When you know they don’t quite get it

I am travelling and engaged with commitments today and so am fitting this blog into a shorter time-span than I usually make. The floods in Australia have now become tragic (loss of many lives) but the Prime Minister still is insisting that the Federal government “will bring the budget to surplus in 2012-13, and, yes, that will entail some tough choices” even though it is being predicted that the impact on real growth of the Queensland economy virtually shutting down at present might be of the order of 1 per cent (see this account). Given the tepid economic growth that was revealed in the September quarter this would suggest that we are going back into recession territory. My advice to PM Julia in relation to her surplus aspirations – “automatic stabilisers – learn about them”. You can see the negative impact of the excessive rain over the last few months on coal exports already – see ABS data release yesterday for International Trade in Goods and Services. Anyway, I was thinking about this early today before I started attending to my commitments here (in Melbourne) and it related to something that I read in the New York Times this week. The issue is that so-called progressives often let the team down by using inappropriate constructs in the public debate. I am never absolutely sure whether they use these constructs because they don’t know better or they want some point of intersection with the mainstream debate. I usually conclude the former and there are times when you realise you know they don’t quite get it.

The subtitle of this blog could have easily been When you’ve got friends like this … Part 4 as it sort of belongs in the series of blogs – The enemies from within – When you’ve got friends like this … Part 1 – – When you’ve got friends like this … Part 2 – When you’ve got friends like this … Part 3.

The common theme of those blogs is that progressive elements in the public debate sometimes make it harder to maintain a case against the deficit terrorists because they slip into erroneous (mainstream) constructs that reduce back to the mainstream position – more or less. That is what this blog is about.

People write to me saying how they think Paul Krugman is a leading voice in progressive economics to which I muse – if only. Sure enough he has been mounting a pretty vehement attack on the deficit terrorists in recent years and certainly is trying to appear different to the main-streamers who dominate the debate. But sometimes – amidst all the seemingly “progressive” writing you get a glimpse on what lies underneath.

In his New York Times article (January 6, 2011) – The Texas Omen – you get such a glimpse.

Krugman is talking about the “deteriorating” budget situation in Texas, apparently, up until now the model for the conservatives who promote “the belief that you should never raise taxes under any circumstances, that you can always balance the budget by cutting wasteful spending”. He rightfully scoffs at the validity of that (religious) belief.

A minor point relates to nomenclature. For a national government, there is no such thing as a deteriorating budget situation – a sovereign government faces no revenue constraint. Further, it is difficult to interpret a rising or falling deficit outcome without reference to the performance of the real economy. A nation’s economy can deteriorate if real GDP and employment growth decline. But the budget outcome will just reflect that and of itself is not an issue.

The only sense in which we might consider a “deterioration” in a national government’s budget is when the government deliberately engages in a fiscal austerity campaign to reduce the deficit at a time when the economy clearly requires the fiscal support. But that is not the context in which the descriptor is ever used.

For a state government which is revenue-constrained the situation is somewhat different notwithstanding the superior income raising capacity that a state government has vis-a-vis private households, who are similiarly financially constrained in a budget sense. Clearly, they can face budget difficulties if their revenue base collapses due to declining economic activity and their spending commitments rise to meet the challenge presented by a recession. They can then face higher “funding” costs and potentially the withdrawal of their funding sources should the “markets” lose confidence.

It also doesn’t help that they impose ridiculous “balanced budget” rules on themselves which limit their freedom to meet the challenges presented by recession.

Given all that, I doubt that Krugman is making such a distinction between the financial capacities of a national government relative to a state government. I suspect he would call the US federal budget a deteriorating situation (I haven’t the time today to search for text to verify that suspicion but I recall him using such terminology). I might be wrong and that would be unfair to him – but it is a small point in relation to what we read next in his article.

He suggests that the Texas deficit is worse than the figures suggest. He writes:

The truth is that the Texas state government has relied for years on smoke and mirrors to create the illusion of sound finances in the face of a serious “structural” budget deficit – that is, a deficit that persists even when the economy is doing well. When the recession struck, hitting revenue in Texas just as it did everywhere else, that illusion was bound to collapse.

The rest of the article is an attack on the “complete dominance of conservative ideology in Texas politics” – the latter which will force spending cuts which will reflect “a hard, you might say brutal, line toward its most vulnerable citizens”. While I agree with his projection of how the Texas government will respond to its “crisis” that is beside the point.

The glimpse I referred to above is in the above quote.

When Krugman says that the structural budget deficit is “a deficit that persists even when the economy is doing well” you are led to think that when the economy is doing well there should not be a deficit. This is the standard deficit dove line that most progressive tout – thinking it sets them apart from the deficit terrorists who advocate balanced budgets or surpluses irrespective of the context.

First, some readers have asked me to explain what a structural deficit is. The following blogs will give more insight into structural deficits – Structural deficits – the great con job! – Structural deficits and automatic stabilisers.

The term “structural deficit” is being increasingly used in the public debate as the weak recovery ensues and the talk has turned to credible “exit” plans for fiscal policy. The mainstream economics position that budgets should be balanced or in surplus (and that the deficits being experienced at present will need to be “paid” for by offsetting surpluses then leads commentators to conclude that any estimated structural deficit is a problem.

There is rarely a distinction made between a state-level and national-level government in this context which is important given the former has a financial constraint while the latter does not. Please do not think this means that a state-level government should not run deficits – permanently or otherwise. I contend that a state government can run permanent deficits but has to be mindful of the funding situation it faces. It is clear that a national government can always run a permanent deficit without regard to any “funding” issues although at times it might not be economically sensible to run such a deficit (rarely). More on this later.

So what is a structural deficit? Well it is the component of the actual budget outcome that reflects the chosen (discretionary) fiscal stance of the government independent of cyclical factors.

The cyclical factors refer to the automatic stabilisers which operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.

In times of economic decline, the automatic stabilisers work in the opposite direction and push the budget balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).

This is what the Australian Prime Minister needs to understand when she is predicting the government will continue to push for a surplus in the face of a catastrophic natural disaster which will serious undermine economic growth in the year ahead.

The problem for economists is to determine whether the chosen discretionary fiscal stance is adding to demand (expansionary) or reducing demand (contractionary). It is a problem because a government could be run a contractionary policy by choice but the automatic stabilisers are so strong that the budget goes into deficit which might lead people to think the “government” is expanding the economy.

So just because the budget goes into deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.

To overcome this ambiguity, economists decided to measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the budget balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.

As a result, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. As I have noted in previous blogs, the change in nomenclature here is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation.

The Full Employment Budget Balance was a hypothetical construction of the budget balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the budget position (and the underlying budget parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.

This framework allowed economists to decompose the actual budget balance into (in modern terminology) the structural (discretionary) and cyclical budget balances with these unseen budget components being adjusted to what they would be at the potential or full capacity level of output.

The difference between the actual budget outcome and the structural component is then considered to be the cyclical budget outcome and it arises because the economy is deviating from its potential.

So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the budget balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.

If the budget is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual budget outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual budget outcome is presently.

So you could have a downturn which drives the budget into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.

The question then relates to how the “potential” or benchmark level of output is to be measured. The calculation of the structural deficit spawned a bit of an industry among the profession raising lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.

Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s.

As the neo-liberal resurgence gained traction in the 1970s and beyond and governments abandoned their commitment to full employment , the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see my blogs – The dreaded NAIRU is still about and Redefing full employment … again!.

The NAIRU became a central plank in the front-line attack on the use of discretionary fiscal policy by governments. It was argued, erroneously, that full employment did not mean the state where there were enough jobs to satisfy the preferences of the available workforce. Instead full employment occurred when the unemployment rate was at the level where inflation was stable.

The estimated NAIRU (it is not observed) became the standard measure of full capacity utilisation. If the economy is running an unemployment equal to the estimated NAIRU then mainstream economists concluded that the economy is at full capacity. Of-course, they kept changing their estimates of the NAIRU which were in turn accompanied by huge standard errors. These error bands in the estimates meant their calculated NAIRUs might vary between 3 and 13 per cent in some studies which made the concept useless for policy purposes.

Typically, the NAIRU estimates are much higher than any acceptable level of full employment and therefore full capacity. The change of the the name from Full Employment Budget Balance to Structural Balance was to avoid the connotations of the past where full capacity arose when there were enough jobs for all those who wanted to work at the current wage levels.

Now you will only read about structural balances which are benchmarked using the NAIRU or some derivation of it – which is, in turn, estimated using very spurious models. This allows them to compute the tax and spending that would occur at this so-called full employment point. But it severely underestimates the tax revenue and overestimates the spending because typically the estimated NAIRU always exceeds a reasonable (non-neo-liberal) definition of full employment.

So the estimates of structural deficits provided by all the international agencies and treasuries etc all conclude that the structural balance is more in deficit (less in surplus) than it actually is – that is, bias the representation of fiscal expansion upwards.

As a result, they systematically understate the degree of discretionary contraction coming from fiscal policy. The only qualification is if the NAIRU measurement actually represented full employment. Then this source of bias would disappear.

So whenever I see reference to the term “structural deficit” I am immediately curious and on guard as to the understanding the commentator/researcher etc has of the estimation of the potential capacity in the economy.

Why all this matters is because, as an example, the Australian government thinks we are close to full employment now (according to Treasury NAIRU estimates) when there is 5.2 per cent unemployment and 7.5 per cent underemployment (and about 1.5 per cent of hidden unemployment). As a result of them thinking this, they consider the structural deficit estimates are indicating too much fiscal expansion is still in the system and so they are cutting back.

Whereas, if we computed the correct structural balance it is likely that the Federal budget deficit even though it expanded in both discretionary and cyclical terms during the crisis is still too contractionary.

Now back to Krugman.

Krugman is a self-styled progressive deficit dove. In my view they actually make the political case for full employment harder to make because they are held out as the “left wing” of the debate. So regression towards to mean takes us further to the right. Centrist positions now are out there a fair distance to the right and a long way from what we used to call the centre!

The standard mainstream government budget constraint (GBC) framework is used by so-called progressive deficit-doves and focuses our attention on the ratio of debt to GDP rather than the level of debt per se. This framework is based on the accounting relationship linking the budget flows (spending, taxation and interest servicing) with relevant stocks (base money and government bonds).

This framework has been interpreted by the mainstream macroeconomists as constituting an a priori financial constraint on government spending and by proponents of Modern Monetary Theory (MMT) as an ex post accounting relationship that has to be true in a stock-flow consistent macro model but which carries no particular import other than to measure the changes in stocks between periods. Keep in mind, however, the distinction between a state and national government. The following discussion applies to a sovereign national government and I will comment later on how it works for a state government (like Texas).

The GBC literature emerged in the 1960s during a period when the neo-classical microeconomists were trying to gain control of the macroeconomic policy agenda by undermining the theoretical validity of the, then, dominant Keynesian macroeconomics.

The neo-classical attack was centred on the so-called lack of microfoundations (read: contrived optimisation and rationality assertions that are the hallmark of mainstream microeconomics but which fail to stand scrutiny by, for example, behavioural economists).

This was a very technical debate (beyond today’s blog) but the whole agenda was total nonsense and reflected the desire of the mainstream microeconomists to represent the government as a household and to “prove” analytically that its presence within the economy was largely damaging to income and wealth generation.

Anyway, just as an individual or a household is conceived in orthodox microeconomic theory to maximise utility (real income) subject to their budget constraints, this emerging approach also constructed the government as being constrained by a budget or “financing” constraint. Accordingly, they developed an analytical framework whereby the budget deficits had stock implications – this is the so-called GBC.

So within this model, taxes are conceived as providing the funds to the government to allow it to spend. Further, this approach asserts that any excess in government spending over taxation receipts then has to be “financed” in two ways: (a) by borrowing from the public; and (b) by printing money.

You can see that the approach is a gold standard approach where the quantity of “money” in circulation is proportional (via a fixed exchange price) to the stock of gold that a nation holds at any point in time. So if the government wants to spend more it has to take money off the non-government sector either via taxation of bond-issuance.

However, in a fiat currency system, the mainstream analogy between the household and the government is flawed at the 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.

From a policy perspective, they believed (via the flawed Quantity Theory of Money) that “printing money” would be inflationary (even though governments do not spend by printing money anyway. So they recommended that deficits be covered by debt-issuance, which they then claimed would increase interest rates by increasing demand for scarce savings and crowd out private investment. All sorts of variations on this nonsense has appeared ranging from the moderate Keynesians (and some Post Keynesians) who claim the “financial crowding out” (via interest rate increases) is moderate to the extreme conservatives who say it is 100 per cent (that is, no output increase accompanies government spending).

So the GBC is the mainstream macroeconomics framework for analysing these “financing” choices and it says that the budget deficit in year t is equal to the change in government debt (ΔB) over year t plus the change in the monetary base (ΔH) over year t. If we think of this in real terms (rather than monetary terms), the mathematical expression of this is written as:

which you can read in English as saying that Budget deficit (BD) = Government spending (G) – Tax receipts (T) + Government interest payments (rB_t-1), all in real terms.

However, this is merely an accounting statement. It has to be true if things have been added and subtracted properly in accounting for the dealings between the government and non-government sectors.

The model is usually expressed in terms of ratios (with respect to the size of the economy) and so the following equation captures the approach:

Note the bias against the expansion of H (monetary base) – the term drops out because the mainstream eschew this approach. In fact, at the state-level, this model is more relevant because state governments do not have currency issuing capacities (although they could overcome that by issuing warrants).

So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP. The real interest rate is the difference between the nominal interest rate and the inflation rate.

This standard mainstream framework is used to highlight the dangers of running deficits. But even progressives (not me) use it in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn.

Many mainstream economists and a fair number of so-called progressive economists say that governments should as some point in the business cycle run primary surpluses (taxation revenue in excess of non-interest government spending) to start reducing the debt ratio back to “safe” territory.

So where do deficit doves fit into this framework? While the doves work within the government budget constraint framework which is clearly flawed when MMT is understood these economists still argue that it is more fruitful to concentrate on stimulating economic growth, than it is to anxiously guard government deficits

Deficit doves think deficits are fine as long as you wind them back over the cycle (and offset them with surpluses to average out to zero) and keep the debt ratio in line with the ratio of the real interest rate to output growth. Torturous formulas are provided to students on all of this under the presumption that the government does have a financing constraint but as long as it is cautious things will be fine.

Deficit doves are within the same species as the “deficit hawks” in that they believe that the long-term deficits pose serious risks although short-term deficits might be necessary during a recession. A standard aspiration for a deficit dove is thus to propose the government runs a “balanced budget” over the business cycle which is clearly dim-witted as a stand-alone goal and un-progressive in philosophy.

From the dove viewpoint, public borrowing is constructed as a way to finance capital expenditures. Since government invests a lot in infrastructure and other public works, those investments should at least allow for a deficit. This was already recognised by the classical economists as a golden rule of public finance.

The problem that deficit doves ignore is that the budget outcome is not autonomous – that is, a deterministic balance that is controlled by the government. The budget outcome in a modern monetary economy is endogenous and determined, ultimately by the non-government saving desires. While the government can try to reduce its deficit by cutting net spending if this runs, for example, against the desires of the private domestic sector to increase their saving ratio (assuming, say a current account deficit) then the government’s aspirations will be thwarted.

The fiscal drag will combine with the spending withdrawal of the private domestic sector (and the leakage from net exports) and the economy will contract further pushing the deficit back up via the automatic stabilisers.

It is impossible for a government in a fiat monetary system to guarantee a budget deficit outcome if it is working against the behaviour of the non-government sector.

Context is everything. The reason that the deficit dove position is unsound at the national level is because they ignore the context. For example, if a government is facing an external deficit and the private domestic sector are net saving (spending less than they are earning) then to maintain economic growth the government has to be running a budget deficit.

So unless a nation can generate significant current account surpluses, then the balanced-budget over the cycle rule that deficit doves hold out will be equivalent to aiming for the private domestic sector to be dis-saving and becoming increasingly indebted over the same cycle (to the extent that the external account is in deficit).

The average extent of this private domestic sector deficit position would mirror the average current account deficit (if a budget balance was achieved). This would be tantamount to returning to the unsustainable growth path where the private domestic sector accumulates ever increasing levels of debt. That is total idiocy and reflects a lack of understanding of the way the monetary system and the aggregate relationships between the government and non-government sector work.

But what about state-level analysis? Clearly, and as noted above there are significant differences between a national government which is never revenue constrained because it is the monopoly issuer of the currency and a state-level government, which faces a GBC. Please read my blog – When governments are financially constrained – for more discussion on this point.

It is clear that 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 has typically been 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. The latest scandal in my home state (NSW) surrounding the power generating sale is a case in point and I will write more about that in due course.

But does this mean that a state government should balance its budget always, over the business cycle or whevenever? The answer remains – it depends on the context although there has to be some focus on funding exigencies for a state government.

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.

A state government can run permanent deficits as long as it maintains strong state growth and its borrowing generates an appropriate social return on the investment.

The other advantage that a state government has over a private household is that is taxation capacity is profound and its borrowing ability is typically superior. A state government can usually issue low risk bonds which attract low borrowing costs a luxury that private corporations and households do not have.

As an aside, this is one of the reasons why private-public partnerships are so fraudulent – the private sector financier can never borrow as cheaply as a typical state government. Please read my blog – Public infrastructure 101 – Part 1 – for more discussion on this point.

So there is no presumption that a state structural deficit should be zero when its economy is growing (performing well). Indeed, the on-going structural deficit might be the reason that sustainable growth is being achieved. The state government has to be mindful (as does a national government) that nominal aggregate demand growth has to be balanced with the capacity of the economy (regional or otherwise) to support such expansion in real terms.

Conclusion

A single phrase is enough to give the game away! Nomenclature is important and that is why I stress cautious use of terms that might confuse – like “money”. The major modern developers of MMT have talked a lot between ourselves about these sorts of issues to avoid falling back into mainstream terminological traps.

Anyway, my day is calling and I have commitments now until very late. Bit busy this week (well busier than usual).

That is enough for today!