It is all about aggregate demand

Today will be a relatively short blog as an attempt to honour my Friday promise to myself to make more space for other things I want to do. Further I have had some major hardware crashes at my research centre which have taken time today. But I had to comment on an Op-Ed article in the UK Guardian (June 30, 2011) – Public spending has not been cut, it’s just been stopped from rising – which was written by one Baron Desai. The good Baron tries to give us (and a fellow Lord) a lesson in macroeconomics. Unfortunately, before one starts lecturing they should first understand the topic. In this case, it is all about aggregate demand and the way government spending adds to that (including the operations surrounding government spending).

Baron Desai was formerly an economist at the LSE and I met him in the early 1980s. The meeting was set up by a former colleague of mine (who taught me in my Master’s coursework) and who had done his PhD under Desai’s supervision. At the time I was exploring the possibility that he might also supervise my PhD. For various reasons I decided to go Manchester University instead. The attraction to Desai related to the fact he had written several books on Marxian economics and also an econometrics book which was provided a major attack on Monetarism at the time.

Desai has also been an active member of the British Labour Party and like many sold out when he was given a life peerage as Baron of St Clement Danes.

Anyway, in this article Desai attacks an earlier Guardian article (June 21, 2011) – Britain’s economy is stagnating before the cuts bite. Osborne needs a plan C – written by Keyne’s biographer Robert Skidelsky.

Skidelsky compared the logic underpinning the fiscal austerity plans of George Osborne with the “Keynesian view”.

He said that:

The Osborne theory is that any reduction in government borrowing is equivalent to transferring money to the private sector. The private sector will have … more … to spend – to invest in and lend to businesses rather than the state. Workers released from the public sector will be absorbed in private sector jobs. Since private spending is more profitable than public spending and since, in addition, the tighter Conservative deficit reduction programme will boost confidence in the economy, the result will be a net increase in aggregate demand, and a higher growth rate. Fiscal contraction is the royal road to buoyant recovery.

That is what I now refer to as the fiscal contraction expansion logic. Cutting spending creates more spending.

Skidelsky then says that:

The Keynesian view is the exact opposite. Taking £112bn out of the economy will be a net subtraction from aggregate demand. The £83bn cuts in public spending will not be matched by an equivalent increase in private spending because their first effect will be to reduce employment, and hence reduce the national income. (The newly unemployed will earn less than before.) So part of the money the government “saves” will simply disappear as the national income shrinks. Fiscal contraction is the royal road to stagnation, not recovery.

We could quibble about terminology (for example, that the government “saves” when it contracts a deficit – no it doesn’t but that is another story) but I thought it fair to present Skidelsky in his own words.

Desai attacks this representation.

He agrees with Skidelsky that Britain “is very much in the slow lane of global recovery, and this is all before the cuts have started to bite”, No-one could disagree with that observation – it is patent from the data releases that have come out in the last year. The prognosis is not good.

But Desai disagreed with the notion that “cuts in public spending will not be matched by an equivalent increase in private spending”.

So I thought I might explain where Desai goes wrong which doesn’t necessarily mean I agree with Skidelsky – who is an old-fashioned Keynesian deficit-dove with all the baggage that accompanies that position (the topic of other blogs).

Desai posits that “Britain’s slow recovery” arises from the nature of the crisis which he claims is not because there is was “lack of effective demand” but was “due to overspending on the part of households and governments”. He also claims that the ceding of “manufacturing activity to emerging economies” and the replacement of that capacity “with private or often public services which generate jobs but not as much wealth” has meant that Britain has “deluded … [itself that is is] … rich by borrowing”.

Effective demand is a term used to denote spending desires that are backed by cash and executed. So in the literature there is a distinction between notional and effective demand – where the former refers to spending desires that are not backed by purchasing power. The distinction plays a crucial role in the Keynesian debunking of orthodox macroeconomics (particularly in debates in the 1960s). But that debate is separate to the point Desai is making.

Three points need to be made in reply. First, the crisis is all about a lack of effective demand. The persistently high unemployment is all to do with a a lack of jobs. Firms only employ if there are sufficient spending to purchase the output that the workers produce. So the evidence of a demand deficiency is the mass unemployment that emerged in most advanced nations in 2008 and hasn’t gone away.

This demand deficiency shows up in terms of real GDP gaps and reduced rates of capacity utilisation.

So I think Desai is wrong to characterise the crisis in this way. It is clear that the collapse in aggregate (effective) demand followed a period of growth that was made possible by the unprecedented rise in household debt. The credit binge that preceded the crisis left households extremely vulnerable to small changes in economic conditions (like employment rates, interest rates etc).

It is also clear that a rising proportion of the credit outstanding by 2007 was held by borrowers who were incapable of meeting the terms of the loans especially once the front-loaded enticements terminated (low entry loans etc). Once the defaults started and the financial system became exposed to the unknown risks that had been created by the trail of derivative products that the investment banks etc had laid, the financial crisis morphed into a real crisis (private spending fell and unemployment rose).

This in turn intensified the financial nature of the crisis and for many workers who lost their jobs their loan commitments became impossible to service.

So “good debts” became “toxic debts” because of unemployment and the loss of income that guaranteed. In that context, the crisis intensified because there were further demand contractions within the private sector and for most nations their external sectors were still draining demand via current account deficits.

Second, the financial crisis could have been sequestered more fully from the real economy if governments had have responded more appropriately with larger deficits and more employment-rich policy initiatives. Bailing out insolvent banks was a very poor strategy. They should have let the banks go broke (that is, allow the capital to be lost) then take over the deposit books under nationalised structures to protect the workers’ savings.

So the enduring nature of the crisis and the slow recovery are all about a deficiency of aggregate demand. Further, the financial nature of the crisis (that is, the problem did not emerge as a result, say, of a lack of confidence among investors in the real economy leading a fall in productive investment) means that any revival of private spending will be slow to return. So private firms and households are first of all going to try to reduce their debt levels to restore some security to their balance sheets.

This means that the government not only has to run increased deficits to cover the spending gap but also will have to run these elevated deficits for much longer than if the crisis had have started in the real economy. That point is usually overlooked by the conservatives.

Third, the idea that public sector service jobs do not create much wealth is a very blinkered view of welfare. Personal care services enhance our well-being. The problem has not be the change in industrial composition of output away from manufacturing. It is too simplistic to see the growth of manufacturing (often only the assembly operations) in emerging economies as being a vehicle to undermine wealth creation in advanced nations. Many of the high value activities associated with manufacturing remain in the advanced nation anyway.

But the manufacturing operations also lift real wages in the poorer nations which then creates markets for tertiary services that the advanced educated nations can produce and which benefit both the poor and advanced nation.

Desai then chose to give Skidelsky a lesson in macroeconomics. Pity he hasn’t worked it out properly himself.

In trying to work through the notion that the lack of growth in public spending will result in “money” being taken out of the spending stream, Desai said:

Where would the £83bn that Osborne has decided not to spend have come from if he did wish to spend it? Since households are in debt, as is the government, the money would be lent by the business sector. If Osborne does not spend, he does not borrow. So the money stays back in the business sector’s balance. There is no question of ‘transferring money to the private sector’. It is of not removing it in the first place.

So if tomorrow’s Quiz asked the question: The funds that the government borrows come from its own spending – True or False?

Desai would select False and fail badly.

What is the correct statement?

The British government is cutting its spending flow as an attempt to reduce its budget deficit which is the balance between the flow of spending put into the economy in a period and the flow of revenue taken out of the economy in the same period.

Please read my blog – Budget deficit basics – for more discussion on this point.

It is clear that under current institutional arrangements – that is, the voluntary constraints the British government places upon itself such that it issues debt to the private sector to match its flow of net spending (the deficit) – that if it actually succeeds in reducing this relative flow of spending then it will borrow less.

It is, of-course, highly unlikely that the British economy will grow under these circumstances – growth in private spending is not strong and net exports are draining demand.

So a contraction in British government spending growth will widen the percentage spending gap – which is the difference between actual spending growth and the growth in demand that would be sufficient (and required) to fully employ all productive resources. The partial saving grace is that the growth in productive capacity is also sluggish because private investment is low.

That will mean that potential growth in the medium- to long-term will be reduced and Britain will be materially poorer as a result.

But the reduction in government borrowing from the private sector doesn’t leave that sector with “more money”. The conception that there is a finite pool of “savings” out there which can be borrowed from by the public and private sectors is plain wrong.

The fact is that the pool of available funds is sensitive to the state of the business cycle which in turn is driven by aggregate effective demand. So the withdrawal of the net public spending flow is likely to slow the growth of national income and reduce the available savings.

If the government had have increased their discretionary deficits then national income growth would have been stronger and the spending would have thus created the “money” which the government would have borrowed back.

So from a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Its what astute financial market players call “a wash”. The funds used to buy the government bonds come from the government!

There is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.

Additionally, credit-worthy private borrowers can usually access credit from the banking system. Banks lend independent of their reserve position so government debt issuance does not impede this liquidity creation.

Further, whereas Skidelsky and Desai clearly think that budget deficits destroy “national saving” the reality is the opposite. Deficit spending generates income growth which generates higher saving. It is this way that Modern Monetary Theory (MMT) shows that deficit spending supports or “finances” private saving not the other way around.

Further, the concept of a fiat currency issuing government “saving” in its own currency is nonsensical. Saving is the act of postponing consumption in return for higher consumption possibilities in the future. It is an act of an intrinsically revenue-constrained entity like a household (or non-government entity in general).

But the national government that issues its own currency can spend whenever there is something for sale in that currency and never has to “save up” to exploit better spending opportunities in the future.

Desai then concludes that:

The longer-term need is for investment in productive activities, not ditch-digging public spending … Eventually the answer is private sector investment, which will be in wealth-creating enterprises and not job creation in the public sector.

The term “ditch digging public spending” is a disgracefully ignorant way to represent public sector activity. There are hundreds of thousands of productive jobs that would advance public purpose that the private sector will never offer but which could be usefully funded within the public sector.

There is not a shortage of jobs but a shortage of funds (government spending) to make the jobs possible. Perhaps our Labour-leaning Baron has lost touch with the real world.

Please see the blogs that come up using this search string for further discussion of how a Job Guarantee can form an integral part of any government’s fiscal intervention.

That is not to say that private investment is also not desirable at this point. But given there is a reluctance on the behalf of private investors to spend at present then public spending is necessary. The cutting of public spending growth will also most likely further erode the confidence of private investors given that unemployment will likely rise or endure at the high current levels.

Firms only invest to create productive capacity which they can use to provide goods and services for sale. If private consumers and government are not spending at a commensurate rate then firms will not invest. It becomes a vicious circle.

To stimulate private investment the government needs to increase employment growth and ensure real wages grow in line with productivity which increases confidence among private households. In turn, this leads to increased sales and the virtuous cycle continues.

One of the consequences of this is that the budget deficit declines as growth strengthens. It is all about maintaining appropriate growth in effective demand.

Conclusion

I am glad I didn’t study at LSE under the arrangements that were being discussed at the time.

CofFEE Server

The main server for my research centre (CofFEE) collapsed today (major hardware failure) and will take about four days to rebuild (once new hardware is sourced). Given it is a weekend coming the service will not return until later next week I suspect. Sorry for that.

Saturday Quiz

The Saturday Quiz will be back sometime tomorrow – and I plan to make it harder than last week given the boasts of 5/5 outcomes that have been coming in over the last week.

That is enough for today!