Today I’m going to do something that I usually refrain from doing; that is, I’m going to engage with some of the crank arguments that come from the so-called ‘Austrian economists’. (Actually I have done this once before, but shhh… I’m secretly ashamed…).
I’m going to take up three lines of argument that certain Austrian pundits make that are logically connected but which do not seem logically connected in the minds of these pundits. Let us take as our sample pundit Peter Schiff, as he is certainly the most vocal and visible of the Austrians. The first line of argument is that the dollar is going to collapse because foreigners are going to dump it as their reserve currency. Schiff has been making this argument since 2003.
Tied to this is the fact that the US economy has been running persistent trade deficits for years. In the populist language of the Austrians this is registered as the US’s “lost ability to produce” which can be seen being spouted by Schiff here. According to Schiff the trade deficit will eventually lead to a run on the dollar which will then generate massive amounts of inflation in the US presumably as foreign goods and services become more expensive in dollar terms. What he is referring to, of course, is a classic currency crisis.
Now, let’s imagine for a moment that this argument holds up. Let’s imagine that Schiff is correct on the impending dollar collapse (even though he’s been wrong for 10 years running for reasons that are obvious to anyone who follows global macroeconomic events). But let’s give him the benefit of the doubt and pretend that he’s right. What is his prescription? Well, this is where Schiff’s argument goes from being somewhat grounded, if extremely misleading, to being launched right into the stratosphere and leaving reality behind: he thinks that US interest rates need to be higher and the dollar stronger.
I know… need I say anything else? Anyone with any economics training at all must be completely baffled by this argument. Indeed, I think the only reason that Schiff hasn’t been called out on it up until now is because his whole narrative has never been laid out in any consistent manner. I feel that by pointing to the obvious error here I will be patronising my readers somewhat, but I will do so nevertheless for posterity’s sake: a rise in interest rates and an accompanying rise in the dollar would severely damage US competitiveness, cause imports to rise as they become cheaper in dollar terms and cause exports to fall as they become more expensive in foreign currency terms. In a few words: the trade deficit would get much, much bigger.
In fact, as those with a more sophisticated knowledge of macroeconomics will know, this will have effects on the relative positions of the private and governments sectors too. We know this because the sectoral balances accounting identity must hold at all times. That accounting identity is as follows,
If the trade balance component in that identity deteriorates — that is if ExP fall and InP rise — then one of four things will have to happen: (1) private savings will have to fall/private debt will have to rise; (2) private investment will have to rise; (3) government tax revenues will have to fall; (4) government spending will have to increase. In reality, the result will be some combination of the above, although (2) is clearly the least likely. The end result will be an increase in the government and private sector deficits.
But then, perhaps we’re getting overly complicated here. Perhaps we should just stick to what is a simple point: if interest rates rise and the dollar’s value rise this will lead to a much larger trade deficit. This is not high theory either. We can simply examine the historical record in this regard. All we need to do is go back to the late-1970s and early-1980s when Fed chairman Paul Volcker raised interest rates to historic highs to fight inflation. Here is what happened.
First of all, as Schiff says, the dollar’s value increased enormously. The high interest rates in the period 1978 to 1985 led the dollar to increase in value by about 40% (all data is from FRED),
And what happened to the trade balance? Well, obviously it went massively into deficit as imports became cheaper in real terms and exports became more expensive,
Of course, this dynamic is obvious to ANYONE who knows basic macroeconomics. I’m not even talking about ‘mainstream’ versus ‘Austrian’ or ‘Austrian’ versus ‘Keynesian’. All schools of thought would recognise that an increase in the value of a currency would, ceteris paribus, lead to a deterioration in the trade balance. This is so obvious it seems embarrassing to assume that someone who paints themselves an economics expert would not realise it…
And what about our accounting identity? Did it hold in this period? Did the government deficit increase as the trade balance deteriorated? Of course it did. Accounting identities must hold!
It should thus be obvious that what the likes of Peter Schiff are selling is snake oil of the highest order. They complain about the trade balance and warn that it will lead to a dollar collapse and inflation when foreigners stop “lending the US money”. But then they prescribe something that would obviously worsen the trade balance (and the government deficit).
Frankly, it’s shocking that they get away with airing their views in public without being subject to ridicule. But then, these people usually exist outside of the realm of academic economics and are not subject to basic checks and balances. Their audience are also likely not rational people so such rational arguments will not sway them. God help us all if the likes of Ron Paul get into power… although watching the confusion of the Austrian pundits as Armageddon reigned down would be rather amusing.
Update: A more thorough investigation of the logic underlying Schiff’s argument can be found here.
The reason that Austrian school “economists” like P. Schiff can get away with their nonsense, is that the general public does not understand economics and/or confuses it with finance, which many find complex. Hence the public, which includes many journalists too, is not able to scrutinize those economic snake oil sales men.
I don’t think you’ve properly represented his argument. Schiff also wants massive government spending cuts, massive tax cuts, and an end to all forms of welfare (as far as I can make out, from his ravings). He wants there to be a huge recession with mass bankruptcies and extremely high unemployment. He wants this because he thinks that US wages and prices will then fall drastically, which will make US exports more competitive even with a strong dollar. Basically he wants higher purchasing power for the rich and a working class reduced to desperate poverty, so that they learn their proper place and stop being so lazy. This is an ‘internal devalution’ similar to that going on in Greece. He wants the US to be like Greece.
It still doesn’t make sense. As I showed above, if you allow the dollar to appreciate the trade deficit will get bigger and the government budget deficit will also get better.
His entire argument makes absolutely no sense.
if you have massive unemployment and widespread poverty then imports will go down. This has happened in Greece, which now even has a current account surplus.
If you totally slash government spending, regardless of the effects on the economy, and have a fire sale of public assets, the deficit would come down. This is seems to be happening in Greece, slowly, but they have also raised taxes. Schiff would probably want to raise certain taxes on poor and middle class people “to pay down the debt”, because he thinks they are leeches on rich ‘wealth creators’ like himself.
You’re making the assumption that the government keeps spending, doesn’t renege on its social spending promises, and tries to keep unemployment down. He doesn’t want any of that. He wants the US to suffer. He wants the government to default on its promises to pretty much everyone but bond holders. He keeps going on about how the US needs a major recession (i.e. a depression) to “cure” its “problems”.
Greece’s currency did not massively appreciate.
The fire sale example doesn’t work either because Schiff advocates increased private savings. Such asset purchases would reduce savings.
I make no assumptions. I just point out that Schiff’s argument violates basic accounting. Lay it out yourself and try the math.
(S – I) = (G – T) + (X – M)
Substitute in an approximation of the current US numbers:
(4%) = (8%) + (- 4%)
Now, we appreciate the US dollar and this deteriorates (X – M) by, say, 2%. And we want to increase private savings, (S – I), through the interest rate hikes by, say, 2%. What happens?
(6%) = (???%) + (- 6%)
Simple, the government balance, (G – T), goes to a 12% deficit.
You cannot violate accounting.
domestic private saving is S, not (S – I).
S = I + (G – T) + (X – M)
If the Fed raised interest rates to appreciate the dollar, the current account deficit could still shrink if domestic demand for imports fell and/or exports increased relative to imports. How could this happen? Well, if average incomes fell (due to rising unemployment) then there would be less demand for imports. And if wages and prices fell enough to offset the stronger dollar (due to very high unemployment), then exports could increase relative to imports, so long as there was sufficient demand from abroad.
Using your figures, let’s say S is originally 4% and I is 0%.
4% = 0% + (8%) + (- 4%)
If you balanced the government budget and the current account, investment (I) would have to rise to 4% to maintain the same level of private saving.
4% = 4% + (0)% + (0%)
Schiff would no doubt argue that investment would increase as wages and prices fell. Which from a Keynesian point of view is complete nonsense of course, unless for some strange reason foreign countries decided to massively increase spending on both consumption and investment at exactly the same time that the largest economy on the planet entered into a massive depression.
(S – I) = private NET saving. If Schiff wants an increase in saving then NET saving has to increase. Come on… accounting 101.
The rest of your comment suffers from a fallacy of composition and a confusion of NET private saving — which is what an “increase in saving” would entail — and private saving. I assume that Schiff is making a similar mistake. But it’s still a mistake.
“If Schiff wants an increase in saving then NET saving has to increase”
No, private saving net of private investment (S – I), i.e. ‘net private saving’, can decrease at the same time that private saving (S) increases. This is because:
S = I + (G – T) + (X – M)
which is just a rearrangement of (S – I) = (G – T) + (X – M)
Let’s say that (S – I) = 4%, (G – T) = 2%, and (X – M) = 2%
For simplicity let’s say that I = 0%, so S = 4%
Now if (G – T) and (X – M) both fall to 0%, S will also be 0%.
However, if I simultaneously increases to 6%, then S will be 6%. In this case, (S – I) will have fallen to 0%, but S will have increased to 6%.
You’re just talking in circles now.
Schiff said that the dollar should rise while private sector savings increase due to an increase in the interest rate. The latter must be NET private saving because if it is just (S) then there is no real increase in savings because the amount by which (S) rises is sucked out of another segment of the private sector in the form of increased (I). Put another way: there is no net increase in assets and thus no INCREASE in savings in the aggregate.
Let’s say that (I) increases by 10. Well, where did this come from? It’s either (a) a depletion of a stock of savings outstanding or (b) a private sector debt. This adds 10 to (S). But what is the savings increase in the private sector as a whole? In the case of (a) the stock of savings is unchanged because the savings is just moved from one account to another and in the case of (b) the asset and the liability cancel out.
This is all basic GDP accounting. You can argue with me to you’re blue in the face but at the end of the day if a credit to a savings account is offset by a debit to an investment account private sector saving has not seen an increase as the asset on one side of the balance sheet is cancelled out by the liability on the other.
Schiff doesn’t understand the relationship between saving and investment because he thinks in terms of a very simple loanable funds model.
“Schiff said that the dollar should rise while private sector savings increase due to an increase in the interest rate. The latter must be NET private saving because if it is just (S) then there is no real increase in savings because the amount by which (S) rises is sucked out of another segment of the private sector in the form of increased (I). Put another way: there is no net increase in assets and thus no INCREASE in savings in the aggregate.”
This is incorrect. What you’re basically saying is that private saving does not equal S. But S is the definition of private saving in the sectoral balances equation you are using. (S – I) is private saving minus investment.
Those are flow relationships. You’re not taking into account stocks and balance sheets. Increases in (I) don’t come from nowhere. They either deplete savings or they increase dissaving (i.e. debt).
If one person goes into debt (to invest) and another saves, that doesn’t mean that no saving has taken place. It’s a mistake to describe this relationship as ‘zero saving’. In this situation you have both financial savings in the form of a bond, and real savings in the form of the real investment financed by the bond.
Come on, dude. Do the balance sheet effects out yourself.
Firm issues bond (liability). Investor takes bond (asset) and gives firm cash (asset). This is an asset SWAP. The investor does not have MORE assets, it has simply exchanged one asset (cash) for another (bond). The firm then invests the cash.
Net effect? The firm has a liability in the form of a bond on its books. That is a debt or “dissaving”. The invested money accrues as an asset to someone else, say a worker who is paid a wage. The investor who bought the bond has no net change. They have swapped one asset (cash) for another (bond).
Again, net effect? Investment produces an asset in the form of income which accrues as saving and incurs a liability in the form of a bond. That is all. No increase in saving — or, if you want to be precise, NET saving, which is what matters.
Are you familiar with the sectoral balances framework? If so, do you know that we always — ALWAYS — talk about NET saving because of these issues?
“Firm issues bond (liability). Investor takes bond (asset) and gives firm cash (asset). This is an asset SWAP”
Yes, but it is also SAVING. The investor has savings in the form of the bond. The firm creates real savings in the form of real capital (factories etc).
Cash/money/currency doesn’t necessarily need to change hands for this to happen. You can have a debtor-creditor relationship without any cash involved.
Also, the relationship doesn’t necessarily need to be one of debt. The firm could sell ownership (equity) in the business to finance its investment. So an increase in I is not necessarily an increase in private debt.
“Are you familiar with the sectoral balances framework?”
I don’t mean to be rude but you seem to be unfamiliar with it, as the sectoral balances equation clearly states that private saving equals investment + the government deficit + the current account balance.
Cash/money/currency doesn’t necessarily need to change hands for this to happen. You can have a debtor-creditor relationship without any cash involved.
Every setup of a new financial relation involves some form of money. You cannot buy debt or stock or anything else without it in a non-barter, i.e. monetary economy. But I also think it’s wrong to say that the stock of money created to finance the act must persist indefinitely for there to be saving. For the circuit to close, the initial money debtor must earn back his debt and pay it down, leaving only ‘real’ saving as a residue. It is this act of earning (not that of paying down) that constitutes real economic activity. So the discussion is: which is more conducive to real economic activity: a) allowing for more money saving or b) allowing for less money saving or, related c) what is the ideal path of money’s worth in real terms?
And I think Philip is right in pointing out that it is one thing to argue for a closed economy (closed world, I’d say), but another to argue for an open economy and that our fellow Austrianites are hopelessly inconsistent in this respect.
You’re still not listening to what I’m saying.
(1) In the case of the asset swap there is no INCREASE in savings. Savings in the form of cash is swapped for savings in the form of a bond. There is no net effect. I.e. there is no NET increase in savings.
(2) The real savings created by the firm are offset by the liability incurred. Again, there is no net increase in savings.
(3) Even if cash doesn’t change hands the same asset/liability structure is set up. In the case of a bank loan, for example, the firm can invest the credit it is given by the bank but it will also incur a liability. Again, no net change in savings.
(4) If equity is sold this should, ceteris paribus, lessen the value of outstanding equity on the market. I.e. if new shares are issued the value of the overall shares of the company is diluted. Thus the increase in saving by the person buying the new equity is offset by the diminished saving of those holding the old shares that decline in value. In essence, the ownership of the company — which is a form of saving — is diluted.**
(5) You’re taking the sectoral balances framework too literally. When others use it they talk about net private savings when they talk about an increase in savings. This is because of the recognition that left to itself the private sector cannot create new assets without incurring new liabilities in some form.
** I believe it was for considerations like this that Wynne Godley, who originated the sectoral balances framework, counted equities as debt in his accounting matrices. See: ‘Monetary Economics’ pp28-29
Also, I should say, barring all the above. Schiff is talking about raising interest rates massively. So, within the context of the argument in the piece you are arguing for a major increase in investment in an environment of high interest rates.
I’ve laid out your argument at face value here:
Even veneering over the issues raised in this comment thread the accounting still doesn’t add up. Schiff’s argument makes no sense. None. Not even on its own terms.
Globally, net saving of financial assets amounts to 0. To argue that there is a net of anything, you must divide the world into sectors. And I son’t see any reason why a division into gvt. and non-gvt. is the only valid base case nor why any other division, say into corporate and non-corporate is in any way analytically inferior. It may be a good starting point for understading currencies, but it isn’t the be-all and end-all of financial analysis.
But that’s probably off topic.
It is slightly off topic. But regarding the Gov/Non-Gov versus Corp/Non-Corp in Post-Keynesian economics it is assumed that investment is a function of effective demand in modern economies. Thus corporate investment is seen as a largely passive function of outstanding effective demand. This means that talking about the government rather than the corporate sector as an active agent makes somewhat more sense. In my experience, it almost certainly does.
Just to be clear, and maybe Philippe would agree: I’m not defending Schiff in any way nor am I saying his arguments are consistent. Thy’re most obviously not. It’s more about being consistent in his criticism.
The only useful definition of effective demand is the sum of all expenditure and thus of all supply sold within one period. I don’t see why this is in any way a unique function of gvt. spending. I’ll grant you that the counter cyclical nature of the gtvt. budget as well as its status as debtor and sovereign in one give it a distinct position within a national economy. But it is by no means the only, nor even the largest source of effective demand, not even in times like these. And as for outstanding effective demand, I’m really not sure what that means. Effective demand is a flow, outstanding denominates a stock. Potential effective demand owing to outstanding stock of monetised gvt. deficit, maybe. But then again, there were times when investement was largely funded by corporate borrowing whereas gvt. deficits were funelled back through high taxation. So a large stock of outstanding gvt. debt is no necessary condition for investement.
You didn’t read what I wrote, Oliver…
Post-Keynesians since at least Kalecki have viewed investment as largely a FUNCTION of effective demand. Investment CREATES effective demand, but it is CAUSED BY effective demand. (This is the “accelerator principle” in Keynesian economics and it is very robust).
Thus, it is logical to say that private investment is largely passive to other changes in ED. What are the most prominent changes empirically? Simple: changes in the government budget balance caused by policy decisions. That is why we focus on the government. In practice it works too.
Well, maybe I’m dense or we’re just talking past each other.
Are you saying investment sparks a virtuous cycle and thus creates more investment? I agree with that.
And are you then saying, if no one wants to invest because no one else is investing, then the only agent with the freedom to invest anyway is government? I agree with that, too (that’s what I meant with counter cyclical above). Although one must be careful to take into account the endogeneity of the gvt. budget. So it’s probably better to say, the budget stance is a policy variable.
But what’s your definition of effective demand? And why is the private sector passive wrt to it? Still non capisco.
Post-Keynesians see the investment cycle as a self-reinforcing phenomenon (acceleration principle). It is then disturbed by other forces (crises, government policy decisions etc.). Empirically you are best off following the government policy decisions as the main ‘driver’. This is not to say that the government budget balance is not endogneous to some extent — it is — but I guess it is less endogenous than the other variables.
This is reflected in the argument the MMTers make that you can basically predict a lot of crises by just waiting for the government balance to go into surplus. This is not a perfect argument (countries with massive trade surpluses will be a confounder). But it is largely correct.
Ok, we’re more or less on the same page then.
not sure about your definition of effective demand, though. effective demand is what is effectively demanded – a pleonasm really – no matter by whom.
I don’t recall defining effective demand.
My point exactly. But you use the term, so you must have at least a notion of what it means. I was interested in that notion.
I’m not here to hijack your blog with off-topic nit picking though, so we can leave it at that if you like.
Looks good to me…
As it says, in the aggregate effective demand = aggregate demand.
Yes, effective demand is new stuff bought in a market, aggregate demand is new stuff bought in all markets and, since income = output, aggregate demand = gdp (assuming a closed economy). Each time someone buys something newly produced, the value added paid constitutes effective demand. One cannot be passive wrt to it, nor can any expenditure be a function of it. You either engage in it or you don’t. So corporate investment is seen as a largely passive function of outstanding effective demand doesn’t make any sense. Corporate investment is effective demand to the extent that it consist of buying new stuff. And outstanding effective demand is just ineffective demand, i.e. it isn’t demand at all.
It makes perfect sense. I think you should read your Kalecki, to be honest…
Investment is not effective demand. It is a component of effective demand. Effective demand drives investment. Does this mean that, in part, investment drives investment? Of course. But it is not the only thing that drives it — as it is only one component among others of effective demand.
Government expenditure is, I think, the key component of effective demand when considering the macroeconomies of most countries today.
That’s it really. If you think that doesn’t make sense then sorry, I can’t help you…
I guess you are right Philippe. “He is not even wrong” but appeals to uneducated libertarians.
Schiff’s argument would make sense if you don’t factor in globalization trade, like America back in the 50s and 60s where domestic consumption was high.
A strong dollar would mean you could buy commodities cheaper, make products cheaper, prices would go down, American domestic consumption would go up buying the products they make themselves, and you can get away with paying less wages due to falling prices. That’s these LIbertarian’s logic, but they failed to factor in neoliberal globalization free trade, and America’s lack of protectionism and tariffs. Prices still remained high even though slave trade made them cheaper for the retailers, but retailers have a maximize profit mentality, so no matter how low it costs to manufacture Wal-mart products by developing nations, prices will still remain constant in the US. Gotta maximize that profit margin for the shareholders.
Look at China, as the Yuan goes up in value, China’s leadership’s new 5 and 10 year plans are geared toward domestic consumption and less reliance on exports.
That’s not true. In the 50s and 60s the high interest rates would have caused a recession. And any attempts to reign in the budget deficit would have prolonged it.
Schiff’s plan is complete nonsense.