Tag Archives: Leverage

Mankiw on the Congressional Tax Plan

In the New York Times, Greg Mankiw applauds the tax reform plan discussed in Congress. He emphasizes four points:

  • The reform would move the US tax system toward international norms, from worldwide to territorial taxation.
  • It would move the system from income towards less distorting consumption taxation, by allowing businesses to deduct investment spending immediately.
  • The reform would change the origin-based into a destination-based system (taxing imports and exempting exports, a.k.a. “border adjustment”), with similarities to a value-added tax, making it harder to game the system. “[T]he immediate impact of the change would be to discourage imports and encourage exports. … the dollar would appreciate … The movement in the exchange rate would offset the initial impact on imports and exports.”
  • The reform would abolish tax deductions for interest payments to bondholders, eliminating incentives for corporate leverage. “A business’s taxes would be based on its cash flow: revenue minus wage payments and investment spending. How this cash flow is then paid out to equity and debt holders would be irrelevant.”

Banks Are Not Intermediaries of Loanable Funds

In a recent Vox blog post, Zoltan Jakab and Michael Kumhof argue that macroeconomic models where banks intermediate loanable funds get it seriously wrong.

In the intermediation of loanable funds model, bank loans represent the intermediation of real savings, or loanable funds, between non-bank savers and non-bank borrowers … [but in reality] [t]he key function of banks is the provision of financing, meaning the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor.

This difference has important implications. Compared to intermediation of loanable funds models, money creation models predict larger and faster changes in bank lending and real activity; pro- or acyclical rather than countercyclical bank leverage; and quantity rationing of credit after contractionary shocks. New loans in loanable funds model are accompanied by additional savings and thus, higher production or lower consumption. In money creation models, in contrast, they simply reflect an expansion of banks’ balance sheets that is only checked by profitability and solvency consideration. Moreover, “the availability of central bank reserves does not constitute a limit to lending and deposit creation. This … has been repeatedly stated in publications of the world’s leading central banks.”

A large part of [money creation banks’] response [to a contractionary shock], consistent with the data for many economies, is … in the form of quantity rationing rather than changes in spreads. … In the intermediation of loanable funds model leverage increases on impact because immediate net worth losses dominate the gradual decrease in loans. In the money creation model leverage remains constant (and for smaller shocks it drops significantly), because the rapid decrease in lending matches (and for smaller shocks more than matches) the change in net worth. … As for the effects on the real economy, the contraction in GDP in the money creation model is more than twice as large as in the intermediation of loanable funds model, as investment drops more strongly than in the intermediation of loanable funds model, and consumption decreases, while it increases in the intermediation of loanable funds model.

Debt Supercycle rather than Secular Stagnation

In a Vox column, Ken Rogoff argues that the world economy experiences a “debt supercycle” rather than the onset of secular stagnation in the West.

Rogoff argues that macroeconomic developments since the financial crisis are in line with historical experience, as documented in his book “This Time is Different” (with Carmen Reinhart): A large fall in output followed by a sluggish recovery; deleveraging; protracted higher unemployment; and a strong rise of the government debt quota are typical after a boom and bust of house prices and credit.

According to Rogoff, policy makers should have implemented more heterodox policies including debt write-downs; bank restructurings coupled with recapitalisations; and temporarily higher inflation targets. Rogoff supports the (in his view, orthodox) fiscal policy responses that were adopted but criticizes that many countries tightened prematurely.

Rogoff acknowledges that secular forces shape the macroeconomy, in particular population ageing; the stabilization of the female labor force participation rate; the growth slowdown in Asia; and the slowdown or acceleration (?) of technological progress. But

[t]he debt supercycle model matches up with a couple of hundred years of experience of similar financial crises. The secular stagnation view does not capture the heart attack the global economy experienced; slow-moving demographics do not explain sharp housing price bubbles and collapses.

Rogoff doesn’t accept low interest rates as an argument in favor of the secular stagnation view. Rather than reflecting demand deficiencies, low interest rates (if measured correctly—Rogoff expects a utility based interest rate measure to be higher) could reflect regulation (favoring low-risk borrowers and “knocking out other potential borrowers who might have competed up rates”) and to some extent central bank policies.

Rogoff argues that the global stock market boom poses a problem for the secular stagnation view. He proposes changed perceptions about the likelihood and cost of extreme events (Barro, Weitzman) as factors to explain both low real interest rates and the stock market boom (after an initial asset price collapse during the crisis).

Regarding policy prescriptions to expand public investment in light of the low interest rates, Rogoff notes that

it is highly superficial and dangerous to argue that debt is basically free. To the extent that low interest rates result from fear of tail risks a la Barro-Weitzman, one has to assume that the government is not itself exposed to the kinds of risks the market is worried about, especially if overall economy-wide debt and pension obligations are near or at historic highs already. [Moreover] one has to worry whether higher government debt will perpetuate the political economy of policies that are helping the government finance debt, but making it more difficult for small businesses and the middle class to obtain credit.

Rogoff considers rising inequality to be problematic (and a possible factor for higher savings rates):

Tax policy should be used to address these secular trends, perhaps starting with higher taxes on urban land, which seems to lie at the root of inequality in wealth trends

He concludes that the case for a debt supercycle is stronger than for secular stagnation:

[T]he US appears to be near the tail end of its leverage cycle, Europe is still deleveraging, while China may be nearing the downside of a leverage cycle.