Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
In the last few days I have read some really loony stuff. One article from an esteemed investment advisor (which I will not dignify by a link) was arguing that the build up of public debt is signalling the death knell for democracy and that capitalism will survive but our freedoms will be gone. I asked some basic questions – which freedoms are they exactly? – and – Why should a rise in private wealth lead to constitutional change or revolution that would deprive us of a vote? But the trend in policy is becoming very clear. Fiscal policy makers are succumbing to the relentless attacks from the deficit terrorists and withdrawing the essential stimulus that has been propping up growth. Most economies are starting to slow again as a result. The response is to seek solace in monetary policy – as if it is effective. The point is that the neo-liberal years have seen the promotion of monetary policy as the principle counter-stabilisation tool – driven by the obsession with inflation. This ceding of macroeconomic policy responsibility to unelected officials in central banks was a major erosion of our democratic rights. Moreover, it has been a failed policy strategy. It is neither an effective inflation control nor does it promote growth. So we are just heading back to where the crisis started. Pity the unemployed.
The UK Guardian reported on September 21, 2010 that:
The black hole in Britain’s public finances worsened last month when government borrowing hit a record high for an August.
This was in response to the British Office for National Statistics releasing the latest public finance data which showed that the public deficit was “the largest for the month of August since modern records began in 1993” (Source).
The response from the Treasury a href=”http://www.guardian.co.uk/business/2010/sep/22/austerity-uk-economic-prospects-cbi”>reported in the UK Guardian was that:
Although broadly in line with the Office for Budget Responsibility’s forecast, today’s borrowing figures demonstrate why the government needs to tackle the deficit … If the government had not announced decisive action to bring borrowing down, debt interest would have been over £65bn by 2014-15, more than is spent on schools or defence.
I have written a bit about holes of various descriptions before. Often the black hole is related to some bucket.
The conclusion I make when I read this sort of statement in the financial press is this: there is no hole because there is no bucket.
Many people do not exactly know what a budget deficit is.
Every day the government is crediting private bank accounts (directly or via cheque issuance) to pursue its socio-economic program. Each day also, they collect tax revenue by debiting private bank accounts (or writing receipts over counters to payees). The tax revenue is accounted for but “doesn’t go anywhere” in a physical sense. It provides no less or more spending capacity for a sovereign government.
A deficit arises when the spending exceeds the revenue and the net result is an addition of net financial assets (bank reserves). In achieving this outcome, the government hopes that its spending will boost aggregate demand (“finance” the leakages from the income-expenditure system), and, hence maintain high levels of employment and material prosperity.
The only hole I can see is one that needs to be filled. That is the spending gap – the leakages from the income-expenditure system – that are created when there is a CAD and/or a desire by the private sector to save.
Budget deficits should aim to fill that hole in and not allow aggregate demand to “fall through it”, which would lead to income and employment collapses.
If budget deficits are underwriting income growth, then workers can enjoy more secure employment and achieve their saving desires. So in a flow sense, the terminology “black hole” which is meant to invoke dread is just meaningless distraction intended to present something that is good as a bad. That is the ideological nature of all this reporting.
It is interesting though that there were not too many people complaining in the early days of the crisis in 2007-08 when billions of public funds were being handed out to the top-end-of-town which helped them keep their (unproductive) jobs (including Wall Street and City of London bankers).
Then it was all good. Now their jobs are secure and they are back to screwing the daylights out of the economy (by extracting real income that should be underwriting real wages growth for the workers) – the deficits become bad. It is just ideological cant!
Please read my blog – We are in trouble – squirrels are falling down holes – for more discussion on this point and about holes generally.
Of-course, one article I read today was focusing on the stock issues arising from the deficits. I will talk about that a bit later if I get time.
The UK Guardian published some reactions from the bankers in the City of London to the ONS statistics release.
One character who works for IHS Global Insight (a misnomer by any measure) claimed that:
The public finances disappointingly deteriorated in August, thereby keeping pressure on chancellor George Osborne to fully deliver on the targeted overall spending cuts in October’s comprehensive spending review. Indeed, the increased August public deficit is likely to reinforce the government’s determination not to ease up on its austerity efforts – given that this remains critical to the UK retaining its AAA credit rating.
He should experience a year in the unemployment queue.
Please read my blog – Bite the bullet and get shot in the mouth – for a discussion of the latest UK credit rating.
But importantly, there is no such thing as the “public finances deteriorating”. What does that mean? In relation to what? For the neo-liberals who think that budget surpluses are the exemplars of fiscal prudence any move towards or into deficit represents a deterioration. It is always surprising to me how on one hand the conservatives hate government intervention but then on the other hand eulogise the government taking more off us than they return (surpluses).
Budget surpluses reduce the non-government sector purchasing power. The government squeezes the liquidity of the non-government sector and compromises the capacity of the sector to fulfill its tax liabilities. The result is that private wealth has to be liquidated and the income losses that arise from that (no receipt of interest payments) further undermine the non-government standard of living.
How come the conservatives think that is desirable? I think it is a deplorable aspiration in most situations. Surpluses may be required when there is a net exports boom to prevent aggregate demand from outstripping the real capacity of the economy to response via production (that is, there is an inflation risk). But in those situations I would be discouraging net exports and allowing the domestic residents to enjoy more of the national resources in real terms.
Budget surpluses should never be contemplated while there are inadequate public services and less than desirable provision of public infrastructure (such as, public hospitals, schools, universities, sports academies etc).
But the other thing that the banker fails to mention is the cause of the rising deficits. The rising unemployment and sluggish economic growth is hardly evidence that the national government in Britain is “spending too much”. It is the exact opposite. The automatic stabilisers are continuing to deliver these fiscal outcomes. The rising deficit is “a bad deficit” in the sense that it is being driven by the stagnant nature of economic growth in Britain.
So my way of saying it is that the public finances are recording a larger deficit which is a sign of a deterioration in the real economy. In that context, it makes no sense to attack the symptom. Better to attack the source and stimulate spending and employment growth.
It is clear that the austerity push will undermine that.
On September 22, the Confederation of British Industry released its latest economic forecast and concluded that growth will slow as a result of the fiscal austerity measures which will be announced in detail by the British government in the coming weeks.
They said that the “action to get the public finances back onto a sustainable footing will no doubt temper the recovery going into 2011”.
So if the CBI is correct, the government is claiming they have no choice but to erode economic growth.
But moreover this just tells me that the Government isn’t spending enough. I support more spending on schools but less on defence. The beauty of fiscal policy is that you can change the overall level of the flow while simultaneously altering the composition. You cannot achieve flexibility with monetary policy. More later on that.
All the rest of the bank economists that were interviewed by the Guardian also made comments about the figures being “bad”, “disappointing”, “the most alarming figure”, “worrying”, without mentioning the high unemployment, the falling per capita income, and the rising poverty rates. The real issues are not on the radar of these commentators.
The essence is that what their input to the public debate provides zero knowledge. It is all ideology – the language of neo-liberals. At some point in time, the rest of us are going to catch on to the fact that pursuing these policies undermines our living standards. The current crisis has been different to previous downturns because it has really driven a spike into the middle classes (via the housing market collapses and the entrenched unemployment).
So a broader group of disadvantage is now being generated and the problems that have typically been confined to the bottom quintile of the income distributino are populating the next quintile and even beyond. Further, in some nations, the youth have effectively become disenfranchised by their lack of access to the labour market.
These social changes will take some time to be reflected in the political debate. The Tea Party syndrome is clearly a sign – which is taking the social action in the wrong direction. But I also think there will be a green-left backlash in the years to come. The youth are green and greens are not natural bed-partners with the T-loonies.
Anyway, today, I also read the minutes from the September 2010 meeting of the Bank of England’s monetary policy committee (MPC).
The MPC noted that long-term yields on government bonds around the world are continuing to fall as deficits rise. They noted that growth was slowing around the world.
It was suggested that “the probability that further action would become necessary to stimulate the economy and keep inflation on track to hit the target in the medium term had increased” and the MPC subsequently voted that the:
The Bank of England should maintain the stock of asset purchases financed by the issuance of central bank reserves at £200 billion.
So they prepared to buy up government bonds (gilts) or credit ease through buying private sector assets. That is, they are seeing quantitative easing as a continued policy option. Please read my blog – Quantitative easing 101 – for more discussion about QE.
Similarly, the September 21, 2010 meeting of the US Federal Open Market Committee concluded that the:
… pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract, but at a reduced rate in recent months. The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term.
The FOMC also considered inflation to be “somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability”. That is, they are worried about deflation.
The lack of price impetus is a direct result of the constrained aggregate demand and the large underutilisation of labour and capital.
The FOMC concluded that they would hold rates constant and “maintain its existing policy of reinvesting principal payments from its securities holdings”.
Various commentators are now arguing that with a double-dip recession bearing down on us and government engaging in “necessary” fiscal consolidation the central banks need to be doing more. For example, the Economist Magazine commentary on the FOMC decision said that:
… the Fed did not change policy at this meeting. And in fact, no change in policy was deemed the most likely outcome of the September gathering.
This is obviously frustrating … The bottom line is that the Fed could and should do more and most observers-including those drafting the Fed statements-seem to acknowledge this. It’s a shame that we’ll have to wait two more months, at least, to see something done at last.
So if you put all this together you realise that we are back to where we started in a policy sense – a dogmatic reliance on monetary policy and an eschewing of fiscal policy.
It was that policy bias that helped get us into this mess in the first place.
So once again we are still trying to ride the one-trick pony (monetary policy) which has inherited a few new tricks in the last few years – none of which have stimulated aggregate demand.
With fiscal austerity now also beginning to undermine aggregate demand, the policy response of many governments is now totally concentrated on quantitative easing (and low interest rates).
We should be absolutely clear on what the BOE (and the Federal Reserve) is doing. Essentially, they are buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (central bank reserve balances). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.
In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates.
So the hope is that by holding down longer rates and reducing the cost of investment funds, the policy intervention will stimulate aggregate demand. But there is another side of the coin. The lower rates reduce the interest-income of savers who may then reduce consumption (demand) accordingly. How these opposing effects balance out is unclear. The central banks certainly don’t know! Overall, this uncertainty points to the problems involved in using monetary policy to stimulate (or contract) the economy. It is a blunt policy instrument with ambiguous impacts.
So does quantitative easing work? Answer: Not in any significant way.
The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment.
It is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.
But this is a completely incorrect depiction of how banks operate. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.
The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.
The major formal constraints on bank lending (other than a stream of credit worthy customers) are expressed in the capital adequacy requirements set by the Bank of International Settlements (BIS) which is the central bank to the central bankers. They relate to asset quality and required capital that the banks must hold. These requirements manifest in the lending rates that the banks charge customers. Bank lending is never constrained by lack of reserves.
Here is a basic question the proponents of quantitative easing need to answer: If economies are now slowing in more or less direct response to the withdrawal of the fiscal support and with short- and long-rates remaining low (and falling at the long end) but still credit demand is weak why would we think more of the same monetary response will suddenly change things for the better?
The debate is now once again focusing on the primacy of monetary policy. We continue to believe it is an effective counter-stabilisation tool and that fiscal policy is to be neutralised.
I don’t think quantitative easing is harmful. I also have done work which shows that inflation targeting has not reduced output and inflationary variability or reduced inflation persistence. This is consistent with other empirical research in Australia and overseas.
Inflation targeting countries failed to achieve superior outcomes relative to non-inflation targetting countries.
The real costs of the “inflation targeting” emphasis lie in the ‘ideology’ that accompanies it such that fiscal policy has to be passive. The failure of economies to eliminate persistently high rates of labour underutilisation despite having achieved low inflation is directly a consequence of this fiscal passivity.
We thus need to move towards a new paradigm where inflation control can coincide with full employment.
Which leads me to this article – Britain’s economy is broken. This is how to start fixing it – which appeared in the UK Guardian on September 21, 2010.
The article could have easily been re-titled as – Capitalism is broken. This is how to start fixing it – although we would have had to have a special introductory chapter dealing with curiosities such as the Eurozone. That monetary system requires some prior treatment (like dissolution) before we start purging the neo-liberal elements that have pushed the world’s economy into such disrepair.
The authors muse that the financial crisis “marks a progressive moment” where the “era of runaway financial markets is over” – at least among the left-wingers who “have murmured those phrases over and over” at academic conferences etc. However:
Out in the real world, meanwhile, a crisis of the private sector has been turned into an existential threat to the public sector by David Cameron and George Osborne, who will next month announce the most savage spending cuts since the second world war.
The truth is there is no such thing as a “progressive moment”, certainly not in Britain. The two great crises of capitalism of the last century – the depression and the oil shocks of the 70s – led to Conservative prime ministers, Stanley Baldwin and Margaret Thatcher. But there are progressive opportunities, and this certainly qualifies: a point at which a knackered economic model is revealed for all to see as eminently fit for replacement.
And yet Labour hasn’t debated what that alternative should be – not just during this summer’s leadership campaign but for the best part of two decades. It’s not too much of an exaggeration to say that since 1994, the party’s mainstream outsourced its economic thinking to Gordon Brown, who in turn took his cues from straightlaced economists and the City. The result was neoliberalism-lite, and some of the most unsightly political contortions ever pulled by a prime minister. Who would ever have thought a Labour leader could go softer on the banks than his Conservative opposite number? Yet Cameron has consistently talked tougher on the City.
I have a lot of sympathy for this view. The response of the progressives has generally been pathetic largely because there is an unwillingness to really seek an understanding of how the monetary system operates. So at the political level it is considered “cute” to operate with epithets such as “we will also run surpluses but be fairer about it” than to fundamentally challenge the mainstream macroeconomics myths.
The left have let us all down in this regard.
Please read my blogs – The enemies from within and When you’ve got friends like this … Part 1 and When you’ve got friends like this … Part 2 and The progressives have failed to seize the moment – for more discussion on this point.
The authors argue that they set up the New Political Economy Network to develop alternative economic policy. They publish a journal Soundings to advance the debate.
They have also published a new e-book which outlines “ideas for what a new political economy for Labour should look like”.
I will write a thorough review of the book once I have thought more about it. In general, I agree with a significant amount of what is written. I also do not want to undermine progressive developments.
But you have to worry when you read that:
The popular association of Keynes with budget deficits and an active fiscal policy is, however, misguided. Keynes argued that this policy was required in times of exceptionally low demand in the economy, as in the 1930s or currently; but it was not his preferred solution to what he termed ‘the economic problem’. In the ordinary run of things he would have preferred to run an economy by monetary rather than fiscal policy …
Over the next few years – in sharp contrast to the austerity policies of the coalition – the economy will need higher government spending on infrastructure: social housing, transport projects and the green industries of the future. Over the medium term, however, the monetary lever will be more important than the fiscal, as Keynes, by background a monetary economist, also recognised. A policy of fiscal Keynesianism based on boosting consumption – essentially the macroeconomic policy pursued by governments up to the mid-1970s – will eventually force demand to levels well in excess of supply and result in inflation.
Which is why I am not a Keynesian. The e-book insinuates that budget deficits are only to be used when demand is “exceptionally low” and typically the main aggregate policy response will be monetary.
I disagree totally with this and fail to see it as a progressive macroeconomic position.
Budget deficits are required whenever there is a non-government spending gap. That will always be the case if the non-government sector overall desires to save.
Given that it is preferable that economic (green) growth is associated with the non-government maintaining sustainable levels of indebtedness and having overall savings (to allow for risk management etc), this means that budget deficits are always required.
That Modern Monetary Theory (MMT) insight should be the basis of a progressive attack on the orthodoxy. There is no inevitability that inflation will result if governments maintain high levels of demand and support private consumption. The trick is to understand that the deficits are also supporting net private saving (the other side of the consumption coin). Deficits beyond that support level do introduce inflation risk. But then who advocates that?
The starting point of a progressive attack then is to understand how the monetary system actually works and the opportunities it provides a sovereign government. I don’t sense that is understood in this e-book.
A reliance on monetary policy has allowed high rates of labour utilisation to persist even when the economy has been growing. Persistent labour wastage always indicates that fiscal policy is too constrained. The primary role of fiscal policy is to ensure high levels of spending are maintained to keep employment at high levels and underutilisation of labour at low levels.
The emphasis of monetary policy on price stability has been at the expense of a fiscal policy emphasis on employment stability. Proponents of inflation targeting claim that in the long-run real output growth will be favourable if inflation is stabilised but fail to convincingly explain why high levels of labour underutilisation persist.
Critics of this orthodox ideology challenge its claim that price stability maintained ostensibly via the creation of a buffer stock of unemployment is preferable to a policy environment where full employment and price stability is maintained via active fiscal policy with monetary policy passively setting a rate structure consistent with robust long-term investment.
Proponents of MMT argue that full employment can be maintained by the introduction of an open-ended (infinitely elastic) public employment program that offers a job to anyone who is ready, willing and able to work and cannot find alternative employment – that is, a Job Guarantee.
These jobs ‘hire of the bottom’ in the sense that the minimum wages paid which are not in competition with the market sector wage structure. By avoiding competing with the private market, the Job Guarantee anchors the nominal value of money and the economy avoids the inflationary tendencies of old-fashioned ‘military Keynesianism’, which attempts to maintain full capacity utilisation by ‘hiring off the top’ (making purchases at market prices and competing for resources with all other demand elements).
The major test of inflation targeting or active monetary policy (buttressed with passive fiscal policy) is whether it can achieve and maintain full utilisation of labour resources in a stable price environment. The evidence to date is that monetary policy has failed to deliver on this goal.
A progressive position will never in my view subjugate fiscal policy and promote monetary policy as the principle counter-stabilisation policy tool.
More on the e-book another day.
That is enough for today!