Given yesterday's detailed monetary policy analysis, I am using today to present an array of…
Today’s blog was a little later than usual for various reasons – travel, time differences and other activities that had to take precedence. The title comes from a paper I wrote in 2008 which was published last year and reflects the notion that fiscal policy – appropriately applied can always make a difference for the better. I have noted some scepticism about this proposition and claims that the situation in countries such as Iceland refute the confidence I have in the effectiveness of fiscal policy. My response is that these claims misconstrue my statement and like a lot of criticisms of Modern Monetary Theory (MMT) they choose to set up stylisations that are not those advanced by the leading writers of MMT. So I thought I would just reflect a bit on that today.
As noted in the introduction, someone rather pointedly commented the other day that Iceland categorically refutes my claim that “there is no financial crisis so deep that cannot be dealt with by public spending”. I am sorry to inform you all but that so called refutation is false and reflects a failure to understand what my claim means. In general, it also reflects a willingness of critics to invent characteristics of MMT have never been expounded by any of the key authors (as far as I am aware).
The statement – “There is no financial crisis so deep that cannot be dealt with by public spending” – was the title of a paper I published last year – you can read the Working Paper version for free (fairly close to the final publication). It reflects a basic insight that is derived from MMT once you fully understand that school of thought – its scope and its limitations.
There is a hint among the comments I have read on my blog about the external sector that would suggest that the leading proponents of MMT think that fiscal policy can “bail” an economy out of any problem. Where readers get that misrepresentation from is anyone’s guess but they certainly do not get it from my writing.
So lets get it straight and stop the misrepresentation once and for all. When I say (and the other leading MMT writers say) – “There is no financial crisis so deep that cannot be dealt with by public spending” I do not mean the following:
- That fiscal policy can overcome the real losses to a nation’s standard of living that are associated with a major fall in its currency when there is a significant dependency on real imported goods and services.
- That fiscal policy can ensure that debts denominated in foreign-currency (public or private) can be honoured at all times.
What the statement means is that a situation can always be improved from where it is as a result of the operations of a crisis in the private financial markets. It doesn’t mean the state reached after the fiscal intervention will be Shangri-La! It means things can always be made better. A nation has to confront its real resource constraints. Fiscal policy in the short-term cannot ease those constraints although it can ensure that the real resources available are utilised more fully.
A nation with heavy import dependencies (that is, real resource shortages) is also likely to suffer if its exchange rate collapses or world export markets for its goods and services slow appreciably. Fiscal policy can help to attenuate the losses but cannot “create food out of thin air”.
So in appraising what the statement means we should avoid setting up red-herrings or straw persons.
I last wrote about Iceland in this blog – Iceland … another neo-liberal casuality. I would read that as background to today’s post to get a better insight into what happened there.
By way of updating some key statistics the following graphs might help.
The following graph shows you the evolution (from March 1997 to June 2010) of the kronor/USD parity and net exports. You can access excellent Icelandic exchange rate data from its central bank and National Accounts data from Statistics Iceland .
You can see that the external deficit widened significantly in the period leading up to the crisis and the kronor was strengthening against the US. the situation changed dramatically as the meltdown began.
Critics of MMT will use this sort of graph to make their case. I wouldn’t if I was them.
The next graph shows you the breakdown of the net exports into the growth of exports and imports over the same period. You can see that the net exports movement is dominated by the collapse of imports. There has been some volatility in export growth but imports boomed then collapsed. Why?
The final graph shows the evolution of net exports in relation to the primary causal factor – the collapse in real GDP growth and its impact on imports.
Finally, the next graph shows the evolution of the aggregate unemployment rate as pre-crisis and following the crisis (and the IMF bailout and austerity program). So there is a huge percentage of Icelanders being wasted at present. They are producing nothing and suffering heavy kronor income losses. There is great potential for fiscal policy to utilise this labour force and no financial constraint on the government in doing so.
Historically, Iceland grew and its citizens enjoyed a very high standard of living courtesy of its fishing industry. In 1999, fish products comprised 61.4 per cent of total exports and by 2009 this figure had dropped to 37.3 per cent (Source – Statistics Iceland ).
Under heavy neo-liberal influence, the government privatised and deregulated the banking system and provided financial incentives for the banks to grow.
Previously the Icelandic banking system was very conservative working within the local depositor base and lending to home buyers and local business. With the neo-liberal abandonment of proper financial oversight the privatised banks went crazy. They started to tap into the global wholesale markets and borrowed billions. They also developed the overseas retail operations like Icesave.
They then loaned huge sums to the newly emergent global entrepreneurial class in Iceland, imbued with the same free-market rhetoric that has brought the world to its knees. They engaged in a vigorous foreign asset acquisition program – buying incidentally a lot of British business assets. By the end of the growth period, the banks had grown to more than 10 times the size of the economy.
Most of the spending by the Icelandic banks collapsed in value as the crisis hit. It is clear that the claims that financial markets drive optimal resource allocation is false – Icelandic banks engaged in very poor investments.
Their problems began came courtesy of the US sub-prime collapse. In the first 9 months of 2008 the Icelandic króna depreciated dramatically (over 35 per cent) and this put pressure on the private banks in Iceland who were very highly leveraged in foreign currencies. The global financial crisis made it very hard to refinance their commitments.
It is clear that the Icelandic government failed to implement proper prudential supervision or enforcement of the banking regulations that they had taken from the EU (as a result of their plans to enter the European Economic Area).
So one of the first principles of MMT – proper supervision and oversight of the financial system – was absent in the case of the neo-liberal obsessed Icelandic authorities.
While the sub-prime crisis forced the meltdown, the fact remains that the Icelandic banks were always going to fail given the high-risk strategies they were pursuing. If you go back through the document trails prior to the collapse you can see growing disquiet from foreign governments about the hedge fund mentality of the Icelandic monetary authorities and its banking system.
However, once the crisis hit, the government did not try to liquidate the banks. It could have easily nationalised the banks and guaranteed kronor-denominated deposits or guaranteed all deposits in kronor. The losses to depositors would have been much lower if it had have followed this course of action.
Further, when the banking system did collapse, instead of calling in the IMF – which may have supported the exchange rate but forced the country to adopt harsh domestic austerity policies – the government should have defaulted on all foreign-currency debt.
The lax regulation also manifested in the fact that the Icelandic government allowed private citizens to enter into foreign currency-denominated loan contracts with the out-of-control local banks. So the exchange rate depreciation sent these loan obligations soaring. The government should have prohibited its home mortgage market being funded with foreign-currency loans. That is a key element of a sound financial market oversight.
The Government of Iceland also failed to act according to best-practice sovereign government principles outlined by MMT. You can find data for the Icelandic government’s debt management HERE. This document gives a breakdown of the outstanding public debt holdings for Iceland for August 2010. It shows there has been some retreat from their earlier positions.
So 65.0 per cent of total domestic debt is in the form of various (conventional) Treasury bonds (with 6 per inflation indexed – why?), about 17.3 per cent of domestic debt is in the form of debt notes issued to the Central Bank (so the Treasury can issue debt to the bank), and 3.7 per cent of the domestic Treasury debt arises mainly from the operations of the state owned National Power Company.
20.6 per cent of the domestic Treasury debt arises from the capital contribution from the state to the new banks arising out of the restructuring of their banking sector post-crisis.
Domestic debt comprises 71 per cent of all outstanding public debt and the overwhelming proportion of foreign-currency debt is denominated in Euros (88.5 per cent) and all foreign debt is of a long-term nature.
If you go back a few years at the height of the neo-liberal madness you can find some interesting official documents. This presentation from the official debt management agency in Iceland showed how cocky they had become under the blind-cover of neo-liberalism. It was outlining the prospects for 2008 and claimed that their were “robust central government finances”. They said:
– Budget surplus due to privatisation income and economic growth
– 2005: 4.5%; 2006: 5.3%; 2007: 3.7%; 2008: 1.3%
The surplus can be traced primarily to the recent economic upswing, income from privatisation and modest growth in government spending.
They tell us that “at the end of 2007” “Foreign debt amounted to … almost 51 per cent of total debt”.
Interestingly, they also admit that despite running surpluses they would still be issuing debt. Why? They tell us in the next slide:
The primary purpose of the new issuance is to promote an active secondary market and to strengthen price formation of the domestic fixed income market.
Role of Government securities in domestic market
– Price reference for other financial products
– Long-term investment vehicle
– Safe haven in times of financial instability
The point is that they are not issuing debt to “fund” government net spending (because the budget was in surplus). They are instead, providing corporate welfare, to allow the financial markets to make more profit and create risky financial products with the knowledge that a risk free asset was available in the form of the government bond.
The fact is that the Icelandic government didn’t have to issue any debt ever – that is, even when it was running deficits. It was 100 per cent sovereign in its own currency – the kronor.
The 2007-08 Presentation also boasted that the Iceland government maintained triple A to AA+ ratings with a stable outlook from the key international rating agencies.
Please read my blogs – Ratings agencies and higher interest rates and Time to outlaw the credit rating agencies – for more discussion on why the ratings agencies should be ignored in the context of public debt.
If you read the history of the debt management outlooks provided by the official debt management agency in Iceland it is clear that they were living in a neo-liberal dream world. They were running budget surpluses courtesy of privatisations and the nominal largesse being created by the debt-infested financial sector.
The government was borrowing (more than 51 per cent of its total debt) in foreign-currencies mostly Euros. None of the domestic debt (in kronor) presented a problem – meltdown or not.
The problem they faced was the significant proportion of non-kronor debt. Given this is in a foreign currency, meeting the obligations of the creditors represents a real impost on the standards of living for Icelandic citizens especially as the currency depreciates. This aspect of Iceland’s current malaise is not a result of its government following basic principles that arise from an understanding of MMT.
On the contrary, the conduct of the Icelandic government leading up to the crisis was in violation of sound fiscal practice as outlined by MMT. The Icelandic government was behaving as an exemplary IMT-ratified body – following all the principles laid out by the neo-liberals for prudent and responsible fiscal policy. The government set in place a growth strategy that did not exploit their natural and population resources but rather allowed the heavily deregulated finance (banking) sector to run free.
It was never sustainable and as soon as the crisis hit, the foreign-currency denominated debt (public and private) became the millstone. From the public perspective, it reduces the government’s capacity to lead the economic back into recovery. It means if it wants to honour this debt it has to sacrifice large chunks of its export revenue and cut back imports severely. In other words, undermine the real standard of living of its citizens.
Further, by agreeing to take over the debts of the failed Landsbanki which was privatised under the neo-liberal rush to obliterate public activity and developed very high international and risky exposure, the Icelandic government is breaching sound fiscal management. The debts of the private sector are not the problem of the sovereign government of Iceland.
If they really wanted to bail out the banks, however, given that they are sovereign in their own currency they always pay in kronor and let the creditors of these private institutions take the exchange loss as part of their lack of due diligence in lending to these banks (which were really huge hedge funds) in the first place.
Further, the elite in Iceland are trying to force the country into the Eurozone and a lot of the kowtowing to the Euro bosses with respect to honouring debt and the acceptance of the IMF bail-out arrangements is being driven by that folly. Iceland should never borrow from the IMF nor should it join the EMU.
The government should immediately default on all foreign-currency loans as Argentina did in 2002. The threats that Iceland will be excluded from the world financial system if they behaved in this way are largely without any substance given what Argentina proved when they defaulted.
The government rhetoric also is claiming that by joining the EMU they will be “shock-proofed” from further crisis. They should cast their eyes to the south – across the sea – and see how badly Greece, Spain, Portugal and to the south-west Ireland are faring as a result of following that myth. Joining the EMU should be the last thing the tiny island should do.
All public obligations should only be in kronor. In that sense, Iceland does not constitute a good example of an “MMT-inspired” economy failing. Rather, it is exactly the opposite!
It is clear that Iceland has a heavy import reliance – for advanced goods and services. The collapse of the kronor pushes the price of those commodities up. This vulnerability is always there for a country that imports food and other essentials.
The correct role for the IMF in these situations is not to impose onerous conditions on the nation in difficulty but instead to buy the local currency to ensure the exchange rate does not price the poor out of food. This is a simple solution which is preferable to to forcing these nations to run austerity campaigns just to keep their exchange rate higher. But imported food dependence exposes a nation to exchange rate volatility.
The role of the sovereign government in these cases should not be to run policies that promote low levels of domestic activity.
There is no evidence that budget deficits create catastrophic exchange rate depreciations in flexible exchange rate countries? Iceland was running budget surpluses! There is no clear relationship in the research literature that has been established. If you are worried that rising net spending will push up imports then this worry would apply to any spending that underpins growth including private investment spending. The latter in fact will probably be more “import intensive” because many nations import capital.
The exchange rate depreciation in Iceland has caused considerable hardship. The government has implemented some restrictions to ensure that foreign currency (from exports) be used to buy essential products (food, medicine etc).
The government can in this situation use fiscal policy to ensure that the “costs” of the crisis are minimised. That isn’t the same thing as saying the losses will be small! But clearly the government could provide jobs at a minimum wage (which may be low in real terms given the exchange rate effects on the price level and the availability of real goods post-crisis) to any citizen who wanted to work in preference to being chronically unemployed. There are many activities that well targetted government spending could promote to create domestic activity which reduces the reliance on imports. For example, Job Guarantee workers could start making things that the nation would normally import including processed food products.
Moreover, a fully employed economy with skill development structure embedded in the employment guarantee are likely to attract FDI in search of productive labour. So while the current account might move into deficit as the economy grows (which is good because it means the nation is giving less real resources away in return for real imports from abroad) the capital account would move into surplus. The overall net effect is not clear and a surplus is as likely as a deficit.
Finally, even if ultimately the higher growth is consistent with a lower exchange rate this is not something that we should worry about. Lower currency parities stimulate local employment (via the terms of trade effect) and tend to damage the middle and higher classes more than the poorer groups because luxury imported goods (ski holidays, BMW cars) become more expensive.These exchange rate movements will tend to be once off adjustments anyway to the higher growth path and need not be a source of on-going inflationary pressure.
Please read my blog – Bad luck if you are poor! – for more discussion on this point.
The other point to note about Iceland is that it has a very advanced educational system with a highly skilled workforce. It also has huge untapped stocks of natural resources (for example, aluminium). However, I realise there is a huge environmental debate going on in Iceland about the exploitations
So the population has some choices to make. If it wants a higher material standard of living based around a recovery in imports then it will have to rely more on its natural resources and the value-adding that its highly skilled workforce should be able to provide. If the green lobby wins then it will have to accept lower levels of imports.
Finally, the government should also sack the officials at the Icelandic Tourist Board !
I have also read claims by commentators here that a sovereign government will eventually exhaust its domestic “funding” options and have to seek funding from foreigners. It is unclear whether this meant that the “foreign loans” would be in local currency or in the foreign currency.
The point is totally illogical from a conceptual perspective for any sovereign government.
It is interesting to note that in 2007 the functions associated with debt management in Iceland were transferred from the Treasury to the Central bank proving that the institutional machinery surrounding public debt issuance is largely arbitrary and can be changed by government fiat.
Further, ask yourself the question: What would happen if no one turned up to the next bond auction in Iceland? Would the government immediately stop spending – close its public services down, force unsafe hospital procedures, turn off all the lights, sack the police force? Answer: unless they were completely stupid – no! If this became a chronic inability to float public debt they would soon enough change the rules that they had voluntarily put into place in the first place.
In that sense, they probably allow the central bank to buy all or significant portions of the debt but then they would realise that all that was happening was that the fiscal spending was adding to bank reserves whatever accompanying arrangements were put in place and they could always deal with the interest rate effects (the downward pressure) arising from excess reserves by instructing the central bank to pay a support rate on overnight reserves held by the commercial banks with the central bank.
So would they ever have to seek foreign funding in any guise? Answer: never. A sovereign government can never run out of money and never needs to issue public debt as a matter of necessity. The public debt issuance is entirely voluntary and such voluntary actions have a habit of being quickly changed if they present too many “political” problems.
It is thus a total lie to claim that a government will inevitably run out of domestic funding sources.
And that is independent of the reality that the bond markets can not get enough public debt at present in most nations.
Now to important things
Let’s now turn to important things. I am currently in London and staying at the Hyde Park Hotel in Bayswater. It is a good spot – Bayswater that is, not necessarily the hotel. Our two-person room requires one person to exit the room while the other moves around! It makes me wonder how Jimi Hendrix fitted in here with his Stratocaster! Which brings me to the claim to fame of the hotel is that it was the first London home of Jimi Hendrix and he lived here between November 1966 and February 1967.
He wrote the great song – Stone Free from Room 86 at the hotel. Take a moment out of what you are doing and listen to – Stone Free – its a poor quality recording but the live footage was recorded in February 25, 1967 (so early days in London) from a small club in Chelmsford, England. Most notably check out the Marshall stack which was a modest set up when compared to his later wall of amps/speakers.
|This poster confronts you when you walk in the hotel door (click for a larger image):||
Here is the entrance plaque to my hotel (click for a larger image).
I tried to stay out of the photo but it was hard given I was holding my phone up and the plaque was so shiny:
There was also an exhibition at the Handel House Museum where the composer Handel lived for many years and wrote some of his famous works including the Messiah. The residence is at 23 Brook Street, Chelsea, which is just up the road at the other end of Hyde Park. In February 1968, Jimi Hendrix moved into the top floor flat of that property and lived there for a few years.
The exhibition celebrating the Hendrix-connection had among the items on show some self-portrait sketches by Hendrix and handwritten lyrics to Love Or Confusion written on notepaper from the Hyde Park Towers hotel.
And before we finish with Jimi for the day here is an epic recorded live at a Paris concert. This song is the “tasteful” guitarist’s “stairway to heaven” (for all the guitarists out there you will know what I mean):
Anyway, I always carry a travelling guitar with me to keep my practise up and later today my scales may morph into a few riffs of Stone Free.
Yesterday, I travelled from Maastricht to London via the marvellous Eurostar.
It is clear to me that Australia needs a Eurostar between Newcastle and Sydney and then onto Melbourne. It is a much more relaxing way to traverse distance than flying. From Maastricht it is also a much easier way to get to London or Paris. You end up right in the centre of London and within 20 minutes I was out at Bayswater via the underground. Flying would see you land at Heathrow then having to take at least an hour to get through the queues, then an hour by underground into King’s Cross-St Pancras – where the Eurostar arrives.
I am doing some research (out of curiosity) on transport policy at present because while the arguments in Australia against a very fast Eurostar-style train are all centred on whether it could make a profit I cannot see why the government should not just create a national resource as part of the policy towards meetings its environmental targets. So I am investigating whether the concept of profit – once you add in the social dividends (reducing social costs and enhancing social benefits) would yield a positive figure.
Bruce McFarling? You know a lot about trains – what say you about that idea?
Anyway, I am in London for the rest of the week and have several meetings. My blog may be a little late each day (Australian Eastern Time) given the time difference and my need for exercise each morning. I am staying right next to Hyde Park and without my bike here I have to make do with the fabulous running tracks all through the Park. The perimeter track is 4 miles or so and so a few laps of that each day will do the trick.
Keeps me company while I rage against the neo-liberal machine sitting here typing just above the room where Jimi wrote Stone Free. Good mix really.
Back tomorrow – lots of work to do today.
That is enough for today!