Sometimes everything comes together in unintended ways. That has happened to me this week. I…
When I saw the headline on this article – Time to plan for post-Keynesian era – in the Financial Times yesterday (June 7, 2010) I wondered which Keynesian era we were talking about. It was written by Jeffrey Sachs who is well-known for his anti-stimulus viewpoints. The upshot of his argument, however, is that he recommends deficit reduction strategies because the bond markets will get upset otherwise. At the same time he advocates medium-term investments in green technology and education which I support but which will not be consistent with deficit reductions.
Sachs claims that:
Mainstream Keynesian economics is facing its last hurrah. The global fiscal stimulus championed last year by the Obama administration is coming undone, repudiated by the same Group of 20 that endorsed it last year. Now, against a backdrop of a widening sovereign debt crisis, we need to abandon short-term thinking in favour of the long-term investments needed for sustained recovery.
Keynesian stimulus was premised on four dubious propositions: that it was needed to prevent a global depression; that a short-run fiscal boost would jump-start the economy; that “shovel-ready projects: could combine short-term cyclical and long-term structural agendas; and, last, that the rapid rise of public debt occasioned by stimulus need not be a concern. That these ideas were so widely accepted was a testament to the perennial political attractiveness of tax cuts and spending increases.
Okay, so he is now calling the current fiscal response a “Keynesian stimulus” and this is the Keynesian era he is referring to. I beg to differ. What we have seen in the last two years is a mix of half-hearted fiscal stimulus with a blind belief that monetary policy would do the “hard yards”.
The reality is that in most nations, the stimulus has been too modest – because the treasuries were still harbouring neo-liberal persecptives. Further, the stimulus packages were not targetted at creating employment, which would have provided the greatest fiscal multipliers.
But having said that the overwhelming evidence that is now available from a variety of sources from the IMF, OECD, national treasuries and central banks is that the stimulus packages, deficient as they were, still provided the dominant spending boost to arrest the slide into depression. Please read my blog – Fiscal policy worked – evidence – for more discussion on this point.
Even the most recent National Accounts for Australia published last week show that if the public infrastructure projects, which accompanied the stimulus packages, had not been implemented we would have been in negative growth in the March 2010 quarter. And we would have been in recession throughout 2009 if not for the public spending boost to aggregate demand (indirectly via household consumption and directly via government spending).
This puts paid to the claim made by Sachs that:
In fact, the ubiquitous references last year to the Great Depression were glib; the policymakers had panicked. Adroit central banking could and would prevent depression.
The evidence I cited above also suggests that monetary easing played a much lesser role in maintaining sufficient aggregate demand to prevent a slide into depression. It is clear the central bankers didn’t hold the horses back with the huge cuts in short-term policy rates and in many nations significant quantitative easing initiatives.
But you just have to look at the behaviour of the spending aggregates to realise that the interest-rate sensitive components wallowed in the dumps over the last few years. The growth that has been observed since the crisis began has been overwhelmingly driven by public spending in one way or another.
Sachs then claimed that:
The hastily assembled stimulus packages were a throwback to naive Keynesianism. The relevant fact was that the US, UK, Ireland, Spain, Greece and others had over-borrowed for a decade, so a decline in consumption after 2007 was not an anomaly to be fought but an adjustment to be accepted.
It is true that in many countries, the form of the stimulus packages left a lot to be desired. In Australia, despite the strong contribution to growth, the public investment packages have been clumsy. But this raises an interesting question: Is this a basic flaw in using fiscal stimulus to underwrite aggregate demand when private spending has collapsed or is it a reflection of the neo-liberal dominance?
My view is clear. For years now the neo-liberals have been eschewing the use of counter-cyclical fiscal policy and as the dominance of inflation-targetting monetary policy was made concrete, fiscal policy was assigned a passive role. That is, it was used to reinforce the monetary policy stance. With this ideology prevailing, it is little wonder that governments ran down their capacity to implement large-scale infrastructure projects.
Government departments used to have large planning capacities and projects would be thought out in advance and would be ready – well-designed and costed – for when the fiscal tap had to be turned on. In general, the evaluations that have been done over the years point to these projects being well implemented and providing enduring benefits. I can think of many projects around the world that have been completed as part of a fiscal counter-stabilisation program which now provide huge financial and non-pecuniary benefits.
So there is no inherent flaw in the “Keynesian” approach to large-scale infrastructure programs being used as a primary platform for providing fiscal stimulus to an ailing economy.
And while I agree that the challenge in the downturn was to allow the private sector to reduce their debt exposures and realign consumption to more sustainable levels, this doesn’t negate the use of fiscal interventions at all.
Building public infrastructure is not a consumption activity but it does provide employment boosts to arrest the rising unemployment that the collapse in private spending has engendered. Typically, the unemployed are not the persons who hold the most debt. So well-targetted fiscal stimulus, aiming to provide jobs to the disadvantaged and, in turn, allow that cohort to maintain their minimum consumption standards doesn’t thwart the middle-class deleveraging efforts.
In a macroeconomic sense, the government has to go into deficit for the non-government sector to be in surplus. Deleveraging is enhanced if there is no collapse in output and income. The latter just ensure the excessive private sector debt becomes a debt crisis.
While I am sure that the sub-prime boom put loans into the hands of people who would never really be able to pay them back much less service them consistently, the reality is that the rising unemployment in the US worsened the debt crisis. Good debts became bad debts through unemployment.
Sachs further develops his argument:
The talk of a green recovery, in which the fall in consumer spending would be offset by investments in sustainable energy, made sense and still does. Yet it was quickly undermined by the politicians’ insistence on “shovel-ready” projects. The shift to sustainable energy systems is a vital but long-term task. It could never be a short-term jobs programme. Maybe in China there are shovel-ready projects of sufficient scale, but not in the US.
I agree that governments are failing to invest appropriately in green technology to replace coal. There are huge opportunities to fund R&D and manufacturing enterprise to develop and produce new green renewables. I would do all of that within the public sector.
But it is true this is a medium- to long-term strategy and would not have produced a many jobs overnight. I travel to the US a lot and have seen many of the big cities close up. My estimate is that the poor in China are not that much worse off than the poor in the US. The urban amenity in some of the US cities is appalling. The standard of housing in many cities, particularly the suburbs or shanty towns (trailer parts etc) is very low.
If you compare a Dutch city (very clean and orderly) to a US city (usually dirty and chaotic) you will realise that there is a deficit of labour being expended in the US cities. The regional landscape is also run down in the US. I could envisage millions of low-skill, labour intensive jobs being created by the public sector that could address many of these issues.
I would introduce a Job Guarantee immediately which would not only provide as many jobs as there were people wanting them but it also would have involved a much lower fiscal outlay. Please read my blog – When is a job guarantee a Job Guarantee? – for more discussion on this point.
Sachs then reveals his lack of understanding of monetary systems. In noting that the US government “inherited the largest peacetime budget deficit in US history” (so what!) he concludes that:
The US was not in a credible position to raise an already enormous deficit “temporarily” because the prospect for future deficit cutting was and remains extremely clouded. America has absolutely no consensus on how to restore budget balance, as it is trapped between a federal government that provides too few public investments and services and a public that is almost maniacal in its opposition to tax rises. One cannot build a credible long-term fiscal policy by starting off in the wrong direction, with larger rather than smaller deficits.
There is no such thing as an enormous budget deficit per se. Rising budget deficits usually signal a deterioration in the real economy (falling output growth and rising unemployment) but the actual fiscal outcome has no dimension that we delineate as improving or deteriorating or large or small. It is what it is. Given it is endogenously determined by the state of private spending, the dynamics of the budget balance just provides information about the state of the economy.
The path of the US deficit is largely dependent on the growth of the economy. It will fall when growth is sufficient. Stimulating employment growth and getting more people back paying taxes is the obvious source of budget retrenchment.
The policy emphasis in the US and everywhere should be on getting growth started. Policy makers would be well advised to stop publishing statistics about the size of the budget deficit. The sky won’t fall in if people do not know.
The US has no consensus on this because almost none of the influential commentators demonstrate an understanding of the real problems facing the US economy. They have become so obsessed with the financial ratios that they have lost sight of the fact that around 17 per cent of the available labour supply is idle.
Say it again: around 17 per cent of the available labour supply is idle.
That is a huge income loss to the economy (and a huge foregone tax take as well).
Finally, there is no sense in the statement that a budget deficit today reduces the capacity of a sovereign government to run a budget deficit tomorrow or the next day or the day after that. The components of the budget are flows and exhaust each period. The stock they leave – given that sovereign governments are not revenue-constrained but still insist on issuing debt to match their net spending – is the public debt stock.
But the public debt stock is our wealth and the interest payments are our income. Since when has rising wealth and rising income been something we should be scared off and want to reverse? None of the public commentary really reflects these realities.
At least Sachs understands that:
… draconian cuts in … [public] … spending … is the wrong approach. We should avoid a simplistic austerity … [program] …
Draconian cuts in spending will undermine growth and drive deficits up. Please read my blog – Amazing reversals – democratic repression – for more discussion on this point.
Sachs proposes a five-point plan for recovery:
First, governments should work within a medium-term budget framework of five years, and within a decade-long strategy on economic transformation. Deficit cutting should start now, not later, to achieve manageable debt-to-GDP ratios before 2015.
Trying to impose some time dimension on the budget outcome is mindless. The budget outcome reflects the dynamics of private spending (via the automatic stabilisers) and trying to “manage” the private spending cycle is likely to be counter-productive. It is a far better strategy for governments to support the private spending cycle – that is, make sure that when private saving intentions rise, net public spending also rises.
But introducing 5-year frameworks etc to satisfy the bean counters in some government department is not sensible.
Further, draconian cuts are only larger than smaller cuts. While there is a huge spending gap, it is counter-productive to introduce discretionary cuts to fiscal policy.
Sachs’ second point:
Second, governments should explain, and the public should learn, that there is little that economic policy can do to create high-quality jobs in the short term. Good jobs result from good education, cutting-edge technology, reliable infrastructure and adequate outlays of private capital, and thus are the outcome of years of sustained public and private investments. Governments need actively to promote post-secondary education.
There are many “high-quality jobs” already being performed in the public sector. The private sector doesn’t have a monopoly on high-quality jobs. Further, I am always bemused when we applaud private firms creating thousands of low-skill, low-paid and precarious jobs (K-mart, Walmart etc) but we then claim that low-skill public job creation is wasteful and meaningless.
As noted above there are countless low-skill jobs that can be produced within the public sector which provide productive and meaningful output and stave off poverty for those who receive them. I did a very large Australian study in 2008 identifying these sorts of jobs – the Report was entitled – Creating effective local labour markets: a new framework for regional employment polic.
I have also done work in South Africa on their public works program and despite its modest coverage (courtesy of the neo-liberal bean counters in the treasury there) – it produced more than a million jobs in the first five years and significantly reduced poverty among those who received the work.
The US is not above the rest of us in having low-skill workers who could be meaningfully engaged. Far from it!
Sachs’ third point:
Third, governments must of course also ensure social safety nets: income support for the poor, universal access to basic healthcare and education, a scaling up of job training programmes and promotion of higher education.
Sachs’ fourth point:
Fourth, governments should steer their economies towards needed long-term structural transformation. External-deficit countries such as the US and UK will need to promote exports over the next few years, while all countries must promote clean energy and new transport infrastructure.
I agree that “clean energy and new transport infrastructure” is an essential area that requires public investment.
I don’t agree that nations should deliberately seek to adopt export-led growth strategies. It is better to import than to export. And as long as other nations desire to accumulate financial assets denominated in your currency then why would you want to send more of your real resources to them and get less of their real resources?
Sachs’ final point:
Fifth, governments and the public should insist that the rich pay more in income and wealth taxes – indeed, a lot more. The upward re-distribution of the past 25 years has made our economies into extravagant playgrounds for the super-wealthy. Politicians of both the mainstream left and right in the US and UK have fawned over those who pay their campaign bills in return for low taxation. Even playgrounds should collect tolls – when it is billionaires in the sandpit.
I agree that there should be a major re-evaluation of the distribution of income. But I would be focusing on the command on real resources and using tax policy to modify that rather than seeing taxation as “funding” government spending. It clearly does not fund anything in a sovereign country.
But I would take this further. As I outlined in this blog – The origins of the economic crisis – the neo-liberal period has been marked by a fundamental shift in the relationship between real wages growth and productivity growth. The latter has outstripped the former by some considerable margin over the last 25 years or so in most countries.
This has provided a major redistribution of real resources to profits and that is one reason the financial sector has been able to proliferate. I would start with wages policy rather than taxation policy in redressing this imbalance. If we don’t redress it then we will be back in crisis again before we know it.
Sachs rightly says that to rebuild our economies “the watchword must be investment rather than stimulus”. Well investment is stimulus. I don’t see how an ambitious public investment program such as he has outlined will not involve (rightly) on-going budget deficits.
His position should come as no surprise. On March 14, 2010 he co-authored an article – A frugal policy is the better solution – with the now British chancellor George Osborne.
In that article they wrote:
Virtually all policy analysts agree that the path to renewed prosperity in Europe and the US depends on a credible plan to re-establish sound public finances. Without such a plan, the travails which have hit Greece and which are threatening Portugal and Spain will soon enough threaten the UK, US, and other deficit-ridden countries. In the recent duel of macro-economists, one camp has called for early budget consolidation, followed by further measures over five years. We agree. Others want more fiscal stimulus, delaying deficit reduction. We believe delaying the start of deficit reduction would put long-term recovery at risk. Such an approach misjudges politics, financial markets, and underlying economic realities.
So you immediately realise that they have no appreciation of the differences in the monetary systems that operate in the EMU and elsewhere.
You will note they talk about “politics, financial markets, and underlying economic realities”. My view is that politics are made and governments that demonstrate leadership can influence the political climate. The current situation is that the politicians are not leading but passively bowing to the demands of the bond markets and the mainstream economists.
This article just apes the mainstream viewpoint that bond vigilantes will bring down any government irrespective of the monetary system that is operating. My view is clear. If the circumstances were such that a sovereign government finds it inconvenient to bow to the wishes of the ratings agencies and the bond markets then they will defy them. They will because they can.
Just have a look at Japan. They didn’t blink when the ratings agencies were downgrading the sovereign debt to low-grade quality.
Further, if yields on public debt issues were considered to be excessive by the government you can be sure that the central bank would be out there operating in that segment of the yield curve in one way or another.
And ultimately, the government would revise the rules and stop issuing debt altogether. Please read my blog – Who is in charge? – for more discussion on this point.
As to the underlying economic realities, the article said:
The general notion that delay is beneficial in the short term because it provokes more spending today – irrespective of future debt burdens – is also wrong, in theory and in practice. If the starting position is a large structural deficit, further fiscal “stimulus” can darken consumer and business confidence by creating fears about future debt burdens. These fears may be translated directly into higher borrowing costs today for government and the private economy. There are many well-studied examples of “negative fiscal multipliers”, in which credible fiscal retrenchments in fact stimulated the economy, via greater consumer and investor outlays, by reducing borrowing costs and spurring confidence.
Sachs must have been listening to Barro too much when they were at Harvard together. Please read my blog – Pushing the fantasy barrow – for more discussion on this point.
The theory they invoke is Ricardian Equivalence which claims that consumers assume that the increased government spending has to be paid back. When? there is no explicit answer in their models – all the teaching models assume very short time periods so they can fit the graph on a PowerPoint slide! Totally arbitrary like all of the mainstream so-called “rigorous analysis”.
So with consumers armed to the teeth intellectually with their New Keynesian models the mainstream claims that as the government spends, consumers increase their saving and the net effect is zero.
The high-tech New Keynesian models that Barro uses are just fronts for ridiculously simple – almost banal ideas. These ideas are hidden behind a wall of second-rate mathematics to beguile the readers and to hold out a sense of authority.
As a trained economist with formal mathematical skills I can tell you that the mainstream models – particularly the ridiculous New Keynesian models – deserve no attribution of authority at all.
The models are predicated on several assumptions which have to hold in entirety for the logical conclusion to follow? Should any of these assumptions not hold (at any point in time), then these models cannot generate the conclusions that fiscal policy is powerless and any assertions one might make based on this work are groundless – meagre ideological raving.
First, capital markets have to be “perfect” which means that any household can borrow or save as much as they require at all times at a fixed rate which is the same for all households/individuals at any particular date. So totally equal access to finance for all.
Clearly this assumption does not hold across all individuals and time periods. Households have liquidity constraints and cannot borrow or invest whatever and whenever they desire. People who play around with these models show that if there are liquidity constraints then people are likely to spend more when there are tax cuts even if they know taxes will be higher in the future (assumed).
Second, the future time path of government spending is known and fixed. Households/individuals know this with perfect foresight. This assumption is clearly without any real-world correspondence. We do not have perfect foresight and we do not know what the government in 10 years time is going to spend to the last dollar (even if we knew what political flavour that government might be).
Third, there is infinite concern for the future generations. This point is crucial because even in the mainstream model the tax rises might come at some very distant time (even next century). There is no optimal prediction that can be derived from their models that tells us when the debt will be repaid. They introduce various stylised – read: arbitrary – time periods when debt is repaid in full but these are not derived in any way from the internal logic of the model nor are they ground in any empirical reality. Just ad hoc impositions.
So the tax increases in the future (remember I am just playing along with their claim that taxes will rise to pay back debt) may be paid back by someone 5 or 6 generations ahead of me. Is it realistic to assume I won’t just enjoy the increased consumption that the tax cuts now will bring (or increased government spending) and leave it to those hundreds or even thousands of years ahead to “pay for”.
Certainly our conduct towards the natural environment is not suggestive of a particular concern for the future generations other than our children and their children.
Barro’s theorem led to a torrent of empirical work, particularly after the US Congress gave out large tax cuts in August 1981, which was the first real world experiment possible (that is, if you consider the US as they do to be the real-world!).
The tax cuts were legislated to be given over 1982-84 to stimulate aggregate demand. Barro’s adherents all predicted there would be no change in consumption and saving should have risen to “pay for the future tax burden” which was implied by the rise in public debt at the time.
But, if you examine the US data you will see categorically that the personal saving rate fell between 1982-84 (from 7.5 per cent in 1981 to an average of 5.7 per cent in 1982-84).
Anyway, now we have a laboratory – George Osborne is in charge of fiscal policy in the UK and will pursue austerity plans. We will see how strong the British economy is by the end of this year.
The emphasis by Sachs on medium-term public investment in sustainable energy and education is fully supportable. But it doesn’t imply a reduced fiscal involvement in the economy. I would suspect it implies larger budget deficits.
But he is incorrect if he thinks that growth will come by engaging in discretionary budget cuts now while private spending is so weak. Employing such a strategy will only worsen things.
Governments should be firmly concentrated on stimulating and maintaining short-term growth at present. Targetted employment creation is the best way to achieve this while we wait for the animal spirits to return and private investment to recover.
After all, the high automatic stabiliser component of the deficits at present is just an indicator of weak private spending. That is the problem not the size of the deficits.
That is enough for today!