I read an article in the Financial Times earlier this week (September 23, 2023) -…
It is now 2.15 am in Boston on a Thursday morning (16:15 Thursday afternoon in Australia East Coast). I always try to stay on Australian time when I make these short trips. It is hard while you are away but easier to adjust back when you get home. No real jet lag. Yesterday (Wednesday) I gave a Teach-In on the concept of fiscal sustainability to an interesting group of participants ranging from those with an active role in the financial markets to those with more general business interests. The participants came from all around as far as I can gather – many from New York which is a fair hike for a single day workshop. The discussion that followed my presentation was very interesting and while the concerns reflected the usual issues – solvency, exchange rates, intergenerational issues – the standard of debate was civilised. I don’t know how many Warren and I convinced to probe deeper but I hope we planted some seeds of doubt in the minds of the audience that the mainstream macroeconomics position is wrong and therefore untenable. After the Teach-In I read the BIS Annual Report 2009/10 – which signalled to me that they are now firmly part of the problem that we face when dealing with the task outlining fiscally sustainable policy positions.
On June 28, 2010, the Bank of International Settlements released their Annual Report for 2009-10 – Full PDF available. In the Overview of the Economic Chapters their message is clear although seriously deficient in its understanding of the difference between sovereign debt and privately-held debt. It also fails categorically to understand what the fiscal options of a sovereign government are.
Their basic claim is that:
The financial crisis has left policymakers with a daunting legacy, especially in industrial countries. In setting policies, they must adopt a medium- to long term perspective while they cope with the still fragile and uneven recovery. Households have only just begun to reduce their indebtedness and therefore continue to curb spending. Extraordinary support measures helped to contain contagion across markets, preventing the worst. But some measures have delayed the needed adjustments in the real economy and financial sector, where the reduction of leverage and balance sheet repair are far from complete. All this continues to weigh on confidence. The combination of remaining vulnerabilities in the financial system and the side effects of ongoing intensive care threaten to send the patient into relapse and to undermine reform efforts.
Macroeconomic support has its limits. Recent market reactions demonstrate that the limits to fiscal stimulus have been reached in a number of countries. Immediate, front-loaded fiscal consolidation is required in several industrial countries. Such policies need to be accompanied by structural reforms to facilitate growth and ensure long-term fiscal sustainability. In monetary policy, despite the fragility of the macroeconomy and low core inflation in the major advanced economies, it is important to bear in mind that keeping interest rates near zero for too long, with abundant liquidity, leads to distortions and creates risks for financial and monetary stability.
So this opening gambit is replete with all the neo-liberal fallacies that are being used to undermine effective fiscal responses to the crisis. Here is another unelected body, which really is meant to be the central banker for the central banks, lecturing democratically elected governments about what they should be doing.
I also find interventions like this interesting because the BIS has promoted the independent central bank line that the mainstream economists try to argue is the only way to discipline inflation and keep the markets happy. But then they think they can pass comment on fiscal policy. Further, how does this square against the recent ECB “fiscal” interventions. The whole construction that the neo-liberals put on the separation of monetary and fiscal policy is deeply flawed anyway, but you would at least expect them to be consistently flawed.
Further, I agree that governments have not set in place the necessary policy changes to allow the private sector to consolidate precarious balance sheets and the banks around the world are still very shaky. The bank bailouts were a mistake. The government should have nationalised the ailing banks and dealt with the toxic assets as the owner not the benefactor.
The BIS is also pushing the emerging line that the crisis was somehow something to do with structural rigidities in the real economy which need to be eliminated. This is code for deregulation of labour markets, winding back of welfare and pension entitlements and cut-backs in public services generally. Whatever we might think about these things they had nothing to do with the crisis and its severity. The argument the conservatives push is that if employment entitlements and protections were reduced significantly unempoyment would not have risen by as much as it has in various countries.
This is a spurious argument in the extreme. It really rehearses the old arguments that excessive real wages and/or other labour cost imposts (protections etc) cause mass unemployment. The argument always encounters the fallacy of composition when applied at the macroeconomic level. What might apply for an individual firm will not apply at the macroeconomic level because in the latter case demand and supply relationships become interdependent. What does that mean?
It means that for a firm, saving on labour costs might induce it to hire more. It knows the lower wages (costs) will not impact much (if at all) on the demand for the goods and services it sells. But at the macroeconomic level, we have to realise that wages are both a cost (which affects supply) and an income (which affects demand).
So a cut in wages will reduce unit costs (assuming it doesn’t impact on productivity adversely – which it probably will) but also reduce aggregate demand. The conservatives do not understand that macroeconomic level changes are, by definition, big. Please read my blog – What causes mass unemployment? – for more discussion on this point.
The BIS also join the throng that try to define fiscal space (and sustainability) in terms of what the bond markets think is possible. The operational reality is that what the bond markets think is not a constraining factor for sovereign governments. Why?
This came up in the Boston Teach-In I conducted today. It was argued in the Q&A section by one person that the bond markets reactions can alter yields and make it hard for governments to finance themselves. My answer was obvious. Only if the government allows that to happen. All the power lies in the policy hands of the government.
The arrangements that see governments issue debt $-for-$ into the private markets to match their net spending are purely voluntary and can be changed virtually any time the government wants. The institutional machinery erected by sovereign governments to facilitate the debt-issuance provide no funds to the government. It is really a reserve draining operation.
If the outcomes from the bond auctions were preventing the government from doing what it thought was best for advancing public purpose then the government could assert their power and eliminate the bond markets from the picture. It could do this in a number of ways.
For example, the central bank could control rates along the yield curve or better still the government could just stop issuing debt instruments altogether and deny the private markets the benefits of the guaranteed return when otherwise the funds would just sit there as reserves earning nothing (preferably). Please read my blog – Who is in charge? – for more discussion on this point.
The only limits that macroeconomic support has reached in the sovereign nations are political and ideological in nature. There are no financial limits. My focus today at the Boston Teach-In was to emphasise the real limits on fiscal policy.
A sovereign government always has a choice:
- maintain full employment by ensuring there is no spending gap – that is run budget deficits commensurate with non-government surpluses; OR
- maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a budget surplus will be possible.
The difference between the two options manifests as good deficits in the first case (typically) and bad deficits driven by automatic stabilisers as the economy stagnates in the second case.
In option two, the automatic stabilisers ultimately close spending gaps because falling national income ensures that that the leakages equal the injections – so sectoral balances hold. But the resulting deficits will be driven by a declining economy and rising unemployment.
Fiscal sustainability is about running good deficits to achieve full employment if the circumstances require that. You cannot define fiscal sustainability independently of the real economy and what the other sectors are doing. So while deficits will be typically required given that external deficits are common and the private sector desires to save overall, there are circumstances where the government can fulfill public purpose and ensure the spending gaps are closed yet still run budget surpluses. When? Answer: when there is a strong net exports position.
Once we focus on financial ratios, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end). That is why fiscal rules as stand-alone goals are meaningless or ideological. So the BIS talk about macroeconomic limits – which is cast in terms of the financial ratios and the reaction of the bond markets to them – is really meaningless when you get down to the operational realities of a sovereign economy in a fiat monetary system. In other words, the BIS is part of the problem and should be largely ignored.
The public debate is littered with statements that conflate political and ideological concepts with economic concepts. This conflation all but renders the economic content of the debate meaningless. Fiscal sustainability is about real economic goals. Governments should always be brought to account on that basis. There is no basis in allowing private bond markets to determine fiscal policy in a democracy.
I will write a separate blog on the BIS claim that ” it is important to bear in mind that keeping interest rates near zero for too long, with abundant liquidity, leads to distortions and creates risks for financial and monetary stability”. This is largely nonsense. For example, when are we going to become clear that bank reserves are not lent and therefore have no implications for inflation. Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.
The BIS continue to emphasise the need for “fundamental reform of the financial system” which “should produce more effective regulatory and supervisory policies as part of an integrated policy framework”. I agree with the need to fundamentally reform the global financial system but the problem is that the narrative that the BIS and similar are developing is putting the power back in the hands of the financial sector which is then using that power to derail meaningful financial reform.
The BIS then talk about fiscal sustainability:
… GDP in most advanced economies is still well below pre-crisis levels despite strong monetary and fiscal stimulus. The rapid increase of government debt raises urgent questions about the sustainability of public finances …
The level of public debt in many industrial countries is on an unsustainable path. Current budget deficits, partly cyclical but also swollen by policy responses to the crisis, are large in relation to GDP. And expenditures related to ageing populations are set to increase considerably over the next few decades. Recent events in Greece and other southern European countries have shown how quickly investors’ doubts about the sustainability of public finances in one country can spill over to others. In addition, high levels of public debt may lower long-term economic growth and ultimately endanger monetary stability. These risks underscore the urgent need for credible measures to reduce current fiscal deficits in several industrial countries. Tackling the long-term fiscal imbalances requires structural reforms aimed at boosting the growth of potential output and containing the future increase in age-related expenditures. Such measures may have adverse effects on output growth in the short term, but the alternative of having to cope with a sudden loss in market confidence would be much worse. A programme of fiscal consolidation – cutting deficits by several percentage points of GDP over a number of years – would offer significant benefits of low and stable long-term interest rates, a less fragile financial system and, ultimately, better prospects for investment and long-term growth.
I agree that the private sector has to consolidate its balance sheet but there is no comparison between private debt and public debt. The fact that GDP is “still below pre-crisis levels” means that the fiscal stimulus was not sufficient across the board. There is still massive excess productive capacity in our economies which will only be brought back into use with increased spending. There is no legitimate analogy between government and private debt. We won’t find a definition of fiscal sustainability by drawing analogies with the household budget – “government budget constraint” – basis of mainstream thinking. The conflation between the household and government budget which is at the core of mainstream macroeonomics is flawed at the most elemental level.
A sovereign government is never revenue constrained because it is the monopoly issuer of the currency. It can always service and roll-over its debt liabilities. There is never a solvency risk. Please read my blog – Debt is not debt – for more discussion on this point.
But this is an extraordinary statement by the BIS.
First, there is no credible analogy between “Greece and other southern European countries” and any sovereign nation. I noted at the Boston Teach-In yesterday that coming to terms with the notion of fiscal sustainability requires that we initially define the monetary system we are talking about and the essential characteristics of each. Any notion of fiscal sustainability has to be related to intrinsic nature of the monetary system that the government is operating within.
Typically, commentators do not undertand either point. They conflate monetary systems and also fail to understand the opportunities and constraints that each poses for the government. It makes no sense to apply gold standard logic where the currency was convertible to another commodity of intrinsic value and exchange rates were fixed to a fiat currency system to a fiat monetary system with non-convertible currencies. Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for more discussion on this point.
Further, you cannot conflate the operations of the EMU or any pegged currency system with those pertaining to a sovereign nations. It is just pure misinformation to do that. I used the example of Reinhart and Rogoff today, which is a highly selective analysis that has been inappropriately applied to all situations.
Second, the concept of fiscal sustainability is intrinsic to the ageing population – intergenerational debate but not in the way that the public thinks about it and certainly not in the way the BIS is constructing it in this Report. There is no financial crisis ahead with respect to increasing health care and pension entitlements. The government will always be able to afford to pay these bills. The actual issue is about real resource availability. By focusing on the financial we are undermining the real capacity to deliver these goods and services.
Please read my blogs – Another intergenerational report – another waste of time – and Democracy, accountability and more intergenerational nonsense – for more detailed discussion on this point.
Third, I love their admission that austerity “measures may have adverse effects on output growth in the short term”. I read this in the light of the leaked UK Treasury Report that has now hit the public domain. The UK Guardian (June 29, 2010) that the UK – Budget will cost 1.3m jobs – Treasury. This leaked report shows that over the next five years 1.3 million jobs will be lost to the British economy as a result of the “Treasury assessment of the planned spending cuts”.
Five years is hardly short-term!
The Guardian reports that:
Unpublished estimates of the impact of the biggest squeeze on public spending since the second world war show that the government is expecting between 500,000 and 600,000 jobs to go in the public sector and between 600,000 and 700,000 to disappear in the private sector by 2015.
The chancellor gave no hint last week about the likely effect of his emergency measures on the labour market, although he would have had access to the forecasts traditionally prepared for ministers and senior civil servants in the days leading up to a budget or pre-budget report.
A slide from the final version of a presentation for last week’s budget, seen by the Guardian, says: “100-120,000 public sector jobs and 120-140,000 private sector jobs assumed to be lost per annum for five years through cuts.”
So the British government knowingly is inflicting massive damage on its citizens and then in its official discourse with the voters not admitting the same. I do not consider a loss of 1.3 million jobs to be consistent with the BIS assessment that austerity cuts “may have adverse effects on output growth in the short term”. The same pattern of losses will be felt in all nations that embark on this mindless and unnecessary policy path. Please read my blog – The Great Moderation myth – for more discussion on this point. In that blog I critique the logic used by central bankers (and the BIS) to defray their responsibilities in creating real damage.
The reality is that the losses will be large and persistent. Further, in the real world, it is clear that a prolonged period of reduced real GDP growth lasts beyond the formal disinflation period and that the potential real GDP growth path also declines as the collateral damage of low confidence among firms curtails investment (which slows down the growth in productive capacity).
And I haven’t even mentioned the pathologies that accompany high and persistent unemployment. They include not only the daily income losses which are huge but also the increased crime rates, the family breakdown, the increased incidence of mental and physical health disorders, the increased alcohol and substance abuse and the generalised misery that the victims of the failed policy regimes are forced to endure. Please read my blog – The daily losses from unemployment – for more discussion on this point.
You really get a feel for the bias in the BIS Report when they claim these losses – which all the credible research has shown to be huge and enduring – are only tentative (use of the word “may”) and not persistent and that “the alternative of having to cope with a sudden loss in market confidence would be much worse.” Please read my comments above on why the bond markets do not hold the power.
Governments clearly still apply voluntary constraints which have no intrinsic applicability to a sovereign government operating in a fiat monetary system. These constraints are ideological in origin and should be exposed as such. But given that fiscal sustainability does not require the national government issue any debt – public debt issuance is just corporate welfare. Further, debt-issuance has been seen as being intrinsic to the central bank’s liquidity management operations (reserve drains) – but that is even redundant with the recognition now that central banks can just offer a return on overnight reserves.
Financial Times economics writer Martin Wolf offers some useful insights in his recent article (June 29, 2010) – This global game of ‘pass the parcel’ cannot end well.
He is writing about the G20 meeting which concluded in Toronto at the weekend. He says:
The call for “growth-friendly fiscal consolidation plans” provides something for everybody. But it assumes what is to be proved: that rapid fiscal consolidation will now support growth, rather than undermine it.
This is exactly the problem – the fiscal conservatives who are pushing the austerity line assume it will work. They make some hand waving gestures about improved net exports as real exchange rates fall or suggest that businesses and households will be so relieved that the governments will be reducing the debt burden on them (allegedly this reduces future taxes) that they will start spending again. It is highly unlikely that any of this will happen soon enough or in sufficient magnitudes to provide sufficient spending offsets to the public spending cuts.
The leaked UK Treasury Report clearly doesn’t believe there will be offsets.
Wolf also offers some interesting commentary on the BIS Annual Report. He says:
The latest annual report from the Bank for International Settlements makes the point clearly: it shows that three important deficit countries – the US, UK and Spain – had what appeared to be well-contained public debt positions, so long as household debt was exploding relative to gross domestic product. In the case of Spain, the government debt even consistently improved. The ratio of household debt to financial assets also gave a misleadingly good impression of the healthiness of the underlying debt. Then, with the financial crisis and the bursting of asset bubbles, came household deleveraging and fiscal leveraging.
These are mirror images: if the private sector runs a financial surplus (an excess of income over spending), there has to be either a fiscal deficit or a current account surplus (or both). The bigger the private surplus, the bigger the fiscal deficit or current account surplus must be. If, in reverse, fiscal deficits are to fall, the private sector must spend more relative to income or the current account must improve. Evidently, this needs to happen with higher spending, not lower incomes, particularly after a deep recession.
So he is talking about the sectoral balances and is one of the few influential commentators to actually understand the import and meaning of them. We know that the goverment deficit has to equal $-for-$ the non-government surplus and vice versa. The non-government sector is the sum of the private domestic sector and the external sector (which may have foreign government elements within the transactions flows).
This means that if the non-government sector is to be surplus (excess of income over spending) the government sector has to be in deficit. As Wolf notes, a non-govenrment surplus can arise in a number of ways given the composition of the aggregate. An external surplus greater than the private domestic deficit or vice versa, or both sectors being is surplus.
In general though, once the private sector has made its spending decisions based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment for their to be what I call fiscal sustainability. The private sector typically desires to save over the business cycle and this has implications for the government sector when there are external deficits (the typical case). Non-government spending gaps over the course of the cycle can only be filled by the government sector. So we are back to those two policy choices: (a) run good deficits; or (b) allow the economy to stagnate and end up with bad deficits anyway.
If you want to reduce private debt and the nation in question runs external deficits then you have to simultaneously advocate increasing budget deficits. There is no other way that is orderly (you might advocate default as an option). The fiscal deficits support the desire to save by ensuring aggregate demand is sufficient to support high levels of output and employment and the resulting incomes then permit the private sector to save without damaging demand.
That support role that budget deficits play is always ignored by the “austerical” gang.
Wolf then concludes that:
… it is quite clear that an isolated discussion of the need to reduce fiscal deficits will not work. These cannot be shrunk without resolving the overindebtedness of damaged private sectors, reducing external imbalances, or both. The games we have been playing have been economically damaging. We will be on the road to recovery, when we start playing better ones.
I agree with this statement.
What the austerity lobby has to outline is how the balances are going to be redistributed if there is insufficient private spending support for output growth and excessive private debt levels, external deficits and the government is then mindlessly pushed towards surplus – that is, forced to withdraw its fundamental role in supporting private savings.
Their response to date reveals they don’t even understand these complexities.
My conclusion at yesterday’s Boston Teach-In was that there is a crying need for a new macroeconomics narrative which would help us understand:
- The operational features of the monetary system.
- The opportunities each monetary system presents to the national government.
- The ability of a sovereign government to maintain continuous full employment.
I emphasised that to engage in that narrative we have to abandon the focus on financial matters and reorient the debate toward the real side of the economy. The new macroeconomic narrative is essential if the public is to be disabused of the myths that have been used to erode the collective will.
Governments that abandon full employment and then punish the victims of this policy failure including low wage workers should not be supported. A fiscally responsible government aims to maximise the potential of all of its citizens.
Public policy should always reflect that goal.
Finally, here is the fiscal sustainability checklist that I provided the audience:
- Saying a government can always credit bank accounts and add to bank reserves whenever it sees fit doesn’t mean it should be spending without regard to what the spending is aimed at achieving.
- Governments must aim to advance public purpose.
- Fiscal sustainability is not defined with reference to some level of the public debt/GDP ratio or deficit/GDP ratio.
- Fiscal sustainability is directly related to the extent to which labour resources are utilised in the economy – that is, full employment.
- A sovereign (currency-issuing) government is always financially solvent.
- You cannot deduce anything about government budgets by invoking the fallacious analogy between a household and government.
- Fiscal sustainability will not include any notion of foreign “financing” limits or foreign worries about a sovereign government’s solvency.
That is enough for today!