Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
It is interesting how the big neo-liberal economic organisations like the IMF and the OECD are trying to re-assert their intellectual authority on the policy debate again after being unable to provide any meaningful insights into the cause of the global crisis or its immediate remedies. They were relatively quiet in the early days of the crisis and the IMF even issued an apology, albeit a conditional one. It is clear that the policies the OECD and the IMF have promoted over the last decades have not helped those in poorer nations solve poverty and have also maintained persistently high levels of labour underutilisation across most advanced economies. It is also clear that the economic policies these agencies have been promoting for years were instrumental in creating the conditions that ultimately led to the collapse in 2007. Now they are emerging, unashamed, and touting even more destructive policy frameworks.
The OECD recently released a paper (May 31, 2010) entitled – The Political Economy of Fiscal Consolidation – by one Robert Price, which is in this vein – trying to regain some lost authority in the debate.
It should fail to do so given its flaws. But I guess with the media in a deficit frenzy, conservative think tanks trying to beat each other to come up with the biggest and scariest national debt clock, and witless politicians bending to every erroneous pressure that is being put on them to invoke austerity packages, this sort of paper will be referred to for the next month as something of substance. It isn’t! I would be better used as landfill.
Price says the paper:
… discusses the political economy factors which have created problems of fiscal sustainability in OECD economies and those which may have prevented or propitiated fiscal consolidation.
This is a 43-page documents so some 12,000 words or more. Not once is the string “unemployment” found in the text yet it is about fiscal policy. That one observation is enough to tell you that the OECD has a strange construction of the notion of political economy.
As you will read, the focus is all on financial ratios – deficit to GDP and public debt to GDP ratios – both of which are largely meaningless in economies with sovereign governments.
The paper presents a juxtaposition between lax governments (who create deficit biases) and the institutions that discipline this laxity:
… governments can reap a potential electoral advantage over their opponents by raising and spending money against future tax income. On the control side, the principal actors and interests include central banks and financial markets, which have an interest in preventing inflation and protecting the property rights of money and bond holders in general … As underwriters of government indebtedness the general public play an ambivalent role: they have to service government debt via taxation, but the benefits of borrowing may accrue to different groups of voters (both within and across generations) from those that pay.
I find that an extraordinary construction of the interactions. The good guys are the central banks and bond markets, the government is inherently bad and likely to be wasteful and the rest of us …!
First, democracy is about electing governments based on what we want them to do and holding them accountable if they don’t do it.
Second, the central bank and the treasury are part of government in a fiat monetary system whether they like to pretend otherwise or not. The sham of independence just means that the treasuries have become a passive partners and have allowed central banks to use unemployment as a policy tool to keep inflation stable. Central banks have thus been consistently working against the broader interests of the community. The on-going dead-weight losses arising from this strategy have been enormous and denied by the central bankers. They put out flawed and misleading research reports which try to hide the fact that the sacrifice ratios have broadly risen during the era of inflation targeting.
Third, a democracy should only have controls within the elected institutions with the right to seek legal redress where all citizens are equal unto that law. Why do we accept the fact that an unaccountable body like the central bank should have the principal macroeconomic policy role and stop elected governments from implementing their mandate? The unemployed cannot vote out or sue the central bank board for deliberately implementing policy that renders them impoverished.
Fourth, the general public do not service government debt via taxation. That is a fraudulent statement. Taxes do not fund anything in a modern monetary economy. The government taxes to create a demand for the currency and to fine-tune aggregate demand to avoid inflation. It may also tax to capture rents (as in the current mining tax dispute in Australia) or re-allocated resources away from “bads” (for example, alcohol, tobacco). A sovereign government, which issues its own currency never taxes to raise revenue even though it might say it is doing that.
Fifth, financial markets are largely unproductive and pursue greed. The maximisation of the benefits of greed should not be the basis for “controlling” what a democratically elected government should do.
The notion of “deficit bias” comes from the so-called public choice theory. Price says this literature identifies:
… an endemic bias towards deficit finance because governments can provide the electorate with benefits that do not have to be immediately paid for. Provided voters value public expenditure and consistently underestimate its costs in terms of higher future taxes, politicians can indulge in opportunistic deficit-financed public spending increases and tax cuts prior to elections, inducing a political business cycle …
However, if you are familiar with this literature then you will know it has proven to be an empirical failure. Even Price admits that the “models have come up with mixed empirical results and the hypothesis is often contradicted empirically”. But, not to let some facts get in the way of his ideologically-driven narrative Price continues to use the model anyway.
This is a common practice in mainstream economics. They invent some stupid theory which satisfies their ideological persuasion at the time. Then they decide they better “test it”. The testing models are always compromised because the theory has no empirical mapping anyway. The empirical models typically fail. Conclusion: no worries, the data was wrong! I have seen and heard this so often that it is not funny.
Price also wants to make something of this point:
Towards the end of the dotcom boom OECD-area fiscal stance became distinctly pro-cyclical, particularly in the larger euro-zone economies, pushing up structural deficits …
So what? This is an interesting point that keeps coming up – that a government should never run an expansionary fiscal stance in a growth period. Whether the discretionary component of the budget should be pro-cyclical all depends on the state of private demand and how much unemployment there is. But then Price doesn’t even consider the real economy in his polemic disguised as a credible research report.
This is the way to think about this issue.
First, the automatic stabilisers always operate in a counter-cyclical fashion. So they dampen aggregate demand in an upturn (tax revenue rises and welfare payments fall) and boost aggregate demand when economic growth falters (tax revenue deteriorates and welfare payments rise). So in a major downturn, the automatic stabilisers will always be pushing the budget balance towards deficit, into deficit, or into a larger deficit.
Second, the actual budget balance can be decomposed into the cyclical component (the automatic stabilisers) and the discretionary component which is now called the “structural deficit”. I have discussed how that decomposition is engineered in several blogs and noted that the mainstream approach is to overestimate the structural component.
Please read the following blogs – The dreaded NAIRU is still about! – Structural deficits – the great con job! – Structural deficits and automatic stabilisers – Another economics department to close – for more information on this point.
But the essential point is that there is no pre-conceived “good” structural balance. It all depends. On what? Answer: on the state of private spending.
In this context, one of the most important elements of public purpose that the state has to maximise is employment. It is not the only thing the government should be pursuing but employment is a basic connection that people have with the economy and it is usually the difference between living in poverty or not.
Once the private sector has made its spending (and saving decisions) based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment. Given the non-government sector will typically desire to net save (accumulate financial assets in the currency of issue) over the course of a business cycle this means that there will be, on average, a spending gap over the course of the same cycle that can only be filled by the national government. There is no escaping that.
The national government then has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary structural deficit is defined by this political goal. It will be whatever is required to close the spending gap.
However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government structural deficit will be somewhat smaller and perhaps even, for a time, a budget surplus will be possible.
But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the budget outcome towards increasing deficits.
Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment.
The budget will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.
So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment – which I define as 2 per cent unemployment and zero underemployment.
Fiscal sustainability cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end).
So it will not always be the case that the dynamics of the automatic stabilisers will leave a structural deficit sufficient to finance the saving desire of the non-government sector at an output level consistent with full utilisation of resources.
What this means that it is perfectly reasonable for there to be on-going structural deficits reinforcing the cycle and “financing” the desire of the non-government sector to save.
Remember a government deficit is always equal $-for-$ to the non-government surplus (and vice-versa).
This is how Price captures the emergence of the neo-liberal era. He notes that prior to the OPEC oil shocks, the dominant view was that “deficit finance could stabilise output, subject to some trade-off with inflation”. So up until the mid- to late-1970s governments used fiscal policy to maintain full employment (broadly). Price then says:
But the process of globalisation – by which trade leakages and interest rate effects reduce fiscal multipliers, especially for small, open economies – tended to create a relative conformity of views with respect to what fiscal policy can achieve compared with a growth-oriented policy of structural reform, where the public sector’s contribution is to create the conditions for private sector wealth creation. The financial crisis has called this consensus on public sector ‘neutrality’ into question, since large discretionary fiscal interventions have taken place which has been labelled a ‘new fiscal policy activism’
That is a very soothing description of the paradigm shift in macroeconomics that occurred during the stagflationary period that began with the oil price hikes.
Price’s claim that globalisation technically renders fiscal activism fraught reflects a poor understanding of the monetary system works. Given that the Bretton Woods system had already collapsed (1971), the increasingly globalised economy actually presented sovereign governments with increased capacities to use fiscal policy to pursue domestic policies.
Monetary policy no longer had to deal with managing the exchange parity and so fiscal policy was not subject to the “stop-go” growth constraints coming from the the current account.
The way governments reacted to the OPEC price hikes was nonsensical. They treated a supply shock as a demand shock and deliberately contracted their economies and added the “stag” to the “flation”. The correct way to deal with the shock was to insulate what was effectively a real terms of trade deterioration (for all oil dependent) nations from the domestic cost structure.
In effect, each nation experienced a real income loss (from the imported raw material price rise) and so there was less available for distribution to other claimants on real output – workers and capital. The correct response would have been to mediate this distributional incompatibility by ensuring that all claimants took the loss proportionately until the oil dependency was reduced by consumer and producer substitution (smaller cars, no oil heating, etc).
This policy incompetence not only created the stagflation but also allowed the neo-liberals (motivated by Friedman’s natural rate hypothesis and all the rest of the nonsense that the mainstream of my profession pumps out) to look credible. And so the demand-side management approach (so-called Keynesian approach) that had delivered sustained full employment was abandoned in favour of the pro-market, deregulation, persistent unemployment approach.
We have been living with that waste ever since and the global financial crisis was the culmination of the trends that had been building up for many years – a growing gap between real wages and productivity growth and a massive redistribution of real output to profits; the casualisation of the labour market; the deregulation of financial and other markets; etc.
The global financial crisis has demonstrated beyond doubt that the so-called “conformity of views” about the ineffectiveness of fiscal policy has dramatically failed. It should be abandoned. Private markets do not self-regulate, they are prone to dishonest and corrupt behaviour, they cannot deliver full employment, and they periodically need huge public bailouts. That sort of model cannot be the blueprint for a sustainable future.
Price also claims that the capacity of citizens (voters) to influence government policy creates a deficit bias. Fancy that. Isn’t that what the process of politics is about? Politicians say they will do A, the citizens want A, they elect the pollies who will deliver A, they use deficit spending to do so, and according to Price this is dysfunctional.
He also calims that “a lack of political cohesion appears to make it difficult to muster political support for fiscal consolidation when the necessity coincides with periods of cyclical weakness”. No! Governments are politically sensitive and when they deliberately inflict wide scale damage and hurt onto their voters, the voters get annoyed.
Further, there is never a case for fiscal consolidation (meaning austerity) in periods of cyclical weakness. That is the raison d’etre of fiscal policy activism – to counter periods of cyclical weakness driven by a collapse in private spending. It almost amazes me that the OECD can allow its workers to write this stuff and think that it is serious work. What concept of fiscal policy does Price have? Certainly, it cannot be remotely akin to what every reasonable person would consider to be its purpose.
Price then takes us into the grubby world of Ricardian equivalence (RE) (without mentioning the term until later). He claims that the private sector might respond to fiscal expansion by reducing their own spending but that:
The evidence that does emerge on private sector responses to budget deficits is mixed, but private and public saving do tend to vary inversely
There is no credible evidence supporting the RE view of the world. It was fraud from the start. Please read my blog – Pushing the fantasy barrow – for more discussion on this point.
But the so-called evidence Price notes – private and public saving do tend to vary inversely – inasmuch as we can attach any meaning to the terms is not evidence at all.
First, it makes no sense to say a sovereign government is saving in its own currency when it runs a budget surplus. Saving is the act of foregoing consumption now in order to have more consumption in the future. It is the act of a revenue-constrained spending unit (such as a household).
A sovereign government can spend whenever there are real goods and services available for sale in the currency it issues and it past budget outcome has no bearing on this capacity.
Further, budget surpluses do not go anywhere – in the sense that the savings of a household are stored in an accounting system and can be drawn down on request. There concept of the government storing up its surpluses is just inapplicable and devoid of meaning. The sovereign government issues the currency so how can it save it?
So what Price is really saying is that there is an inverse relationship between government budget balances and the non-government balance. Clearly that is true as an accounting statement and is derived as such from the system of national accounts. The government cannot run a surplus without the non-government sector running a deficit and vice versa.
Second, with that in mind, consider the causality. When private saving rises, consumption and/or investment spending falls, output and employment fall, and the budget balance moves into deficit (or larger deficit) via the automatic stabilisers. Does this inverse relationship tell us anything about the private sector attitudes about the effectiveness of fiscal policy? Not a lot at all.
Further, when there is a downturn and governments use discretionary stimulus measures to bolster aggregate demand, output and income rises. This, in turn, stimulates private consumption and saving. So the observation that rising saving accompanies expanding deficits doesn’t indicate that private agents are behaving in Ricardian manner – consumption also rises.
While Price cautions interpreting the “inverse correlation” in a Ricardian way, he still chooses to leave the impression that private agents may act to thwart the effectiveness of fiscal policy. But there is no credible evidence that suggests they do.
Price then considered the “role of financial market discipline” on governments. He claims that “markets can sometimes penalise governments for over-borrowing” and that:
… Real bond yields do seem to be pushed up as governments compete for loanable funds with the private sector, although the extent is subject to some controversy … Most research shows the effect to be very incremental and small …
Apart from the fact that governments do not compete for loanable funds given that they provide all the funds they borrow back via the spending, what exactly is the point? If there is no credible evidence available then you cannot generalise and say that markets penalise governments for over-borrowing.
He then acknowledges that “for long periods, financial market influences can be benign. The budget constraint eased in the 21st century, as evidenced by historically low bond yields” – he considers this to be “too accommodating”. He says it was a ‘conundrum’ “that the build-up in US government and external debt did not trigger a market reaction in the United States”.
It was only a puzzle to those who don’t understand that a sovereign government borrows back what it spends (irrespective of the institutional arrangements that seem to disguise that fact). Further, public debt is risk-free private wealth with a guaranteed income stream attached to it. The performance of pension funds etc over a fairly long period is not much better (risk-adjusted) than cash! So public bonds as a store of wealth are not exactly unattractive.
Price almost acknowledges this:
Subsequent to the crisis, governments (with some exceptions where sovereign risk premia have increased) have been able to finance large increases in debt at continuing favourable rates, partly because risk premia on other financial instruments have risen. The markets have thus been party to the process of fiscal ‘deconsolidation’. This behaviour would seem to be consistent with historical experience of a strong market appetite for government debt when inflation is low, but does not preclude a sudden reversal.
The exceptions are not sovereign governments.
I love the term “fiscal deconsolidation”. How biased the debate has become when a discretionary response to the worst calamity since the 1930s is constructed as being a negative outcome. The only negative outcomes relate to the real economy – the lost incomes, the lost jobs, the lost industries, etc. The budget outcome is what it is.
But moreover, his initial claim that the financial markets will kick heads doesn’t seem to be consistent with “historical experience”. Just ask Japan about that also.
The paper then considers the concept of fiscal sustainability. Price says:
There is no consensus on, and no accepted theoretical basis for, judging the extent to which a budget position is fiscally sustainable … At its simplest, sustainability can mean debt stability – present or future. But even if fiscal parameters are adjusted to the point where the debt ratio will eventually stabilise, there is no guarantee that it will be financeable without pushing up interest rates and ‘crowding out’ the private sector, generating inflation, or raising tax rates to unsustainable levels .. The most operationally influential consolidation objectives have been the 3% deficit rule, as imposed by the Maastricht Treaty, a balanced budget rule, or a balanced budget excluding public investment (the ‘golden rule’).
First, there is an accepted basis for judging the extent to which a fiscal position is sustainable. From the perspective of Modern Monetary Theory (MMT) sustainability for a sovereign government can only be assessed in how the fiscal position contributes to the achievement of real goals – such as environmentally-sustainable growth, full employment and rising standards of living distributed across all persons.
It is also acknowledged that price stability is desirable and does not have to be compromised by a government pursuing the real goals noted in the last paragraph.
The financial ratios mentioned are largely irrelevant and are endogenous and driven by private spending and saving decisions.
I also laughed when I read that the “most operationally influential consolidation objectives have been the 3% deficit rule” from Maastricht. Yes, very operational was my first thought. Adherence to the rule in the non-crisis period has forced governments to deliberately maintain persistently high levels of unemployment and stifle economic growth.
And in the crisis period, it was breached quickly as the automatic stabilisers went to work. So what sort of rule is it that would force the discretionary component of fiscal policy to work against the automatic stabilisers in a time of crisis? Only a rule that failed to represent the purpose of fiscal policy. It is a rule that deliberately sets out to undermine fiscal policy.
Further, I also love the way these writers work. Previously, Price has noted that financial markets have been benign and there have been low yields historically associated with public debt. But then, he just cannot help saying that even if you stabilise the debt ratio “there is no guarantee that it will be financeable without pushing up interest rates and ‘crowding out’ the private sector, generating inflation, or raising tax rates to unsustainable levels”.
None of those outcomes have been consistently related to budget deficits in the past. Just because the erroneous mainstream macroeconomics textbooks tell us these are the problems means nothing. These textbooks were incapable of presenting any theory that explains what has been going on over the last decade. All their predictions have been demonstrated to be wrong.
The paper goes onto to consider the benefits of fiscal rules and independent fiscal institutions.
Fiscal rules have been central to the search for fiscal discipline. The number of fiscal rules in force has increased continuously over the last fifteen years, especially within the European Union …
And … if we compare the economic performance – the real sector – jobs and growth – we will see that nations that impose these rules have performed much worse than those without strict rules.
The EU is not a shining example of anything remotely sensible when it comes to managing the member state economies – either before or during the crisis.
The trend that is emerging in the current macroeconomic policy debate is to introduce further voluntary constraints on our elected governments to prevent them expressing free will. I see this as a fundamental shift to totalitarianism – the denial of the voter to discipline economic policy settings.
Please read my blog – Fiscal rules going mad … – for more discussion on this point.
In terms of the “case for independent fiscal institutions” Price says:
The spread of fiscal rules has been associated with an expansion of independent fiscal institutions, the underlying rationale for which is that specific tasks of fiscal policy should be delegated to bodies which are less likely to be affected by distorted incentives …
So deny the citizens their right to determine the course of fiscal policy.
Towards the end of the paper Price rehearses the ageing population myth arguing that governments should run surpluses to pre-fund “at least some future social service liabilities — especially pensions” but face political problems convincing their electorates of the advantages of this strategy.
He says that sovereign funds can help:
A minority of OECD countries have built Sovereign and Public Pension Reserve Funds (SPFs) to finance at least part of the implicit liabilities stemming from pay-as-you-go public pension schemes … Investing surplus assets in privately issued securities could impose large deadweight losses on the economy because it creates incentives for private firms to lobby for public investments and the temptation for political intervention in the allocation of funds could increase. Alternatively, if the assets accumulate with the central bank it may jeopardise its independence, as noted above. An approach is thus needed that avoids the deadweight losses from private lobbying and inefficient investment of surpluses and ensures the diversification of funds across marketable assets.
The whole debate is founded on flawed reasoning. There is no financial crisis ahead for governments with pension liabilities. The only issue will be the availability of real resources. Please read my blog – Democracy, accountability and more intergenerational nonsense – for more discussion on this point.
But the sovereign fund issue is one of the big deceptions in this debate.
An understanding of MMT will tell you that a sovereign government’s ability to make timely payment in its own currency is never numerically constrained by revenues from taxing and/or borrowing. Therefore the purchase of a sovereign fund in no way enhances the government’s ability to meet future obligations. In fact, the entire concept of government pre-funding an unfunded liability in its currency of issue has no application whatsoever in the context of a flexible exchange rate and the modern monetary system. That is, it represents lunacy!
The misconception that “public saving” is required to fund future public expenditure is often rehearsed in the financial media. In rejecting the notion that public surpluses create a cache of money that can be spent later we note that Government spends by crediting an account held by banks at the central bank. There is no revenue constraint despite the image the elaborate institutional structures that government erect to suggest there is.
But government cheques don’t bounce!
Additionally, taxation consists of debiting an account at an account held by banks at the central bank. The funds debited are “accounted for” but don’t actually “go anywhere” and “accumulate”.
The concept of pre-funding future liabilities does apply to fixed exchange rate regimes, as sufficient reserves must be held to facilitate guaranteed conversion features of the currency. It also applies to non-government users of a currency. Their ability to spend is a function of their revenues and reserves of that currency.
So at the heart of all this nonsense is the false analogy neo-liberals draw between private household budgets and the government budget. Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained.
However, trying to squeeze the economy to generate these mythical “pools of funds” which are then allocated to the sovereign fund as if they exist is very damaging. You can think of this in two stages. First, the national government spends less than it taxes and this leads to ever decreasing levels of net private savings.
The private deficits are manifest in the public surpluses and increasingly leverage the private sector. The deteriorating private debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity.
Second, while that process is going on, the national government is actually spending an equivalent amount that it is draining from the private sector (through tax revenues) in the financial and broader asset markets (domestic and abroad) buying up speculative assets including shares and real estate.
That is what sovereign funds are about. It amounts to the treasury competing in the private equity market to fuel speculation in financial assets and distort allocations of capital.
However, as you can see from pulling it apart, this behaviour has been grossly misrepresented as providing “future savings” to pay for the superannuation liabilities. Say the sovereign government ran a $15 billion surplus in the last financial year. It could then purchase that amount of financial assets in the domestic and international capital markets. But from an accounting perspective the government would no longer have run that surplus because the $15 billion would be recorded as spending and the budget would break even.
In these situations, the public debate should be focused on whether this is the best use of public funds. It would be hard to justify this sort of spending when basic infrastructure provision and employment creation has been ignored for many years by neo-liberal governments.
How can the government justify purchasing speculative financial assets which it has lost several billion on while holding when there were more than 9 per cent of willing labour resources either not employed at all or being forced to work less hours than they desired because of overall spending constraints in the economy?
If we want to provide for a better future the government should be spending sufficient amounts to make sure everyone has a job. That is a minimum requirement for improving the future prospects. Then it might spend some of the $60 billion it put in the speculative sovereign funds on medical research to find cures for cancer and HIV and to make our public schooling system the best that money can buy. That would be a funding the future. The sovereign funds do nothing to enhance the futures of the citizens.
Please read my blog – The Futures Fund scandal – for more discussion on this point.
So you can see where the literature from these international economic organisations is heading. The pressures on government to relinquish their democratic responsibilities are going to be immense in the coming years. The democratic repression will increase not decrease and the only ones who will suffer will be us – and particularly the most disadvantaged citizens who will languish in unemployment and poverty.
I have worked out a new fiscal rule which should be implemented: All members of the government and the central bank board members lose a certain percent of their annual salary for every percentage point the broad rate of labour underutilisation exceeds full employment. After some gap – maybe a labour underutilisation rate 2 or 3 per cent higher than full employment the salaries go to zero!
That is enough for today!