Open Economies

A revised and slightly simplified version of the 1996 paper got published in the Cambridge Journal of Economics three years later (Godley 1999a). It is this publication that induced Lavoie to contact Godley at the end of 1999. Godley had produced a rough draft of the monograph that he had long intended to write, but it was only after having recruited Lavoie as a co-author in 2001 that further progress was made. Godley and Lavoie shared the writing, with Godley providing most of the ideas and Lavoie most of the literature background. Godley built and ran the models, while Lavoie did the simulations and corresponding figures. This collaboration, except for two weeks spent together at the Levy Institute and then at King’s College, Cambridge, was done mostly through long-distance phone calls and e-mail exchanges. It turned out to be highly successful, because the two authors shared very similar views on microeconomics and macroeconomics, as well as an identical understanding of the role of credit and money.

In 1999, Godley also produced another SFC model, this one dealing with an open economy (Godley 1999b). This was the first of a series of papers and book chapters that purported to analyse ‘open economy macroeconomics using models of closed systems’, as the title of the paper said, with all flows and all stocks fully accounted for wherever they arise. Godley’s open-economy models reproduced the compensation thesis that Lavoie had put forward previously on the basis of endogenous money theory, that is, the claim that a country on a fixed exchange rate with balance-of-payment surpluses would not see its monetary base increase, in contrast to the standard result of the Mundell-Fleming model. Whereas international trade theory is usually based on a two-country and two-good framework, this is not the case in mainstream international macroeconomics, where the economy under study is presumed to be small and open with an exogenous ‘rest of the world’. Godley produced instead models where feedback effects from one country to the other were taken into account, thus providing a whole set of real and financial interactions between countries. In these models, a vast array of variables (GDP; trade, capital, and CABs; public and foreign debt; foreign reserves or exchange rate; the stock of money; domestic, export, and import prices) become fully endogenous in both countries.

As argued by Jacques Mazier, a Professor at the University of Paris 13 and a specialist of open-economy macroeconomics, Godley’s SFC approach and models are much superior to mainstream models—the general equilibrium representations of the world economy or the simplified portfolio model of exchange rate and portfolio account balances based on net assets. In both sets of mainstream models, output and government deficits are assumed to be given, an assumption that proved to be highly unrealistic during the recent global financial crisis; hence the whole adjustment process is assumed to fall on relative prices. Furthermore, the supply of assets is also assumed to be given, so that these models are devoid of a consistent analysis of the stock- flow financial dynamics. Thus, the integration between real and financial variables appears rather limited. By contrast, in Godley’s open-economy SFC models, production is determined by aggregate demand.

An example of the usefulness of the SFC approach is the paper based on a three-country model which was published in January 2007 in the Cambridge Journal of Economics (Godley and Lavoie 2007b). The model consisted of two Eurozone countries associated with a single central bank (the European Central Bank—ECB) linked through a flexible exchange rate with a third country—the USA. The model showed that if a country within the Eurozone (say Germany) improved its trade performance vis-a-vis the USA, this would lead to a twin government budget and current account deficit in the other Eurozone country (say Italy), thus by no fault of its own. The model also showed that this situation would become unsustainable, with ever-rising deficits and interest rates, unless the ECB accepted to purchase the securities issued by the deficit country. An alternative closure of the model assumed that the deficit country would pursue fiscal austerity policies. The model showed that these policies would succeed in eliminating the twin deficits, but at the cost of a large recession for the deficit country, while the surplus country would not benefit any more from its improved trade performance.