Sometimes everything comes together in unintended ways. That has happened to me this week. I…
In a blog last week – These were not Keynesian stimulus packages – I considered the trend among faux-progressives to invoke Keynes as their mentor as they advocated or were cutting back public deficits in a pro-cyclical manner. That is, they were proposing to cut back deficits just when they should be providing strong support for aggregate demand in the context of weak demand. The specific discussion was focused on a recent Australian Fabian Society essay (April 11, 2011) by the Australian Treasurer Wayne Swan – Keynesians in the recovery. There are two points I want to revisit in regard to this paper – one specific and one general. Both points demonstrate that the fiscal strategy of the Australian government is based on a false premise and that they are selling that strategy by distorting the historical evidence.
But first an aside.
I will have to be careful with my use of the term “mainstream macroeconomics” and “mainstream macroeconomists” by which I have meant the overwhelming proportion of my profession that extols the virtues of alleged “self-regulating markets”, a view that is built on a thoroughly inapplicable view of the way the monetary system operates. The “mainstream” think a currency-issuing government is like a currency-using household only bigger – a super household if you like.
They then build a logic that is used to attack public deficits as dangerous that is nothing short of a fantasy world.
But things have changed recently. Apparently, Modern Monetary Theory (MMT) which I clearly write about is now mainstream too. This article (April 8, 2011) – Why Gold and Silver Will Go Higher – purports to give advice to investors. My advice to the investors who might read this stuff is – delete the page from your bookmarks.
The article was talking about how the US government wasn’t the slight bit interested in reducing their deficit and:
… the whole dollar system is a sham now built on Ben Bernanke’s ability to push buttons on a computer.
No sham, just a fiat monetary system. The government is the currency issue and most issuance is done electronically even though I doubt Ben Bernanke is the officer that is engaged in the specific central bank operations that credit and debit bank accounts in the private banking system on behalf of the government.
Then (in horror at the US government having this capacity) the article said this:
But what most people don’t know is that there’s a whole, mainstream school of economics that actually believes that deficits don’t matter. Not now, not ever. Deficits, they say, simply cannot bankrupt a country with the power to print its own currency. They’re called neo-Keynesians or Chartalists, or proponents of Modern Monetary Theory.
These people hold enormous sway in the Federal Government, and their theories give tacit approval to the Federal Government to do what it will.
I looked up my diary over the last few years to check how many meetings I have had with US government officials. Answer: None although some E-mail correspondence. The resulting policies do not resemble the advice I gave in those E-mails.
So I am guessing that Warren, Randy, Scott, Randy, Pavlina et al (my US MMT mates) are living it up in Washington – Government gurus … the thing is they haven’t told me that. Maybe they are holding out on me for a top job in Wall Street because they are influential intellectuals who “hold enormous sway in the Federal Government”. There is plenty of corruption money to share around guys (generic) – that is what being mates is all about.
Anyway, back to the theme today – the way the Australian government is behaving – which generalises to how the G-20 Finance ministers are behaving (more on their lunatic output overnight tomorrow – I think!).
Recall that the Australian Treasurer said the following:
… if we are going to be Keynesians in the downturn, we have to be Keynesians on the way up again. That means a speedy return to surplus.
The political reality that is he addressing is that the Federal Labor government is losing credibility as a progressive force in politics. Their constant neo-liberal macroeconomics mantra clearly runs counter to what “progressives” think is a reasonable demonstration of responsible government although there is no clearly laid out guide to that from the majority of “left” inputs.
But one theme seems to resonate and that is that progressives think Keynes was “good” and stood for something they can identify with – government intervention etc. Most of the progressives also think it is reasonable to expand the deficit in bad times and cut it in good times – the balanced budget averaged over the course of the business cycle idea – although when you probe that view it is clear they do not understand the implications of that rule for the other sector balances.
There is total ignorance in fact demonstrated when you put it to these “deficit doves” that a nation with an external deficit will on average over the business cycle force the private domestic sector into deficit of the same magnitude as the external deficit if the government actually balanced their budget over the same cycle (on average).
They also cannot appreciate that this would mean that the private domestic sector would be accumulating ever increasing levels of private debt – the exact dynamic that led to the global financial crisis.
The smarter ones then talk about export-led growth – probably after reading some IMF paper – to which you ask: (a) how will that occur? and (b) why would you want to deny your citizens of net imports from abroad? The answers are never acceptable.
Anyway, for the public debate all this essential understanding amounts to “too much detail” and so the Treasurer can get away with this loose association with Keynes as a way of appealing to the cohort that their policies are alienating.
In the blog last week I showed how the policy stance adopted by the Government in the downturn was hardly one that Keynes himself would have proposed. But what about the approach in the upturn – to speedily introduce harsh fiscal retrenchment. Well first you have to an upturn strong enough to support growth sufficient to ensure full employment.
On Saturday (April 16, 2011) the ABC carried the story – Massive budget cuts expected in May.
The story noted that:
Confidential Treasury figures showing a $13 billion fall in economic growth this financial year are expected to force drastic cuts to the Federal Government’s May budget.
The Federal Treasury is expected to again revise down this year’s economic growth figures because of weaker-than-expected consumer demand.
Okay, here is a question that any Economics 101 student should be able to answer.
Q: Given that economic growth is slowing because of “weaker-than-expected consumer demand” and net exports are providing a negative contribution to growth overall, what should the government do to protect national income and employment growth?
A: (by some sensible and educated student) The government should attempt to offset the negative growth contribution coming from private spending by increasing public net spending.
Teacher assessment: 100 per cent correct.
Australian Treasurer response (as gleaned from the quote above in his Australian Fabian Essay): Keynesians in the downturn – increase deficits.
Teacher assessment: 60 per cent correct and the extra marks would have been given if you had have said that you would use the increased deficit spending to target employment via direct job creation.
Australian Treasurer answer (as reported by the ABC news story):
“These are impacts in the short term and there’s no doubt there will be an impact on the budget bottom line this year … But as we go into the forward estimates, as we go into the years ahead, growth will be strong. Short-term weakness, medium-term strength.
The Treasurer who is now at the G-20 meeting expanded on this line to journalists in Washington:
JOURNALIST: Why then if there such a big hit to the economy is it so important to return to that surplus right on target [inaudible]?
TREASURER: … both in the medium-term we’ll be strong. The mining boom and the investment pipeline that comes with that will mean that growth will be strong. Unemployment is already low, so by 2012/13 our economy will be approaching capacity. So what we have is an impact on growth now and an impact on Government revenues … What we must ensure we do is come back to surplus in 2012/13, because by then our economy will be at capacity and it’s very important to make room for the private sector.
JOURNALIST: The Government made a promise to get back to surplus by 2012/13 before … they will affect Australia’s ability to get back on time?
TREASURER: These are impacts in the short-term. There’s no doubt there will be an impact on the budget bottom line this year. But as we go into the forward estimates, as we go into the years ahead, growth will be strong. Short-term weakness, medium-term strength.
At present there are at least 12 per cent of productive labour resources in Australia that are idle – either unemployed or underemployed. The concept of making “room” for the private sector because we are approaching capacity makes a farce of the Treasurer’s concept of “full capacity”. We are no where near full capacity even though a few regions are booming.
Further, the point that the Treasurer ignores is that economic outcomes are not discrete independent events. Expectations and sentiment link decisions to spend by players in each sectors and outcomes become interdependent.
The Treasurer is assuming that the sharp fiscal contraction – now being marketed in the media as “drastic cuts in the budget in May” – will have no lasting negative effect on private sentiment.
The other major mistake he is making is that the slowdown is all seasonal and driven by the natural disasters that have beset our nation and wider region in the last 5 months or so – cyclones, floods, earthquakes and tsunamis. Clearly these disasters have had a negative impact but consumer spending was slowing well before the disasters and output growth started to slow in lock-step with the declining fiscal stimulus.
Unfortunatel for us Australians, the response by the Federal Opposition’ was about as lame as the Governments to the slowdown. Their leader said:
We wouldn’t have wasted the money that this government has wasted. If the Government had been tough on itself it wouldn’t have to be tough on the Australian people at the upcoming budget.
Well if the Government had have followed the advice of the Opposition and not provided the stimulus they did then the Australian economy would have gone into an drawn out recession – perhaps not as bad as in the US and the UK but much worse than our recent experience demonstrated.
So the cyclical deficits would have been bigger and the real economy would have been in much worse shape with a longer recovery period ahead. Unemployment would have risen to the forecasted 8 or so percent (estimated at the beginning of the crisis).
Please read my blog – Fiscal policy worked – evidence and Fiscal austerity is undermining growth – the evidence is mounting and Tick tock tick tock – the evidence mounts and US fiscal stimulus worked – more evidence – for more discussion on this point.
The point is that fiscal policy in Australia is now deliberately becoming pro-cyclical as it is in the UK, the US and the Eurozone and elsewhere. Economists long
Now, lets go back to the Treasurer’s Fabian essay. In justifying the intellectual lineage of the position of the current government (that is, to run pro-cyclical fiscal policy) he appealed to history and the approaches taken by some of the famous Treasury heads.
By way of summary, Swan said that the policy environment in Australia under the various Labor Governments dating back to the Great Depression:
… that was to guide the emergence of Australia as a 20th Century social-democratic state: demand management in pursuit of full employment and rising prosperity through balanced budgets over the economic cycle.
First, the Hawke-Keating Labor government (1983-96) clearly abandoned the commitment to full employment. They oversaw persistently high unemployment and set up a wages policy that led to dramatic cuts in real wages both absolutely and relative to productivity growth. The wage share in national income fell sharply during the 1980s under this Labor government. They refined the neo-liberal approach to macroeconomic policy in Australia.
Second, what about this idea that historically federal governments have “balanced budgets over the economic cycle”. This was just a single line in his speech but an extremely important part of his claim that the current Government is Keynesian and that now is the time to cut back and push for surpluses – to average out in balance over the cycle.
No-one in the media (as far as I know) has actually challenged that depiction of our past. The myth remains that responsible governments “balance their budgets over the business cycle”.
Well that would mean that for as long as we can get data, successive Australian governments have been grossly irresponsible. The reality is that budget deficits have been the norm over any of the successive business cycles. There is no evidence that Australian governments “balance budgets” over the cycle.
The further evidence is that as the neo-liberal persuasion has become dominant in macroeconomic policy, Australian governments have attempted to run discretionary surpluses. The outcomes of this behaviour have not been good and overall this period (since around the mid-1970s) have been associated with lower average real GDP growth and more than double the average unemployment rate.
To probe this point a bit further I played around with some data pertaining to budget and national income outcomes. I compiled a dataset frmo 1953-54 to 2010-11 (that is, fiscal year data) from two sources. The earlier data (1953-54 to 1970-71) is from the historical publication by R.A. Foster and S.E. Stewart (1991) Australian Economic Statistics, 1949-50 1989-90, Reserve Bank of Australia, Sydney.
The second time series (1970-71 to 2010-11) is from Statement 10 which is the data appendix to Budget Paper No. 1 published by the Commonwealth Government when it delivers its annual budget.
There are some issues about combining this data set and with each individual data set. But in general the graph below is a reasonably reliable depiction to the history of Federal Government Budget outcomes over this period. The columns show the Federal Budget balance as a per cent of GDP (negative denoting deficits) while the green line shows the average quarterly real GDP growth (averaged over the financial year at June).
The red vertical lines denote the trough of the respective business cycles. So the real GDP growth line approximates where in the year the negative real GDP growth manifested. But for our purposes it is near enough.
The upper numbers in boxes are the average deficits over each cyclical periods. The average deficit over the whole period was 0.8 per cent of GDP. The average real GDP growth per quarter from 1959-60 was 1.2 per cent and after 1975 this dropped to 0.8 per cent. The unemployment rate averaged below 2.0 per cent in the pre-1975 period and averaged around 5.5 per cent after 1975.
The 1975 Budget was a historical document because it was the first time the Federal Government began to articulate the neo-liberal argument that budget deficits should be avoided if possible and surpluses were the exemplar of fiscal responsibility.
Some points to note:
1. One the rare occasions the budget was pushed into surplus (usually by discretionary intent of the Government) a major recession followed soon after. The association is not coincidental and reflects the cumulative impact of the fiscal drag (that is, the surpluses draining private purchasing power) interacting with collapsing private spending.
2. There is no notion over this period that the budget outcome was “balanced” over the business cycle. The historical reality is that the federal government is usually in deficit. If I had have assembled more historical data which is available in the individual budget papers going back to the 1930s then it would have just reinforced the reality that surpluses have been rare in our history independent of the monetary system operating (the old convertible system or today’s non-convertible system).
The fact that the conservatives were able to run surpluses for 10 out of 11 consecutive years (1996 to 2007) is often held out as a practical demonstration of how a disciplined government can run down public debt and provide scope for private activity. The reality is that during this period we have witnessed a record build-up in private indebtedness.
The only way the economy was able to grow relatively strongly during this period was that private spending financed by increasing credit growth was strong. This growth strategy was never going to be sustainable and the financial crisis was the manifestation of that credit binge exploding and bringing the real economy down with it.
Did Keynes advocate balanced budgets over the cycle?
The other part of the Treasurer’s story is that Keynes advocated balanced budgets over the course of the business cycle. Is that true?
Researchers go back to Keynes 1924 Macmillan publication – A Tract on Monetary Reform – where he argued strongly that price stability was a policy target and this including avoidance of deflation. This was in the context of nations being reluctant to allow their pegged currencies to depreciate which would have provided in Keynes’ assessment high employment. At the time Britain languished with high unemployment and Keynes began to articulate a view that not only was the reluctance to depreciate undermining employment growth but also that the government should use fiscal policy (via direct job creation in public works) to reduce unemployment.
I won’t consider in this blog the arguments that Milton Friedman (and the long line of Monetarists that followed him) made that the Tract was really the first Monetarist statement. That is a complex argument and I might write a separate blog on that if there is interest.
As Keynes’ view unfolded over the bleak 1920s in Britain he did argue that governments should run deficits when private spending declined and reduce those deficits when future growth was strong enough. The intent was that the budget was to be more or less balanced over the business cycle.
He never argued that governments should start cutting back deficits now and create surpluses just in case private spending growth is strong in the future. He readily understood how pro-cyclical policy would undermine private confidence.
In the context of today, with private spending still weak, notwithstanding some evidence that private investment might strengthen over the next few years, Keynes would worry about the negative consequences of a further weakening of aggregate demand and national income generation arising from a harsh fiscal contraction.
Further, in the context of the time, the classical economists (who Keynes’ discredited) advocated balanced budgets each year – the sort of rules that are now being discussed by conservatives.
So Keynes was reacting to that and noted that such a rule would be inflexible and damage the chances of the economy achieving full employment.
His view was that budgets might be balanced over the business cycle if that was consistent with full employment. He also favoured running balanced budgets on the recurrent (operational) budget – that is, consumption spending and allowing the capital works budget to vary over the cycle. This was consistent with his view that the principle fiscal intervention should come from regionally-targetted public works schemes aimed at maximising the employment dividend from the fiscal outlays.
The capital budget would be the vehicle for balancing over the cycle if that was appropriate.
If you examine the current government policy and its proposed fiscal retrenchment you will not see that sort of approach being adopted. I will comment more on that when the actual document is delivered in May 2011.
But Keynes would never has agreed to the blind administration of a fiscal rule of the type the Australian government is pursuing. He would never have agreed to “forward-looking” pro-cyclical fiscal policy.
Further, much of the smoothing out of demand over the cycle (which is really what the “balanced budget over the cycle” is about) was seen to come from the cyclical component of the budget. The Australian government is manipulating the structural component to attack the cycle – that is the worst thing you can do.
The reality is that if we truly measured the current budget stance at a properly calibrated full capacity benchmark we would find the structural component is already close to balance and by the time the Government has finished its so-called Keynesian adjustments the budget will be very contractionary.
Of-course, the “Keynesian position” is rejected by those who consider functional finance to be a better approach to fiscal management. Functional finance underpins MMT.
Please read my blog – Functional finance and modern monetary theory – for more discussion on this point.
As I explained in this blog – The full employment budget deficit condition – the goal of fiscal policy is to ensure there is full employment. Whether that requires a deficit or a surplus in any particular period is neither here nor there.
The fact is that the budget outcome should never be the goal of policy. The goal should be to maximise real outcomes and maintain price stability. The problem is that in elevating the budget outcome to the centre stage and setting artificial rules, governments are very likely to damage prosperity.
And, undermine the achievement of their rules anyway – automatic stabilisers oblige!
That is enough for today!