Srinivas Thiruvadanthai on the Sectoral Financial Balance Approach to Macroeconomics

David Beckworth: Our guest today is Srinivas Thiruvadanthai. Sri is a managing director and the director of research at the Jerome Levy Forecasting Center. Sri joins us today to talk about [the] sectoral financial balance approach to macroeconomics, as well as the safe asset supply challenge. Sri, welcome to the show.

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

Sri Thiruvadanthai: Thank you David for having me, as I'm a big fan of your podcast, I am privileged to be on this now.

Beckworth: Oh, well thanks, that's good to know we have another fan out there. Now, for listeners, Sri and interact a lot on Twitter. Sri's also an active blogger in addition to his day job where he does research for his clients, so Sri makes a nice contribution to those of us who care about macroeconomics, and it's a real treat for me to get him on this show. And he's going to keep me honest, just like he does on Twitter, so I'm looking forward to our conversation. Now with all of our guests I typically get into this question with them first and I ask how did you get into economics? I'm dying to hear your story, Sri.

Thiruvadanthai: Yeah, you know, my background originally, like many Indians, obviously, economics was not the high priority. You either wanted to be an engineer or a doctor, not because you loved those things, but those were the only tickets to a middle class livelihood.

Thiruvadanthai: So I went to college and did engineering, but I don't think I particularly liked that stuff. And then when I went and worked in a bank, I mean it was really a long-term industrial credit corporation of India in 1991. And that's when India actually went with all those major reforms, right? And what we felt at the bank and all these reforms were really highly touted by all the economists, but at the bank, for the first six months that I was there, we were not doing any lending whatsoever. We were only collecting bad loans.

Thiruvadanthai: And the ground reality of bank lending versus all the high-level talk about economics is what really got me started into thinking about how economies work and how it's intricately related to the financial system. And that's when I decided to come and do graduate study in economics.

Beckworth: Yeah, now you studied under Bill Barnett, who's a previous guest of the show. He's of the Divisia money supply fame, is that right?

Thiruvadanthai: That's right.

Beckworth: Yeah.

Thiruvadanthai: That's right.

Beckworth: Now I'm just curious, because he makes the convincing case at least in my view that the Divisia money supply measure is a better measure than the simple sum, if you're going to use it. I'm just curious, have you used it a lot in your career?

Thiruvadanthai: I have not used it a lot in my career, per se.

Beckworth: Okay.

Thiruvadanthai: But one of the things that the Divisia tells you, basically, is the aggregation method matters a lot, right?

Beckworth: Yep.

Thiruvadanthai: I mean so that's really the critical thing. And Bill actually got into this debate with Friedman way back in the '80s when Friedman was looking at the raw money aggregates and Bill was looking at it through the Divisia and they were giving very contrasting signals about what was happening to money, money stock.

Thiruvadanthai: And basically Bill's point is, not just in money, aggregation matters in a lot of things. And that's been a big part of his work. And some of his students have gone on to do a lot more with it, but he's also done other lots of interesting stuff with it. But basically he, [Walter] Erwin Diewert [inaudible 00:03:52], and a lot of these guys have been thinking deeply about these aggregation issues which are very tricky for a very long time.

Thiruvadanthai: You know, of course, from the post-Keynesian perspective, the aggregation issue is more related to the capital controversy, and so, but my point which I often tweet about is that you find these debates are there even in the mainstream, but not many people are aware of it.

Beckworth: Yeah, it's a very interesting perspective on money and in general on the proper measurement in economics, and I definitely learned a lot. And one of the great applications of Divisia money supply measures is you can look at the Volcker recessions in the early '80s and you can see that maybe he overdid it a bit, and that's one of Bill Barnett's arguments, that there was a recession that could've been milder. But if you looked at the simple sum measures that the Fed was doing, they didn't see it in real time.

Thiruvadanthai: Right, right. I mean, I think there are two issues, right? Back then, the CPI, if I'm not mistaken, used to use user cost. So basically, mortgage interest rates went into the CPI. So when interest rates were going up, it was also going into the CPI, so it was actually aggravating the problem in some sense. And Bill is right, and I think the initial Volcker hike was probably justified, but he did overdo it.

Beckworth: Yeah.

Thiruvadanthai: But I think lots of other people who are, even from a monetarist standpoint, have come to that view, I think.

Beckworth: Yeah. Now you mentioned post-Keynesianism. Would you classify yourself as a post-Keynesian?

Thiruvadanthai: I think I would. I mean, I'm sympathetic to post-Keynesian[ism] in most ways. Although-

Beckworth: Well what does that mean?

Thiruvadanthai: ... I generally don't like to typecast myself into any particular…

Beckworth: Okay. Well, what does post-Keynesianism mean, for our listeners?

Thiruvadanthai: So I mean, basically there are three key aspects of post-Keynesian economics that differs from the conventional Keynesian or mainstream, right? One of the things that matters in post-Keynesian economics, and I think it is the critical one is demand matters, and demand matters not just for the short run, it matters even in the long run.

Beckworth: Okay.

Thiruvadanthai: That is number one. Number two I would say is that balance sheets and financial flows matter, which is the, both Minsky and Wynne Godley, although they come at it from different angles, would say the same thing within, that balance sheets and financial flows matter. So the economy is a financial organism and you have to look at it as a financial entity.

Thiruvadanthai: Number three I would say is that the economy is, this goes back to Keynes himself, that it is a monetary economy, and you cannot analyze it like a Walrasian economy and have money as an afterthought. And I think these are the three key distinguishing features.

Beckworth: That's interesting. So just to summarize, demand matters a lot, not just in the short run, so like hysteresis arguments, and I think there's been a revival of this idea over the past decade given the slow recovery. Also that there's balance sheets to the broad economy, and we'll talk about in a minute sectoral financial balance approach to macro, and that money matters.

Beckworth: And I've done some work on that last point using monetary search models, because I agree, kind of the standard workhorse model macro kind of does take money as an afterthought when in fact it is consequential. Now let me ask this question, at your work at the Jerome Levy Forecasting Center, you take these ideas and put them into practice, is that right?

Thiruvadanthai: That's right. So what we have is we tried to forecast aggregate profits from a flow of funds perspective. So you take the profits equation, which is an identity, but how do you turn it into a dynamic forecasting tool? That's what we try to do. But what we are trying to do also is, how are those financial flows being affected by the balance sheets? And people's preference for balance sheet structures and things like that, how do they affect the financial flows?

Thiruvadanthai: And we are also looking at, some other things we are looking at bottom up, like for instance, capital spending and things like that. We are also trying to look at, you know, in industry, what are the orders, what is the order book looking like? So it's a mishmash of various kinds of approaches. But it is very iterative, labor intensive, with a lot of subjective judgment in it. So it's not model-driven even though there is kind of a model there.

Beckworth: Yeah, well let's talk about this idea of sectoral financial balance approach. I want to begin our conversation by bringing up a comment you had on Twitter recently. You said "basic national income accounting and flow of funds should be a part of every macroeconomics course. No point in teaching other stuff if you don't understand this." And I think you're getting into the importance of understanding the economy from a balance sheet perspective, is that right?

Thiruvadanthai: That is absolutely right. And I mean, I have taught a macro course on and off, and I find that the GDP accounting, yes it is taught, but it's just one small portion and then you get into a lot of other things.

Beckworth: Yeah.

Thiruvadanthai: And here is a basic problem, right? I mean you see even practitioners, let alone academics, they don't understand the GDP accounting very clearly. And I posted something on Twitter yesterday, and especially the chain-weighted GDP, they don't understand. This goes back to what Bill is talking about with the Divisia indexes as well. You can't add up the chain-weighted GDP.

Thiruvadanthai: And many people know that, but they don't realize all the implications of it. And so that's why I feel like it is important to teach people some of these basic accounting, what goes where, the double entry accounting of GDP from the product side and the expenditure side and the income side, how does it relate to gross domestic income, the flows of income, and we are taught circular flow of income, but it's soon forgotten. And I think emphasizing that one person's spending is another person's income will automatically at least make you think before making many partial equilibrium fallacies that people often tend to make.

Thiruvadanthai: And let me just give you one example, right? People think that, okay, cutting wages is what's increasing profits. That's true for probably one company, but that's obviously a fallacy of composition at the macro level. You cannot do that. I mean, so those kind of things, you see, many people still say that oh, the corporate sector has cut wages and that's why the profit margins are high. That's not true at all for the corporate sector. And these kind of ... At least we won't be making elementary fallacy of compositions.

Beckworth: Yeah, I think that's probably one of the defining characteristics of macroeconomics, or at least why macroeconomics is different than micro is this fallacy of composition, what's true maybe for an individual is not going to be true collectively for all of us. And I kind of, going back to the very basics, the very idea of double entry bookkeeping. And I tell my macro students, "Man, if there's an important course you can take in college it's just basic accounting."

Thiruvadanthai: Yes.

Beckworth: Learn what a balance sheet is, because I find it more and more useful when I think broadly about the US economy. But it is, it's striking, and I think a lot of people miss this. And I often will be sloppy and miss this point too, but one example to illustrate this, for every debtor, there must be a saver somewhere, and vice-versa. So when we talk about, oh, we need to get rid of all our debt, well then what are we going to use as saving vehicles if we do that?

Beckworth: And I think it's easy just to think on one side and forget that the other side, and so I think one of the benefits of the sectoral financial balance approach is it does force us to think about the bigger picture and to wrestle with this fallacy of composition.

Thiruvadanthai: Yes, yes. And this also comes back to the, a lot of the fallacies even with respect to government debt, people conflate whether it's a financial constraint with real constraints, right? Which is one of the points that MMT people tend to make is about what is a real constraint of the economy? Is it a real constraint or is it a financial constraint? And most financial constraints are self-imposed.

Thiruvadanthai: Now, that doesn't mean we should have no financial constraints, just like constitutions and supermajority rules are self-imposed constraints, and we need them for some reason. I mean, there is some reason why they work. And so it is not that we should do away with all self-imposed financial constraints, but what we should do is think through them rather than just parrot them as shibboleths without really understanding why they exist and what they mean, you know? And I think that's what is coming out in the last several years now, all of these things are bubbling forth as people are starting to question the paradigm.

Beckworth: Okay, Sri, let me get really into the basics here for people like me and our listeners who may not be very familiar with this sectoral approach to macro. My understanding is that there are three sectors you start with when you are using this approach, is that right?

Thiruvadanthai: That's right. So Wynne Godley and Lavoie have written a book on it, for those people who are interested delving more deeply into it. The sector financial approach is basically, think of it as net lending net saving of each sector or net free cash flow for each sector. And the three large sectors are the government, domestic private sector, and the rest of the world.

Thiruvadanthai: So all of these sectors together, it's a cash flow balance. It basically has to add up to zero. So if one sector is saving, some other sector must be borrowing. And so that's basically the approach. Now, that's the flow part of it. It's also tied to the stock of debt and the stock of assets. So the Wynne Godley approach, that's why they keep talking about stock-flow consistency, is that every flow is tightly related to the stock so that you're not making any accounting error in accounting for these stocks as the flows.

Beckworth: Okay.

Thiruvadanthai: So at the Levy Forecasting Center we make one small amendment to it. What we do is we look at the corporate sector, we separate the domestic private sector into corporate and household sector. And the reason why we do that is corporate behavior, I mean the idea that corporate and household behavior are conflated together and every household is also an owner of a firm is appealing, but that's not how most people behave.

Thiruvadanthai: And secondly, the corporate behavior, we believe that profits ultimately drive the economy. Because in a capitalist economy, it is a desire for profits that drives companies to invest and hire. And so the behavior of profits is central to understanding the business cycle, as well as, of course, understanding the long term evolution of the economy. So that's why we separate those two things out.

Beckworth: And the Levy Forecasting Center was actually pretty spot-on leading up to the Great Recession using this approach, is that right?

Thiruvadanthai: Yes, that's right. David, my senior colleague, David Levy, his grandfather who actually started this whole concept, in fact he discovered this identity before Kaletsky. But basically the family has been using it for three generations to make money for themselves more than selling the forecast or consulting services. They are their own biggest clients.

Beckworth: Huh.

Thiruvadanthai: So David actually had a hedge fund he ran just to bet on the housing collapse, and unlike other people he didn't have any sweetheart deals being able to short lower tranches of the subprime, he did it the old-fashioned way, through the public markets, betting on the Euro interest rates would collapse to zero. So he basically bought out of the money calls on Euro dollars. And he took a fund that was $10 million and made it to $100 million, so basically 10 times return, more than 100 million, I think it ended up being 110 or something like that.

Beckworth: Interesting.

Thiruvadanthai: So that was his bet. And in fact he's been a long-term bond bull since the '80s. So all of that approach comes from both Minsky and in Stein’s insights on balance sheets as well as marrying it to the profits approach.

Beckworth: Okay, and we will provide a link to the Wynne Godley book, because I know that's often talked about as a good source material if you really want to understand this material. But let me just walk through a couple more examples just so this is very clear in our minds what we're saying here.

Beckworth: So if we want to save, and many people do save, right, I don't consume my income right away. For example, my paycheck comes in, it sits at my bank, and maybe I am explicitly saving for the future. I mean, to the extent that any of us save, it has to be offset in someone else's balance sheet somewhere else, is that right?

Thiruvadanthai: That's right. I mean, in conventional economics, saving, it's automatically assumed that whatever you save is automatically getting invested into some capital goods or something like that, right? And it basically flows from thinking about, again, in a barter economy kind of situation. Well, there's no money to save, right? So basically when you are saving, by definition, when Robinson Crusoe is saving corn, it also becomes seed corn. In a sense, it is either inventory or some conscious investment decision that is automatically tied to it.

Thiruvadanthai: And Keynes's key insight was, that's not the case. And when you save, all you are doing is you are deferring consumption. By doing so, when you're not saving, somebody else is not getting income, right? If you had been spending, if you desired to increase your saving, reduce your spending, that means somebody else's income that they were planning on, were expecting, didn't happen.

Beckworth: Okay. Let's take this to the national level and work through some examples with this, again, just to kind of flesh this idea out. So in the late 1990s, the US government under President Clinton and Congress began to run budget surpluses, they were actually bringing in more income to the federal government than they were spending. And therefore they started to pay down the national debt. And that, for many observers, was a great celebrated time, we actually were paying down our national debt. What does the sectorial financial balance sheet approach tell us about that particular incident?

Thiruvadanthai: Right. So if the government is running a positive, a surplus, which means it is now a net lender, not a net borrower, on a flow sense, and it's paying down the debt in a balance sheet sense, so there is two things that is happening, right? So that means if the government is running a surplus in a flow sense, some other sectors must be running deficits. And indeed, the private sector was running huge deficits in the US, right? You look at the corporate sector, was running large, negative-feed cash flows. And the household sector's saving was coming down, the flow sense saving not the savings which is a stock.

Beckworth: Okay.

Thiruvadanthai: The result was, on the balance sheet side, the government was also running down its debt level so the adjustment of the private side was the private sector stock of safe assets, which is government securities, was coming down, and also its debt level was going up.

Thiruvadanthai: Now, from a mark to market sense, the household sector was doing well because the stock market was exploding higher. In a Minskyan sense, the balance sheet was becoming more risky and leveraged because on the asset side you had an incredibly speculative asset going up, whereas you were building up debt on the liability side. And so that's the gist of the danger that was going on in the private balance sheets because of the surpluses. You had, simultaneously, you were reducing the safe assets in the asset side, increasing the speculative assets, and at the same time increasing the leverage on the liability side. And while everything was going up, nobody, of course, cared. But when it came down, you had a big corporate credit crunch in 2000 to 2002.

Beckworth: So let me summarize how I understand what you just said. Since the government was shrinking its stock of debt, that meant that there were fewer assets for households and others to invest in as a safe asset, you mentioned. They went looking somewhere else, so the government's balance sheet was shrinking, someone else's balance sheet had to be expanding to meet the demand for some store of value. And so you have to look again at a bigger picture, look at broader balance sheets.

Beckworth: And I think one of the stories is, is that Wall Street attempted to make some kind of substitute safe asset, and ultimately this leads us up into the housing boom, AAA-rated mortgage back securities, credit default swaps, but what I think you're saying is there's a substitution from the government's balance sheet to the private sector's balance sheet, took leverage off one, you put it on the other.

Thiruvadanthai: You're right. And so that happened after the stock market crash, is suddenly there was, people realized that their balance sheet structure, the asset side was way too risky and so there was a huge demand for safe assets domestically, but even globally, because everywhere we had had a stock market bubble burst, not a bubble elsewhere, but still, it was a pretty big decline. And what happened was, there was also, at the same time, the EM demand for reserves, which was creating another avenue for safe asset demand.

Thiruvadanthai: So although we did, with George Bush cutting taxes we did immediately go back into deficits quickly, it was still not, the supply of safe assets was merely not enough compared to the explosion in demand. And so what Wall Street did was create safe assets, effectively, by taking mortgages and creating CDOs and creating a AAA tranche out of it. And I mean, stepping back, there's nothing wrong necessarily in the private sector creating safe assets. In some way banking is about that, right?

Beckworth: Right.

Thiruvadanthai: Banks create deposits, out of, on the asset side, they hold risky assets, they do create safe assets. Now, here is where the debate about the full reserve banking comes in, we can't get into all of that. But there's nothing wrong with it, the question is can we create it in a balanced way that does not create financial instability? And that is the eternal question about managing for macroprudential arrangements and how do you have balanced growth in the economy along with balance sheet structures that are resilient? And that is really the policy question that has come out of the Great Recession.

Beckworth: Right. Now let me ask this question, if we take this sectoral financial balance approach seriously, and I think it has a lot of great insights and think we should, should we view it as a substitute or a compliment to traditional macroeconomics?

Thiruvadanthai: I would think of it as a complement. I mean, much as I tend to critique the traditional macroeconomics, I think there are great insights in everything and we should be eclectic about what we use and I think that's the ... My approach is we should be using all the tools available and think of it more holistically.

Thiruvadanthai: I want to make one more point, which leads to people like you who are nominal GDP targeters, and I think that the merit to the idea, which many of you point out, is that if you keep up nominal GDP targets, then you would not have financial instability. While I don't completely agree with that, but I think there is a merit to that idea, that if you keep up the nominal GDP target ... I think to keeping up the nominal GDP target though, you do need more resilient financial structures.

Beckworth: Right.

Thiruvadanthai: And you do need a balanced fiscal side doing its job as well. I think it's not enough for just the monetary authority to be able to do it on its own, and I think that's where I disagree with the ... I don't disagree with the philosophy behind the NGDP targeting, I disagree with what are the techniques that you need to be able to get to NGDP targeting, and I think that's where you need an important role for fiscal policy, to be able to achieve the NGDP target.

Beckworth: Yeah. So nominal GDP targeting is really just keep demand growth on a stable path, avoid booms and busts and aggregate demand growth. And so your question is, well how do we do that best? Can we really rely just on monetary policy? And that's where we have some differences, and the implementation issue definitely comes into play.

Beckworth: But let me ask this question, as a ... Again, you don't want to call yourself a post-Keynesian per se, but there's a lot of ideas you do take seriously from them. Post-Keynesians, would they still take the equation of exchange seriously? So in other words it might be fiscal policy, might be monetary policy, might be the mix of both, but at the end of the day we still think, the combination of the stock of money, how often it's used, does drive the growth of spending in the economy.

Thiruvadanthai: Correct. I think that is true. In a broader sense, I think the key difference, again, with the post-Keynesians in some ways, they look at the overall stock of government liabilities and don't like to separate out the money from the-

Beckworth: Okay.

Thiruvadanthai: ... from the bond. Now, the MMT take it to the extreme. Many post-Keynesians, like Tom Pelly, are a little bit more in the middle. They do think that money might be different and monetary policy has its own important role, but there is a greater tendency to view, compared to monetarists which are on one extreme, that money is special, whereas MMT's the other extreme which thinks that all government liabilities should be taken together, looked at it as a consolidated balance sheet, which kind of looks like also the fiscal theory of the price level although--

Beckworth: Right.

Thiruvadanthai: ... I am sure that most MMT people would not like the fiscal theory of the price level. But I guess post-Keynesians are somewhere in between. In some situations, money is important, and in some situations, it's more important to look at it as overall stock of government liabilities including money.

Beckworth: Yeah, so you could think of MV where M is very broadly defined. In fact, going back to Bill Barnett, he has that Divisia M4 measure which includes everything from cash up to treasury bills. And if you look at it, it's interesting, you see that it actually does collapse during the Great Recession, we do see a collapse, it's the institutional money assets that collapse as a part of M4. But yeah, so I understand that, I'm actually very sympathetic to that. You want to think of money more broadly, there's a continuum of liquid assets, not just traditional money as we understand it.

Beckworth: Let me ask this question, just a little pushback I have to give you on the sectoral financial approach. Kind of the mainstream critique, I think, is that we're just doing accounting here, we're not doing behavioral explanations when we do sectoral financial balance approach, so how would you reply to them?

Thiruvadanthai: That is actually true to some extent, that is not wrong. But not being cognizant of the accounting identity leads you into policies that simply are not going to work. For example, let's take expansionary austerity or something like that, right? So what you're basically saying is, the government is now going to reduce its deficit. Okay, fine. So the accounting identity is telling you, even if you do not take it as a behavioral identity, if the government is going to run its deficit, that means some other sectors have to be, they are going to either reduce their surpluses or go into deficit. That's just an accounting fact, it has to be true by definition.

Thiruvadanthai: So then, it forces you to think, who is in a position, whose balance sheets are in a position to be able to do that? Is it the household sector, is it the corporate sector, is it the rest of the world sector? Who is going to be able to do that? Then, you immediately… in the European situation where you saw that how corporations had very high leverage, households especially in Spain and places like that had high leverage with the housing bubble. So you quickly come to the conclusion that oh, that's not possible, which means what is the only other avenue is either the economy is going to shrink or you are going to have current account surpluses, or current account change, which is exactly what they have done. Europe has basically a beg-thy-neighbor approach, and they've all run very large current account surpluses, fobbing off the problem to the rest of the world. That's really what has happened.

Thiruvadanthai: So, but that's what this forces you to think through, is it's a constraint. I mean, Gary Becker said, I think is that if you have, all you need is an ... you don't need any behavioral utility theory of maximization. Most things can just come from basically looking at budget constraints. And think of the accounting identity as a constraint to what are the possibilities?

Beckworth: Yeah, that's a great point. Again, if you force it off one balance sheet, it's going to go onto someone else's balance sheet and the question is, which balance sheet is more robust, able to handle added leverage on it? And that's a great question. So this forces us to think through those realities. And you're right, it's just an application of budget constraint thinking.

Thiruvadanthai: Yeah.

Beckworth: Very interesting. Okay, well let's segue into another area, which actually at least from my perspective does draw upon balance sheet thinking, and this is the safe asset shortage challenge. You've already touched on it with some of your comments, but let me motivate it by talking about some work I've done in the past. I wrote a paper in 2016 with Chris Crowe and I recently did an article for a magazine where I called the US a banker to the world.

Beckworth: And it's not an insight unique to me, it goes all the way back to Charles Kindleberger in 1965 and there's been a number of other researchers who've written papers like this, but the idea is if you look at the US economy as a whole, so the private and public sector consolidated into one entity and you look at the balance sheet they have with the rest of the world, you see that the US economy's balance sheet with the rest of the world looks a lot like a bank's balance sheet, so on the liability side there tends to be more liquid, safe assets. And again, varying degrees, Treasuries being the ultimate, but you can think of private sector repo or commercial paper as well, things that are increasingly less liquid but still liquid enough that the world demands them.

Beckworth: And then the liabilities side, what we owe to the world, what we issue to the world tends to be weighted towards that. On the other side of the US economy's balance sheet, the assets that we own abroad tends to be risky or higher-yielding assets. And for me it was kind of a mind-blowing moment when I first saw this, like oh, that's very fascinating. But it took a balance sheet approach.

Beckworth: But any event, it leads us to this idea that the US is supplying safe assets to the world like a bank does to the local community, it provides deposits, provides money-like assets. And my question to you to start off this conversation is, how did we get at this point? Why do we have a safe asset problem? Is there some kind of long-term structural reason for this? And does it explain the decline in interest rates we see around the world?

Thiruvadanthai: No, this is an excellent question. And this is ... If you go back to the Bretton Woods agreement, what happened was, basically we didn't have any capital flows. I mean, I wouldn't say any capital flows, capital flows were highly restricted and regulated, right?

Beckworth: Yep.

Thiruvadanthai: So essentially, there was reserve demand, and the US supplied the reserve demand at that time through, not by running current account deficits, but by running capital account deficits, right? So what we did was a Marshall Plan initiative, which is essentially giving people US dollars, effectively, in one form or the other. And then we had large aid programs for the developing countries. So that was more driven by, to keep the domestic current account balanced, or at least in surplus.

Thiruvadanthai: And so the need for dollars was supplied through the capital account. But those needs were relatively limited, given that you didn't have huge balance sheets around the rest of the world to be supported by dollar reserves, because capital was not mobile. But after '73, the end of the Bretton Woods, what happened was you moved to a world with increasingly mobile capital. And by 1990 many more EMs were joining and by 2000 a lot more EMs were joining, although not all of them have complete capital convertibility, but clearly they're much more open to capital flows.

Thiruvadanthai: So initially what went from a trade demand for reserves to now a balance sheet demand for reserves, and that is a huge difference. So if you look at most EMs, if you look at their reserve position it's huge compared to some of the traditional measures of reserves with respect to things like, okay, how many months of import cover or how many months of even short term debt cover, all those look probably decent for most of them. In fact, Brazil if you look at it, they have enough reserves to cover their entire foreign debt.

Thiruvadanthai: So that's not the problem. But if you look at it now from their own domestic balance sheets, and if capital is convertible, now most Brazilians or most EM countries, their people are not going to view their own domestic bonds as safe assets. So what they tend to view is either US bonds, maybe German bonds, Japanese bonds, as safe assets, and predominantly US treasuries.

Thiruvadanthai: So now as global balance sheets have grown, because EMs have grown dramatically and importantly their domestic balance sheets have also grown, that demand for safe asset has grown exponentially since the 1990s. That is really the key issue why there is a global safe asset shortage. EM capacity for producing safe assets has not kept up with their growth. Because nobody thinks that the Chinese government bond is a safe asset.

Beckworth: Right.

Thiruvadanthai: Yes it's a safe asset insofar as they're not going to default on their own currency, but people don't think that that's going to, that's where I want to park my portion of my lifetime assets as insurance.

Beckworth: And that's very interesting. I was at a conference recently where Arvind Krishnamurthy presented a paper where he talks about this safe asset shortage, and he makes references to several other papers, and it really made me ask this question: is it inevitable that there will be just one main provider of safe assets? In other words, if we ran the world 1000 times ... Of course we can't do this, but if you had a randomized, controlled experiment you could run Earth multiple times, would it necessarily be the case that you would always end up with a main supplier of safe assets?

Beckworth: Because you could think of, in the future, like you mentioned, where maybe China, one day institutions are good enough that people would hold Chinese bonds as safe assets as well, and this research suggests that because of network effects, because of people wanting to have a highly liquid asset, there tends to be a convergence to one main provider of safe assets, a money of monies, and I wonder I guess in the future if that will hold true.

Beckworth: Now, these are theoretical results, but ... And we've seen historically, right, Great Britain was the main reserve currency country, its safe assets were the main, then it became the US. So an interesting question to me is will we at some point in the future break free from the US being the main producer of safe assets, or are we on a path dependency where the network effects are so strong it'll be hard to break it?

Thiruvadanthai: Right, I mean that's a very, very good question and I don't have an answer for that. I mean I think there has always been a push to find a multilateral solution to this. So if you go back to Bretton Woods, Keynes suggested a bancor. The US of course shot it down. There has always been a wish for a multilateral solution with multiple safe assets. And the financial community always look to the Euro as going to be able to fill that role, and I have seen this for 10, 15 years, every time, "Oh, the Euro is the next great savior," and somehow I remain unconvinced.

Thiruvadanthai: And this is basically the issue comes down to, on the political side, again, do we need a hegemon in the political side? It's mirrored on the financial side, but is there one single provider of safe assets? And I don't know whether I have an answer for that, but the fact is we have not come to ... Yes, we have the UN. But does a multilateral solution really work? I don't know. It depends on people who have critiques of the UN. And my view is, yes, we do need to get from just the financial side to a multilateral solution, but that multilateral solution would have to include, most importantly, equal penalties on creditors, which is countries that run chronic current account surpluses as much as countries that run current account deficits.

Thiruvadanthai: And that's the sticking point that was there in 1944 with Keynes and the Americans, and that continues to be, still, the sticking point. And I do not know whether we will ever be able to get over that. And as far as I am seeing for now, I don't see any way into multilateral solution. Maybe we will get there, maybe my vision is not broad and expansive enough to be able to see those solutions right now. The world as it is right now, I don't think we are getting out of the dollar.

Beckworth: I agree, and Mark Carney gave a talk last week, as you know, where he proposed that the major central banks of the world issue digital currencies, and then on top of that there'd be a synthetic, hegemonic currency, or a new currency to replace the dollar in digital currency. But I really find that hard to believe that would ever happen, for several reasons. One, politically, I don't think the US would give up seigniorage and the prestige of its dollar.

Beckworth: But I think more importantly there's an economic reason why that would never happen. And I was just looking at the numbers today, so if you look at the number of US assets abroad, so that whole balance sheet story I was telling, there's 28 trillion, and this is flow of funds accounting, the national income numbers are a little bit different. But you got up close to 30, and by my estimate, about 16 trillion of that are highly liquid.

Beckworth: So just to be conservative, I could throw the throw the 20 or 30 trillion, I'll be conservative. Let's say there's 16 trillion in highly liquid assets abroad that were issued in the US, dollar-denominated, and the BIS also reports there's another 11 trillion in dollar denominated assets out there that were issued by foreign countries. So you're getting to 27 trillion, and then you throw in another trillion of dollars, we're close to $30 trillion in assets floating around the world that are dollar-denominated. And if you want to be a competitor, you need to have at least that much to offer. I mean, you've got to have a substitute.

Thiruvadanthai: Right.

Beckworth: And it doesn't seem anywhere possible for any entity to suddenly issue that kind of numbers in terms of assets.

Thiruvadanthai: Right, right, absolutely right. And I think this goes back to the fundamental issue with ... That the Europeans, for instance, I don't want to rain on them, but they've not shown leadership in that regard, right? I mean, they've always wanted to say "Okay, the euro's going to supplant the dollar as a reserve currency." But do they have what it takes? I mean, either they have to run current account deficits, which they clearly don't have any stomach for doing, or they eventually have to take up, create central government in Europe that is able to provide either grants to the developing countries or through swap agreements with the ECB to the developing countries, being a lender of last resort, effectively, right?

Beckworth: Right.

Thiruvadanthai: So a lot of the safe asset and reserve demand is driven by the fact that when there is a flight to safety, everybody wants to crowd to something. And domestically we solved the problem so that we don't have bank runs my deposit insurance plus adding a lender of last resort. Who is that lender of last resort in the global community? So if an emerging market is running out of foreign currency, who's going to do that? I mean, ultimately, there's the IMF, but the IMF will be swamped by the scale of the demands that we have. So IMF has not shown itself to be able to do that.

Thiruvadanthai: And so essentially comes down to the US does that role during a crisis by both running its deficit higher, and eventually the Fed eases and creates the dollars that the global system needs in that situation. And I think those kind of roles, imperfectly played, are the problem. You want a much better system than that.

Thiruvadanthai: But I mean, it's easier said than done given the global political environment, with Brexit, with increasing strains around WTO, we already have fraying global cooperation around the existing things and we are thinking about even more ambitious global cooperation. I think for now it's a non-starter. Maybe it will happen sometime later, but right now I can't see how it's going to happen.

Beckworth: And to be fair, this role that we play as the lender of last resort, the provider of safe assets to the world, does come at a cost to the US economy, stronger dollar, which leads to higher trade deficits on balance, budget deficits, and in general a higher, more leveraged US economy, both public and private sector sides of the economy, because this demand lowers financing costs for the US.

Beckworth: So you have these costs we bear, and there's been a recent proposal to do something about it. Now, I think this proposal, my own view is I think it's misguided, it's well-intentioned, but I think it's ultimately misguided, because it could have some adverse effects on the global supply of safe assets. But there is a proposal, a bill that's been proposed by senators Tammy Baldwin, who's a Democrat from Wisconsin and Josh Hawley, who's a Republican from Missouri. So it's a bipartisan bill, it's got a lot of attention, a lot of journalists have been writing about it.

Beckworth: But what it would do is it would tax the foreign purchases of US financial assets, and the goal is to reduce the demand for the dollar, drive down the value of the dollar a little bit, and then that would make the trade deficits smaller, maybe negligible. I mean that's the idea, they have some other parts that really even go farther than that, they require the Fed to do this, to apply this charge in a way that would eliminate, if I understand correctly, the current account deficit over maybe the medium term, five years or so. But the key idea is to tax foreign purchases of US assets like Treasuries, securities, as a way to push back some of that cost that we bear as the banker to the world. And I'm interested to hear your take on that, what do you think it would do?

Thiruvadanthai: It would not achieve any of the purposes that they are saying. And again, this is, again, looking at it from the narrow prism of flows and real economy rather than the overall perspective of balance sheets, and this is where the critical view of balance sheets is important.

Thiruvadanthai: Okay, so the core of the argument is, there is a Dutch disease because the demand for safe assets drives up the dollar and keeps it artificially inflated, which then depresses exports and pumps up our imports and therefore we have this current account deficit. That's fine, that is true. The problem is, now, suppose you make it more expensive for people to own those safe assets. So the US is no longer going to provide safe assets. Fine, so the dollar goes down, and our exports are going to go up, and maybe our imports are going to go down and our trade deficit is going to disappear. Let's say that's the theory.

Thiruvadanthai: Now, let's look at what's happening to the rest of the world. You suddenly made it difficult for them to access safe assets. Does that mean that natural demand for safe assets went away? No. It didn't go away. If demand for safe assets could go away for that easily, then all the world's problems would be solved very quickly.

Beckworth: Right.

Thiruvadanthai: So all those people, let's say the billionaires in China, India, wherever they're living, in those countries, the need for reserves. So you are now saying, okay, you can't hold it in dollar-denominated assets. So what do you hold now? Probably, I don't know. They will probably want to hold gold, I don't know, whatever they would want to hold, gold or anything, those prices of those things will go up, which only will lead to more holding of those things. It is not going to satisfy the actual demand for safe assets. And the contractual impact of that influence is going to actually reduce domestic demand in most of those countries, because suddenly the impact of not having sufficient safe assets is going to make people more risk-averse from the balance sheet perspective.

Thiruvadanthai: And that will reduce lending, that will reduce investment in each of those countries, and we are already faced with a situation where there is a global glut of, a term that I hate to use, a global savings glut. It's not a savings glut, there's a global general glut in production related to demand. And all you're going to do is depress demand even more. So this will be like Smoot-Hawley, effectively. It won't be necessarily as bad, but it would be Smoot-Hawley round two, that's exactly what this would be.

Beckworth: Which is not a very happy thought.

Thiruvadanthai: No.

Beckworth: We want to avoid that, absolutely. Yeah, when I think about this, as you mentioned, there would still be a demand for safe assets, right? I wonder if we pass this bill, which effectively reduces the supply of safe assets we're providing to the world, and people just keep coming to the US anyway. If anything, it's the same amount of demand for a smaller stock of safe assets, which would just drive their price higher, drive interest rates lower, and therefore the negative interest rates we see around the world would be even lower, too.

Thiruvadanthai: That could very well be the case. I haven't thought through that, your argument. I really have to think through that. I mean, that is possible. I'm not discounting it. I mean, it would lead to ... Basically what you are driving at, and which I agree with is that it will lead to perverse outcomes, not the outcomes that the ...

Beckworth: Yes.

Thiruvadanthai: That the people who are promoting this bill think will happen. It's just a very narrow ... They're looking at it from a very narrow perspective.

Beckworth: Here is one example that may or may not be useful in thinking through this, right? So again, the way I look at this bill is it effectively reduces the supply of safe assets. Have we seen any other period in which this happened? And I would argue we have. We saw this in the Great Recession, the financial crisis. So the US was providing safe assets, Treasuries as well as other safe assets, private label safe assets, so some of those mortgage-backed securities, CDOs you were talking about.

Beckworth: And for a while they were viewed and treated as safe assets, and then suddenly they weren't, right? So suddenly there was a huge decline in the stock of safe assets, there weren't as many mortgage backed securities that were rated AAA anymore. And so what happens? So we effectively saw a reduction in supply of safe assets, what happens? There's a race to Treasuries, race to really safe assets, whatever's left. And that drove the value of the dollar up and lowered interest rates. And I just wonder if that experience might be useful in thinking through what could happen with this bill.

Thiruvadanthai: Right, so we might get more deeply negative interest rates in the US. Yes, that's an excellent point, the Great Recession is a perfect example. Suddenly you took away a huge supply of safe assets, and also, first of all it plunged the global economy in the worst crisis of the Depression.

Beckworth: Yep.

Thiruvadanthai: And I would say the rest of the world is in worse shape today than it was in 2008. Back then, the EMs had the capacity to run countercyclical policies. They don't have that now, I would say. So we will get into a worse mess today. And yes, what you're saying, I agree with you, and I think it will only lead to more perverse outcomes than what these people are thinking.

Thiruvadanthai: In fact, if you're thinking about it, people want that safe asset, they can't access enough of it, but the liability structure is still there in terms of the dollar-denominated liabilities that are there around the world. So there's still a huge amount of demand for dollars, it might only drive the dollar up more than drive it down.

Beckworth: Yeah, you might actually see more dollar-issued securities overseas, more euro dollars, more dollars issued by other countries, dollar-issued securities outside the US, which itself would then create additional burdens, because now they have currency mismatch issues on their balance sheets.

Beckworth: So I guess my question then is, I want to be fair and acknowledge this does impose a cost on the US economy, there's no doubt about that. But I think both of us agree, the alternative is even worse. If we were to try to apply this bill. So what would be maybe a better solution? I mean, are there any other things we can do to ease the pain of the cost of being the banker to the world?

Thiruvadanthai: I think one ... My preferred solution, but again, this requires some multilateral cooperation.

Beckworth: Okay.

Thiruvadanthai: Is that the Fed should effectively, if we are going to have free trade with any country, the Fed ultimately has to be the banker of last resort for that country as well. Which means the Fed has to provide the dollars on demand. If it doesn't do that, then we really cannot have free trade with that country and free capital flows with that country, that's really the problem.

Thiruvadanthai: And so what this really forces us to think through alliances, the countries that we want to be doing free trade with, are we comfortable providing them dollars on demand? So who is this coalition of the willing that we are going to have? And that's the only way to get out of the exorbitant privilege, and ... So, because when I propose this idea of the Fed providing unlimited swaps to EMs and somebody said "Would you want to do that to China?" And "Would you want to give" ... So I said "That's the political question that we have to decide on, who are the countries that we want to provide this with?"

Thiruvadanthai: And the other side of the question is only those countries that we are willing to provide those with are the ones we can actually afford to have free trade and free capital movement. We cannot really do it with anybody else, that's the real constraint there. Otherwise you're going to have to live with this Dutch disease problem like we have lived with for the last 20, 25 years, and we'll continue to do that. I mean, those are the two solutions in my mind.

Beckworth: That's interesting. So you're suggesting if we have a trade agreement with another country, part of that trade agreement would be that we commit to a permanent currency swap line like they did in the Great Recession?

Thiruvadanthai: Right.

Beckworth: Okay. And just for the sake of our listeners, explain to our listeners what that would, what is a currency swap line?

Thiruvadanthai: So if there is a dollar shortage in the respective currency in the country and there's a huge demand for dollars, and there's a run on their reserves, we would supply them with dollars on a swap basis, the Fed would supply, so that it's essentially preventing a bank run.

Thiruvadanthai: So what that would do is two things: it would make them not need to hold a huge amount of reserves, number one. Number two, it would also make their own treasury securities more quasi-safe assets, thereby alleviating some of the pressure on the Treasuries being the only real safe assets, and also thereby reduce the Dutch disease on the dollar.

Beckworth: Interesting. Hadn't thought of that, yeah.

Thiruvadanthai: Yeah, that is the solution. But it is an enormous political thing that you are going to be willing to provide, we can't escape the political issue there. Who are we willing to provide dollars on demand?

Beckworth: Right. Very interesting idea though, and I see your point. The swap lines would effectively turn the domestic assets, say if it's Mexico ...

Thiruvadanthai: Right.

Beckworth: And make them seem more secure. So in theory, if there was a run on the Mexican banking system, the Bank of Mexico coming to the Fed, get all the dollars needed to meet the demand. But just knowing that that's available would minimize the chance of a bank run in the first place.

Thiruvadanthai: Yes.

Beckworth: Okay. Wow. So this would be a lot like, if I'm thinking through this correctly, like the burden that Germany feels for the Eurozone.

Thiruvadanthai: Right.

Beckworth: The US would feel that for the world. I can imagine the political blowback this would create here in the US.

Thiruvadanthai: Right, I mean that's the whole point. All of these are, we don't take any political position, we are still taking a political position. There is a status quo, which is clearly moving-

Beckworth: Right, yeah, absolutely.

Thiruvadanthai: ... So we have a lot of thorny political questions that we have to deal with, and the answers to that cannot be purely technocratic. The technocrats can provide the set of solutions, but the answer has to ultimately come through politics. We cannot wish that away. As Samuel Huntington said, we need politics, we just can't wish it away at the end of the day. And I think we are at the juncture here.

Beckworth: Yeah we are, for sure. I think the rise of populism is a manifestation with some of these costs we've been talking about. Maybe we're not putting our fingers on the cost as a body politic properly. We know something's wrong, we're just not clear how to address it and populism is one approach that's been tried. Well, our time is up. Sri, thank you so much for coming on the show.

Thiruvadanthai: Thank you so much David.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. And while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

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