avoid GDP
fluctuations. Independently of their causes (changes in foreign spending behavior or
changes in domestic spending behavior), shifts in the [Private Sector Surplus + Trade
Deficit] curve will not cause GDP fluctuations unless governments fail to adjust their
deficits accordingly – i.e. unless the GSFB curve is vertical. Sincerely , Daniel Negreiros
Conceição
Anonymous | July 20, 2009 at 3:28 pm | Reply
Y ou should note that although the public deficit in the SHORT term manages to avoid a
catastrophic collapse in demand , the new equilibrium point is at a lower GDP with a
constant supply of public debt (which by itself is unsustainable unless something moves
the equilibrium back to full employ ment). In other words , Krugman praises the worst of
all worlds : Key nesian deficit and equilibrium below the potential GDP. Brilliant , isn´t it ?
Scott Fullwiler | July 20, 2009 at 4:27 pm | Reply
Hi DanielCompletely agree. I didn't mean to imply that had left any thing out . . . made that
same mistake with Bill's post on an earlier version . . . I was mostly try ing to point out that
the results are unchanged, as y ou've noted.Also . . . y es, the dichotomy we alway s use is
government sector vs. non-government sector, and the latter includes the current
account balance.My use of the PFSB vs. the CAB+Gov Def line was based on 2 reasons (by
the way , CAB is a much better term than I was using):1 . We mostly care about the
outcomes for the domestic private sector in terms of net borrowing/sav ing (a la Minsky ).
The government deficit is a residual. It's also not hard to use a CAB and Gov Def graph to
show how the CAB+gov def line is evolv ing on its own.2. The PSFB line is upward sloping
and the CAB line is downward sloping, so it seemed more intuitive to split those up.
Indeed, depending on the country , it's unclear whether a PSFB+CAB line would be upward
or downward sloping, and would likely be different for different countries.As y ou note, it
really doesn't matter overall . . . both are equivalent. Very nice piece!!Best,Scott
Daniel Conceicao | July 21, 2009 at 12:18 am | Reply
Dear Anony mous,The reason for aggregate incomes and aggregate production to fall as
the result of changing spending propensities by the non-government sectors (as is the
case in our current recession) is exactly the fact that the proposed policy goal of a vertical
GSFB curve has not been achieved. My argument is that a vertical GSFB curve is the
optimal case. Note that a steeper curve means a more responsive (i.e. more counter
cy clical) government deficit. The deficit will remain at any given level just for as long as
the gap between GDP at full employ ment and non-government sector spending remains
fixed. Therefore, in the case of a vertical GSFB curve the “supply of government debt” will
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remain at the level demanded by the non-government sector and it will not be “constant”
unless non-government spending propensities remain fixed. In fact, a constant supply of
public debt would be observed if the GSFB curve were horizontal, not vertical. It follows
from this that relatively flatter GSFB curves describe sets of policy instruments less
adaptive to changes in economic circumstances. One can look at the steepness of the GSFB
curve as showing the government’s promptness to deal with changing economic
environments and avoid fluctuations of income away from the level associated with full
employ ment. Would the government’s behavior described above generate unsustainable
conditions? I do not believe it would. Here are some reasons why . First of all, a vertical
GSFB curve describes a government that has found the perfect set of counter cy clical
policies so that reductions (increments) in spending by the non-government sector are
perfectly offset by increases (reductions) in the government deficit so that the economy
remains at full employ ment GDP despite demand shocks. Therefore, by definition the
government deficit/surplus cannot be too large or too small. It is just right given the state
of non-government spending. In other words, the proposed policy goal is designedexactly to maintain the economy operating at full capacity , not above it and not below it.
Therefore, by definition the proposed policy goal does not face supply constraints that
may threaten its sustainability . It simply guarantees that there will be no unnecessary
underutilization of the economy ’s resources. One could be tempted to denounce the
proposed policy goal as not being financially sustainable. First of all, it has not been
advocated here that governments should sustain any given level of deficit. What has been
proposed is that governments can avoid GDP fluctuations by accommodating changes in
desired non-government sector positive balances by allowing its financial balances to
adjust accordingly . During “good” times, when the non-government spending propensity
is relatively high this policy goal may be achieved with a relatively small government
deficit. For net exporting countries, the policy goal may be achieved without government
deficits or even with temporary small government surpluses. It is mostly during moments
when non-government spending falls drastically that the government deficit will be
expected to be relatively large.
Daniel Conceicao | July 21, 2009 at 12:21 am | Reply
Continuing…Nonetheless, even if the policy goal of maintaining GDP at the level
associated with full employ ment requires prolonged large government deficits, the
situation is alway s financially sustainable. The risk of inflation has already been dismissed
since we have shown that one of the effects of a vertical GSFB curve is to keep aggregate
spending from rising above the level of GDP associated with full employ ment. In other
words, the deficit can never be too large. But can governments alway s meet debt
obligations if the deficit remains persistently large? As many have demonstrated
(including almost all bloggers and commentators who post here more sy stematically such
as L. Randall Wray , Stephanie Kelton, Bill Mitchell and Warren Mosler) before, sovereign
governments operating in a floating exchange rate sy stem can alway s meet any financial
obligation denominated in their own domestic currency unless some unjustified fiscal rule
has been (self) imposed upon them. Sincerely ,Daniel Negreiros Conceição
Daniel Conceicao | July 21, 2009 at 12:22 am | Reply
Dear Scott,Seems we are thinking on almost exactly similar lines. I look forward to hav ing
the chance to talk to y ou in person in the future just to see if we can find some minor
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reason for disagreement (though this seems unlikely at this point). Thanks for the helpful
comments and support,
Eric Tymoigne | July 21, 2009 at 7:32 pm | Reply
Dear Daniel, Scott, Rob and Bill,Great stuff but I would suggest calling y our lines desired
PSB (PSBd) and desired (GSFBd). Reading y our post, we are going back to the irrelevant
and confusing expost/exante debate. Y ou seem to assume that the sum of the actual
balances equals zero only "expost" "at equilibrium" (i.e. after adjustment of income).That
is clearly not correct, the accounting identity holds all the time, before, during and after
the process. Stated differently , the sum of actual aggregate financial balances alway s equal
zero no matter where GDP is on the horizontal axis. Desired balances may not sum to zero
though (which is clearly the case on y our graphs).
Scott Fullwiler | July 21, 2009 at 9:28 pm | Reply
Hi Eric Agree. I actually wrote in an earlier draft that these were identities, so we are
alway s moving along the curves (shifting one or the other), but I like y our suggestion
better.And Daniel . . .I'm actually moving toward agreeing with y ou regarding the best
way to draw the graph. Rev ision of my post potentially coming if I find the time.Best,Scott