Sometimes everything comes together in unintended ways. That has happened to me this week. I…
I don’t run a blog on demand service. But today a specific request – almost a desperate plea – from one commentator to provide some analysis of a specific article coincided with many requests I have had for clarification about when a government is revenue constrained. The specific article in question apart from being one of the worst examples of uniformed economics journalism covers the ground about levels of government perfectly. So I decided to behave like a blog on demand service today despite wanting to write about how the US is a failed state. That will wait until Monday though and by then even more Americans will have slipped into poverty driven there by failed US government policy and a sclerotic system of government dominated by two main parties that are now incapable of governing in the public interest.
As an aside, I laughed this morning when my mate Marshall Auerback e-mailed me with the quip that Christine O’Donnell was a perfect candidate to advance the case for extreme fiscal austerity because she appears to be against stimulus of any kind. That was an amusing start. But apparently “she is very good looking” and given the quality of the US system of elections that she will apparently “get many votes through that alone” (Source). I have no opinion about either point! But how the hell does someone like that get anywhere near the halls of power? Answer: the failed state conjecture!
The specific article I was asked to discuss was published by our national daily (the only national newspaper) The Australia which is the centrepiece of News Limited (a la Fox) attack on sensible debate in this country. It is a bit more literate than the US Fox channel and its right-wing vehemence and outright biases are slightly more muted. But it is Rupert’s baby nonetheless.
The article (published September 17, 2010) carried the headline – States’ debt binge to top $240 billion as private sector faces squeeze.
While the article is focused on the behaviour of the Australian state governments the analysis I provide here is relevant to any federal system.
Australia’s system of government comprises a hierarchy with federal, state and local levels. The federal government which is fully sovereign in the sense that it issues its own currency and floats it on international markets.
The Australian government is never revenue constrained as a result of it being the monopoly issuer of the currency (the $AUD). Its status is equivalent to that of the national governments in the US, Japan, the UK, etc. The national governments in the Eurozone do not share this status and are not sovereign in the Modern Monetary Theory (MMT) usage of this term.
Below our national government are state governments (6 states and 2 territories). These governments have specific spending and revenue-raising responsibilities and powers as specified in the constitution. We do not have the ridiculous balanced budget rule that the US system enforces on their state governments. State governments are free to run deficits if necessary and can raise debt if desired. They have no income taxing powers and raise most of their cash from land taxes (stamp duties) and receive significant redistributions of federal revenue via an revenue-sharing arrangement.
Local governments are in charge on urban amenities and levy rates on land values which provides most of their revenue.
To give you an idea, the following graph is taken from the 2010-11 Budget Papers for the New South Wales government (the state I live in) and shows where the State government gets its revenue from. The domination of Commonwealth (that is, federal) redistributions is typical across the nation although different states exhibit variations on their own revenue sources. Some have less taxation capacity (because of land value variations) and impose more fines.
But the general point is that there is significant vertical fiscal imbalance in the Australian government system with the federal government having the lion’s share of the revenue sources, yet the states having significant spending responsibilities under the Constitution. This largely arose from the federal government assuming the states rights to raise income tax (in 1942) and the High Court banning the states from raising excises which are only federal powers.
Anyway, this blog isn’t about the relatively mundane structure of government in Australia or their fiscal relationships. My own view is that state governments should be eliminated (they are mostly corrupt bodies in the hands of land developers) and local government cleaned up (to eliminate the influence of land developers) making us a two-layer system of government. Then the national government could fund the Job Guarantee and the local governments would implement it along the lines laid out in this report – Creating effective local labour markets: a new framework for regional employment policy
But back to the article in question.
You immediately get the bias that is embedded in the article by the inflammatory headline – binge. That is what drunks do.
The article says that:
BORROWING by state governments is forecast to hit more than $243 billion, reducing available credit for the private sector as the economy recovers.
This is putting new pressure on Julia Gillard to rein in the federal budget and reduce debt … the borrowing is forecast to soar 52 per cent from $159.6bn this year to $243.2bn in 2014 to help fund upgrades to rundown transport, electricity and water infrastructure.
First, when you scale this against the State Product the proportion of borrowing over proposed by state governments over the next several years is minimal.
Second, the statement that state government borrowing is “reducing available credit for the private sector” is patently false. Yes, the state governments are revenue-constrained like a household. It is at this level of government that the analogy between the government and the household budget has resonance.
This means that the state governments have to finance their spending either via taxes and charges, borrowing, or asset sales. Over the neo-liberal period, the states adopted the view that borrowing was evil and so privatised significant assets (at bargain basement prices after paying huge fees to investment banks to facilitate the sales). It was a total disaster. Many of the assets have had to be re-purchased by government because the private operator went broke and the essential services would have been lost.
As an aside here is some personal experience.
Over the growth period leading up to the recent recession, the NSW government squandered a huge boost in stamp duty revenue that came there way as a result of the Sydney property boom and oversaw the largest degradation in public infrastructure in our history. The state government pursued surpluses over the entire boom period instead of maintaining the essential state infrastructure. It hired a massive squad of private consultants to help it cut spending. It entered into various public-private-partnerships which devolved its responsibilities for public infrastructure provision and handed them over to private equity interests who evaluated their investment decisions based on private profit rather than public good.
The capacity of public hospitals was devastated; railway bridges became dangerous. By the time the credit boom that had driven the NSW property boom was over and the commodity price boom saw the mining states (WA and Queensland) start booming, the NSW economy – the largest in Australia – was dead. All under the watch of NSW Treasury and its culpable Executive Directors. I could go on about the handling of the NSW economy by the state government at length. I no longer use the word government and NSW in the same sentence!
In the 1990s the NSW government, in pursuit of surpluses, began a privatisation binge. It started flogging off valuable state assets at massive discounts (to ensure the sales succeeded and hence avoid the political embarrassment) where the consultants who brokered the deals made millions and the state of public service fell.
I was involved in one of those sales – the privatisation of the Port Macquarie Base Hospital, which is located in a medium-size regional centre on the East coast about 310 kms north of Sydney.
I was asked by the Port Macquarie community group who opposed the privatisation to help them prepare an economic defence against the arguments developed by the NSW Treasury. The government was running a very high profile public campaign to make its ridiculous decision to privatise the main public hospital in the region look like a good decision. They kept quoting from a Treasury report about how good a decision they had made.
However, the government refused to make the modelling report public and just hectored the opponents who wanted to see the evidence. They kept referring to the report but no-one could evaluate whether the case being made was defensible or not.
The matter went the Land and Environment Court which handles disputes about planning and land use. As part of preparing the economic case for the community group who had mounted the court challenge, I received a leaked copy of that main Treasury evaluation report (I have friends everywhere!).
It was a disgrace and the modelling was seriously flawed. My evidence to the Court would have been devastating for the Government’s case. But I never got to provide the evidence as it was declared “inadmissible”.
This decision by the Court arose after several hours of legal debate which arose because the NSW government and its developer mates (who wanted to get their hands on the public assets) opposed the community group’s use of my evidence. The argument was that because the Report was leaked, any information in that Report could not then be used to develop alternative economic modelling which would be against the privatisation.
There was no claim that my evaluation was wrong – just that nobody could hear it because the Report was leaked. The legal babble was pretty amazing and after two days the judge declared my report “inadmissible”. The Government etc, in other words, had silenced me using legal technicalities rather than economic arguments, which was where the debate should have been focused.
The community group’s challenge was subsequently defeated and the Government privatised the hospital (it was the the first hospital privatisation in Australia). It was a total disaster.
The service contract gave the monopoly private operator much higher per head care payments that were offered anywhere else in Australia. As time passed, the standard of care fell and the public costs of providing health care in the region rose. The company fighting to make higher profits cut nursing staff further. According to NSW Health Department performance metrics, under privatisation, the hospital developed one of the longest waiting lists and one of the poorest performance records of all NSW hospitals. The private operator also found it hard to make profits.
Eventually, the NSW government was forced to buy-back the privatised Port Macquarie Hospital. All of what happened was foreshadowed in the modelling I provided in my suppressed Report. It was clear before the privatisation that it would fail because the economic cost-benefit analysis conducted by the NSW Treasury was seriously flawed. When I presented a more reasonable discounted cash flow analysis the privatisation was always doomed to fail (quite independent of your emotional position about public-private ownership). You can read about the failed privatisation here.
These privatisations and outsourcings and whatever else they have been called are one of the dirty jokes that the neo-liberal era visited on all of us in the name of economic efficiency and responsible government. I use the word “joke” because the beneficiaries of all this public largesse must have been laughing all the way to the bank as the stupid public officials (governments etc) fell prey to their lobbying and joyfully handed over the keys to the public purse. Overall, these events were an integral aspect of the way governments abrogated their true responsibilities to pursue and safeguard public purpose. Governments should never have become agents of private profit. The fact they have become such agents goes a long way to explaining why this huge global economic and social crisis is now upon us.
The other strategy that these neo-liberal obsessed state governments adopted was to pretend they had no funds for infrastructure development and so needed to form so-called public-private partnerships.
With PPPs, public purpose disappears and governments become underwriters of private profit. In NSW trade union superannuation funds have become compromised by the participation in PPPs and the conflict of interest that it presents the union movement. In PPPs, the risk is never transferred to the private sector. The only things transferred are public oversight in the infrastructure planning process and the delivery of public services; huge volumes of public funds; and, ultimately, the overriding public purpose of interest becomes usurped by the unquenchable pursuit of private profit. Not a good look at all.
Please read my blog – Landlocked … but still swamped by budget hysteria – for more discussion on this point.
I should also note that the household-government budget analogy never has resonance at the federal level if the national government is sovereign.
Anyway, back to the article. My meandering reflects that it is late Friday afternoon and it has been a long week already!
The fact is that the issuing of debt by the state government is an essential way it can raise funds to finance large and expensive public infrastructure developments which underpin economic growth in the state economies.
The reluctance to borrow over the last decade or more by state treasurers to has been a myopic strategy. The governments were drowning in property tax revenue and decided to wipe out their outstanding debt because the deficit terrorists had convinced them that the debt was evil and compromising the capacity of the state to grow.
Nothing could have been further from the truth. The Government’s reluctance to use their burgeoning coffers to fund infrastructure growth has reduced the potential growth path of the states and the debt retirement and interest savings have destroyed the wealth holdings and incomes of private savers.
The run-down of existing infrastructure is now revealing itself to be a myopic strategy – one that will cost more in the long-run than if there had been steady capital spending growth over the life of the Government.
State governments are now realising that their past penury is catching up with them. At last they are realising that debt can be good a good thing – spreading the burden of public investment over the generations that will benefit from it.
Education is a good example. Investment in public education underpins child and community development but as the state governments built their surpluses in recent years they allowed teachers’ pay and conditions to lag behind other occupations.
The Government is starting to realise that a responsible fiscal position for a state government is that they should borrow to build public infrastructure. These assets spread benefits into the future and borrowing allows future generations to pay a share of the costs in some proportion to the benefits they receive.
The Government’s previous exhortations that debt was irresponsible have been abandoned and they will now borrow to provide $3.5 billion for increased spending on roads, rail, hospitals and education.
So the renewed commitment to borrowing is a signal that the state governments are behaving the way they should act. The lack of attention paid to essential infrastructure including public hospitals, public schools; public transport; mental health and disability services; water and the environment has created a state of crisis.
Why have they waited so long to realise that state budget deficits funded by debt provides public infrastructure and services which generate enduring benefits beyond immediate users? This enhances productivity and economic growth and creates new employment and apprenticeships.
Government inaction has seen the mentally ill receiving treatment in prison because of a lack of crisis and community care. It has forced young people with brain injuries to live in Commonwealth nursing homes because of a lack of supported state accommodation. The public transport systems are in chaos. Our public schools fail to provide safe and stimulating learning environments for our kids.
Does the private sector get squeezed by state borrowing?
Short answer: No!
The Australian article claims that:
The burgeoning public debt levels have sparked warnings about higher interest rates as the private sector competes for funding as the economy gathers pace.
Australian Chamber of Commerce and Industry director of economics and industry policy Greg Evans pointed to International Monetary Fund research that found rising public debt levels could lead to interest rate rises.
The financial crowding out hypothesis is a central plank in the mainstream economics attack on government fiscal intervention.
At the heart of this conception is the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.
In Mankiw’s awful macroeconomics textbook, which poisons thousands of young minds daily and is representative of the overall approach taken by my (disgraceful) profession, we are taken back in time, to the theories that were prevalent before being destroyed by the intellectual advances provided in Keynes’ General Theory.
Mankiw assumes that it is reasonable to represent the financial system as the “market for loanable funds” where “all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.”
This is back in the pre-Keynesian world of the loanable funds doctrine (first developed by Wicksell).
This doctrine was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving. So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.
The following diagram shows the market for loanable funds. The current real interest rate that balances supply (saving) and demand (investment) is 5 per cent (the equilibrium rate). The supply of funds comes from those people who have some extra income they want to save and lend out. The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.
Note that the entire analysis is in real terms with the real interest rate equal to the nominal rate minus the inflation rate. This is because inflation “erodes the value of money” which has different consequences for savers and investors.
Mankiw claims that this “market works much like other markets in the economy” and thus argues that (p. 551):
The adjustment of the interest rate to the equilibrium occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage … would encourage lenders to raise the interest rate they charge.
The converse then follows if the interest rate is above the equilibrium.
Mankiw also says that the “supply of loanable funds comes from national saving including both private saving and public saving.” Think about that for a moment.
Clearly private saving is stockpiled in financial assets somewhere in the system – maybe it remains in bank deposits maybe not. But it can be drawn down at some future point for consumption purposes.
Mankiw thinks that budget surpluses are akin to this. They are not even remotely like private saving. They actually destroy liquidity in the non-government sector (by destroying net financial assets held by that sector). They squeeze the capacity of the non-government sector to spend and save. If there are no other behavioural changes in the economy to accompany the pursuit of budget surpluses, then as we will explain soon, income adjustments (as aggregate demand falls) wipe out non-government saving.
So this conception of a loanable funds market bears no relation to “any other market in the economy” despite the myths that Mankiw uses to brainwash the students who use the book and sit in the lectures.
Also reflect on the way the banking system operates – read Money multiplier and other myths if you are unsure. The idea that banks sit there waiting for savers and then once they have their savings as deposits they then lend to investors is not even remotely like the way the banking system works.
This framework is then used to analyse fiscal policy impacts and the alleged negative consquences of budget deficits – the so-called financial crowding out – is derived.
One of the most pressing policy issues … has been the government budget deficit … In recent years, the U.S. federal government has run large budget deficits, resulting in a rapidly growing government debt. As a result, much public debate has centred on the effect of these deficits both on the allocation of the economy’s scarce resources and on long-term economic growth.
So what would happen if there is a budget deficit. Mankiw asks: “which curve shifts when the budget deficit rises?”
Consider the next diagram, which is used to answer this question. The mainstream paradigm argue that the supply curve shifts to S2. Why does that happen? The twisted logic is as follows: national saving is the source of loanable funds and is composed (allegedly) of the sum of private and public saving. A rising budget deficit reduces public saving and available national saving. The budget deficit doesn’t influence the demand for funds (allegedly) so that line remains unchanged.
The claimed impacts are: (a) “A budget deficit decreases the supply of loanable funds”; (b) “… which raises the interest rate”; (c) “… and reduces the equilibrium quantity of loanable funds”.
Mankiw says that:
The fall in investment because of the government borrowing is called crowding out …That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment. Thus, the most basic lesson about budget deficits … When the government reduces national saving by running a budget deficit, the interest rate rises, and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.
The analysis relies on layers of myths which have permeated the public space to become almost “self-evident truths”. Sometimes, this makes is hard to know where to start in debunking it. Obviously, national governments are not revenue-constrained so their borrowing is for other reasons – we have discussed this at length. This trilogy of blogs will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 | Deficit spending 101 – Part 2 | Deficit spending 101 – Part 3.
But national and state governments do borrow. The former for stupid ideological reasons and to facilitate central bank operations and the latter because they are financially constrained.
So doesn’t this borrowing increase the “public” claim on saving and reduce the “loanable funds” available for investors? Does the competition for saving push up the interest rates?
The answer to both questions is no!
MMT does not claim that central bank interest rate hikes are not possible. There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates. MMT proposes that the demand impact of interest rate rises are unclear and may not even be negative depending on rather complex distributional factors.
Remember that rising interest rates represent both a cost and a benefit depending on which side of the equation you are on. Interest rate changes also influence aggregate demand – if at all – in an indirect fashion whereas government spending injects spending immediately into the economy.
But having said that, the Classical claims about crowding out are not based on these mechanisms. In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. The result competition for the “finite” saving pool drives interest rates up and damages private spending. This is what is taught under the heading “financial crowding out”.
A related theory which is taught under the banner of IS-LM theory (in macroeconomic textbooks) assumes that the central bank can exogenously set the money supply. Then the rising income from the deficit spending pushes up money demand and this squeezes interest rates up to clear the money market. This is the Bastard Keynesian approach to financial crowding out.
Neither theory is remotely correct and is not related to the fact that central banks push up interest rates up because they believe they should be fighting inflation and interest rate rises stifle aggregate demand.
From a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Its what astute financial market players call “a wash”. So at the federal level, the funds used to buy the government bonds come from the government!
The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved.
What about the impact of state government borrowing on financial markets?
The significant point to understand that there is no finite pool of saving that is competed for by any level of government. At the level of commercial banks, loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”.
So credit-worthy private borrowers are not constrained by the state borrowing.
Further, total saving grows with income. Importantly, deficit spending by both federal and state governments generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or “finances” private saving not the other way around.
If the state governments are using the borrowed funds to develop productive public infrastructure that also leveraged by the private sector to expand their profit-making opportunities then the future growth path will likely be higher. This will not only stimulate growth in saving but also expand the revenue-base that the state government may tap in future years.
However, other forms of crowding out are possible. In particular, MMT recognises the need to avoid or manage real crowding out which arises from there being insufficient real resources being available to satisfy all the nominal demands for such resources at any point in time.
In these situation, the competing demands will drive inflation pressures and ultimately demand contraction is required to resolve the conflict and to bring the nominal demand growth into line with the growth in real output capacity.
Further, while there is mounting hysteria about the problems the changing demographics will introduce to government budgets all the arguments presented are based upon spurious financial reasoning – that the government will not be able to afford to fund health programs (for example) and that taxes will have to rise to punitive levels to make provision possible but in doing so growth will be damaged.
However, MMT dismisses these “financial” arguments and instead emphasises the possibility of real problems – a lack of productivity growth; a lack of goods and services; environment impingements; etc.
Then the argument can be seen quite differently. The responses the mainstream are proposing (and introducing in some nations) which emphasise budget surpluses (as demonstrations of fiscal discipline) are shown by MMT to actually undermine the real capacity of the economy to address the actual future issues surrounding rising dependency ratios. So by cutting funding to education now or leaving people unemployed or underemployed now, governments reduce the future income generating potential and the likely provision of required goods and services in the future.
The idea of real crowding out also invokes and emphasis on political issues. If there is full capacity utilisation and the government wants to increase its share of full employment output then it has to crowd the private sector out in real terms to accomplish that. It can achieve this aim via tax policy (as an example). But ultimately this trade-off would be a political choice – rather than financial.
The Australian article quotes the Australian Chamber of Commerce and Industry director of economics and industry policy who offers the following nonsense:
Business wants government to return the budget to balance and reduce public debt as a stronger budget position means greater flexibility to deal with future economic shocks but it is also important in reducing pressure on long-term rates … Higher than necessary long-term rates impact economic growth and the investment decisions made by business. In periods of economic expansion it makes it harder for smaller and more exposed borrowers as they effectively get crowded out of the market, making it more difficult to access funds at reasonable levels.
He would never pass a macroeconomics course at any university that I was teaching at!
This is a common myth though. A sovereign government (such as our federal government) has no more or less flexibility as a result of its past fiscal outcomes. Whether it was in deficit or surplus in the past means nothing in terms of its capacity to spend in the current period. Spending in the current period places no constraints on its capacity to spend next year or the year after.
It might be that by running appropriate budget deficits now it can net spend less next year as economic activity improves but that is not a financial constraint. It just says that budget deficits will have economic outcomes that may require varying fiscal positions in the future.
But why is this quotation being offered in the context of a rave about revenue-constrained state governments? The journalist clearly has got the levels of government confused and fails to understand that the analysis of the implications of spending and borrowing is quite different at each level. She is seemingly desperate to get as many myths into her article as possible and so just had to pump out the tirade from the business lobby which is not even pertinent for her article’s main message.
The previous analysis on crowding out should allow you to reject the nonsense the business representative is offering anyway, whatever level of government.
The rest of the article is a series of quotations from business economists – each one falling into the “crowding out-need for fiscal discipline” logic failure.
One quote comes from the Federal Opposition Treasury spokesperson which confirms why they would have been unfit to govern (they lost the recent federal election). Mr Hockey says the:
… massive surge in public sector borrowings is going to crowd out the credit markets at a time when we’ve got above-trend growth … There is only so much money available to Australia as a proportion of the global economy. If there is a gap between the demand for funds from Australia and our proportion of the size of the global economy, then it does have an influence on the availability of funds more generally to the Australian private sector.
That could be a question for students – as a demonstration of some of the worst pieces of economic reasoning you could ever find. Who is advising this man? Where was the advisor educated? For sure, it will be another university that goes on my black ban list for prospective students wanting to learn some real macroeconomics.
The ability of the banks to expand credit is not constrained in the way suggested. It is all about price not volume. Please refer back to my earlier discussion above about crowding out.
What are the implications of state government borrowing for federal spending capacity?
You will note that the article claimed that the increase in state borrowing (to fund infrastructure) is “putting new pressure on Julia Gillard to rein in the federal budget and reduce debt”. Julia Gillard is the Prime Minister for those who haven’t realised that we actually now have a federal government after the non-result at the August 21 election.
Does this statement have any credibility? Answer: None!
Why? For all the reasons noted above. The federal government is never revenue constrained because it is the monopoly issuer of the currency. It voluntarily chooses to borrow (erroneously thinking that it somehow indicates fiscal responsibility). But it really (conceptually) borrows back what it has spent. Its a wash.
It doesn’t compete with anyone for funds in this regard.
This article will qualify as a finalist for the worst article by an economics journalist for 2010 which I will announce in my annual awards on December 31.
It rehearses every myth and lie and misunderstanding that you can find. I take that back. It failed to squeeze in a discussion about the ageing population.
The Saturday Quiz will be back sometime tomorrow – even harder than last week!
That is enough for today!