SRINIVAS THIRUVADANTHAI: In capitalism, what typically has happened always with these physical aspect as we have had wars. The rise of capitalism has been with a lot of wars. What that does is it actually clears out all the capacity. A very sad and tragic way to do it, but that's what it does. That's what Minsky said, stability creates instability from the perspective of financing structures but more broadly, from the ecological perspective, too. How do you create a resilient system, and inflation targeting is about low and stable. That's a very bad approach, in my view.
MIKE GREEN: Mike Green for Real Vision. I'm here in New York City, super excited to sit down with my friend Sri Thiruvadanthai of The Jerome Levy Forecasting Institute. Sri and I sat down about eight months ago, and it was just a fantastic conversation about how he thinks of the world in terms of flows and systems of national accounting. I want to revisit that with Sri and I also want to extend it into the emerging markets. In particular, I haven't had a chance to talk with Sri a lot about India. I'm going to push on that today. I hope you find it as interesting as I know I will.
Mike Green, I'm here in New York, sitting down again with Sri Thiruvadanthai of The Jerome Levy Forecasting Institute. You and I sat down six months ago, eight months ago?
SRINIVAS THIRUVADANTHAI: Yeah, I think so. About at that, yeah.
MIKE GREEN: Yeah, which was people loved it. It was fantastic. I had a fantastic time talking with you. You and I have spoken a number of times in person, but primarily we interact over Twitter, where you're @TEASRI, T-E-A-S-R-I. Your continual just brilliant insight in terms of what's going on in the emerging world and the developed world as well because you approach the world from a slightly different framework. We've talked about it in the past, can you just reorient listeners in terms of how you think about the world in the Kalecki equation, what that means.
SRINIVAS THIRUVADANTHAI: Basically, the approach is a flow of funds approach to the economy. The idea-- what motivates it is capitalist economies are ultimately driven by profits, because businesses want profits and profits is what drives them to invest into higher, higher and that's what drives business cycles. The flow funds approach, what it tries to do, the Kalecki-Levy equation, is trying to forecast profits from top down perspective, from the aggregate perspective, rather than trying to get it bottom up, which you have tons of people trying to do. Because from the top down, you have fallacies of composition that become very clear.
It also tells you what are the sources of growth? Where are the profits going to come from? What's going to drive the economy? When you look at it from that perspective, a lot of the problems around the world that are there right now become very clear.
The other thing is it integrates well to the balance sheets. When people say there is too much debt or the Richard Koo's balance sheet recession, which is an add-on in his framework, this actually integrates that into the workings of the real economy.
MIKE GREEN: Well, and by taking a balance sheet approach, or an income flow of balance sheet approach, or unifying it, you mentioned that a lot of people are doing it the bottom up. People are doing it both from an individual forecasting basis. They're doing it from an accounting standpoint, but it takes on a very different characteristic. When you take an accounting course, you realize that you're being taught a framework for how to track flows, and the building of stocks and balances.
In a national accounting system, which is really more to what the Kalecki-Levy equation is focused on, what are any inconsistencies or challenges around the world that pop out? In particular, people are pursuing the wrong approaches towards addressing it.
SRINIVAS THIRUVADANTHAI: Right. For example, one of the things that you will see people's talk about, one of the things that we have pursued for the last 25 years is we can use monetary policy to manage aggregate demand. If you look at the idea behind monetary policy is somehow we will cut interest rates and inflation expectations will go up, therefore, people will bring back their spending, but there is no reference really to balance sheets. How does actually monetary policy work?
In fact, Bernanke and Gertler wrote a paper way back in 1999, saying what's inside the black box, and we know that it doesn't work by the rule, lowering cost of capital lower actually affecting the interest sensitive sectors. How does it work? Basically, they also say it works through balance sheets, although they of course, use it-- cultured in a lot of neoclassical verbiage but the basic point is monetary policy works either by lowering the discount rate, or because it relieves some liquidity pressures, it raises the value of assets or collateral, and debt service, and thereby it helps resuscitate the economy.
What it does really is two things, wealth effects through the asset prices. The second is leveraging. Basically, takes a situation and makes those assets and balance sheets more strained by easing the conditions, but by keeping rates low, or whatever you try to do. You actually try to get out of a situation which might have been caused by strained balance sheets by making the balance sheets even more strained.
MIKE GREEN: Well, what you're describing is effectively by lowering interest rates, you're lowering the cost of leverage allowing and facilitating more leverage, which gives-- it's not really a monetarist money illusion but it is in a credit based system, what you're doing is you're giving the capacity to expand the balance sheet.
SRINIVAS THIRUVADANTHAI: Exactly.
MIKE GREEN: The presumption is that doing so will enable investment that raises future incomes, improves productivity, establishes additional surplus and make things better. This time around, it seems like what we've largely done is prevented the volatility associated with change of controls. If you eliminate bankruptcies, you minimize uncertainty about asset values, you minimize the disruptions associated with an asset transfer that's forced by a credit document, but you also don't get much innovation.
SRINIVAS THIRUVADANTHAI: Right. I think there are two things. Innovation partly proceeds by-- if you think about what happens with innovation, let's go back to the 1930s, it was a period of huge amount of innovation actually, but what happened was because people were shell shocked and businesses were shell shocked, they were actually not innovating in that. At the end of the war, because businesses had not invested for 15 years, now technology had gone made a huge leap compared to it, so the people were driving like 20-year-old jalopies and the new trucks were far more efficient.
It also was the case that people's balance sheets were clean. They were completely liquid, there are no asset to depreciate. They were willing to take on and replace the old asset by the new asset and drive productivity. Right now, if you go to businesses or to individuals, anybody, nobody wants to take up the overload of putting up a new asset.
We have some private equity clients, and they tell us the best business is maintenance, repair and operations. Because there are businesses which have 30, 40-year-old electric motors that are running fine, and they don't want to replace it with the new generation one. They just want to keep repairing it because the depreciation overload of something is still there on their balance sheet, and they don't want to take up more balance sheet overload.
Part of the reason they don't want to take it is they are not sure about growth, and why don't we have enough growth. It comes back to the same issue is if balance sheets are high, you can't run a hard economy, because if you run a hard economy and inflation gets a little bit higher, doesn't have to go to 5%, 10% but even if it goes to 4%, people suddenly start getting nervous about devaluation of their assets, which the Fed has to assuage by tightening.
Then you bring the whole thing down, like in 1999, 2000, or even 2008. When people say, hey, the hawks that were so stupid in middle of 2008, but my point is, how do you know that? You only know that in hindsight that it was stupid. What about 1967? That also in hindsight, you know that the doves then were stupid. How could they have been both wrong at the same time?
MIKE GREEN: Well, I would actually argue that they both were wrong, but because they had improperly specified variables. The increase in inflation associated with 1967 is this largely a function of an explosive growth of the population. You needed more households, you needed more dishwashers, you needed more items that were required a higher return on investment in order to you're competing with other sources of capital. That type of inflation should be met with a capital deepening.
You should be encouraging new factories to be built and because we didn't do that in the 1960s, 1970s, we saw foreign competitors do that and ship into the United States. This time around, it's not entirely clear to me at all that the solution is to lower interest rates and preserve capacity in an economy that's already saturated in a lot of places.
SRINIVAS THIRUVADANTHAI: Exactly, exactly. We have to actually rationalize capacity, which is some of these what you call zombie firms. By rationalizing capacity, you allow for regeneration, because then, you replace. When you actually bring in new capacity or replace stuff, you're going to bring in new generation of equipment, new generation of capital, and new forms and new ideas, which will lead to productivity gains.
MIKE GREEN: We see this in commodities all the time. We talked about a cost curve where when prices are exceptionally high, there's tons of capacity that is relatively low productivity that continues because there's so much demand prices or have created an umbrella. When prices fall, those firms are forced in distress, the assets that they own, the resources that they have are freed up or liberated for more productive components to use, and either different combinations of labor or different combinations of let's tap in the tailing pools or let's take the earth moving equipment from that location and put it into a more productive location at a low cost.
SRINIVAS THIRUVADANTHAI: Right, right.
MIKE GREEN: Is there a point at which this ability to forestall and almost a Minsky-ish framework creates a bigger volatility blowup?
SRINIVAS THIRUVADANTHAI: There is a physical aspect of it, which we were talking-- in capitalism, what typically has happened always with these physical aspect is we have had wars. The rise of capitalism has been with a lot of wars. People don't realize that. They're, of course, the most good disruptive ones being this first war and the Second World War. What that does is actually clears out all the capacity. A very sad and tragic way to do it but that's what it does.
Not only now you have to put up the new capacity, which of course creates demand for workers, but you're replacing it with new generation equipment, which creates productivity. On the asset balance sheet side, most of those things are also resulting to reset of balance sheet, essentially, you can call it a jubilee or whatever it is, but basically, you're wiping slate screen once in every few decades. Very painful, but that's what you did.
The question is, we do not want to do that, because the economic consequences are painful, mostly borne by-- disproportionately borne by the poorer segments of society. How can you do the transition without having a lot of pain, or is it possible at all to do it? I don't know the answer to that question. That is really the issue if you think about it.
That's what Minsky said, when he said stability creates instability from the perspective of financing structures is what he said, but more broadly, from the ecological perspective, too. It's like the small brush fires prevents the larger one. How do you create a resilient system? The whole approach of the last 25, 30 years has been terrible in terms of most of the thing it's been about inflation, inflation targeting is about low and stable.
That's a very bad approach, in my view, because you don't want to control vol. In controlling vol, you have created a big skew, like 2008 was an example of a skew. People will say, oh, that was once in a century thing, non-predictable. I would say it was a direct consequences of policies that be followed. I think we'll get one more again, whether it be the US or elsewhere, it doesn't matter. With the global economy, we'll get one more game because of the policies that we have followed of trying to suppress vol both in the economic sense and in the balance sheet sense.
MIKE GREEN: That analogy here is with the brush fires preventing the large catastrophic forest fires, or certainly reducing the severity of them when they occur. That analogy jumps out immediately, that effectively what we've done is we've suppressed even major fires now. We've managed to put them out by forming the runway primarily with various forms of liquidity, reductions in debt service, etc. I think both you and I are extremely concerned about this.
The other thing that-- particularly somebody who is familiar with systems of national accounting is aware of is that there's inherent limitations based on how you choose to define this. My biggest complaint about systems of national accounting are that they fail to consider human capital, both in the form of the education, the healthcare, the investment in citizens, is created, but also by the flows. I look at the United States, Canada and Australia, as other good examples, New Zealand, not to leave them out-- of countries that have positive immigration pressures, effectively having a phenomenal business model that says, you run the risk of giving birth to a child, educating a child, raising a child, and we'll take the most motivated members of your society for free.
Thank you very much. Yet, that doesn't show up anywhere in a trade surplus or a trade deficit. We don't see the China is hemorrhaging human capital, and that the US is picking it up, although trying its best to minimize the quantity that it seems to get now.
SRINIVAS THIRUVADANTHAI: Yes, it also doesn't pick that up. Another point that you have made in the past also is it doesn't pick up the fact that when you're bringing in, you're bringing in young members of the other society. Those are people who are also not just going to contribute, but they're also going to add to demand from the perspective if they're going to come in, they're going to buy a house or send their kids to school, buy durables, which starts the whole cycle. You're not replacing the people who are 80 years old.
Yes, it doesn't account for it. I think there are so many things, there is only the framework is limited to some extent. No matter what you do, it's very hard to, that we always see some things outside the framework. I think that's why judgment comes in. You can't really completely run a system no matter what you do it. Well, whenever you see all these large scale econometric regression models, at the end of the day, they will have the judgment come in and override it to some extent.
I have seen some of these models very closely. Larry Myers, who was professor at Wash U when I was there, had a very successful forecasting form, but he didn't have his own input into the model at the end of the day, his judgmental input.
MIKE GREEN: Well, and we have seen this throughout the history of econometrics, that it has been a combination of very sophisticated models with tons and tons of variables and if you actually dig into the individual coefficients of them, they're not stable, they're not linear by any stretch of the imagination. This is where much of the discussion around complex, chaotic and dynamic systems comes in.
When we look at the core of the assumptions in them, though, and that really is I think what both you and I are can concerned about, there are linear assumptions, for example, the Euler coefficient, that it presumes the answer to well, if there's a problem, lower interest rates. Is there anything that could cause that to change? Are you seeing any discussion around this idea?
SRINIVAS THIRUVADANTHAI: Actually, there is. In fact, somebody tweeted yesterday, there was a lot of people that are starting to take this approach. I'm still not completely happy with them, but the fact is, they're taking cognizance of many of these issues, including financial frictions, and things like that, which is not my preferred way of going about it, but at least they are trying to get to some of these problems. I don't think you can still do it within the framework that they are doing it, but they're getting an awful lot out of this.
For instance, even if empirically, if you look at one of the things that they figured out is Nakamura and Stein's and other people about the elusive costs of inflation. They basically said that the New Keynesian model's basic fundamental presumption that high inflation causes-- high inflation means high price volatility causes high dispersion of relative prices, and therefore has enormous welfare costs, because it distorts the signals relative pricing. They went back to the '70s and they looked at the data and they said we can't find it. We can't find that dispersion.
People are starting to question it, certainly they're starting to question it. It doesn't mean we need to go back to high inflation or anything like that. First of all, it won't fare fly politically. That's a separate issue. The point is people are starting to question it within the mainstream, and there are a lot more people coming on, but a lot of the policymakers keep in mind the people who broke their teeth in the '70s and that's their formative experience that seared into their minds. It's very hard for them to shake that.
MIKE GREEN: First of all, I completely agree with that. There's a certainty associated with the process of getting a PhD that somewhat locks you into a mental model. By the time you come out of it, it's difficult to think outside of the academy.
The second thing that you're hitting on is that this is actually a period of tremendous innovation in terms of how people are thinking about it. We heard the first arguments against lower interest rates in the form of the [indiscernible], who, under the sponsorship of James Bullard at the St. Louis Fed, hypothesized that since the real interest rate was just real plus inflation, and we only could control nominal, the way to get inflation up was to raise interest rates, to have higher interest rates.
There's definitely some truth to that, because among other things, it would address some of the surplus production capability. It would raise the return associated with incremental capital once you've been through that disruptive dynamic. You're perversely brought back to this. Andrew Mellon, liquidate stocks, liquidate labor, et cetera, which we all know, in the context of the Great Depression sounds absurd because of the human suffering. It's a brush fire. It's a way to clear things out.
SRINIVAS THIRUVADANTHAI: Right. I just want to be a little bit careful because I often give Austrians a lot of