Marc Lavoie on Canadian Central Bank Policy, Real-time Payments, and the Post-Keynesian Tradition

Should the Federal Reserve emulate Canada in respect to the central bank’s operating system?

Marc Lavoie is a professor of economics at the University of Ottawa and the author of a recent article on the Bank of Canada’s operating system. Marc is also the coauthor of a popular textbook titled, Monetary Economics: An integrated Approach to Credit, Money, Income, Production, and Wealth. He joins the show today to talk about these works and more. David and Marc also discuss differences between post-Keynesian and mainstream macroeconomics, the history and defining characteristics of Canada’s corridor operating system, and what ideal central bank policy might look like for Canada in the future

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

David Beckworth: Our guest today is Marc Lavoie. Marc is a professor of economics at the University of Ottawa and an author of a recent article on the Bank of Canada's operating system. Marc is also the coauthor of a popular textbook titled Monetary Economics: An Integrated Approach to Credit, Money, Income Production, and Wealth. Marc joins us today to discuss these works. Marc, welcome to the show.

Marc Lavoie: Yes, thank you.

Beckworth: I was excited to come across your article on the Bank of Canada's operating system. As you know, Marc, we've been discussing operating systems on the show already. It's been a hot topic down here in the US, with the Fed's operating system, some of the challenges they have.

Beckworth: And so, it was great to find someone who's written a detailed article on what Canada is doing, because Canada seems to be doing it right, whatever they're doing, or at least doing it better than we are in the United States. Also, your textbook, I've had many listeners actually write in or call in and say they want to have you on the show because you've got a pretty well-known textbook. And so, I want to get to both of those on the show. Now, I also understand, Marc, that you are a former Olympic fencing athlete. Is that correct?

Lavoie: Yeah, that's right. I was at the Olympics in 1976 in Montreal, and in 1984 in Los Angeles.

Beckworth: Wow. I think this is the first time we've had an Olympic athlete on the show, so it's pretty awesome.

Lavoie: There's always a first.

Beckworth: Yeah. You're an Olympic athlete and you're a fairly well known macro economist. You don't get that combination very often, if ever. So, thanks for coming on the show, and before we get into your material and the work that you've done, tell us a little bit about your journey. How did you get into macroeconomics?

Lavoie: Well, my father was an economist. He was a representative for Canada at the trade negotiations in the late 50s and in the 60s. So, that might be the reason I got interested into economics, and yeah, I thought macro was more interesting than micro, because macro dealt with these big questions such as money, unemployment, inflation, and so on.

Beckworth: Yeah, and you come from a country that has, in my view, done relatively well compared to the United States on many of the questions we look at in macroeconomics. So, for example, during the Great Depression, I understand Canada had a Great Depression, but they didn't lose banks like the US did. And they've had a relatively resilient financial system compared to the US, and that their monetary policy seems to be doing better. It seems on many fronts, Canada has done a better job, at least it looks better and it seems easier, than what we've dealt with in the US. So, I'm thrilled to get a macro economist from Canada on the show to talk about it.

Beckworth: Now, I want to begin with your paper on the operating system in Canada, and the title of it is, *A System of Zero Reserves with Clearing Outside of the Central Bank, the Canadian Case.* We'll provide a link to it on the webpage for the show. And again, the reason I want to talk about this is that the bank of Canada makes it look so easy when it comes to operating systems, and you compare that to what we've had in the US, it's just remarkable. And we're going to go into great detail here in a bit, but so many things about the operating system there are just so fascinating. You mentioned in the introduction, very few reserves or settlement balances, as you call them, are actually using the system.

Beckworth: The system is cleared outside the central bank through a private clearing system. The central bank doesn't have to intervene that much actually to hit its target. In fact, it hits its target rate, the overnight rates track the target rate very closely. They do a relatively good job, and again, compared to the US and the floor system, which was supposed to increase interest rate control of the Fed, the corridor system in Canada has done a much better job. In fact, I always use Canada as kind of a benchmark case for what a corridor system could be, and Canada has a symmetric corridor system. The US had an asymmetric one before 2008.

Beckworth: So, just to be clear, those of us here in the US who would like to see the Fed go to a corridor system, we mean something like Canada as a symmetric corridor system. Interestingly, Canada, they had a corridor system before the financial crisis. They temporarily went to a floor system, and then they came back to a corridor system. So, it's possible. There's lots of questions I have, so we'll get into them as we get into to your article. But I'm just wondering from your perspective up North there in Canada, looking down here at the US, or do you ever wonder why we struggle so hard with our monetary policy and our operating systems down here?

Differences Between the US and Canadian Banking Systems

Lavoie: Well, I think that perhaps the main reason is a simple one, is that in Canada we only have about 15 direct clearers or banks that are involved with the clearing and settlement system. So, things are much simpler than they can be in the United States. We don't have foreign central banks who wish to hold the deposits at the Fed or at the central bank. So, it's true, I mean, as you explained, it is true that we have a good clearing and settlement system in place. But I'm not sure that it would be possible to implement exactly the same thing with as much success in the United States simply because you have many more banks and a much more complicated system as far as I can understand.

Beckworth: Yeah, that's kind of been the answer I've gotten too, is banks down here are very different. That's kind of a defining characteristic of the banking system. It's very diverse. There's many, many banks, very different sizes, and in the case of reserves or settlement balances in the US, only a few big ones hold most of what's left. One of the issues during the repo market crisis, "Well, where are they sitting? Who's holding them? Are they distributed evenly or not?" And so, it's true, and I've heard this as a critique against Canada, that Canada has a more concentrated banking system, but the tradeoff is you seem to have had a better experience with financial stability.

Beckworth: So, do you view that as a good trade off? It's more concentrated, the banking system, on one hand, but on the other hand you seem to do better financially?

Lavoie: I think so. If you take the European case, you can see there's a lot of competition out there, and their system is also pretty fragile. Later, we'd be talking about Post-Keynesian theory.

Beckworth: Yup, absolutely.

Lavoie: But I think one of the beliefs among us is that full out competition does not necessarily bring more stability. So, I think the banking system is a good example of that.

But I think one of the beliefs among us is that full out competition does not necessarily bring more stability. So, I think the banking system is a good example of that.

Beckworth: So, it's a good trade off. And again, just to reiterate some of the facts from Canada during the Great Depression, which Canada also experienced, zero banks were closed down. That's what I've read in several places.

Lavoie: Yes.

Beckworth: Now, there were some consolidations emerging that had to occur, but zero bank shutdown in Canada where we had around 9,000 in the US. Part of the problem in the US is I wouldn't ... you attribute it to competition. I attribute it to unit banking laws. Many of these banks were only allowed to have one branch. They couldn't diversify. I know in Canada, for example, because you have so few banks, they have branches throughout the country, so they're more diversified, portfolio of assets are better. So, there's just many things they did right that we haven't done right in the US, and maybe we can't replicate it. Maybe it's impossible to turn back the clock and get something like Canada. But I do think we can do better.

Lavoie: During the Great Depression you had, in the US, you had these laws where banks could only be state banks, they could only be in one bank. So, of course, you couldn't have the spread in deposits and loans. But during the Great Depression in Canada, the belief is that many, perhaps all of our banks, were insolvent, but because nobody ever said anything, then they just keep on going until things got better, and they became solvent again.

Beckworth: Yeah. Well, there's lots to learn from Canada's experience. What's interesting, also, you mentioned you’re a post-Keynesian, and we'll talk about that second half of the show. So, there's been a number of us here in the US who've been advocating or would like to see the US move to something more like a corridor system, a symmetric corridor system. And the people I see promoting it the most are people like myself, George Selgin, Bill Nelson, people who kind of…mainstream macro folks. But I've also seen a lot of post Keynesians, that they point to Canada as a better example of how an operating system should work. So, it's an interesting convergence of some different views, and maybe we'll come back to that later as well. Go ahead.

Lavoie: Well, on this issue, I personally believe that the floor system can be just as efficient as corridor system.

Beckworth: Oh, you do?

Lavoie: Yes. I don't think one is necessarily or has to be better than the other. Up until very recently, the floor system in the US worked quite well. The actual federal funds rate or the repo rate was very close, was inside the target. So, I must say, I discussed this with a PhD student of mine and we were trying hard to figure out why it is that the repo rate went out of where it should have been. But anyway, you could see also everybody was very worried around Christmas time, what would happen to the repo rate, or the fed funds rate, and everything was under control at the end of the year.

Beckworth: Yeah. Well let me respond to your point that a floor system could work well, and I know in textbooks it's true, that a floor system in theory should work very, very well. In the US, what I saw was that they implemented the floor system, but it became a leaky floor system. They had to put the overnight repurchase agreement in because rates were falling below the target rate. So, they had to make it up as they went along to keep it working. It was kind of a patched up floor system. Again, maybe this goes back to the issue raised earlier, that our banking system is so unique, so heterogeneous that maybe that was inevitable.

Beckworth: But I like to believe there's a way to make things simpler moving forward. But let's move on to your article, because it's a really great one. It's a great look at Canada. And I want to mention also real quickly, Marc, that I was at the American Economic Association meetings here in January. I went to a session where the Deputy Governor Carolyn Wilkins was there from, the Bank of Canada. There's a time where you can ask questions from the audience, and I was able to ask her, "So, what is it that you guys do that makes it seem so easy compared to what we do here?" And she gave answers that line up nicely with what you gave in your article.

Beckworth: So, it's a nice segue, nice motivation into your article. So, let's just jump into your article. And again, the title of the article is *A System with Zero Reserves and with Clearing Outside of the Central Bank: the Canadian Case.* So, tell us about what this is and how did Canada get it? What's the history behind Canada moving towards this system?

History of Canada’s Operating System

Lavoie: Well, I think we can say it all started at the end of the 1980s. There were two civil servants or two central bankers who came up with a zero reserve system. So, their names were Donna Howard and Kevin Clinton. As I said in the paper, I remember very well because I was present at the very first presentation on the possibility of a zero reserve system, and then gradually it got implemented. So, by 1994 the Bank of Canada had got rid of compulsory reserve requirements, and then gradually, they introduced the corridor system. At the same time, they also introduced a more sophisticated clearing and settlement system with the Canadian Payment Association.

Lavoie: So, that regroups the main banks, and yeah, by 1999, so 20 years ago, the system was fully in place. And so, what we have now in Canada, 20 years later, is the same as what was put in place in by 1999.

Beckworth: Yeah, that's an interesting story on one level, because it tells how two economists can be very influential in changing opinion and leading people down this path. So, are these individuals still there or are they still working at the Bank of Canada?

Lavoie: No.

Beckworth: Okay.

Lavoie: Well, Donna Howard retired just a few years ago, and Kevin Clinton much earlier. But the funny thing is that at some point I asked Kevin Clinton, where did he get the idea of this corridor system and so on. And he said he got it from the Bank of Sweden. But when I checked what or when the Bank of Sweden implemented such a system, it was after the Bank of Canada.

Beckworth: Huh, who went first, huh?

Lavoie: So, we don't really know where the idea came from except perhaps it came from their minds.

Beckworth: Yeah. No, it's a fascinating history, and again, the influence of ideas, economists can change policy, and two individuals worked hard, and they changed the direction of the Bank of Canada, and the Bank of Canada had an amazing success with the system. Now, let's go over kind of the highlights of it and then we'll dig down deeper into each of them. But you list like, I think it was 10 characteristics that make it unique. So, why don't you just go over those 10 characteristics, how it's unique and kind of different than other central banks.

Ten Characteristics That Make Canada’s Operating System Unique

Lavoie: Okay. Well, the first one we already discussed, there's no compulsory reserve requirements for Canadian banks. Usually, reserve requirements are there to smooth the overnight interest rate. But if you have a proper corridor system, and enough certainty, then as we have found out over the last 20 years, the behavior of these overnight interest rates can be quite smooth despite having zero reserve requirements. The second thing is that, in contrast to what is the case in England or in Britain, the Canadian banks don't hold precautionary reserves at the central bank. So, this helps a lot because the Bank of Canada knows, so to speak, that the demand for reserves is indeed zero and not some positive number.

Lavoie: So, I've been told that in Great Britain, it's not like that. Third, the third point is that all payments go through a clearing house, which is privately run. As I said, it's run by the Canadian Payments Association, and it's not run on the books of the Central Bank. So, I believe that this is also something quite different. However, settlement occurs on the books of the Bank of Canada, just like in other countries. The Bank of Canada is a participant to the clearing house. Then, we get into the issue, and when I was working on this about 10 years ago, I was always wondering, is the Canadian system a gross settlement system or is it a net settlement system? Well, it is both.

Beckworth: Yeah, that was interesting. I read that. I was surprised.

Lavoie: Yeah, it's both in the sense that it is certainly a net settlement system, because all the netting is being done at the clearing house, but at the same time, when a payment goes through, so when there's some payment that clears, it's definitive. So, at the same time, it's a real time settlement system. The banker knows that when he or she receives a payment, it's good. Another difference ... and that's unique, it's unique to Canada. That's really unique. Then, in Canada, our overnight target rate is a collateralized rate and not an uncollateralized one like in the US, and the overnight interest rate is always very close to the target.

Lavoie: I was checking the day before yesterday, and in Canada right now the target is 1.75, and the number was always, the last few days, has always been one 1.74, 1.745, so it's less than one basis point from the target. As you mentioned at the beginning, this is achieved despite the fact that there's hardly an intervention by the central bank in the repo market and/or with other kind of open market operation. And so, the main tool for the Bank of Canada, and it's been like this for a long time now, is by moving around the bank deposits of the government from either the central bank to the commercial banks, or from the commercial banks to the central bank. That's their main tool, and the numbers change substantially.

And so, the main tool for the Bank of Canada, and it's been like this for a long time now, is by moving around the bank deposits of the government from either the central bank to the commercial banks, or from the commercial banks to the central bank. That's their main tool, and the numbers change substantially.

Lavoie: That's also something I checked the day before yesterday. The numbers can be huge to compensate for either taxes coming into the account of the government and to central bank, or the government making payments for its expenditures. Finally, another key difference is that in Canada, in contrast to almost all of the other countries in the world, the Bank of Canada buys on the primary market 10 percent to 20 percent of the issues of treasury bills or government bonds that are made. So, whereas in the States, as I understand it, the Fed buys them on the secondary market only.

Beckworth: Yeah. That last feature was really remarkable. I had George Selgin on maybe a month ago or so in the show and one of the proposals out there is to get a standing repo facility. And George has proposed opening it up to the treasury or having the treasury, at least in times of crisis, being able to directly interact with the Fed, the central bank, and in many places, like you said, that's not the case. Where in Canada, it's been standard operating procedure for some time. So, that was really surprising to learn as well. Again, maybe there's some lesson there for other central banks.

Beckworth: Now, I want to come back to one of the, I think key elements of the Bank of Canada's operating system, and this is the large value transfer system, or the clearing house that does all the clearing of payments. Now, you mentioned there is another payment system but the large value transfer system, and the acronym is LVTS-

Lavoie: LVTS. Yes.

Beckworth: Yes. The LVTS is the main payment system, it's like 90 percent of all transactions. And you mentioned the other one, it's smaller retail payments, and they eventually would get processed, too, under the same system. So, is it fair to say this is kind of the backbone, the key part of what makes the Canadian system work so well?

The Importance of the Large Value Transfer System

Lavoie: Maybe, because as I said, I'm not too sure about the American system, but I remember when I was reading about it, people from the Fed or scholars complaining that in the US there is always the issue of the float, the so-called float. So, I don't know if it's an issue still, but in the papers that I read at the time it was. And that meant that it was always possible for a bank to get debited on a payment, whereas the other bank would not yet get credited for it. And so, this may happen in the ACSS, in the secondary payment system, but it never happens in the LVTS. So, in Canada the float is not an issue whatsoever.

Beckworth: Yeah, I think that is a key issue here in the US, and in fact, we've had a show talking about this because the Fed has indicated it's going to pursue a real-time payment system. But this real-time payment system is going to take maybe five years it says, or longer, we don't know for sure. But the existing payment network, the legacy payment network that the Fed has, it's not a 24/7, 365 day year operation. So, they have like the Fedwire, they also have the National Settlement Service. These are multilateral settlement services owned and operated by the Fed, but they're not available all the time.

Beckworth: They shut down on holidays, they're slow, and so it is a big deal here. We've had Aaron Klein on the show, George Selgin too, and that they all talked about how your payment, and when it actually clears can be several days. In Canada, it's a same day clearing. Now, you mentioned it's a hybrid system.

Lavoie: Yeah. In the LVTS, it's the same day.

Beckworth: Yeah.

Lavoie: In the other system, there's a one day lag, but it doesn't matter because as you said, eventually, all the balances, positive or negative, have to go through the LVTS. So, there's no float. As far as I understand, there's zero float in Canada.

Beckworth: Yeah. So, this is a way to minimize the need for settlement balances, number one. I think from the macro perspective, that's what's interesting to us, is what would be the demand for settlement balances if you had a more real-time payment system? But number two, from a kind of a consumer's perspective, it's nice to get payment immediately. If you're a lower income person and you can't use your funds immediately, that becomes a big deal here in the US. So, it's something that the Canadians don't deal with. But again, it's interesting, this other point about the LTVS is that it's this hybrid system. It's both a net and a real-time gross settlement system.

Beckworth: It's a bit of both, and my understanding is the reason it has elements of both is that it gives you the speed, kind of a real-time payment, but it doesn't require all the collateral because you're still netting it. It's still kind of … it's less collateral heavy compared to a pure system.

Lavoie: Yeah, because it's net, there's a lot less collateral being involved, and because it's in real time, and because there's no float. There is no uncertainty about what is your position in the clearing house, whether you have positive or negative balances. It's the same for the Bank of Canada. I think this is something I emphasize a lot in the paper. It's this issue of certainty, is that by the time the clearing and settlement system closes down, each bank knows exactly what its position is in the clearing house, and the central bank knows exactly what is its own position overall in the clearing house.

Lavoie: So, it can decide how much of its government deposits it has to move to the commercial banks, or vice versa, going the other way, how much it has to move in order to achieve overall a total amount of settlement balances that will be exactly equal to zero. Well, in reality, it's not exactly equal to zero. It's always $250 million, but it's like nothing, overall.

Beckworth: Yeah. Now, I've heard that the Bank of Canada or the Canadian Payment System is going to eventually move to a full or pure real-time gross settlement system. Is that right? Are they going to transition out of this LVTS?

Lavoie: I didn't hear about this.

Beckworth: Okay, maybe I'm mistaken.

Lavoie: Because there's a lot of talk about blockchain and all that, and from what I read, the belief was that the LVTS is working so well. There's no point in trying to implement such a thing.

Beckworth: Yeah, I'd hate to ruin something that's working really well.

Lavoie: Yes.

Beckworth: Now, I want to go back to, again, thinking about this in terms of what would it mean for the US. Now, as I mentioned earlier, I was able to ask Deputy Governor Carolyn Wilkins at the meetings this year. I asked, "How do you guys do it? How do you make it look so easy?" One question I kind of followed it up was with, especially in light of Basel III, which has all these requirements for leverage ratios, and capital adequacy, and all of these new regulations have come online, and she made a couple of points. One of them, I understood, the other one I'm still wrapping my mind around, but one of them is she's made this point that banks in Canada simply have never been used to operating with lots of settlement balances.

Beckworth: They're used to operating with very, very few, and you create that habit, you create that culture. It's easy to go from, in 2009 it went from a corridor to a floor. It was easy to go back to a corridor because that's what they knew, and had been used to it for some time. She also mentioned that one reason it was easy to go back to a corridor system is because the Bank of Canada didn't really ever do QE like the US. Its balance sheet expanded but only for liquidity or credit easing conditions. It wasn't doing outright QE like the US, especially on the scale of the US. So, that also made the transition easier.

Beckworth: But I do think her point about not being used to lots of reserves is an important one. Bill Nelson, who's a previous guest on the show and he's thought a lot about this issue, he made a comment at a conference down here at Brookings on the repo market crisis that really resonated with me. He made this point that he had talked to some of these big banks in New York City that are sitting on these reserves, and he asked them, "Why didn't you lend these reserves out when you could have earned money in the overnight markets?" So, banks were earning close to two percent, overnight markets yields got as high as 10 percent, and they said, this is what they told him, they said, "Yeah, we could have made some quick money had we done that.

Beckworth: But if we had done that, it's so different than what we've done in the past 10 years." The past 10 years, at least since 2008, they've had lots of reserves. Bank supervisors expect them to have reserves. And if you do something very different than what you've done, there's this kind of new culture that's kind of set in since the crisis that anything radical or different, it would have brought the closer look of a bank supervisor, and it just was too risky to rock the boat. So, Bill Nelson's point I think is that there's a difference between, in the US, difference between long-run demand for reserves and short-run demand. So, here in the short run, banks don't want to veer away from reserves because that's what they're used to.

Beckworth: It's what the regulators are used to. But maybe in the long run they could shed some and become more like Canada. The question then ultimately becomes though, they may not be a complete replication of Canada because of what you mentioned earlier, the smaller set of banks, and there's really much more diverse banking system in the US, but maybe we could get part of the way there.

Lavoie: Yeah. Well, coming back to what you said about QE in Canada. Yeah, we did not have QE in Canada. As I said, right now, okay, we talk about zero reserves, but in fact, there's a little bit of it. The Bank of Canada always leaves currently $250 million. So, one could say that's the amount of reserves in the system, but it's tiny compared to transactions every day, which are almost $200 billion per day. So, it's like zero. When things got really bad in 2008, 2009, the largest amount of reserves that we had was 3000 million dollars or $3 billion. So, this was only 10 times more than the small amount which is currently in place.

Lavoie: So, as you said, we did not have QE, so it was really easy to move to a floor, but that was enough to have a floor system. Then, it was really easy to come back to the corridor system because going from 3000 to 500, or 3000 to 250 million was a very small change, in fact.

Beckworth: Yeah, and it didn't last very long either. So, I think in 2010, so it wasn't very long lived.

Lavoie: Yeah, just about a year or something like that.

Beckworth: Yeah. So, again, to flesh out this point by Bill Nelson, banks didn't get used to it. It was a short experience. They didn't get used to it. They were used to operating with the smaller amount of reserves. So, in the case of the US, many of the regulations here, so you can, for regulatory purposes, you could hold like treasury bills or you can hold reserves. But we held them for so long, for a decade in the US, the banks, they don't know. It's kind of a status quo bias. It's inertia. So, one of the reasons for people calling for a standing repo facility is to make it easier for banks to unload those reserves and just hold treasuries.

Beckworth: But in the meantime, it's hard for them to break old habits. So, it's just interesting to see, you can do things very differently with a different setup, different system, different environment, and again, a different experience. To be fair, again, Canada only had a very brief, brief experience with the floor system. Now, I want to go and just talk about the implementation of monetary policy there, so, when the Bank of Canada changes this target rate. We touched on this earlier, the bank doesn't really have to do that much, right? It doesn't have to step in and do a whole lot of open market operations or repos. The corridor itself kind of does the magic for them, or the expectations, how would you explain it?

How the Bank of Canada Implements Monetary Policy

Lavoie: Well, exactly as you say, the bank does nothing on a quantitative basis. It doesn't change the amount of settlement balances or reserves in the system. It just says, "We have moved up or down the corridor." And the overnight rate adjusts right away. It's announced in the morning and that's it. The overnight rate will move towards the new target. It's because the bankers know that the central bank, the Bank of Canada, has the ability or the power to move the actual overnight rate towards the target if it wasn't already there. So, they know what the target is, they figure that it's going to be implemented, and therefore, they go with the announcement.

Beckworth: Yeah. Don't fight the central bank. It's a losing battle.

Lavoie: No, they don't try to do that.

Beckworth: Alright. Well, what are your thoughts on the future of the Bank of Canada? I know we want to move onto to your work on post-Keynesianism, but we're about halfway through the show and I'm curious, if you could wave a magic wand and have the Bank of Canada do anything differently, what would you have it do? Would you have it change its target or would you have it do like level targeting versus inflation targeting? Would you do anything differently? What would you prescribe?

Ideal Future of Canadian Central Bank Policy

Lavoie: Well, it's true that every five years there is a new discussion, there are discussion papers by the central bank trying to figure out, should they move to a new kind of target, or should there be two targets? Like in the United States, you're supposed to have an unemployment target. Well, not a target, but both the inflation rate and the unemployment rate are supposed to be taken into consideration. So, yeah, in Canada we have had the inflation rate target since 1991. Every five years it was discussed again, every five years the Bank of Canada has decided, "Okay, we'll stick with the inflation target."

Lavoie: There's always some people who say, it should be a price level target, but they pretend that it would be more efficient. But these claims are based on abstract models that have nothing to do with reality… models, where there's no bank, or there's hardly any money. So, I think the discussion right now could be whether the Bank of Canada should have more than just an inflation target and have a dual mandate, so to speak, with both, taking into account unemployment. So, I think that's the discussion that will happen over the next few months.

Beckworth: Yeah, so a dual mandate for the Bank of Canada like the US has. So, I know in New Zealand they had a pure inflation target, and they've moved also to dual mandates, so maybe also in Canada in the future.

Lavoie: Yeah, exactly. Actually, if you look at the… it seems to me, looking at the behavior of the Bank of Canada since the subprime crisis, and it seems that this is what they have been pursuing because the target rate of interest, 1.75, is very low when you consider that the rate of unemployment in Canada is at its ever lowest. So, it seems to me that in practical terms, the Bank of Canada has been pursuing a dual mandate despite not announcing it officially. So, why not go for it officially?

Beckworth: Yeah, sure thing. Well, if people at the Bank of Canada are listening, you've heard Marc's suggestion, so maybe they'll follow up in this next review. Alright, let's switch to post-Keynesian economics. So, again, you have this book that people have repeatedly told me to get ahold of, and it's called *Monetary Economics: An Integrated Approach to Credit, Money, Income, Production, and Wealth*, and your co-author is, Wynne. Is it Wynne? Wynne Godley?

Lavoie: Yes.

Beckworth: Yes, so this is a book and I looked at it, and I've had a previous guest on, and we talked about the sectorial financial balance sheet approach, but your book is both, not just balance sheets, but it's also including, you call it transaction flows, or incomes, as well as the balance sheet, but very detailed post-Keynesian approach to macro. Maybe before we get into all of that, maybe you can just kind of step back and say what is post-Keynesian economics and how is that different than mainstream macroeconomics?

Contrasting Post-Keynesianism and Mainstream Macroeconomics

Lavoie: Well, I think the difference is about realism. Those DSG models, which are at the core of mainstream economics, are full of crazy assumptions. So, in a sense, this post-Keynesian economics looks a bit like what used to be mainstream macro in the 60s. So, we don't use these assumptions about a representative agent, which would be maximizing utility, or firms maximizing profits. So, we don't believe in those assumptions. Then, to this, we add things such as markup pricing by firms, firms setting prices on the basis of their unit costs. We always had this idea of money being endogenous with the central bank having as a target, an interest rate and not a stock of money.

Lavoie: So, post-Keynesians, have been talking about this since the late 1960s, and we always kept those ideas. Whereas, as you know, mainstream economists now are also adopting the idea that the central bank has an interest rate target, but for a long time, they were close to the monetarists, and so on.

Beckworth: Yeah. Go ahead.

Lavoie: I should add that there's a link between modern monetary theory and post-Keynesians economics. One could say that modern monetary theory, on some features, is an extreme version of post-Keynesian economics, but the people who are advocating, the scholars who are advocating modern monetary theory, were originally post-Keynesian economists.

Beckworth: Yeah, and you mentioned, just to flesh out the history of this, you mentioned in your article, well, actually, in the first chapter of your book, you mentioned some of the original post-Keynesians were those people who maybe knew Keynes, they had worked with him at some point, with Joan Robinson, Richard Kahn, Nicholas Kaldor, James Meade. Interestingly, James Meade is someone who advocated nominal GDP targeting or something like nominal GDP targeting. Now, of course, he comes from a perspective of using fiscal policy more to get that nominal GDP target, but he's very much about stabilizing demand and being explicit about it.

Beckworth: Here's the question I have for you, would you consider James Tobin, because you talked about him in your chapter, would you consider him a quasi-post-Keynesianist?

Lavoie: Well, he certainly is a Keynesian, and he was very much opposed to Robert Lucas, the New Classicals, the Real Business Cycle in macroeconomic theories. With respect to portfolio theory, we're using many of his equations or ideas, and so there is certainly a good link between what James Tobin was doing and what Wynne Godley and myself did in the book. The difference is that on some issues, James Tobin was still very much neoclassical. This is what we would consider, we would say, "Well, he still had an idea about some exogenous stock of money out there." Things of that sort.

Beckworth: Okay.

Lavoie: In the book, we have a whole chapter at the end where we explained the differences between our approach that we have in the book, which combines the real side and the monetary or financial side, and James Tobin's work in the 70s and 80s, where he was trying to do the same thing. But in our view, with some overly mainstream assumptions, not always realistic.

Beckworth: Okay. Well, let me ask this question about post-Keynesianism. So, one of the things I've learned from the MMT School, in terms of their beliefs, is they have a very different view of what is inflation, what's the inflation, what causes inflation. In particular, they see it as a power struggle between labor and capital, and as a consequence, it's easier for them to motivate wage controls, price controls, even credit controls, as a way to control inflation. Whereas, I think of money still being ultimately determined by demand for money. Now, given it's endogenous, but the demand for money and supply of money, kind of a more traditional story for what's inflation.

Beckworth: Now, what drives the demand for money can be a whole host of other things as you know. But I guess where do post-Keynesians come down? Are they more like the MMT, or are they more like what I think is standard monetary theory?

The Post-Keynesian View of Inflation

Lavoie: Well, I think we're very close to MMT on the issue of inflation. So, indeed, there's a lot of talk about conflictual inflation. Perhaps what MMT does not emphasize enough is the impact of the exchange rate on inflation, in the sense that if you have a depreciating currency, all your foreign products will be costing more, and so, this may generate inflation in your economy. So, that might be the difference, say, between what you hear from MMT scholars and what post-Keynesians in general would be emphasizing.

Well, I think we're very close to MMT on the issue of inflation. So, indeed, there's a lot of talk about conflictual inflation. Perhaps what MMT does not emphasize enough is the impact of the exchange rate on inflation, in the sense that if you have a depreciating currency, all your foreign products will be costing more, and so, this may generate inflation in your economy. So, that might be the difference, say, between what you hear from MMT scholars and what post-Keynesians in general would be emphasizing.

Beckworth: Well that's interesting.

Lavoie: But if I may say…

Beckworth: Sure.

Lavoie: What happens is that MMT authors are mostly American authors. So, in a country like the US, of course, what happens to the US dollar will not have a big influence on the price level or the rate of inflation. Whereas, in many other countries, including all these semi-industrialized countries, or development countries, when there is a change in the exchange rate, there's a big impact on price inflation.

Beckworth: Okay. So, let me ask this question then. Kind of same question, different angle. So, let's define money real broadly. So, everything from currency, to treasury bills. So, institutional money assets, repos, things like that, and everything in between. So, most of that would be money created by private firms, I think consistent with what your view of what money is. So, take that, a very broad, broad measure of money. In fact, there's a group in New York, they created what I call an M4 measure, which has like commercial paper, treasury bills, all kinds of somewhat liquid assets.

Beckworth: But anyway, take a broad measure of money, with a broad measure of money, can you plug it into an equation of exchange and still find that useful? Does the equation of exchange have any meaning? It's just an accounting identity, but does it have any meaning in a post-Keynesian worldview?

Equation of Exchange from the post-Keynesian Perspective

Lavoie: Well, my own view is that, no, it has no meaning.

Beckworth: Okay. So, it's something you guys don't think about and worry about.

Lavoie: Well, for sure, if you have a large increase in credits being granted, this will generate an expansion of economic activity, and so eventually it may generate a higher rate of inflation. But I think you just cannot look at a number and believe that because that number has gone up by five percent… some monetary aggregate has gone up by five percent, that this will lead to an increase in nominal GDP of five percent.

Beckworth: No, I agree with that, actually. I would say you look at M and V, like money and velocity, that they're both changing and we don't know what drives velocity, it may be hard to explain, this kind of an unobservable thing that's going on. But I guess what I'm really getting at then is maybe the policy implications of all of this. So, you would say to a country that's experiencing inflation, an industrialized advanced economy, you would direct them towards price controls as a way to manage inflation. Is that fair?

Lavoie: Yeah, I think yes, I would agree with that. 

Beckworth: Okay.

Lavoie: Because the only other way is to create unemployment, and that has been done in the early 1980s and again in the early 1990s, with great success, one could say. We had the central bank double the interest rates and it was highly successful in reducing inflation, but at the same time, it was highly successful because it managed to almost double unemployment numbers.

Beckworth: Yeah. The early 80s recession was a very sharp and painful recession. There's no doubt about that.

Lavoie: In Canada, we had our first homegrown recession in 1990-92, because there was a real estate bubble in Toronto and the Bank of Canada decided, "Okay, we have to crank up those interest rates from seven percent to 14 percent." And they were highly successful. In those days, we were very much critical of what the Bank of Canada was doing. Over the last 10 or 15 years, it's been much harder to criticize the Bank of Canada.

Beckworth: Marc, help me understand the case for price and wage controls. So, one of the big reservations I have with these net approaches is that something like that, at least my reading of history says, they don't work well. People find ways around them. There's ways to cheat, it can lead to corruption this way. People try to find ways around these controls, and outside of war times, my reading of the history, maybe you have a different one, is that they're very hard to implement effectively. So, what would you say to that?

Do Price and Wage Controls Work?

Lavoie: Well, everything you say is true, but what's the alternative? The alternative is to raise interest rates and punish everybody. Well, there's, perhaps a third way, which would be to have credit controls. So, you don't raise interest rates, but you’ve set up rules such that it becomes much harder for firms or households to borrow, get a mortgage, or whatever. In fact, this is what the Bank of Canada and the Canadian government have been doing over the last two or three years. There were these real estate bubbles in Toronto and Vancouver, and I think that they have been successful by implementing new rules, you need 20 percent of a down payment in order to be able to get a mortgage, whereas before it was five percent, or even zero percent. So, I think there are some alternatives to just cranking up interest rates.

but what's the alternative? The alternative is to raise interest rates and punish everybody. Well, there's, perhaps a third way, which would be to have credit controls. So, you don't raise interest rates, but you’ve set up rules such that it becomes much harder for firms or households to borrow, get a mortgage

Beckworth: Okay. So, it sounds like maybe the word credit control or price control to a mainstream person like myself, it's a loaded term, right?

Lavoie: It's scary.

Beckworth: Yeah, it is, it is. But what you've just described sounds to me like there's maybe better regulation of banks, or you have to have so much down payment when you get a mortgage. That's just the rule.

Lavoie: You either regulate the banks or your regulate the borrower.

Beckworth: Yeah. Yeah.

Lavoie: In the case of mortgages, you would regulate the borrower. The borrower would be facing rules such that he or she would have a lot of difficulty in getting a loan.

Beckworth: Yeah. No, I was going to say personal experience when I lived in Texas. Texas was slow to be a part of the Great Recession and one of the reasons why is that they had much tighter rules on mortgages, because they had been through the housing bust or the recession in the early 80s, I think, and as well as the savings and loan crisis when oil markets crashed. So, they had, at the state level, they had really tightened the screws. You couldn't get like 100 percent financing, for example, in Texas, if I remember it correctly.

Lavoie: Yeah.

Beckworth: In any event, that meant that Texas didn't have all the problems that some of these other states did. But when I look at it that way, and this seems like a practical prudence, financial regulation, if you're going to borrow a lot of money, take funds out for a mortgage, you need to have a lot of capital, a lot of equity, have skin in the game for it. You call that credit control. I guess I'd call that common sense? I don't know. So, the way you've presented it seems much easier, less scary than the word credit control.

Lavoie: Yeah.

Beckworth: Okay. Well, let me ask this question then with post-Keynesian economics, from that perspective, like how would you think about some different historical experiences? I'll throw one out there. For example, President Clinton, under him, there was a budget surplus. So, we actually began to pay down the national debt. So, how would the post-Keynesian view that experience?

Post-Keynesianism in a Historical Context

Lavoie: Well, you can go back to the old Keynesian thinking, which is that you have injections of funds and leaks in funds. So, the surplus of the government is a leak in the sense that it's a restriction on the spending that occurs in the economy. And so, it may have a negative impact on the economy. On the one hand, the economy was doing well during the Clinton years, so the government was getting more income taxes than predicted, so to speak. But because it had a government surplus, then it was slowing down the economy at the same time. So, that's one way to look at it.

Beckworth: Yeah, and where I find that this balance sheet approach useful is that one transaction somewhere has to be offset in someone else's balance sheet elsewhere in the economy, right? So, if the government ... Yeah, go ahead.

Lavoie: No, I was going to say, what you were going to say is true. The sector of financial balance sheet approach, which was very much put forward by my co-author Wynne Godley in his empirical work, in this practical work. I find it good to make sure that the various forecasts which are being made by different agencies looking at different parts of the economy, some of them are looking at the government, some of them are looking at the private economy. Others are looking at the current account balance, or the exports and imports. And this balance sheet approach helps us to understand whether are some inconsistencies in the predictions which are being made. That's what I find as being the most useful.

Beckworth: Yeah.

Lavoie: Because what drives the economy is either… the external driver is either investment, whether, it's corporate investment or real estate investment, or it's government expenditures. So, when you look at these balances, you're looking at the residual, the difference, say, between private saving and private investment. But maybe investment is smaller than saving, private saving, but if investment is very large, then it's going to have a big impact on GDP.

Because what drives the economy... the external driver is either investment, whether, it's corporate investment or real estate investment, or it's government expenditures. So, when you look at these balances, you're looking at the residual, the difference, say, between private saving and private investment. But maybe investment is smaller than saving, private saving, but if investment is very large, then it's going to have a big impact on GDP.

Beckworth: Yeah.

Lavoie: So, those balances are helpful, but you must also take into account that GDP is made up of four components, which is consumption, investment, whether it's corporate or real estate investment, and government expenditures, plus the net exports. So, those are the four components of GDP.

Beckworth: So, you're saying that you got to do more than just the balance sheet approach? You got to do the transaction flow approach as well?

Lavoie: Yes, exactly.

Beckworth: Yeah. That's what I guess noticed in looking at your book, is broader than just the sectorial financial balance sheet approach, but they're still useful. Let me ask this question then, and again, from the post-Keynesian perspective. So, right now, President Trump is running huge budget deficits and you could argue that's adding stimulus to the economy or it added stimulus to the economy, and maybe the effect is wearing out now. How would you, as a post-Keynesian, evaluate that statement?

Lavoie: Well, President Trump is a bit like President Reagan in the sense that both of them are the biggest Keynesian presidents.

Beckworth: Nice.

Lavoie: Because they're running those huge deficits, and when those deficits are being caused by autonomous decisions, then they have a very favorable impact on the economy. So, any Keynesian who was teaching in the 1960s would say exactly that. Post-Keynesians would say it right now, but Keynesians 50 years ago would also say the same thing. It's only over the last 30, 35 years that people would be saying, "Oh, if there is a deficit, people will be scared about their future taxes, therefore they will reduce consumption." So, those are part of the unrealistic assumptions that are being made by some of our mainstream colleagues.

Well, President Trump is a bit like President Reagan in the sense that both of them are the biggest Keynesian presidents...because they're running those huge deficits, and when those deficits are being caused by autonomous decisions, then they have a very favorable impact on the economy.

Beckworth: Alright. Last question because our time is coming near an end here, but would you view your textbook, the balance sheet approach, the income or the transaction flow matrix, all of those models in your book, would you view them as a complement to mainstream macro, something that like a mainstream macro economists could use in conjunction with their existing models? Or, is it an outright substitute, like you'd say, "Stay away from mainstream macro and just use my stuff." Or, could they be used together?

The Balance Sheet Approach: Complement or Substitute to Mainstream Macro?

Lavoie: Well, I think the book had two contributions, so to speak. On the one hand, we presented a methodology which is the so-called stock flow consistent approach, which just make sure that the accounting is right and that there are no black holes. So, this is good both for mainstream economics and non-mainstream economics. On the other hand, all the models that we had as examples of this stock flow consistent approach were based on one could say post-Keynesian assumptions, which in some cases many cases, are quite different from the assumptions which are entertained by mainstream economists.

Lavoie: So, you have those two sides of the book. If I'm talking about the behavioral equations which are in the book, yes, they are an alternative to mainstream thinking.

Beckworth: All right. Well, with that, our time is up. Our guest today has been Marc Lavoie. Marc, thank you so much for coming on the show.

Lavoie: Well, it was a very interesting discussion and many thanks for having me.

Photo by Patrick Hodskins

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.