In May 2023, when the British Office of National Statistics (ONS) released the March-quarter national…
Imagine that the state I live in NSW was for want of a better association Ireland. Imagine Victoria was Greece (a good association because Melbourne is the second largest Greek-speaking city in the world). Imagine Queensland was Spain (both enjoy considerable sun). Imagine South Australia was Portugal (both regions have world-renowned wine making industries). Imagine Tasmania is Italy (both are southern regions in the respective hemispheres). Western Australia can stay as WA although it will not be long before we can add another association (Belgium, France, Estonia?). Anyway, let’s imagine that NSW was Ireland for a moment.
The Australian states are very different in industrial structure and respond differently to changes in the level of aggregate spending and its composition. What would happen across this regional space if the was a very large negative demand shock (which is economist’s jargon for a collapse in private spending)? Would these states find themselves having to close schools, sack police, turn of street lights, ration hospital space, sack millions of public servants and abandon their service delivery roles while cutting the pay of the remainder? It would never be contemplated. Public activities would be scaled up to stimulate “spill-over” growth in the private sector. The regions worst hit would receive the most assistance. The national government of this imaginative world would use its consolidated treasury and central bank capacity to ensure that the asymmetries that arose from the spending collapse were attenuated. If we understood the capacity of the consolidated national government we would also understand that sudden changes in private sentiment (and spending decisions) cause problems but they can be ameloriated with rapid government intervention and a return to growth.
Even in this neo-liberal era, where the conservatives dominate the public debate and largely control the media, that is what happened in 2008 and 2009 in Australia. Our nation did not enter an official recession because there was a timely and considerable fiscal stimulus provided – across the regional space – which maintained growth. The private sector declined but the public activity (either directly or indirectly through contracts to construction etc) ensured that employment remained fairly insulated.
I say fairly (meaning sort of) – because I do not want to give the impression that all is well down here. It is not. But it is a lot better than we find elsewhere. And while the mining sector is trying to revise history to claim it saved the nation from recession the fact is that it contracted in 2008 too.
The problem for Australia is that the government, like the UK and US governments, for example, has fallen prey to the deficit-terrorists and withdrew the fiscal stimulus too early – long before the private domestic sector could do the heavy lifting on the bank of an improving (and now strong) terms of trade. So our economy is wallowing again in slow growth and declining employment.
But the point is clear and was demonstrated categorically in 2008 and 2009. When a set of regions (which is legally within a sovereign currency border) endures a major private spending collapse they can resist recession if there is appropriate national financial intervention.
Now even if the Australian treasury had not taken the two major fiscal initiatives (December 2008 and February 2009) the situation would not have been devastating because the Reserve Bank of Australia – perhaps with some appropriate changes in procedures – could have ensured that all banks were safe (recall the Australian government guaranteed the wholesale funding of the major Australian banks) and could have bought the debt of the “state” governments to allow them to take fiscal initiatives to stimulate their economies.
I would not advocate that because I prefer these “fiscal” policy interventions to be the responsibility of an elected, representative and accountable national government but the capacity is clearly there for the central bank to ensure there is enough “funding” to government at all levels to ensure they can stimulate growth in the face of a private spending withdrawal.
So our imaginative world is not without problems but we would expect to read daily headlines like those from today’s UK Guardian’s Business page (October 11, 2011):
Euro summit delayed as deal proves elusive
Bailout meeting pushed back to 23 October as Osborne calls for stability facility to be expanded
Dexia gets new bailout with €4bn deal
Slovakian discord threatens to derail bailout vote
Spain unlikely to meet deficit target
European debt crisis: Monday’s events
Oil and shares rise on eurozone hopes
Dexia gets €4bn Belgian bailout – video
Portugal’s credit binge hangover
Cocaine testing lined up for Italy’s traders
Osborne calls for decisiveness over Greece crisis
Euro crisis: as recession looms, time is running out
It seems that every month “time is running out” but then it doesn’t.
I also note that among the more bizarre explanations for the crisis was the story (October 10, 2011) – Cocaine testing lined up for Italy’s stock market traders – which related how a Italian politician (the “Family” minister) said that the financial markets were “polluted by the use of narcotic substances, particularly cocaine, which makes you lose a sense of reality”.
And another bank is more or less nationalised by two governments (Dexia) …
And the automatic stabilisers continue to work and confound policy makers (Spain missing its deficit target – how could it not!) …
And the speculators continue to make money while the real economy crashes (Oil and shares rise) …
And some bought too many cars and now have to sell their public transport systems (Portugal) …
And a leading fiscal vandal, not content to unnecessarily devastate his own nation, implores others to follow suit (Osborne) …
And the people in charge of all of this take another break (Euro summit delayed) …
I might line up for a drug test myself – perhaps this is all a drug-induced haze.
But reality strikes – consider the recent New York Times article (October 6, 2011) – The 4-Trillion-Euro Fantasy – by Peter Boone and Simon Johnson – both who are associated with the Peter G. Peterson foundation (aka deficit-terrorism central) and the latter an ex-IMF chief economist. Good credentials for commenting on the Eurozone situation.
It might have been an interesting exercise to write the article for them. Apart from some weird sojourn into a discussion about Indonesia in 1997 as the IMF tried to clobber the elected government into submission to protect the corporations who had borrowed too much on short-term arrangements in dollars, the script read perfectly.
Summary of the article:
The Eurozone is in trouble (Bill: yes).
The Germans and the ECB are intransigent and likely to remain so (Bill: narrative yes, action no).
A big bail out fund will not be acceptable to the “markets” (Bill: the markets can be rendered irrelevant with sufficient leadership).
The bail out would just perpetuate budget deficits which the market would reject (Bill: see preceding point).
Member states cannot be trusted to pursue austerity (Bill: it is stupid to pursue austerity in such a calamity).
Austerity is the only way forward (Bill: no it isn’t – austerity is the certain route backwards).
PIIGS need to understand that when they signed up to the EMU all adjustment had to be via unemployment and wage cuts (Bill: the leaders should be jailed for agreeing to the deal in the first place).
Euro leaders are in denial (Bill: no, they are pocketing high salaries in safe jobs and punishing those who cannot defend themselves).
That is about the article. I could have written about 90 per cent of it word for word such is the repetitive nature of the right-wing narrative these days.
But repetition is good so here is some more.
When there is fiscal austerity and private domestic spending growth is virtually non-existent (as wages and employment fall) the only way a nation can grow is if net exports are strong enough to offset the deflationary forces arising from the public and private spending contraction.
The ONLY time that I am aware of when this has been a successful strategy is when a single nation has pursued it while being surrounded by other nations exhibiting solid growth. I am aware of NO instance in history where global austerity has promoted sufficient net exports to allow each nation to grow.
Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.
Boone and Johnson reject the argument that developing a “large fund of financial support for troubled euro-zone nations” will be “decisive in stabilizing the situation”. Their arguments are largely practical – that the European Financial Stability Facility (EFSF) doesn’t have the 2-4 trillion euros and the IMF couldn’t help much.
They then reject the retort to this from within the pro-Euro lobby that the EFSF could just “leverage up by borrowing from the European Central Bank”. They think this might buy time although would be unlikely to gain political approval.
They also claim that if the ECB did provide the funding for government deficits there would be:
… legitimate concerns about the potential inflationary impact of such measures.
They leave that implication unresolved but are clearly operating in the “Quantity Theory of Money” world which confuses the spending decisions of government and the monetary operations that might accompany them.
This confusion is in all the mainstream macroeconomic textbooks which examine fiscal policy decisions within the so-called Government Budget Constraint (GBC) framework. Governments allegedly have to “finance” all spending either through taxation; debt-issuance; or money creation. It is never stated that government spending is performed in the same way irrespective of the accompanying monetary operations – that is, by crediting bank accounts.
The textbook argument claims that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.
All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.
What would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt? That is, the ECB bailed out all the member states on an on-going basis.
Like all government spending, the member state treasuries would credit the reserve accounts held by commercial banks at the central bank. The commercial banks in question would be where the target of the spending had an account. So each commercial bank’s assets would rise and their liabilities would also increase because of the government deposit.
For each bank, the transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).
Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.
This means that there are likely to be excess reserves in the “cash system” which the ECB would have to consider as part of its liquidity management function. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target. When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.
Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.
There is no sense that these debt sales have anything to do with “financing” government net spending. The bond sales are a monetary operation aimed at interest-rate maintenance.
So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.
What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.
The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (as in Japan).
There is no difference to the impact of the deficits on net worth in the non-government sector.
Clearly Boone and Johnson buy the mainstream economics myth that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, keeps the money supply in check.
- Building bank reserves does not increase the ability of the banks to lend. Please read the following blogs – Building bank reserves will not expand credit
- The money multiplier process so loved by the mainstream does not describe the way in which banks make loans. Please read my blog – Money multiplier and other myths – for more discussion on this point
- Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process. Please read the following blogs – Building bank reserves is not inflationary – for further discussion
The commercial banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.
This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.
It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not. The ECB could fund all the EMU government deficits if it chose without changing the inflation risk. The risk would be in how fast nominal spending growth was in relation to the real capacity of the respective economies to respond with real output increases.
At present, in the EMU, demand-pull inflation (nominal spending that is growing to quickly in relation to real productive capacity) is not a problem. There is no legitimate case that can be made at present that ECB funding would be inflationary.
Boone and Johnson though wonder whether such an ECB intervention would:
… stabilize the situation?
They think not because of the reaction of private markets. They claim that the “private-sector holders of that debt” will “sell, taking advantage of what they worry may be only a temporary respite and, for those who bought near the bottom, locking in a capital gain (as interest rates fall, bond prices rise)”.
First, an ECB funding operation doesn’t even have to involve buying member state debt. At present it does – with the ECB buying government debt in the secondary bond markets. But the ECB could simply engage in fiscal transfers via the national central banks – with a simple change of rules – should there be political agreement.
Second, even if they continue buying bonds in the secondary market – the private-sector holders of public debt get no traction on the solution. Sure the ECB (or the bailout fund) “would acquire a significant amount of Italian, Portuguese, Spanish and other debt (including perhaps that of Greece and Ireland)” but what is the problem with that?
Well apparently, according to Boone and Johnson we would have to enquire about how “the Germans feel about the situation”. The situation would “continue to grate on northern European taxpayers”. Well, not if the ECB just used its currency issuing capacity. Since when do German or Dutch taxpayers receive notices from the ECB to remit them taxes? Anyone out there ever received such a notice?
The stupidity of the Euro bosses’ current approach to the EFSF is that they think the battling member states should contribute to it. That would be like the Australian government asking the states in crisis to raise taxes to fund their own fiscal response. The correct approach at present would be for the ECB to create new financial assets and spend them into the system where the need was most – in the southern states.
The authors sojourn into Indonesia next to make a point that if aid-receiving governments don’t accede to the bullying demands of the big capital nations/institutions (in that case, the IMF, US and Europe) then “(d)onor fatigue” sets in and the bailout is withdrawn.
That has no relevance to the EMU case if the ECB uses its “federal” fiscal capacity to defend the ailing member states.
So the comparison between Italy and Indonesia – has no “value”.
Boone and Johnson do not think the:
… countries backing the enhanced and highly leveraged European Financial Stability Facility … [will] … be willing to face substantial credit losses, i.e., actual and continuing transfers from their taxpayers to Italians and others …
Once again the “credit losses” are irrelevant to a central bank. Please read my blogs – The US Federal Reserve is on the brink of insolvency (not!) and Better off studying the mating habits of frogs – for more discussion on this point.
Further, why should a German taxpayer worry about the ECB funding Greek deficits? Well I think of many reasons none of which would make any sense in a truly federal system. And that – of-course – is the real problem. This is a collection of disparate countries that have diminished their sovereignty to take on the role of a “federal state” but which are unwilling to join up together as a nation. That is why my imaginative game in the introduction is stupid.
NSW thinks of itself as a state of Australia and enjoys all the advantages of being part of that sovereign currency system. While the Euro leaders talk about a united “Europe” – Europe will never be a nation. That is why the basic design of the Euro-system is flawed and has been since inception.
The Euro bosses won’t let the ECB (or an elected federal authority) play the role of the Australian federal government backed by the Reserve Bank of Australia. All this talk of German taxpayers and the rest of it is just evading that real issue. They could dramatically minimise the current problems in Europe in a very short elapse of time if they wanted to – even within their flawed monetary system. But they will never be willing to allow the ECB to play that role in any sensible way.
Clearly the ECB is the only thing stopping the system from collapsing at present – in that its purchases in the secondary bond markets are keeping the insolvency of the member states at bay. But this reluctant intervention is coming at such a cost (the imposed austerity) that it can never be the solution. It is a holding-pattern only. The better plan would be to allow the member states to pursue their own fiscal initiatives to restore growth while funding those policy interventions centrally.
There is really nothing to lose in that strategy and everything to gain. If some nations squander the funding – so what? Their electorates kick the relevant government out at the next election. If they grow to quickly the ECB just puts on the brake.
Boone and Johnson though think the solution is for the “peripheral governments” to:
… stop accumulating debt, and quickly.
I agree and the ECB solution I propose would allow that.
I also agree that the various (so-called) fiscal consolidation plans will not work because “they assume unrealistic growth”. As they note “(d)espite all the reported austerity, the Irish government is still running a budget deficit near 12 percent of gross national product in 2011, while nominal G.N.P. actually declined in the first half of 2011”. And why would we be surprised by that? It was totally predictable.
Growth is needed above all. That should be the focus of policy.
But Boone and Johnson say that:
Europe’s periphery also needs to recognize that it signed up to a currency union, and that requires a new approach to adjustment. Instead of having huge devaluations like those suffered in Mexico under Mr. Zedillo, in Indonesia under Mr. Suharto or in Poland under Mr. Walesa, Europe’s troubled nations need to raise competitiveness by reducing local costs.
That must primarily come through wage reductions and more competitive tax systems. In Ireland a pact with the major unions is preventing further wage reductions, while in Greece the government is strangling corporations with taxes in order to avoid deeper wage and spending cuts. The proposed Portuguese “fiscal devaluation” – meaning lower payroll taxes to reduce labor costs and an increase in the value-added tax to replace the revenue – looks like a weak attempt to avoid talking about the need to cut public spending and wages much more sharply in real, purchasing-power terms.
So back to square one. The IMF has been pushing export-oriented growth strategies onto developing countries for years. Sometimes based on manufacturing (South Korea, Taiwan, Hong Kong and Singapore) while other times relying on cash-crops or resource extraction for the exports. While the earlier manufacturing export strategies of the Asian tigers (which pre-dated the IMF structural adjustment program onslaught in the last 1970s and on) were successful the research evidence is very clear – the most poor nations went backwards under the programs.
In the case of trade, the fallacy of composition becomes an “adding-up” constraint on the capacity of nations to simultaneously export goods to external markets – which often amounts to many nations trying to penetrate the same markets.
The IMF and now the austerity crazies invoke the usual arguments. First, there will be no demand-side constraints because the wealthier nations will grow fast enough to support the higher import volumes and avoid supply gluts depressing export prices. Second, the poorer nations will start trading between themselves. Third, poorer nations steadily introduce capital-intensive production techniques and make way for other nations to export labour intensive goods.
If you read the extensive research literature on this topic you will discover that in reality demand-constraints that arise from competition in limited export markets are binding. Further, glutted markets saw export prices continually collapsing for less developed countries who then had to borrow further from the IMF to make ends meet. In the meantime, these nations undermined their subsistence agriculture by turning it into cash crops and so people starved.
But the current austerity plans have some similarities with the flawed IMF development strategy. So they believe that if the government takes out x per cent of overall spending and chokes the capacity of the private domestic sector to spend (by wage cuts and persistent unemployment) there will be an export-led recovery because the lower domestic costs make the nation more competitive.
But who is going to buy the exports if all nations are doing the same thing. It is here that we encounter yet another damaging fallacy of composition. I have seen a few papers come out in recent months allegedly documenting cases where austerity has led to growth. Two countries are often held out as exemplars of this approach – Canada and Sweden in the 1990s.
In both cases the governments cut back their net spending and growth emerged in subsequent years. So one nation might be able to offset public spending cuts and flat private spending by an improving external sector helped along by increased competitiveness via exchange rate adjustments (or domestic deflation) but this solution cannot work if all countries engage in austerity. That is the fallacy of composition.
Ireland showed some signs of growing in 2010 on the back of US and British growth. But both those nations are now slowing down as they also introduce austerity programs either explicitly or implicitly via the expiration of the stimulus packages.
So the export-led growth strategy cannot apply for all nations which are simultaneously cutting back on their domestic demand.
It is also ironic that the largest of the fiscal interventions (China) has provided some global growth. And even that injection of spending is likely to be trimmed in the coming year.
The Boone and Johnson approach – which involves scorching the domestic economy by undermining pension entitlements and the wages and conditions of the workers and entrenching unemployment and business failure while hoping for an external boost will never work in the current situation.
One country might get away with it but not all countries. 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 austerity lobby are not only undermining the rights and welfare of the citizens but are also undermining the source of the export revenue – domestic aggregate demand.
That is enough for today!