Deterministic fiscal rules undermine public responsibility

Yesterday I was listening to the ABC Radio National program – Counterpoint – which interviewed author David Freedman about his 2007 co-authored book A Perfect Mess. I was very interested in this book when it was published. It is about the value of mess and the costs that organisational freaks impose on us. In the case of fiscal policy – the essence of good macroeconomic management is to allow policy settings to be responsive when needed. Why? To ensure that government action supports aggregate demand and is consistent with private sector saving desires. The control freaks want to impose “organisation” on governments by legislating debt brakes and this type of organisation amounts to a fundamental denial of the need for fiscal policy to be reactive and flexible. That is, of-course, no surprise given that deterministic fiscal rules are proposed by ideologues that are fundamentally opposed to public intervention in the first place. Deterministic fiscal rules in fact undermine public responsibility.

You can listen to the podcast of the ABC Radio National program HERE and I think you will find it interesting (I certainly did).

You also might like to listen to this NPR debate between Freedman and a “professional organiser”.

The authors argue that the obsession with order – organisation, storage and maintenance – takes more time, is more costly and less happiness-provoking that living is mess and disorder. Mess is a creative state and order suppresses creativity.

At the time the book was published it caused somewhat of a controversy. There was this article I recall from my research at the time in the New York Times (December 21, 2006) – Saying Yes to Mess – which examines the obsession with order and organisation that has suppressed our individuality and, moreover, wasted hours of our lives.

The RN program brought back my thoughts of the time. I was particularly interested in author’s view of the way modern organisations – like Universities – hire a bevy of high-paid consultants who know little about the higher education sector (in this example) and prescribe a sequence of corporate restructuring exercises so “we can do our job better”. I especially like the way the consultants talk of universities as corporations – when they are nothing of the sort.

These restructuring exercises all involve imposing order – eliminating individuality and imposing homogeneity and structure for structures sake. They are disruptive, productivity collapses during the period leading up to them and afterwards as the new processes are implemented and they are extremely time consuming. I have worked through several major restructuring exercises over the last 20 years that have seen departments merged, collapsed, eliminated, faculties the same, committees come and go, anything that moves being restructured and I swear none of these changes have made me more productive as an academic.

On the contrary they have undermined my productivity and added layers of bureaucracies and managerialism that have impeded our individual expression, creativity and enthusiasm.

Anyway, am I messy? Here is the desk in one of my offices – this is the neatest one!

But I was thinking about the program last night in the context (somewhat laterally) of the latest speech that German Chancellor Angela Merkel gave to the World Economic Forum in Davos last Friday (January 28, 2011).

The transcript of her talk is not yet available but you can see an analysis of the speech in this Der Spiegel article (January 29, 2011) – Merkel Pushes Ahead with Economic Government Plans – and also the some coverage in the official press release from Davos.

As an aside, it is interesting to compare the German coverage (Der Spiegel) with the press release which presumably captured the breadth of her address. The latter emphasised the global discussion about allowing exchange rates to float and to avoid protectionist trade policies whereas the former focused mostly on the Eurozone issues.

The Chancellor’s construction of the woes of the Eurozone focus on what she claims is “excessive public debt”. She said:

We now have a clear crisis of indebtedness. But let me tell you, there is no crisis of the euro as such. This is a debt crisis. Let me say this very clearly again. The euro is our currency. And it is much more than just a currency. It is the embodiment of Europe today. Should the euro fail, Europe will fail. We are going to defend the euro …

Which effectively amounts to Denial 101.

There is no public debt crisis without the Euro. Greece a public debt ratio of about 144 per cent (of GDP) with Italy about 118 per cent, Belgium 102 per cent, Ireland 98 per cent, France 83 per cent etc. Japan is now over 204 per cent, the UK is about 75 per cent, the US is about 59 per cent etc.

In the latter three countries there is no public debt crisis. Why not? Answer: because those nations have all retained currency sovereignty and have little or zero foreign debt exposure. This means they can always find the wherewithal to honour all outstanding public debt commitments.

None of the Eurozone countries have the capacity to honour their public debt commitments under all circumstances because all their debt is effectively in a “foreign currency” – given they ceded their individual currency-issuing monopolies when they entered the Eurozone.

I realise as a non-European resident I may not appreciate all the cultural nuances involved but there is a mountain of documentation to allow “outsiders” to learn about the European way of thinking (if there is such a thing). But when I read that the Euro “is the embodiment of Europe” I just think how restricted by order the nations within that broad region have become – they have voluntarily surrendered their individual destinies to shape the fortunes of their peoples and, instead, have signed up to a system that guarantees austerity over the long-term.

If the EMU is embodiment of Europe today then I would not be wanting to be part of that coalition.

The Chancellor called for a “pact for competitiveness” among Eurozone members to get the nations to “harmonize their policies”. The Chancellor told the Davos forum that the main problem facing Eurozone nations is that:

We are not competitive enough in Europe.

This is the standard IMF line which sounds harmless enough but upon further scrutiny amounts to a denial of the capacity of governments to use their fiscal capacities to target domestic activities which enhance well-being.

What does she mean – “we are not competitive enough in Europe”? Does she mean that economic growth and therefore rising incomes can only be achieved by promoting positive net exports at the expense of domestic consumption?

Given that each of the EMU nations is forced to accept fixed nominal exchange rates, then the only way they can increase their international competitiveness is by internal cost reduction and/or via productivity growth. The latter evolves more slowly and requires strong growth to ensure that investment in new technologies is strong.

With fiscal austerity now suppressing growth and undermining business confidence one would predict a slower productivity growth trajectory for Europe. So does the Chancellor really want nations in Europe to cut the living standards of their workers by reducing nominal wages so they can compete with … whom?

By way of argument, to improve their international competitiveness, the EMU countries have to engage in what has been referred to as internal devaluation which means they have to cut real unit labour costs – which are the real cost of producing goods and services. Governments setting out on this policy path have to engineer cuts in the wage and price levels (the latter following the former as unit costs fall) and/or promote productivity gains.

So it takes more than just a nominal deflation (wages and prices). The strategy really hinges on whether you can also engineer productivity growth (typically).

Unit labour costs are in nominal terms and are calculated as total labour costs divided by nominal GDP. So they tell you what each unit of output is costing in labour outlays; Real unit labour costs (RULC) are unit labour costs divided by the price level to give a real measure of what each unit of output is costing. RULC is also the ratio of the real wage to labour productivity and is equivalent to the wage share in national income.

For those who are happy with the algebra – RULC are identical to the wage share in national income and are constructed in the following way. ULC = Wage rate times employment divided by total output = W.L/Y. Note that L/Y is the inverse of labour productivity. RULC = ULC/P (where P is the price index). So RULC = (W.L/P.Y), that is the wage share (W.L is the total income payments to labour and P.Y is GDP). It can also be written as (W/P)/(Y/L), which is the ratio of the real wage (W/P) to labour productivity (Y/L).

So to decrease RULCs, you must reduce the wage share which means that the standard of living of workers falls. Without productivity growth, the way to accomplish a fall in RULCs is to ensure that nominal wages fall faster than the price level falls. In the historical debate, this was a major contention between Keynes and Pigou (an economist in the neo-classical tradition who best represented the so-called “British Treasury View” in the 1930s. The Treasury View thought the cure to the Great Depression was to cut the real wage because according to their erroneous logic, unemployment could only occur if the real wage was too high.

Keynes argued that if you tried to cut nominal wages as a way of cutting the real wage (given there is no such thing as a real wage that policy can directly manipulate), firms will be forced by competition to cut prices to because unit labour costs would be lower. He hypothesised that there is no reason not to believe that the rate of deflation in nominal wage and price level would be similar and so the real wage would be constant over the period of the deflation. So that is the operating assumption here.

It is highly likely that an engineered attempt to cut real wages will thus fail. So the internal devaluation strategy relies heavily on productivity growth occurring.

The literature on organisational psychology and industrial relations is replete of examples where worker morale is an important ingredient in accomplishing productivity growth. In a climate of austerity characteristic of an internal devaluation strategy it is highly likely that productivity will not grow and may even fall over time. Then the internal devaluation strategy is useless.

Further, the “supply-side” scenario does not take into account the overwhelming reality that for an economy to enjoy growth it has to be supported by aggregate demand growth. The internal devaluation strategy relies heavily on the external sector providing the demand impetus.

Given that Eurozone trade is heavily internal, it seems far fetched to assume that the trade impact arising from any successful internal devaluation will be sufficient to overcome the devastating domestic contraction in demand that will almost certainly occur. This is why commentators are calling for a domestic expansion in Germany to boost aggregate demand throughout the EMU, given the dominance of the German economy in the overall European trade.

That is clearly unlikely to happen given Germany has been engaged in a lengthy process of internal devaluation itself (the Hartz reforms) and the Government is resistant to any stimulus packages that might improve things within Germany and beyond via the trade impacts.

The following blogs – Export-led growth strategies will fail – Fiscal austerity – the newest fallacy of composition – are relevant to this discussion.

The reality is that an export-led growth strategy cannot apply for all nations which are simultaneously cutting back on their domestic demand. The Merkel approach – to scorch the domestic economies in Europe by undermining pension entitlements and the wages and conditions of the workers – and then hope for an external boost might work for one country but it cannot work for all countries unless there is a revamping of its trade towards (perhaps) Asia. That is unlikely to occur in the foreseeable future.

The only reliable way to avoid a fallacy of composition like this is to maintain adequate fiscal support from spending while the private sector reduces its excessive debt levels via saving.

That strategy is also likely to be the best one for stimulating exports because world income growth will be stronger and imports are a function of GDP growth.

The proponents of austerity are not only undermining the rights and welfare of the citizens but are also undermining the source of the export revenue – domestic aggregate demand.

The Chancellor then called for the creation of an “economic government in the euro zone” as part of the “pact for competitiveness”.

Apparently (Der Spiegel) the plan involves:

… concrete commitments … [by the 17 member states] … to strengthen competitiveness that are more ambitious and more binding than those that have already been agreed by the EU-27 … [with] … closer integration of national financial, economic and social policies is necessary” in order to dispel financial markets’ concerns about Europe’s common currency.

On the face of it, the creation of a common fiscal authority (an economic government for the euro area) would help address one of the basic design flaws in the original (and existing) set up.

In these blogs – Doomed from the start and Euro zone’s self-imposed meltdown – I discuss the design flaws of the EMU.

Prior to the creation of the EMU, each of the member states were sovereign in their own currencies and had their own central banks. That means they were not revenue-constrained and could conduct fiscal policy and monetary policy in a coordinated way to best serve the socio-economic interests of their citizens.

Of-course, in this guise, they succumbed to the growing neo-liberal take-over of macroeconomic policy and typically worried about the size of budget deficits and the public debt. All the usual spurious arguments were used by the conservatives to politically constrain their use of fiscal policy – for example, crowding out arguments (higher deficits cause higher interest rates) and Eurosclerosis that engendered privatisations and deregulation.

Leading up to the unification, the interest rate argument was played to the full. Neo-liberal supporters of the EMU claimed that lower interest rates would emerge throughout Europe. Not only didn’t that happen but it begged the reality – the nations could have unilaterally maintained zero interest rates as sovereign economies by just managing their central bank operations along the lines followed by Japan, for example.

Once again, had they understood MMT and argued the case politically, these nations would now be in much better shape than they are now.

This is why Europe has been sustained very high unemployment rates since the mid-1970s.

So some might say going into the EMU was moot because they were acting as individual non-sovereign governments anyway. True enough. But now they are legally bound rather than politically bound. The political climate can change whereas it will be much harder to unravel the EMU to restore sovereignty to each of the member states.

So in entering the EMU, all those previously sovereign states surrendered this capacity and became users of the currency issued under the auspices of the ECB rather than monopoly issuers of their own currency. In effect, they became states of a federation (like an Australian or a US state).

By surrendering their currency sovereignty – by choice – the leaders in the member states largely mislead their citizens with spurious arguments about optimal currency areas and the rest of the sophistry that the neo-liberal economists happily fed them.

In doing so, they also gave up their monetary policy independence and so differential circumstances cannot be dealt with by variations in interest rates.

Some might also say that this transition doesn’t really alter much because the EMU created new sovereign institutions – the European Parliament and the ECB. But this misses the point that these two institutions are not a consolidated entity serving the same political ambitions. They also act anything but like a sovereign currency-issuing government.

But these nations then agreed to tie themselves up in strait-jackets (aka – the Stability and Growth Pact) to ensure that individual member state governments who are still accountable politically to their own citizens could not pursue their own agendas very easily.

These ridiculous fiscal constraints had no basis in any sound economic theory or practice or the way the real economy and the monetary system interacts. Mostly they were a reflection of long-standing suspicions (racism, etc) – that is, they were ideological and political. Trust between the northern European nations and the South was not particularly high!

In addition, Germany then introduced harsh labour market reforms to not only screw their own workers but also to ensure that the international competitiveness of their EMU partners fell substantially viz Germany.

But the overarching choice by the neo-liberal designers of this system not to include any notion of a system-wide fiscal redistribution capacity in the original design which would ensure the member states achieve similar growth in real living standards under all circumstances was the most telling design flaw.

Purely ideological in nature, this omission prevents the individual nations (and the Euro system in general) from being able to react to asymmetric shocks in aggregate demand of the sort that has rocked the World in recent years.

With a unified economic government the system could have better reacted to the crisis.

But in its absence, the design flaw means that many Euro nations (already damaged by the German strategy leading up to the crisis) are now in extreme crisis and are being forced by the EMU bosses to introduce harsh pro-cyclical fiscal policies to savage living standards of their citizens.

No reasonable economist would ever advocate pro-cyclical fiscal policy. It is the exemplar of the abandonment of public purpose.

All of this also tells us that this is no federation which cares about its individual components.

All functional federations have effective fiscal redistributions to ensure that the real standard of living is similar across the geographic spaces.

But not in EMU.

And once you put all that together you realise all of this is voluntary and a product of political choices. There were no financial constraints on the nations and no economic imperative to enter the EMU. The citizens were blinded by a range of spurious arguments and lies coming from economists in the 1990s.

If they realised that they would always be better off as sovereign nations and there were no financial constraints on them retaining that status then they could better compare the decision to stay in the EMU – a political/ideological choice favouring the elites rather than the common folk – with the other political choices now being made and imposed on them by their leaders – the austerity programs.

So in that context the call for some unified economic government in Europe is – as it stands – a good one.

But of-course the Chancellor does not have the same conception of that idea as I have. For her, the creation of a common economic governance agreement is about imposing order – German order on the member states. It is about control – fiscal rules – and rules about wage costs and pension funding.

It is a recipe for disaster for workers in the individual states, particularly those which do not have strong export sectors – that is, most nearly every other state bar Germany. How convenient that the Chancellor would be promoting this idea.

One of the Chancellor’s suggestions is that member states sign up to the adoption of:

… a “debt brake” based on the German model. The debt brake is an amendment to Germany’s constitution that requires the government to virtually eliminate the country’s structural deficit by 2016.

Please read my blog – Fiscal rules going mad … – for more discussion on why debt brakes are the exemplars of irresponsible macroeconomic policy practice.

The specific provision that was inserted into the German constitution prevents the government from borrowing beyond 0.35 per cent of GDP. The debt brake allows for “moderate symmetric cycles” in borrowing when there are emergencies but must be offset by specific repayment schedules.

But the effect is that the government is forced to balance its budget over the business cycle and repay any debt that has accumulated in the downside of the cycle within the same cycle (on the upturn).

Imposing this rule on Euro nations would be a disaster and undermine living standards.

The requirement that budget deficits should be zero on average over a business cycle not only restricts the fiscal powers that governments would ordinarily enjoy in fiat currency regimes, but also violates an understanding of the way fiscal outcomes are effectively endogenous. Any economist with even the simplest understanding of the way in which automatic stabilisers operate will see the lack of wisdom such a rule.

A sharp negative demand shock which causes an economic downturn will reduce tax receipts and increase benefits, automatically increasing the deficit. Reducing government expenditures in that situation to meet the rule will worsen (prolong) the recession, which is then likely to involve the country in further fiscal rule violations.

But the fear of public debt is likely to impose a system which promotes unsustainable private debt escalation in many nations. An understanding of the way the macroeconomic aggregates (from the National Accounts) work tells us that if the budget is balanced over the cycle then the private domestic balance (the relationship between private spending and income) must be equal to the external balance (net exports) over the same cycle.

So for a nation that on average runs an external deficit, a balanced budget over the cycle would mean that the private domestic sector would be running a deficit equivalent to the external deficit over that cycle. The fiscal austerity that was required to promote a return to the brake would cruel strong growth.

This system would not only be biased towards stagnant growth but would also introduce unstable private debt dynamics which would ensure that outcome. If the private domestic sector was running deficits – the stock manifestation of that is increasing overall indebtedness. That cannot be sustained. So ultimately imports have to be cut if exports are not strong enough and that can only be achieved in a nation with no nominal exchange rate flexibility by cutting income (and growth).

Please read my blog – Norway and sectoral balances – for more discussion on the sectoral balances.

As a matter of accounting between the sectors, a government budget deficit adds net financial assets (adding to non government savings) available to the private sector and a budget surplus has the opposite effect. The last point requires further explanation as it is crucial to understanding the basis of modern money macroeconomics.

In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. In a closed economy, NX = 0 and government deficits translate dollar-for-dollar into private domestic surpluses (savings). In an open economy, if we disaggregate the non-government sector into the private and foreign sectors, then total private savings is equal to private investment, the government budget deficit, and net exports, as net exports represent the net financial asset savings of non-residents.

It remains true, however, that the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save (financial assets) and thus eliminate unemployment is the currency monopolist – the government. It does this by net spending (G > T).

Additionally, and contrary to mainstream rhetoric, yet ironically, necessarily consistent with national income accounting, the systematic pursuit of government budget surpluses (G < T) is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then taxes in aggregate would have to be less than total government spending. That is, a budget deficit (G > T) would be required.

So while Germany might be able to sustain growth by strong net exports (undermining domestic living standards) and therefore run budget balances they are an exception.

If as is usual the nation has an external deficit (X – M < 0) then for the private domestic sector to net save (S – I) > 0, then the public budget deficit has to be large enough to offset the current account deficit. As a matter of accounting if (S – I) < 0 then the domestic private sector is spending more than they are earning (dis-saving).

In this situation, the fiscal drag from the public sector is coinciding with an influx of net savings from the external sector. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process. It is an unsustainable growth path.

A further issue relates to the acceptance by EMU countries of the voluntary monetary policy straitjacket that the creation of the ECB imposed. While the ECB now has a monetary policy monopoly across the EU countries, it is not politically responsible for its actions. The EU countries have voluntarily allowed the ECB to be an unelected and independent body whose sole aim is to control inflation. The fundamental democratic principle that the citizens have the ability to cast judgement on the policies of their representatives at regular intervals has been abandoned in this set up.

This voluntary monetary policy straitjacket suggests that countries have to use fiscal policy to react to economic shocks which affect the real economy. However, by imposing a debt brake on the individual nations this flexibility is lost and there would be a bias to stagnant economic outcomes.

It is often said that the European economies are sclerotic, which is usually taken to mean that their labour markets are overly protected and their welfare systems are overly generous. However, the real European sclerosis is found in the inflexible macroeconomic policy regime that the Euro countries have chosen to contrive. The rigid monetary arrangements conducted by the undemocratic ECB and the irrational fiscal constraints that are already in place (the SGP) is to be adhered to, render the nation states within the Eurozone incapable of achieving low levels of unemployment and increasing income growth.

The imposition of fiscal rules amount to a denial of the basic fiscal policy function – to fill the spending gap. The only sustainable fiscal policy approach is to ensure that net government spending is sufficient to fund the net saving desires of the non-government sector.

Thus when there is a positive desire to net save by the private sector then the government sector has to be in deficit to ensure there is enough spending left in the system to underwrite production levels consistent with full employment.

For more on this see my blogs on – Fiscal sustainability 101 – Part 1 – Fiscal sustainability 101 – Part 2 – Fiscal sustainability 101 – Part 3

Still searching for those Ricardian agents …

If there is one thing that defines the current Australian government it is their resolute but ridiculous resolve to deliver a budget surplus in 2012-13 no matter what. They actually believe that is a good aim which necessitates cutbacks now despite very high rates of labour underutilisation (12.5 per cent), sluggish growth (nearly zero) and several major disasters wiping out production (floods and now a monster cyclone).

No-one doubts their resolve. So business firms should be becoming increasingly confident according to mainstream economists who consider private sector decision makers (firms, households, consumers etc) to be Ricardian agents who allegedly are not currently spending because they are saving to pay for the higher future tax liabilities given the recent budget deficits.

As the government pursues its surplus objectives, these private agents should be perceiving lower future tax liabilities and be more confident if the orthodox story was an accurate depiction of the way the world works.

Today some data was released – the NAB December business confidence index – which showed that confidence has collapsed – “posting its first negative reading in more than a year and a half” (see AAP report).

The report suggests that the Australian economy will slow in 2011 with confidence collapsing:

… in mining and … [falling] … heavily in transport and utilities, wholesale, construction and manufacturing.

While the natural flood disaster has been significant in denting confidence, analysis of the data shows that by “removing the Queensland component from the survey, national business confidence barely escaped negative territory”.

So more general moderation in the business outlook is occurring as another indicator that the economy is slowing as the fiscal stimulus is being withdrawn. Most of the “above trend” growth forecasts from the bank economists are due to their expectation of a strong mining-led investment boom this year. It doesn’t look like it will be quite as strong at all.

But this is real world data and reflects the sort of predictions that Post Keynesians and certainly proponents of Modern Monetary Theory (MMT) would make which are, of-course, diametrically opposite to the Ricardian agent idea.

As the economy slows with the fiscal withdrawal and consumer sentiment remains flat there is no reason why the business sector should be very optimistic or take too many investment risks. There is still excess capacity and the surge in investment recently restocked inventories that were run down during the height of the uncertainty surrounding the crisis (in 2009).

There is not widespread concern about the budget deficit – only whether consumers will keep their jobs and firms will be able to sell what they produce. That is the real world. The Ricardian world is a dream world and should be treated as such.

Conclusion

Anyway fiscal rules are about control – organisation. But whether mess or organisation in our personal lives makes any sense one has to consider what the purpose of
the target of the organisation is.

In the case of fiscal policy – the essence of good macroeconomic management is to allow it to be responsive when needed. Debt brakes amount to a fundamental denial of that need and the essential virtue of fiscal policy. Which is no surprise given that they are proposed by an ideology that is fundamentally opposed to public intervention.

That is enough for today!