Thirlwall’s Law in Historical Context

There has been some reticence on the blogs to discuss Thirlwall’s Law and I myself have also been somewhat reluctant to deal with it in any great detail (although I did hint at some problems with it in this post). I think it might be worth discussing it in more depth, however, because I think that the model it is based on is actually quite interesting — albeit misleading. I will rely for this exposition on a very succinct account of the model in a recent paper by Thirlwall entitled Kaldor’s 1970 Regional Growth Model Revisited.

At the beginning of the paper Thirwall notes the assumptions made by the model. He writes,

The first proposition of the model is that regional growth is driven by export growth. Kaldor regarded exports as the only true autonomous component of aggregate demand, not just at the regional level but also at the national level because consumption and investment demand are largely induced by the growth of output itself. The more specialised regions are, the greater the importance of exports. (p3)

It is precisely in this assumption that the problems with the model become manifest. What the above assumption implies is highlighted by Thirlwall later in the paper when he writes “it is more difficult for a country to rectify an import-export gap than it is to rectify a savings-investment gap” (p5). Now, what exactly is the problem here? Well, let’s begin to examine this with reference to our standard GDP accounting identity.

Y = C + I + G + (X – M)

Okay, so we know from this that imports will be a drain on income growth and exports will add to income growth. But what does it mean to say that the trade balance imposes a constraint on income growth as Thirlwall thinks — and, indeed, as Kaldor in the late-60s and early 70s thought?

Surely we could simply assume that consumption, investment and/or government spending must be able to offset any deterioration in the trade balance. What I mean to say is: while it is true from the simple GDP accounting identity to state that an external account deficit will lead to a decrease in GDP, we must mean something quite different when we say that this imposes a constraint on potential income growth. In order to understand this constraint we must now turn to the period in which Kaldor was writing.

In the late-60s and early-70s the UK was experiencing what came to be known as ‘stop-go’ economic policies. The UK economy would experience a boom — often driven by government fiscal policies — which would then fade away as the balance of payments deteriorated when imports rushed ahead of exports due to growth in domestic income. In order to defend their gold reserves the UK government would then cut spending and raise taxes therefore slowing the economy and dampening import demand.

Understood in this context the constraint that Kaldor referred to is clear: it is the balance of payments constraint associated with a drain on gold reserves in a fixed exchange rate system. So, what happens when we consider a floating exchange rate system? Does the constraint disappear? Yes and no.

In fact, the constraint shifts to the value of the currency. If a country were to run a substantial external deficit under a floating exchange rate system it could easily offset this by boosting domestic demand — either through increased consumption, investment or government spending. Since there are no gold reserves the only possible breaking point would therefore be the value of the currency.

Now, if there are sufficient capital inflows into the country then an external deficit can be sustained without affecting the value of the currency. In such a circumstance — i.e. one in which foreigners want to hold assets denominated in the domestic unit of account — there is quite literally no external constraint so long as the arrangement is maintained.

This is the case today, for example, in most Western countries. Foreigners wish to hold dollar and pound denominated assets for a whole host of reasons — not least because they have export-driven economies that rely on Western demand to grow, but also because of the large financial sectors in, for example, the US and the UK.

(The Eurozone is in an altogether different scenario where, rather ironically given that we are talking about balance of payments constraints, their zealous desire to run trade surpluses is part of the reason why the economy cannot grow — see Merijn Knibbe at the RWER blog on this).

In the case of a developing country, however, even with a flexible exchange rate this constraint could be very real. Such countries, should they run external deficits, face the potential for substantial currency depreciation. This can feed through as domestic price inflation which raises the price of domestic output relative to foreign output and exacerbates the balance of payments difficulties thereby creating a vicious cycle. In such a case, Thirlwall’s Law comes into its own and growth can be said to depend upon the external balance of a country.

What lessons can we draw from this? Well, for one we can say once again that: there are no true Laws in economics. Economics, to repeat a point I never tire of making, is an historical discipline. And if we don’t understand political and institutional arrangements we will understand nothing of relevance or importance. Insights such as Thirwall’s Law (which is not a law at all…) are of secondary importance when faced with the realities of actually existing economic institutions. I think that Kaldor was well aware of this and this is why he used to create new theories for every historical constellation he found himself faced with; that was his genius as an economist.

Those who wield such supposed Laws and insist on their timelessness and Absolute Truth are likely to make rather poor economic analysts. (I’m not referring to Thirlwall in this regard who, so far as I can see, recognises the contingencies involved in what he is saying). Such relationships need to be approached with an understanding that historical/institutional constellations come first and equations such as Thirlwall’s can only be made to generate insights within the framework of analysis provided by a given historical/institutional constellation.