Some hard truths for 2012

Some new research has given me hope that the politicians will soon be in a position to use the fiscal tools at their disposable to solve the economic crisis. We might call it the pigeon recovery. The ABC News reports that Pigeons can count and so I propose we round up a bunch of them from some of those nice European buildings ship them (humanely) to Brussels and the Eurotower and let them count up the unemployment numbers (well they might have to go to Eurostat in Luxembourg). Then they could calculate the real GDP and income losses and by way of a new Google Pigeon-to-English translator convey to the politicians the urgency of the situation and that jobs are created when people or governments spend and that income is created as a consequence and people become more prosperous. Then some homing pigeons could fly some Modern Monetary Theory (MMT) material to the offices of the politicians to give them something to read instead of the latest nonsense from the IMF or some other institutions that have forgotten that unemployment matters and financial ratios are of limited relevance. Once the pigeons have done their work – the Euro leaders will sit down and realise that an orderly break-up of the monetary union is the best long-term strategy for all of them. Speaking of which here are some “hard truths” for 2012.

Yesterday’s blog – A dose of truth is required in Europe – as the title suggests about economists who continue to lie about what is happening.

This week (December 21, 2011) – the IMF Chief Economist’s (Olivier Blanchard) blog – 2011 In Review: Four Hard Truths – was also in search of the truth.

Except it seems our versions of the truth are different. Like, very different.

In my comparison of what the mainstream macroeconomics textbooks write about the way the monetary system operates and how it actually operates (virtually parallel worlds) – Mainstream macroeconomics textbooks do not impart knowledge – I used the popular book by Greg Mankiw as the representation of mainstream pedagogy. I could have easily used Blanchard’s macroeconomics textbook. It makes the same errors.

In February 2010, I wrote the blog – We are sorry – which discussed a “sort of” apology from the IMF (via Olivier Blanchard and co-authors) for pushing policy positions that created the crisis and for failing to see it inevitability.

It was a tortured, excruciating exercise in self-denial peppered with recognition of sin without being able to come out straight and say “We fuc##d up totally”.

Nearly two years later things have got worse and the IMF have been one of the driving forces which have ensured the fiscal-driven recoveries were short-circuited and the world economy is now in a worse position than before.

Now Olivier Blanchard thinks he can tell us what the hard truths are.

He acknowledges that “(w)e started 2011 in recovery mode … there was hope” and “as the year draws to a close, the recovery in many advanced economies is at a standstill, with some investors even exploring the implications of a potential breakup of the euro zone, and the real possibility that conditions may be worse than we saw in 2008”.

Conditions are obviously worse than we saw in 2008 because:

1. Unemployment has risen since then – alarmingly in some nations.

2. An increasing proportion of youth are being denied access to work and experience in most nations.

3. Government services are being cut in most nations and ravaged in some.

4. Social security nets and pensions are being cut which is inflicting massive damage on older workers, retired workers and the poor generally.

5. The political leaders charged with the responsibility to use fiscal and monetary policy to advance public purpose are further away from doing that than ever. They are deliberately choosing to undermine the prosperity of the nations they are elected to govern. Economic policy is destroying growth not supporting it. Economic policy is deliberately ensuring unemployment and poverty rises.

It is obvious that things are getting worse. It has nothing at all to do with what “investors” think or are “exploring”. The fact that bond markets still hold sway at all is a demonstration of the failure of the political elites to understand and/or implement sound fiscal and monetary policy.

However, having said that, where bond markets do matter – courtesy of the ideologically-motivated, flawed design of the Eurozone monetary system – the ECB has shown it can clearly deal the bond markets out indefinitely.

Blanchard’s hard truths are really a mismatch of basic textbook dogma and his obvious recognition that that dogma fails. He wouldn’t admit that or express it in that way but that is what it amounts to.

He say, that the first truth is that:

… post the 2008-09 crisis, the world economy is pregnant with multiple equilibria-self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.

The world economy is always subject to multiple equilibria and expectations drive a lot of activity. One of the classic denials of multiple equilibria is the NAIRU, which Blanchard adheres to.

The original concept (still basically used by the mainstream) is that there is a unique unemployment rate which is invariant to aggregate demand movements where inflation is stable. So attempt by government to lower unemployment (below the “NAIRU”) will fail and only generate inflation.

Please read my blog – The dreaded NAIRU is still about! – for more discussion on this point.

Then their estimates showed the NAIRU (as estimated) to be moving all over the place – basically in a path-dependent trace of the actual unemployment rate. Big problem for their invariance postulate because unemployment clearly moves in response to changes in aggregate demand.

Solution: redefine the concept in an ad-hoc way (that is, make up any story you want) and so the TV-NAIRU emerged – the Time-Varying NAIRU. What drove that? Well it couldn’t be structural forces because at times when the TV-NAIRU jumped in many nations, there were no significant changes in the normal mainstream suspects – such as welfare rules, minimum wages, government benefits etc.

What we were left with was a sham. The reality is that once you recognise hysteresis (path dependence) which allows you to understand structural changes being driven by cyclical movements, the NAIRU concept collapses and you appreciate that there are many different unemployment rates that at any point in time can be consistent with stable inflation – that is, multiple equilibria is common. The challenge for government is to exploit the best of the steady states.

That was what my early work (PhD etc) was about. The logical extension then became the concept of the Job Guarantee which I started working on in my 4th year of undergraduate but left simmering while I was doing other work.

As my colleague Randy Wray noted in his keynote speech at the CofFEE Conference earlier this month:

And then there was the job guarantee, which I immediately recognized as Minsky’s employer of last resort. I can’t remember what Warren called it but Bill called it BSE, buffer stock employment.

I had never thought of it that way, but Bill’s analogy to commodities price stabilization schemes added an important component that was missing from Minsky: use full employment to stabilize prices. With that we turned the Phillips Curve on its head: unemployment and inflation do not represent a trade-off, rather, full employment and price stability go hand in hand.

The government can thus choose – of all the “steady state” unemployment-stable inflation equilibria available – one that provides a job for all when the private market fails.

Olivier Blanchard thinks the lesson of “multiple equilibria” is that”

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets-largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default, and the smaller the distance between the interest rate associated with solvency and the interest rate associated with default. Italy is the current poster child, but we should be under no illusion: in the post-crisis environment of high government debt and worried investors, many governments are exposed. Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there.

Here we depart. Governments which issue their own currency and “control” their central banks can always control the relationship they have with the bond markets. The bond markets need the sovereign government to issue debt but the government doesn’t need the bond markets at all. There would be very little change in government activity if they ceased to issue debt.

But there would be very significant changes in private financial markets and banking if that eventuated.

While it is true that for a private borrower the “higher the level of debt, the smaller the distance between solvency and default” there is no such state for a sovereign government, which has no solvency risk.

I keep hearing that the current crisis is a “sovereign debt crisis”. What might inform us of that? Rising bond yields? Deficits keep rising but yields for the major sovereign nations are flat and low. Japan has experienced rising deficit, rising public debt ratios, zero (about) inflation, and 1 per cent 10-year bond yields for two decades.

Is there are sovereign debt crisis in Japan? Of-course not. The bond markets cannot get enough of yen-denominated government debt.

Not to be outdone, the conservatives claim – well it is only a matter of time. When exactly they don’t say but they have been saying that for 20 years and there are no signs yet of a crisis.

Is there are sovereign debt crisis in the UK? the US? Australia? Canada? etc? There is not. There is no risk of insolvency. Even the mad-half baked Tea Party maniacs were too gutless to force the US government into a voluntary default when the debt limits approached earlier this year.

So how can we construct this crisis – as a “hard truth” – as a sovereign debt crisis?

Clearly a dimension of the the Eurozone strife is the unwillingness of the private bond markets to fund member states who they assess pose a solvency risk. They are correct. The flawed design of the EMU means all member states are default risks – right to the top to include Germany. That assessment has no application for a sovereign government like the US or the UK.

The problem is the design of the Eurozone rather than the public debt and deficits. The “Euro sovereign debt crisis” (a misnomer of monumental proportions) would disappear tomorrow if the nations restored their currencies and renegotiated all liabilities into local currencies.

Which brings me to the awful contribution this week (December 19, 2011) by the Washington Post’s Robert Samuelson – Bye-bye, Keynes?. This article is about how Robert J. Samuelson cannot identify an elephant from any angle.

He thinks it is a serious question to ask why bond yields are low in the US and are rising in Italy and Spain, Greece, Portugal and Ireland. He seems to bemused about how deep that question is – challenging us with its profoundness.

A rude response would be to “get a life”.

A more reasoned response is to suggest that there is an elephant present that he seems to have avoided seeing as it crowds out all available space in the room he is typing from.

He says that “Greece, Portugal and Ireland have already reached” the tipping point of too much debt and “(h)eavily indebted Italy and Spain could lose access to bond markets” and then – in a Hallelujah moment he says:

Thankfully, the United States is not now in this position. Interest rates on 10-year Treasury bonds hover around 2 percent; investors seem willing to lend against massive U.S. deficits. Just why is unclear. It’s not that U.S. budget discipline is noticeably superior.

A whole raft of financial statistics (debt ratios, deficit to GDP ratios) follow to show how “bad” the US is relative to the EMU nations and he thinks for the US that “piling up more debt, it would still risk aggravating a larger crisis later”.

Just why Robert J. Samuelson writes this is “unclear”.

He thinks it has something to do with his claim that “(p)reviously gullible investors will wake up one morning and conclude that the situation is beyond salvation”. He claims that “(i)f history is any guide, this scenario will develop not gradually but abruptly”.

Which history is he talking about? US bond yield history? Upon what basis are these investors gullible?

The reality is that the bond investors know exactly what they are getting themselves in for. They know that US bonds are zero risk and that is why the tenders are always oversubscribed at very low rates. There hasn’t been a time in US history (since we have data) where the bond markets have concluded “the situation is beyond salvation”.

That is sheer fantasy – ignorant and uninformed.

Yields are low and bond auctions over-subscribed because the bond markets know the US government is fully sovereign in its own currency as are Japan, UK, Australia and just about everywhere else.

Bond markets also know that the central banks in these nations can easily control all yields if they wish and totally deal them out of the equation.

I could go on about this (dreadful) article but suffice to say I agreed with most of what Dean Baker wrote (December 19, 2011) in his hatchet job of Samuelson’s article – Robert Samuelson: “Bye Bye Darwin?”. This is a very MMT-oriented reply which means the message is spreading if the CEPR is making these fundamental points about currency sovereignty.

Blanchard’s second “hard truth” was that:

Second, incomplete or partial policy measures can make things worse.

He is criticising the Euro leaders here who have “after high-level meetings promised a solution, but delivered only half of one” – or more accurately made matters worse.

He thinks this is because these meetings “revealed the limits of policy, typically because of disagreements across countries”.

That cannot be said for the US or the UK, for example. All sovereign nations can focus on domestic expansion independent to what might be going on elsewhere if they float their currencies. For example, all sovereign nations could have full employment virtually tomorrow if the government announced a Job Guarantee. They might take some time to organise the work flow but the wages could start being paid immediately.

Just tell the unemployed to sign on at the local depot and you will get all those who are without work but desire some income support turning up.

The Euro story is another matter. The fact the nations cannot agree demonstrates how a full monetary union is unworkable with that collection of nations.

Further, for the US, UK and elsewhere the fiscal stimulus interventions were “incomplete” because the likes of the IMF and other started promoting scare campaigns about the rising deficits. The UK is now contracting (notwithstanding the minor revisions to the GDP figures overnight) because the British government is telling the people that it cannot differentiate itself as a currency issuer from Greece who uses a foreign currency.

Of-course, they know full well the difference but it serves their class interests to obfuscate.

Blanchard’s third “hard truth” is that:

… financial investors are schizophrenic about fiscal consolidation and growth.

The UK Guardian’s Larry Elliot (December 22, 2011) said in his article – IMF’s Olivier Blanchard backs ‘slow and steady’ deficit reduction – that Blanchard was implying that “financial markets are Janus-faced. They bay for austerity but then “react negatively later, when consolidation leads to lower growth – which it often does”.

Janus Bifrons was the two-faced god in Roman mythology – but his two-faced nature was not because he was a hypocrite – rather that one face looked back into the past to be guided by the concrete and the other face looked into the future to express the abstraction (hope).

But that aside – there is this view that the bond markets are the culprits. The reality is that it is governments, ratings agencies, financial market commentators that generate signals that the bond markets react to. The latter just want profit and will go wherever they can. That is why they went back into Argentina after the default. The economy was growing again and there were profit opportunities.

The bond markets do not cry out for “fiscal consolidation”. The rating agencies do that. The right-wing, anti-government commentators and characters like Olivier Blanchard do that.

The bond markets just react – and realise that when things are looking grim as in Europe and the government policy is to push the zone into austerity then negative growth will result and deficits will rise and things get closer to default because the governments all use a foreign currency.

Blanchard claimed that “I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease”.

Where? Private debt levels have to decrease. For nations running current account deficits and maintaining the archaic practice of matching budget deficits with $-for-$ debt issuance that means public debt has to increase.

The only fiscal consolidation strategy should be to get growth moving and to adjust the discretionary budget parameters to ensure that the growth brings full employment. Whatever deficit (or perhaps surplus) that remains at that point is exactly right.

The focus should be on the real economy. By focusing on these irrelevant financial ratios, the governments have lost focus on what they are elected to do.

Finally, his fourth “hard truth” is that:

… perception molds reality.

Again he is focused on the Eurozone where “real money investors” quickly decide that a nation (such as Italy) has become a solvency risk and refuse on-going funding.

Very profound indeed.

Conclusion

My two hard truths – in the context of this article (and Robert J. Samuelson’s article) is this.

1. There is a world of difference between a monetary system that is based on sovereign governments using their own non-convertible currency and thus floating it on international markets and a monetary system where the governments use a foreign currency and operate within a fixed-exchange rate straitjacket.

2. Spending equals income equals output which drives employment and reduces unemployment. There is no such thing as a fiscal contraction expansion when all nations are engaged in the same strategy.

I know there is a debate that the crisis is not about a deficiency of aggregate demand and has arisen because structural imbalances in production and sale decisions occurred. Yes, they did and increased government spending will not replicate the pattern of lost private spending.

But what government spending can do is to create a demand for labour by focusing on public infrastructure projects and public services. That demand for labour redresses the overall income loss – notwithstanding the change in “composition” of final output (before and after the trough) – and provides the basis for the private sector to recover in line with renewed growth in private demand.

The final composition of output and demand (spending) once the economy has recovered and is back to full employment will look very different to what it was before the crisis even if the proportions of public and private activity are restored overall.

In the process of recovery, bad private capital is driven out (goes broke) and new capital comes in. But that process has to be nurtured by an overall increase in aggregate demand courtesy of fiscal stimulus.

Saturday Quiz

The Saturday Quiz will be back sometime tomorrow – but given the season it will be a gift!

That is enough for today!