The absurdity of procylical fiscal policy

The Australian federal election campaign is in full swing and last night the federal opposition in Australia staged their policy launch for the federal election to be held on August 21, 2010. This is a campaign where both sides of politics are running on their respective claims to be better at implementing fiscal austerity measures. It has become a matter of who is promising the biggest budget cuts the earliest. It has made the parties barely distinguishable in terms of their overall policy appeal and has rendered both unfit to govern this country. It used to be said that procyclical fiscal policy was destabilising. This was typically in the context of neo-liberals claiming that expansionary policy always came too late and added to private spending that was already on the rebound and thus increased the inflation risk. But the reverse doesn’t appear to apply for the mainstreamers. Cutting public spending when private spending is weak is being held out as virtuous and the only way to engender growth. This inconsistency exposes the ideological nature of the austerity measures, which reflect as one UK commentator said recently – a desire to complete the neo-liberal demolition of the welfare state started 30 years ago but still incomplete or a reflection that the deficit hawks are total lunatics.

You can access the full text of the Coalition campaign launch August 8, 2010 if you want to waste 10 minutes of your life reading it.

There was not much policy actually outlined but there was a lot of politics. Describing the current federal government as the worst in our history, The opposition leader Tony Abbott said that in the first week of government, that:

… a Debt Reduction Taskforce will be established, co-chaired by Joe Hockey and Andrew Robb, to get to the bottom of Labor’s waste and mismanagement, to see the real state of the government’s books and to prepare a comprehensive plan to start repaying Australia’s $90 billion debt … After all, it’s the reforms of John Howard and Peter Costello, not the Rudd-Gillard government’s spending spree that have protected Australia from the global financial crisis … Only a desperate, a truly desperate, Labor Party could seriously maintain that putting insulation batts into roofs or building overpriced school halls kept Australia out of recession.

The Coalition understands that every dollar that government spends is held on trust from the taxpayers. A Coalition government will never take your taxes for granted because I know just how hard you work to pay for them. That’s why the new spending that the Coalition has announced in this campaign is fully costed and fully funded mostly by reductions in other government spending.

Under the Coalition, spending will always be less and tax will always be lower than under Labor. We will take the high road to surplus of cutting spending, not the low road of increasing taxes, so our surplus will be achieved with the government’s share of the economy smaller than it would be under Labor.

First, far from insulating the Australian economy from the recession, the reforms of the previous conservative government (Howard-Costello) actually increased our exposure to the crisis. That government ran surpluses for 10 of its 11 years in office and the external sector was in deficit throughtout, thus draining aggregate demand.

The only reason the Australian economy kept growing throughout this period was due to the private sector increasing its indebtedness as the financial engineers went into overdraft plying households and firms with credit. The record levels of debt now held by the private sector allowed the public sector to keep running the demand-deflating surpluses.

But this was always an unsustainable growth strategy as the private sector eventually had to reign in this binge and start saving again. At that point the fiscal drag really became evident (as the crisis emerged) and the budget was pushed back into deficit by the automatic stabilisers (falling tax revenue mostly) as the economy slowed.

So after 11 years of running surpluses we still had 9 per cent labour underutilisation rates, record household debt, degraded public infrastructure that was eroding our capacity to grow (for example, the lack of investment in our ports), and a major exposure to the looming global financial crisis.

Second, the spending on insulation batts and school halls in addition to the other components of the fiscal stimulus definitely – unequivocally kept Australia out of recession. Please read my blog – Fiscal policy worked – evidence – for more discussion on this point.

On May 12, 2010 after the Federal government had brought in their latest budget promising to run surpluses by 2012 (an act of vandalism but that is another story), the Opposition Treasury spokesperson (named as one of the proposed co-chairs of the so-called Debt Reduction Taskforce – Joe Hockey – was interviewed by a leading TV journalist. In response to the question about whether the Government estimates of the future surplus could be believed, Hockey said:

No, no one’s treating that seriously Laurie. Both the International Monetary Fund, which the Government is fond of quoting, and the Reserve Bank, which the Government is fond of quoting, both said it will be a slow recovery and yet in the budget papers they are projecting not only a trend growth but above trend growth and not just for two years but their assumptions of getting out of deficit and debt is based on seven years, an unprecedented growth period in Australia’s history. You know what? The debt is still going to be there. $9,000 for every man, woman and child just on today’s figures.

First, if they really believe that the economy is going to grow slowly in the coming year (and I certainly believe that) then their proposal to get the budget back into surplus more quickly than the government is planning would cause us to double dip into recession with a probability of one.

Second, trying to achieve a budget surplus independent of the state of private demand would almost certainly drive the budget further into deficit. The external sector is strengthening courtesy of the commodities boom but it is no where strong enough to allow the public balance to go into surplus given the private sector is trying to increase its saving ratio.

Third, I do not have any responsibility equal to $9,000 for the current level of public debt. Only the national government is legally liable for the repayment and servicing of the debt and I make no contribution whatsoever to that task. The government just credits bank accounts when it repays maturing debt or makes the interest servicing payments.

This theme – holding out procyclical fiscal policy as the exemplar of fiscal responsibility – was elaborated on further by the opposition leader in the campaign launch. It is now being used as the “theme” for the austerity proponents. It is an outright lie that should be exposed for what it is.

The problem is that the Labor government in Australia is so bereft of economic capacity that they believe the myth themselves. The campaign has become a battle of who can get the biggest surplus in the shortest period of time without any reference to anything else.

Abbott said this:

So ladies and gentlemen, it’s more important than ever for government to be frugal when Australian families have to be so careful with their own spending. My wife Margie and I know what it’s like to juggle a family budget and share people’s anger when government wastes billions on indulgent schemes designed to fix headlines rather than to fix problems.

There’s little point announcing new initiatives for families if the money to pay for them has to be borrowed or taken from the very families it’s supposed to help. That’s why the Coalition’s family initiatives in this election don’t rely on extra borrowing or on new taxes on consumers.

First, there is no possible parallel that can be drawn between a household budget and the budget of a sovereign government. Mainstream macroeconomics starts with this flawed analogy between the household and the sovereign government as a means to justify the imposition of fiscal discipline on the government.

They argue that any excess in government spending over taxation receipts has to be “financed” in two ways: (a) by borrowing from the public; and/or (b) by “printing money”. They claim the second option is always inflationary so deficits have to be funded via debt-issuance.

Neither characterisation is remotely representative of what happens in the real world in terms of the essential nature of the operations that define transactions between the government and non-government sector.

Further, the basic analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.

Second, Abbott chooses to rehearse a line that we have been hearing rehearsed in the UK by the new conservative Prime Minister there that when the private sector is being frugal the government also has to be frugal.

Unless the economy has nominal aggregate demand growth well in excess of the real capacity of the economy to absorb it and you would see very rapidly accelerating inflation if that was the case (not slowing inflation as in Australia) then this is absolutely the opposite role that the national government should be playing.

The fact is that private spending is flat in Australia at present. The only thing that has maintained growth to date (as demonstrated by the first-quarter National Accounts data) was the fiscal stimulus.

The two fiscal stimulus packages introduced in late 2008 and February 2009 were correct responses. There was some waste in the spending. There was some poorly targetted spending. The jobs dividend was less than it should and could have been. But there can be no doubt that the fiscal interventions saved the economy from disaster.

Abbott’s speech writer must have read the musings of new British PM David Cameron when he penned the campaign launch speech. On June 7, 2010, Cameron made a speech 1 month into taking office where he sought to explain to the British population why he was introducing a very harsh fiscal austerity program.

You may have seen reference to this speech at the time but it revealed the extent to which the British public had been duped by the electoral spin and how little scrutiny there was in the public debate in Britain from experts with a counter viewpoint. Here is the classic statement that he made in that speech when referring to the Labour government’s fiscal intervention:

Nothing illustrates better the total irresponsibility of the last government’s approach than the fact that they kept on ratcheting up unaffordable government spending even when the economy was shrinking.

This is an extraordinary statement. It led UK Guardian economics journalist Larry Elliot to post a BBC Op Ed on June 13, 2010, entitled The lunatics are back in charge of the economy and they want cuts, cuts, cuts.

Elliot correctly notes that:

Budget deficits are certainly high across the G20 and beyond. But they are high primarily because of the severity of the worst recession since the second world war and because of the action taken collectively by governments to prevent that recession turning into something far, far worse.

If you consider the deficiency in private spending at present then there is a growing need for fiscal support of production and income. There is no magic in this statement

Elliot noted :

In the US, the private sector was in deficit by 4% of GDP in 2006 but is now running a surplus of 8% of GDP. In Britain, the corresponding move was from a 1% deficit to a 10% surplus. He estimates that the global private sector surplus is now $3.3 trillion.

These are counter-balanced by pubic sector deficits that also total $3.3tn. The public sector, in other words, has been compensating for a lack of private demand. This spending was not “irresponsible”, although a collective attempt to rein in deficits when the private sector recovery is so anaemic certainly would be.

But that sort of understanding is now lost on our political leaders.

The UK Sunday Observer published a piece by British Keynesian economist John Eatwell yesterday (August 8, 2010) entitled – Coalition spinmasters have learned Mandelson’s tricks. Eatwell reflected on the absurdity of Cameron’s statement as follows:

The latest GDP figures demonstrate that over the past 18 months it was government expenditure that prevented a sharp recession becoming a sustained depression. Over the past year, demand from households, firms and net exports has fallen. Even now, government expenditure is vital to the maintenance of the fragile recovery.

So there is a serious disconnect between what is actually driving the UK economy and how this is being represented to the voting public. Eatwell calls its spin. I call it ignorant lies or deliberate deception.

Back to the Abbott campaign launch – he chose to conclude his speech in this way:

And let’s start, from day one, repaying the debt, stopping the big new taxes, stopping the boats and helping struggling families.

Which is an outright lie in the sense he is meaning it. The federal government is repaying its outstanding debt all the time as it matures – by simply crediting bank accounts of those who are holding the asset at the time of maturity.

But Abbott is trying to suggest that they will reduce the overall debt holdings from day one – that is an outright lie because they are not remotely in a position to run a surplus yet.

The household sector is trying to maintain a rising saving ratio and we are running an external deficit. If the government could cut enough net public spending in the first week to record a surplus in that week, the economy would collapse in depression.

By the way, as an aside, the reference to stopping the boats relates to the hysteria the conservatives are whipping up about the refugee boats that head to our shores from Asia. The Labor party have also bowed to the pressure by the ignorant xenophobics and both parties are now trying to sound “tough” on border protection. The refugees are often from nations we have helped to invade in the first place. But in terms of overall numbers more illegal immigrants arrive every day by plane as visitors who stay on than ever come on leaky boats. This particular debate is a very shameful part of our national psyche and reflects poorly on both sides of politics.

Back to fiscal matters. A reader (thanks Robert!) asked me to reflect on an interview that was broadcast on the US Real News Network yesterday (August 8, 2010).

The Real News Network claims it “is a television news and documentary network focused on providing independent and uncompromising journalism” allowed the target of the interview to pump out disgraceful propaganda while appearing to be an authority on the subject.

It was a case of an interviewer who didn’t have the capacity to really expose the charlatan he was eliciting responses from. The latter was the well-known opinion writer Eric S. Margolis who is best known for his views on the wars in the Middle East and the struggles between Islam and the US.

The full transcript of the interview is a better way of accessing it rather than wasting your bandwidth watching the video. The responses Margolis provides are truly moronic but scary because he is held out as an authority on the topics he discusses.

The interviewer was the senior editor for The Real News Network, Paul Jay. I decided to interleave myself on the conversation as follows:

JAY: One of the things you’ve been writing recently is in praise of the austerity measures in the UK. You were supportive of the G-20 call for halving the deficit by 2013. You’ve been saying America desperately needs austerity measures, even though they’ll be unpopular. Why do you think so?

MARGOLIS: Debt is what caused the financial crisis of 2007-2008. The United States is drowning in debt. Its whole financial system is being debauched and it could topple any day now. The United States can’t pay its bills. It runs on borrowed money. In fact, the United States, as I’ve been writing, is addicted to debt and to war. And the red Chinese now own $1 trillion of American debt. The only way the American government can keep working is by selling IOUs to the Chinese. This is an untenable and unacceptable situation.

First, given it “could topple any day now” I guess that is why yields on public debt are consistently low and there is an over-demand for each bond auction. The bond markets are clearly signalling they cannot get enough public debt.

Second, I love the reference to “red Chinese”. Margolis is fiercely anti-communist. His reference is designed to press the emotional buttons not speak to people’s intellects.

Third, the US government doesn’t have to sell any IOUs to anyone to “keep working”. It could change the regulations that force it to issue debt to match its net spending any time the bond markets chose to cause it grief.

Fourth, there is zero solvency risk in terms of debt issued by the US government in US dollars. To say otherwise is to misunderstand the capacity the sovereign government has in that country.

Skipping a question, Jay then pointed out that “the crisis of 2008 wasn’t state debt” and this interchange occurred:

MARGOLIS: Well, yes. It was debt, I said. It was debt. It’s all kinds of debt.

JAY: Private, not public. I mean, it became public because the public was asked and agreed to-through the administration, to funnel trillions of dollars back into Wall Street.

MARGOLIS: That’s quite true. But the US government cannot raise enough in taxes now, so it has to finance its current and future operations through ever larger debt demands, which are undermining the commercial markets and jeopardizing it. I’ve just come from Wall Street. I’ve been talking to leading money managers. I manage money myself. And I can tell you that people are really very, very nervous. They say the system is very fragile, and one event could set the thing into crisis again or could topple the banks and make liquidity vanish. So we are drowning in debt.

Debt isn’t debt Eric. So while private debt may or may not be a problem and does raise the question of solvency of the debtors public debt is never an issue in this regard. It is clearly desirable that private debt levels be reduced at this time to reduce the precarious nature of the private balance sheets. But in saying that there are no parallels that can be drawn about public debt. It is simply a totally different construction.

An economic growth strategy based on running budget surpluses (withdrawing net spending from aggregate demand) and then relying on increased private sector indebtedness (negative saving) to keep demand growing is unsustainable. We need to learn that from this current episode.

We need to learn that the budget surpluses are causally related to the private debt binge. If the private sector didn’t increasingly load itself with debt then the government sector would not be able to run surpluses for very long. The output levels (income generation system) would react to the fiscal drag and contract and the resulting cyclical downturn would, via the automatic stabilisers, push the budget into deficit up to the point that the net public spending matched the desired private saving desires. You cannot escape this.

Further, the private debt build-up cannot sustain itself if there is nothing real created. Please read my blog – Debt is not debt – for more discussion on this point.

The other important point that Margolis clearly doesn’t understand is that if you want the private sector to run down its debt and the nation is in external deficit (as in the case of most nations including the US), then the only way this can happen is if the public sector is running a budget deficit.

Under the unnecessary voluntary arrangements that the US government follows whereby it issues debt $-for-$ to match its net spending, despite not being financially constrained, public debt levels have to rise to allow the private sector to reduce its debt levels. It is impossible to have both the public sector and the private sector deleveraging if there are external deficits.

But for Margolis, we shouldn’t let a bit of macroeconomic theory and understanding get in the road of his attack on the “red Chinese”.

Finally, as I noted above – the bond markets are very stable at the moment. So I wonder who Margolis was talking to when he visited Wall Street. Yields in Japan went below 1 per cent last week as bond investors couldn’t get enough of the assets. Please read my blog – The government is the last borrower left standing – for more discussion on this point.

There was an interchange that followed between Jay and Margolis where the latter noted that “Americans are not taxed enough” and that the “Pentagon, consumes 50 percent of the world’s defense spending-50 percent. It is incredible, at a time when the American deficit is at $1.4 trillion for this year, 2010, that the Pentagon is increasing defense spending by 6 percent”. He concluded that the US was “addicted to debt and to war”.

The latter I can agree with!

Jay asked Margolis whether a better way of implementing budget cuts would be to tax the wealthy and target the Pentagon rather than “going after Social Security … after people’s retirement funds”. Margolis gave the extraordinary reply:

Well, unfortunately, you know, we should do what Prime Minister Cameron is doing so well in England, and that is cutting across the board. Everybody’s going to have to pay.

The problem is that the UK austerity program will hurt the weakest citizens – the sick, the disabled, the uneducated and the unemployed (where some of these characteristics closely overlap).

Wall Street bankers will not be hurt by the austerity.

The interview then followed this train of thought:

JAY: Well, isn’t that the point here is that it’s easier to go after less state employees, less teachers, less policeman, less food stamps, it’s so much easier to go after that than take on the powers that be, where the money really is?

MARGOLIS: Everybody has to be taken on.

JAY: But if you take on ordinary people’s spending power, that’s part of what got us into this economic crisis in the first place. There wasn’t enough real purchasing power, and people were using their credit cards.

MARGOLIS: And people got scared. But public sector unions are another major villain, and they need to have their cushy lifestyles cut back. And this is exactly what’s happening in Europe right now. Europeans have decided, who’ve been through inflation of the 1930s, they are making massive cutbacks. Even though everybody’s screaming and yelling about it, they know. They got a big scare with the drop in the euro and the recent crisis there. But Obama keeps pouring on more of what caused the crisis, which is debt.

So the early interview as a “red Chinese” bash and now it is a “union bash”. The public sector unions had very little to do with the factors that caused the global financial crisis.

But interspersed is some ridiculous reference to inflation. There is only a risk of deflation at the moment unless we see an energy crisis initiated by the OPEC countries. But energy price pressures will have nothing to do with fiscal policy settings. They will be cost-push in origin rather than demand-pull and the remedy is not to reduce aggregate demand.

Further, it is true that the public sector has resisted the degradation of working conditions that the neo-liberals have been able to accomplish in the private sector over the last few decades. Now the austerity is focusing on the areas that were best able to defend their members.

The BBC Op-Ed by Larry Elliot noted above commented in the case of the British austerity program:

So why are they doing it? Is it, for all Nick Clegg’s guff about “progressive cuts”, that the real agenda is to complete the demolition job on welfare states that was started in the 1980s? Or is simply that the deficit hawks are simply crackers?

The reality is that the austerity is not addressing any macroeconomic problem. It is all about finishing off the neo-liberal program to shift power to capital and reduce the capacity of the unions to protect their constituents.

The Margolis interview then descended into farce. After telling Jay how impressed he was with PM Cameron, Jay noted that the UK cuts were hurting essential services like education and child-care. Margoli responded by repeating that the cuts must be “across-the-board” to force the country to go on “a crash diet”. Everybody has got fat!

Jay then said:

JAY: Well, I don’t know about everybody. There’s a lot of people working two jobs just to pay their rent and eat. I’m not sure how fat they’re getting. And they’re the ones going to be losing the daycare center.

MARGOLIS: Yeah, but they don’t pay the taxes.

At which point I wondered what planet Margolis has been living on. What has the payment of taxes got to do with the desirability of certain services? Just because we create labour markets where some of the most important workers – the ones that actually look after and nurture our children in their formative years – are grossly underpaid so they don’t pay large volumes of taxes – does that justify further reducing this capacity?

Jay noted that the low-paid workers which the UK government is targetting in its austerity measures are “also not the people that … helped contribute to the finance crisis” and caused the budget deficit to increase to bail out the bankers etc.

He also pointed out to Margolis that cutting these child-care centres etc might reduce the public outlays by some small percentage but the loss of purchasing power will further damage the growth prospects of the economy.

Margolis responded to this by saying:

That’s the risk. That’s the risk … My personal view as a businessman for many years is that what we need is dramatic and drastic cuts, and people will suffer for a short period, but we’ll restore and revitalize our economy so we can go ahead to more future growth. If we don’t do it, we’re going to be saddled with this debt monstrosity from now till kingdom come, and we’re never going to pull ourselves out of this swamp.

The risk is a certainty. Margolis revealed he hasn’t worked that out in any intrinsic way – he is just buying into the religous zeal that the austerity measures will magically increase private spending.

That is, as you cut the very essence of growth – spending – growth appears. Only a religious zealot who had been indoctrinated by the mainstream text book mantras about Ricardian Equivalence could possibly believe this.

Conclusion

Wait until late 2010 and into 2011 – then we will see the damage that is being caused by these “lunatics”.

Which allows me to give Larry Elliot the last word who asked whether the austerity was part of the vicarous agenda to “complete the demolition job on welfare states that was started in the 1980s” or is it “simply that the deficit hawks are simply crackers”?

Either way, we now have the bizarre spectacle of China, Japan, the eurozone and Britain all set on reducing budget deficits while simultaneously pursuing export-led growth. This is a logical absurdity because somebody, somewhere has to be importing all the exports. If the rest of the world assumes that the US is once again going to become the world’s spender of last resort it is seriously mistaken.

Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.

That is enough for today!