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.


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!

This Post Has 20 Comments

  1. Bill,

    Just wondering if you would consider seeking to submit something yourself to ‘Comment is Free’ on the Guardian website. I think they could be quite open to giving you a platform. The website is one of the most visited in the UK, so it could be a good way to get MMT out there, as we don’t have many MMT proponents in the UK.

  2. Hi Bill,
    I don’t like the term ‘economic growth’ to describe an increase in income/output that comes about from a reduction in involuntary unemployment.
    I think it is better to define economic growth as an increase in the underlying productive potential of an economy.
    Hence, in an economy with involuntary unemployment, it is possible, in the ‘short run’ to increase output and employment without any corresponding increase in the underlying productive potential {although the increase in economic activity will probably stimulate investment and increase productive potential}.
    Since the neoclassical/neoliberal economists assume that the economy is ‘always’ at ‘full employment’ {no involuntary unemployment}, then, to them, the use of the term ‘growth’ to describe an increase in income/output is the same as an increase in the productive potential of an economy.
    Similar to the difference between an increase in the price level and inflation?

  3. I remember during the Reagan administration one of his people, I think it was James Watts, said that it didn’t make any difference if we made computer chips or potato chips. At the time I disagreed, but you seem to be saying that he was correct. Would you agree with that statement?

    Another thing is when you discuss the cause of the great recession you point out that it came from the financial sector. I understand that besides the deregulation of the banks during Clinton that his budget surplus brought on the recession at the end of his term. Then, when Bush took office his team created a budget deficit, but that deficit isn’t what brought us out of the recession because it was due to his tax cuts for the rich who didn’t spend but invested. What brought us out of that recession was Clinton’s deregulation and the lack of enforcement of any existing regulation by Bush allowing the banks to lend excessively. Thus, the private sector debt binge brought us out of the recession. The Bush deficit just created fictitious money for the bankers to gamble with.

    First, is this not correct? Then, does this not show that along with a budget deficit we also need a progressive income tax to prevent all of the money digits from being pilled up in the accounts of the rich? What is the MMT stance on a progressive income tax?

  4. I want to strongly second Ben’s suggestion about you contributing to the Guardian’s Comment is Free section, particularly on a Saturday when your readership might be highest. Even the Guardian doesn’t present a clear picture of what it might be best to do under the current circumstances.

    In the best of all possible scenarios, Miliband might even read it. Cameron has a lot of outside help as it were to disseminate his and George’s message of cuts while Miliband has virtually no one setting out a clear alternative that clearly shows why C&O are wrong, whether explicitly Keynesian in outlook or not. And Miliband’s Rottweiler, Balls, is muddled on this.

  5. Yeah, I reckon The Guardian would definitely give you a platform. The only problem is that you’ll have to write in newspaper style which tends to require some rather stringent editing and can be rather time-consuming. If you do consider it though, I’ve got experience sub-editing for newspapers and be more than happy to do so for you prior to submission. I assume you have my email from this comments thingy.


  6. Like Bill is pointing out to understand how the economy actually works we need a basic understanding of our monetary system. All monetary operations are derived in government liabilities. All banknotes, deposits, and treasuries are liabilities to the currency issuer and assets to the currency users as a matter of double entry accounting. When users acquire these liabilities they can either spend (ie. trade) them for items in the marketplace or choose to save them. The more users choose to save rather than spend the more liabilities the issuer will take on. The issuer’s liabilities exists as a convenience to those users who choose to save risk-free instead of spend (invest or consume) in the marketplace. Government liabilities of a currency issuer is the currency user’s savings. There is nothing else it could be. Wakeup mainstream economics and smell the coffee…its time you earn the money your getting paid to do your job. Keep up the good work Bill and continue to challenge the Ivy League idiots over here in the US.

  7. Some of Skidelsky’s ideas are as bad as Desai’s. He wants to “invest in green projects, transport infrastructure, social housing and export-oriented businesses”.

    Green projects are fine, but that has nothing specifically to do with the recession. Plus the labour required for green stuff (solar panels, wind turbines, etc) is pretty specialised. I doubt the ranks of the unemployed could supply the labour in a hurry.

    Re transport infrastructure and social housing, these are projects that take time to get going. By the time they are going, the recession might be over. Moreover, if the consumer and the market dictate that there is more demand for fridge freezers, DIY materials or hair dressers than for transport infrastructure etc, who does Skidelsky think he is overriding the consumer’s wishes? The consumer is supposed to be sovereign, not economics professors.

    Re export oriented businesses, if there is any element of export subsidy involved, that is not allowed by EU or other world wide trade rules. And if there is no element of subsidy, there won’t be any significant effect.


  8. Moreover, if the consumer and the market dictate that there is more demand for fridge freezers, DIY materials or hair dressers than for transport infrastructure etc, who does Skidelsky think he is overriding the consumer’s wishes?

    Wouldn’t this apply to any suggestion that transport infrastructure should be built? What is the market mechanism that would signal consumer/market demand (traffic? isn’t there lots of that, anyway?) and how would “the market” respond? And how does one go about delivering fridge freezers and such?

  9. “Re export oriented businesses, if there is any element of export subsidy involved, that is not allowed by EU or other world wide trade rules”

    Could do the one that people don’t understand – get rid of bond interest. That would ‘subsidise’ all export businesses (or more accurately remove the subsidy from imports).

    Anyway it’s obligatory to put all those businesses in a Guardian piece. That’s the only way it’ll get published 🙂

    We all know that it really doesn’t matter what the government spends its money on as long as the recipients can reasonably be expected to have a high propensity to consume. It’s the second order spending that matters.

    Hence tax cuts and/or enhanced automatic stabilisers.

  10. Dear Bill
    There is an historic example of massive cuts in government spending that wasn’t followed by a recession, namely the Amrican economy after WWII. Between 1945 and 1948, Government expenditure must have decreased by at least 20 percentage points of GDP in that short period.. Yet, the private sector compensated for the fall in govrnment spending, so there was no reduction in aggregate demand. Of course, households didn’t have a big debt load. It was the government that had a big debt.

    Regards. James

  11. “Ditch-digging public spending” – didn’t this used to be a noble piece of public spending in England when they were draining the Fens?

  12. Bill writes: “the national government that issues its own currency can spend whenever there is something for sale in that currency”

    I would like to ask if this is the problem of the developing countris. They have too debt denominated in dollars, not in their own currency. Is this the problem?


  13. They have too debt denominated in dollars, not in their own currency. Is this the problem? Yes, a bad one. Should almost never be done. If you want dollars, to get stuff priced in dollars, you should export stuff to get dollars.

  14. There is a lot of claim here about government spending taking up to slack of private sector contraction, complete with nice equations, so can someone explain why this hasn’t worked in 2 decades and a debt of 200% of gdp in japan?

    would seem to me to imply not all dollars spent are equivalent.

  15. “why this hasn’t worked in 2 decades and a debt of 200% of gdp in japan?”

    Why do you say it hasn’t worked?

    Have you been to Japan recently? Things are bumbling along in an ex-growth fashion.

    When the Japanese public sector stopped spending things got rapidly worse.

    The problem we have in all these situations is that we’ve no idea how bad it would have been without the public sector spending. Of course these days we can just look at Ireland and Greece.

  16. Well yes actually I have been to japan.
    Refer back to

    Japan has virtually no gdp growth, remove government spending from the gdp figures and the private sector has probably spent most of the last 20 years in recession. Housing prices are back to where they were 20 years ago . Prices dip in and out of deflation. The economy seems to have never recovered from its crash, despite a debt of 200% of gdp. If you are arguing 200% debt is not enough how much is enough 1000%? How much of that debt is fixed interest and floating rate? What happens if the rates go up and the cost of the interest on the debt rises to a significant percentage of gdp?

    Why does MMT never consider the cost of servicing government debt, a significant percentage of which is held offshore.

    I am starting to think that government spending is no more than an aspirin that does not address the cause of the recession but bumps up the figures to make them look normal, leading to wonderful euphemism for example in the US as “jobless recovery”, ie no recovery at all.

    Low interest rates seem to have done little but create US carry trades, borrow cheap in the US and invest in emerging markets. How can this money return to the US if it doesn’t make anything to attract emerging markets buying from the US? other than as more government debt thereby making the situation worst.

    The real question comes down to this: What is the actual cost to government of creating one private sector job? Figures thrown around seem to be around $250k/job. At that price the cost to the US government of creating several million jobs in the private sector seems incomprehensible.

  17. Dear Sam (at 2011/07/07 9:16)

    You asked:

    The real question comes down to this: What is the actual cost to government of creating one private sector job? Figures thrown around seem to be around $250k/job. At that price the cost to the US government of creating several million jobs in the private sector seems incomprehensible.

    There is no “actual cost to government”. There is a cost to society – which is the extra food the person who takes the job would consume relative to their current consumption, the extra heating, clothing and all other real resources that person would require including capital equipment to work.

    The budget figures you quote are not costs – they are entries on bits of paper or in electronic accounts.

    Costs can only be meaningfully calibrated in real terms. The government has no financial constraint so trying to compare $ values is rather meaningless. What is the cost to the management of the sporting arena when a team scores a goal and the scoreboards clicks over to record that feat? Will they ever run out of scoring capacity? (Well you might be clever and say the hardware might not have enough data fields to score a very large number – to which I would say – they will just write the score on a bit of paper until they got a scoreboard big enough!).

    best wishes

  18. “Why does MMT never consider the cost of servicing government debt, a significant percentage of which is held offshore.”

    The cost to servicing debt is discretionary. At any point the government could simple stop issuing bonds (as it effectively did do during the QE2 period – the Fed buying Treasury bonds is the same as not issuing them at all).

    So your question is really one for politicians. Why are you spending government money on rich foreigners rather than poor domestic citizens?

  19. “What is the cost to the management of the sporting arena when a team scores a goal and the scoreboards clicks over to record that feat?”

    But what happens when the field owner clocks over the score board without goals being scored?

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