Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
The coming period will be an interesting test. I say interesting in the sense of an intellectual curiosity rather than anything that my sense of humanity might find to be acceptable. I am referring to the widespread acceptance by politicians around the world that fiscal austerity is good for growth. Governments are increasingly getting bullied into adopting austerity measures apparently thinking they will help their economies grow. My bet is that the austerity measures will undermine growth and when growth finally returns it will be tepid and as a result of other factors not related to the austerity. In the meantime there will be massive casualties among the poor and disadvantaged. So if the Flat Earth Theorists (FETs) are correct in a few months we should be seeing rapid growth and reductions in the deficits. Of the countries that have led the charge (for example, Ireland) things don’t look good for the FETs. So we will see. If they are wrong you can be sure that various ad hoc responses to anomaly will be forthcoming. For example, I lost my briefcase on the way to work which had a key to growth in it! Excuses like that. The mainstream have never and will never admit they are wrong. The task will be to show the people that this rabble of economists should be ignored.
In today’s Wall Street Journal (June 18, 2010) former Federal Reserve chair Alan Greenspan was making the case for austerity – U.S. Debt and the Greece Analogy. Please read my blog – Being shamed and disgraced is not enough – for more discussion on what I think of Greenspan strutting the public stage still.
Greenspan says that we should not “be fooled by today’s low interest rates. The government could very quickly discover the limits of its borrowing capacity” and that:
An urgency to rein in budget deficits seems to be gaining some traction among American lawmakers. If so, it is none too soon. Perceptions of a large U.S. borrowing capacity are misleading.
Despite the surge in federal debt to the public during the past 18 months … inflation and long-term interest rates, the typical symptoms of fiscal excess, have remained remarkably subdued. This is regrettable, because it is fostering a sense of complacency that can have dire consequences.
Which tells me that there is no fiscal excess in the US. How could there be when the unemployment rate is 9.7 per cent (May 2010) and the broader measure of labour underutilisation is above 16 per cent.
But I liked the turn of phrase – it is regrettable that things are not going bad as the deficits increase and people might start to realise that the FETs deficit hysteria is just that – an hysterical, ill-informed knee-jerk.
His main argument is that the bond markets will soon punish the US government – “(h)ow much borrowing leeway at current interest rates remains for U.S. Treasury financing is highly uncertain”.
So when you haven’t any case to make you just introduce “uncertainty”. I would bet that the leeway is greater by far than the US government would ever have to borrow!
At least Greenspan makes one correct point, which is usually lost on the FETs:
The U.S. government can create dollars at will to meet any obligation, and it will doubtless continue to do so. U.S. Treasurys are thus free of credit risk. But they are not free of interest rate risk. If Treasury net debt issuance were to double overnight, for example, newly issued Treasury securities would continue free of credit risk, but the Treasury would have to pay much higher interest rates to market its newly issued securities.
So there is no risk of solvency. That should have been headlines. There is no sovereign debt risk in the US.
It is also clear that under the current institutional mechanisms that the US and other governments use to issue debt (including private auctions) the bond markets do have a say in setting the yields on public debt. Please read my blog – On voluntary constraints that undermine public purpose – for more discussion on this point.
The point is that should this unnecessary and voluntary system ever get in the way of the government’s ability to do what it wanted – there would be a change in the institutions. I would doubt that a sovereign government would ever allow itself to be permanently controlled by the bond markets.
The most simple way under the current institutional arrangements was outlined in my blog – Operation twist – then and now. I noted that in a 2004 paper written by Ben Bernanke, Vincent Reinhart, and Brian Sack – Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment – the authors examine the future of monetary policy when short-term interest rates, the principle tool of monetary policy get close to zero (as they are now).
They seek to explore whether alternative strategies would be effective when the short-term interest rate was zero. One policy alternative that can be effective is changing the composition of the central bank’s balance sheet “in order to affect the relative supplies of securities held by the public.”
The authors note that the:
Perhaps the most extreme example of a policy keyed to the composition of the central bank’s balance sheet is the announcement of a ceiling on some longer-term yield, below the rate initially prevailing in the market. Such a policy would entail an essentially unlimited commitment to purchase the targeted security at the announced price.
It is also interesting that the authors (in a footnote on page 25) say that “In carrying out such a policy, the Fed would need to coordinate with the Treasury, to ensure that Treasury debt issuance policies did not offset the Fed’s actions.” So as long as the government operates as a consolidated policy sector their actions will be self-reinforcing.
Mainstream economists have eschewed this sort of strategy and claim that the only way this could be successful would be if it ratified the market. That is, the only way the central bank could “enforce a ceiling on the yields of long-term Treasury securities” would be if the “targeted yields were broadly consistent with investor expectations about future values of the policy rate”.
So Greenspan’s conclusion is heavily predicated on the assumption that the central bank will not operate outside the little neo-liberal box which sees it manipulating interest rates (and causing unemployment) to fight inflation.
The rest of Greenspan’s arguments are about movements in spreads between public and private debt which are largely irrelevant once you realise the government is in charge.
Later in the article there are some interesting points. In talking about the ageing population and the implications for fiscal policy, Greenspan says:
We cannot grow out of these fiscal pressures. The modest-sized post-baby-boom labor force, if history is any guide, will not be able to consistently increase output per hour by more than 3% annually. The product of a slowly growing labor force and limited productivity growth will not provide the real resources necessary to meet existing commitments. (We must avoid persistent borrowing from abroad. We cannot count on foreigners to finance our current account deficit indefinitely.)
Only politically toxic cuts or rationing of medical care, a marked rise in the eligible age for health and retirement benefits, or significant inflation, can close the deficit. I rule out large tax increases that would sap economic growth (and the tax base) and accordingly achieve little added revenues.
Several things are to be noted here.
First, foreigners will stop net exporting to the US when they have accumulated enough US-dollar denominated financial assets. In the meantime, the US citizens can enjoy the real booty. It is true that if the foreigners do saturate their desire for US-dollar financial assets then there will be real cuts in the US standard of living. Enjoy it while you can. I doubt that day is coming any time soon.
But from a Modern Monetary Theory (MMT) perspective, the correct way of thinking about it is that the US consumers are “financing” the foreigners desire to accumulate savings in US-dollar denominated assets.
Second, his ideological propensities are on display. The free market lobby hate taxes. But the empirical evidence is that cutting spending is worse for aggregate demand than increasing taxes because some of the tax rise is taken out of saving. A spending cut is a $-for-$ cut in demand – direct and fast.
Third, the point about running out of real resources is the interesting one. That since sentence is actually what the intergenerational debate should be focused on. The current focus on financial matters is erroneous. The question will always be – will the production system at some future date be able to produce enough real goods and services to satisfy the demand for them?
Thinking about that leads one to conclude that the last thing you would want to be doing now is to cut public investment in technology and education. Those two areas of investment will provide the know-how and the skills to lift productivity in the future.
Further, leaving huge proportions of your willing labour force idle is not the way to deal with the future. Government should aim to maximise income in each period to create as much private saving as is desired.
Finally, if there is a shortage of real goods and services in the future it doesn’t follow that you would want to have less public command over them. It might be a better option to reduce output of the private Walmart type products in favour of more sophisticated public provisions of health and aged care. Ultimately, all these allocation decisions are political anyway.
And Greenspan leaves us with no doubts that he is a FET:
The United States, and most of the rest of the developed world, is in need of a tectonic shift in fiscal policy. Incremental change will not be adequate. In the past decade the U.S. has been unable to cut any federal spending programs of significance. I believe the fears of budget contraction inducing a renewed decline of economic activity are misplaced .. Fortunately, the very severity of the pending crisis and growing analogies to Greece set the stage for a serious response …
So the Greek conflation error again and a blind belief that if you cut spending the economy will grow. It will not!
Sayonara Japan …
But the idea is catching on. The Wall Street Journal carried the story yesterday (June 17, 2010) – Japan’s DPJ Unveils Platform – which reported that:
Japan’s new prime minister told voters to brace themselves for the pain of a major tax increase as a way to avoid a Greek-style debt crisis, adopting a higher sales tax as the centerpiece of his economic and political platforms.
Accordingly, the Japanese government is planning to fast-track a doubling of the “sales tax from the current 5% over the next few years” and has reneged on a promise that it would wait until 2013 before it considered increasing the consumption tax.
The Government is claiming tha this will allow Japan to achieve a 3 per cent nominal GDP growth rate over the next decade “a level Japan hasn’t seen since the early 1990s”.
The Government will also “cap next year’s debt issuance at the current fiscal year’s level and aim to balance its main budget within 10 years”.
The Prime Minister said in releasing his new growth strategy:
We can’t be an idle spectator of the turmoil in Europe started by the fiscal collapse in Greece
So you can see how far this Flat Earth Theory (FET) thinking has permeated. Here we have the PM of the second largest economy in the world (soon to become the third largest) which is totally sovereign in its own currency and as such has no solvency risks saying that a small European nation that is part of a monetary union is an comparitor.
There is no legitimate comparison between a nation that does not issue its own currency, does not set its own interest rate and does not have a flexible exchange rate (any EMU nation) and Japan.
The tragedy that the commentators are drawing this connection every day now as the pressure on fully sovereign nations to cut back is mounting.
The proponents of the tax hike in Japan say that “the rate of the tax in Japan is far lower than in most other developed nations … [and] … it’s so broad-based that a small increase will instantly boost tax revenues”.
The level has nothing to do with the likely marginal impact. It is the change that will impact. Consumers have adjusted to the current level. They will now face a sudden drop in their purchasing power and theory tells us that they will react by reducing spending.
A bank economist responding to the predictions that it would “increase the tax revenue annually by 10 trillion yen ($110 billion)” said:
That’s a substantial amount and definitely positive for the debt market …
Lets assume it is “positive” for the debt market – all this tells me is that priorities of the “debt market” are not those that a government should adopt or pander too when it is seeking to advance public purpose. Being forced to reduce economic activity when it is already close to a sustained recession is not in the interests of the citizens of that country.
As I noted at the outset, as these tensions increase – between what the amorphous debt markets deem suitable and what is best for the nation as a whole – a new discourse may open up challenging the whole neo-liberal obsession with a sovereign government issuing debt when it clearly doesn’t have to.
In terms of the sales tax hike, Japan has been down this road before and appears not to be learning from its past mistakes.
An opposition politician made the obvious point that the move will damage consumption:
Boosting the economy with a tax hike? That’s an obscene stretch …
And another academic critic said:
What I am afraid of is the return of the 1997 experience … The economy may seem to be doing fine right now but it still has weak spots and the recovery is propped up by government stimulus plans …
So what happened in 1997?
In the 1990s, as Japan was struggling to grow again after its property collapse, the pressure mounted on the government to cut its growing deficit. All the same arguments were presented then as now.
The “Ohira shohizei curse” is named after the 1970s Prime Minister (Ohira) who tried to introduce a consumption tax in Japan and his party lost its majority in the 1979 as a result of voter backlash (shohizei is the name for sales tax).
However, in the late 1980s, a 3 per cent tax was introduced and this again damaged the leadership of the government politically. The political damage continued in 1994 when the then Prime Minister tried to increase it to 7 per cent.
But the FETs were out in force as the deficit rose in the second-half of the 1990s and in 1997 the government pushed it up to 5 per cent. The so-called “lost decade” was firmly entrenched as a result.
The following graph shows the quarterly percentage growth in real GDP, real private consumption and real private investment in Japan between March 1996 and December 1998. The datat is taken from the OECD Main Economic Indicators.
This is what the “Ohira shohizei curse” is about. You can see that private consumption responded to the tax hike negatively and this impact endured for several quarters into 1998 (albeit with one quarter of modest recovery) until the government recanted and implemented a new fiscal stimulus. The situation was made worse by the fact that private investment also fell as overall growth plummetted.
While there is a lot of bravado among those calling for the spending cuts and/or tax hikes, they are yet to offer any coherent explanation as to why the obvious outcome will not apply this time. With the world mired in recession or tepid growth and little sign of a private spending comeback, the dangers of a private consumption reversal in Japan are even greater now.
The next graph shows the same growth series for Japan from March 2007 to March 2010. As you can see there is only the most fragile recovery evident in Japan at present. It is highly likely that reducing the spending capacity of consumers will repeat the disastrous 1997 episode. A major difference between now and then was the behaviour of exports. While they slowed considerably in 1997, the collapse in growth in the December 2008 quarter (-14.2 per cent) and the March 2009 quarter (-24.8 per cent) was unprecedented.
The fact that the Japanese government are prioritising what they perceive to be the demands of the bond markets is part of the general trend towards the supremacy of the largely unproductive financial markets in determining policy outcomes. This point was raised by the biographer of J.M. Keynes, Robert Skidelsky wrote in the Financial Times (June 16, 2010) – Once again we must ask: ‘Who governs?’
In the 1970s, as the neo-liberal rise to policy dominance was beginning the vehicle they used regularly was to raise the spectre of “union power”. As Skidelsky says:
In 1974, Edward Heath asked: “Who governs – government or trade unions?” Five years later British voters delivered a final verdict by electing Margaret Thatcher. The equivalent today would be: “Who governs – government or financial markets?” No clear answer has yet been given, but the question may well define the political battleground for the next five years.
I discussed this issue some months ago in this blog – Who is in charge?.
Skidelsky notes that underlying the calls for austerity is the old classical belief that “market economies are always at, or rapidly return to, full employment.” So the mainstream macroeconomics textbook considers policy interventions to be largely a waste of time because the economy will deliver desirable outcomes anyway.
This is the argument that was presented during the 1930s Depression – the “famous “Treasury view” of 1929″. The debate then which has become known as “Keynes and the Classics”. The “Treasury View” failed to deliver policies that solved the Depression and the application of the same sort of policies, which is being advocated now, will also make things worse.
I deal with that debate in detail in this blog – What causes mass unemployment?.
Skidelsky points out that:
By contrast, Keynes argued that demand can fall short of supply, and that when this happened, government vice turned into virtue. In a slump, governments should increase, not reduce, their deficits to make up for the deficit in private spending. Any attempt by government to increase its saving (in other words, to balance its budget) would only worsen the slump.
This viewpoint became the dominant policy perspective in the full employment era following the end of World War II.
But here Skidelsky introduces an interesting nuance. Apart from the Chicago and Harvard ideologues who just push their own work, Skidelsky says that the main driver of the current call for austerity is a claim that governments have:
… to restore “confidence in the markets”. The argument here is that deficits do positive harm by destroying business confidence. This collapse of confidence may come in several forms – fear of higher taxes, fear of default, fear of inflation. Deficits thus delay the natural (and rapid) recovery of the economy. If markets have come to the view that deficits are harmful, they must be appeased, even if they are wrong. What market participants believe to be the case becomes the case, not because their beliefs are true, but because they act on their beliefs, true or false.
So it is about expectations. And the FETs know that the louder they shout and the more mindless media lackeys they can invoke to spread the shouting the stronger the fears will become. It doesn’t matter that there is no substance in any of these fears. That seems to be what is going on at present.
Skidelsky notes that this was rehearsed 1931. The UK Conservative-Liberal coalition “introduced an emergency budget in September 1931” which Keynes described in this way:
… replete with folly and injustice … every person in this country of super-asinine propensities, everyone who hates social progress and loves deflation, feels that his hour has come and triumphantly announces how, by refraining from every form of economic activity, we can all become prosperous again.
There is nothing new about all this. Britain went backwards in 1931 and ultimately had to abandon the gold standard and the resulting depreciation of the currency stimulated exports enough to get some growth going. But the real growth did not come until the war spending in the late 1930s. But the conservative approach was a total failure.
In this sense, Skidelsky says:
We are about to embark on a momentous experiment to discover which of the two stories about the economy is true. If, in fact, fiscal consolidation proves to be the royal road to recovery and fast growth then we might as well bury Keynes once and for all. If however, the financial markets and their political fuglemen turn out to be as “super-asinine” as Keynes thought they were, then the challenge that financial power poses to good government has to be squarely faced.
It is too early to tell but the current situation might reach a stage where the population start to realise that when the governments bend to the amorphous bond markets they are deliberately undermining the general welfare of the people.
I think the Greeks are realising this. The Spaniards will soon. But in every country the aim is to broadcast this high and low. It is also essential that people understand that the constraints on governments are voluntary and only serve the interests of the top-end-of-town.
Then the debate might broaden. What is desperately needed are new think-tanks on the progressive side that can really prosecute the case properly.
The Saturday Quiz will be back sometime tomorrow – even harder than last week!
That is enough for today!