Sometimes everything comes together in unintended ways. That has happened to me this week. I…
On Saturday (March 24, 2012), the Sydney Morning Herald published an article by University of Chicago economist John Cochrane – Austerity or stimulus? What’s needed in the US is structural reform. Earlier, on Thursday (March 22, 2012), Bloomberg published an Op Ed by Cochrane – Austerity or Stimulus? What We Need Is Growth. Different title but same article. However, the title, in each case, conveys a very different message to the reader. In either case, though, the content is the problem. A nation cannot grow without spending.
Several times over the last few years, John Cochrane has popped up in the popular debate extolling what he claimed are the dangers of deficits. So he has often predicted rising interest rates; rising, then out-of-control inflation – in the last few years.
Most of all, it’s sad. Imagine this weren’t economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a stalwart that maybe continents don’t move after all, or that smoking isn’t that bad for you really.
I noted then that Modern Monetary Theory (MMT) was in agreement with Paul Krugman – that mainstream macroeconomics of the type that Cochrane claims expertise and which is taught in universities throughout the world is largely inapplicable to a fiat monetary system.
Rather, it is a concoction of classical theory of value and prices, late C19th marginal theory and monetary theory, and more recent add-ons (Cochrane calls them “frictions” – to the free market models of the classics). Gold Standard reasoning (or the convertibility that followed) is deeply embedded in the framework.
It assumes a government budget constraint works as an ex ante financial constraint on governments analogous the textbook microeconomic consumer who faces a spending constraint dictated by known revenue and/or capacity to borrow. It then imposes on this fallacious construction a range of assumptions (read: untested assertions) about the behaviour of individuals in the system and generally concludes, that even with frictions slowing up market adjustments, free market-like outcomes will prevail unless government distortions are imposed.
That body of analysis and teaching is a dismal failure and has not stood up to the empirical test. The crisis has provided several years of data on which the major contentions can be examined. Do deficits cause inflation? Do deficits drive interest rates up? Do public debt ratios for sovereign nations above 80 per cent come up against insolvency problems, etc.
All the major propositions from mainstream macroeconomics have not materialised despite the rather extreme economic landscape that the World has found itself in – relatively high (and fast growing) deficits; significant expansion of the central banks’ balance sheets (courtesy of quantitative easing).
The nations that are in trouble are those that have deliberately imposed austerity – a theme we will return to soon.
Of-course, we didn’t need to wait for this crisis to disprove the principle mainstream theories. Japan has been doing it for us for over 20 years now. If inflation was the product of rising deficits then Japan should be hyperinflating.
However, despite the fact that the crisis systematically exposed the New Classical views held by Cochrane to be bunk he is persistent to say the least and apparently has good connections with media outlets. The latter regularly publish his views and presumably never question their veracity.
So there has been a sequence of articles from John Cochrane over the course of the crisis predicting doom.
In this blog – How many more experiments do we need (June 21, 2011) – I considered Cochrane’s argument that fiscal stimulus would drive a dangerous inflationary spiral. It was one of many such articles that has fallen foul of the evidence.
See also this blog – Accelerating inflation has to be out there somewhere … in the dark or somewhere (September 27, 2011) – where John Cochrane is again warning us of “substantial inflation” breakouts in the “in the next few years” as a result of the deficits.
We are now in the fifth year of the crisis and lots of “money” has been injected into various economies and inflation is benign. There may be supply-side inflation pressures introduced as a result of energy price manipulation but that is not the type of danger that John Cochrane and his ilk are worried about.
MMT considers that budget deficits carry the risk of inflation as does any growth in spending. Where we depart is in the claim that rising deficits will be inflationary. They will be if if they push nominal demand beyond the full capacity level. The initial logic of the stimulus is to to expand the economy to mop up excess capacity and idle labour.
Once that excess has been brought back into productive use at the current set of wages and prices the inflation can occur if nominal demand keeps growing beyond the level needed to keep that excess to zero.
The point is that there is nothing “ultimately” about it. To be simple, assume the output gap in nominal terms is $100 billion and the government manages to get $100 billion into the hands of the non-government sector (even if it was just a per head cash transfer). This will not likely stimulate inflation because once saving is taking into account the extra spending will be less than required to close the output gap.
The first accounting identity that JOhn Cochrane falls foul of is the MV = PY statement which is the famous Quantity Theory of Money. Here M is the stock of money, V is the velocity of circulation (or the times that M turns over per period), P is the price level and Y is real GDP. The relationship just says that total spending (MV) has to be equal to nominal GDP (real GDP times the price level) as a matter of accounting.
But as a behavioural theory linking M to P (which is what the mainstream attempts to use this relationship for) you need to add some assumptions. The assumptions they make are that V is constant (which it clearly isn’t in empirical terms) and the Y is always at full employment. The latter assumption is clearly comical.
Once you assume away all the interesting things about the economy (that is, the business cycle – by assuming full employment always) then it is trivial that if M rises so will P. But if Y is below full employment then extra spending can clearly stimulate the real side of the economy without increasing prices. The vast array of evidence over many years supports the notion that increases in aggregate spending when the economy is below full employment stimulate real output and only if aggregate demand is pushed beyond the real capacity of the economy do price pressures build (excluding supply-induced inflationary episodes).
In my various blogs considering John Cochrane’s interventions into the public debate over the course of this crisis, I have considered them to demonstrate the application of an analytical framework taken from some textbook that was written in times of fixed exchange rates and convertible currencies rather than being ground in the realities of the fiat monetary system where no currency is convertible into anything but itself.
All the evidence from the real world, continually abuses Cochrane’s main conjecture but he still chooses to assert it anyway.
I last considered John Cochrane’s views in this blog – A dose of truth is required in Europe. In a Bloomberg article (December 22, 2011) – How Bad Ideas Worsen Europe’s Debt Meltdown he conjectured about the impacts of a depreciation if Greece left the Eurozone:
Defenders think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe would be the richest country on Earth. No Chicago voter would want the governor of Illinois to be able to devalue his way out of his state’s budget and economic troubles. Why do economists think Greek politicians are so much wiser?
This sort of scale error also appears in the current article. As I noted in the previous blog, Illinois is not a nation and cannot leave the US at the stroke of a government decision. Greece is a nation that made one big mistake – surrendering their currency sovereignty. They could restore it if they chose to and restore their full nationhood.
Moreover, the Greek government has deliberately trashed up to 50-60 per cent of Greece’s productive capacity in the same way as the Zimbabwean government managed to do as they tried to implement a well-motivated but poorly conceived policy of rewarding the freedom fighters who helped them break the yoke of British colonialism.
From John Cochrane’s comments I concluded he is either very poorly informed about what actually happened in Zimbabwe, or,if he does know the true story, then he is deliberately misleading readers with these statements.
Now to the current article where the tack changes somewhat to emphasise the other obsession of mainstream economics – deregulation and wage cutting. This is dressed up under the guise of “structural reform” (hence the title of one of the articles referred to in the introduction).
John Cochrane acknowledges that fiscal austerity “isn’t working in Europe”:
Greece is collapsing, Italy and Spain’s output is declining, and even Germany and the U.K. are slowing down. In addition to their direct economic costs, these “austerity” measures aren’t even swiftly closing budget gaps. As incomes decline, tax revenue drops, and it becomes harder to cut spending. A downward spiral looms.
Yes, and certainly no inflation problem despite the relatively large deficits in Europe – driven as he notes by the automatic stabilisers (collapse of tax revenue as growth slows).
It is clear that fiscal austerity is having the effect that we predicted when the implementation of pro-cyclical fsical policy was first mooted in 2008 and implemented in Ireland in early 2009.
You cannot grow an economy with less aggregate spending. It is impossible by definition.to grow an economy without an increase in spending. So whatever else one proposes, a plan that sees aggregate spending increase is a necessary component.
Once you appreciate that then it becomes obvious that there are only two sectors that spend: government and non-government. And if the latter is not currently willing to drive growth as sufficient pace, then there is only one show left in town.
The other point is that budget outcomes are what economists call endogenous outcomes – that is, they are determined not only by the spending and taxation parameters chosen by government but also by the state of the business cycle.
For any given cyclically-sensitive tax parameter, for example, the higher the level of economic activity the higher the volume of tax revenue flowing to the government.
In other words, the budget outcome cannot be a viable target for government. It is far better for the government to target high levels of employment, equity, and environmental sustainability in the light of private spending and saving decisions, and then let the budget outcome the whatever the achievement of those calls requires.
Note also that John Cochrane bundles the UK in with the EMU nations, presumably because he is talking about Europe. But a macroeconomist has to be rather careful in the way they aggregate here because at this level the fundamental characteristics of the monetary system become important – a point clearly ignored by Cochrane.
Thus, we have to do always make between a Fiat monetary system (for example, in the UK and the US) – and the European Monetary System (EMU).
Member states within the EMU are financially constrained because they always spend and issue debt in a foreign currency – the Euro. An issuer of a fiat currency is never, intrinsically, financially constrained.
The fiscal dynamics of these two monetary systems are very different and should always be the starting point for any analysis of what is going on at the macroeconomic level.
John Cochrane appears oblivious to this point and thinks an abstract textbook model which does not consider that distinction can simply be applied to any monetary system without loss of application. The fact is that it cannot be.
It is clear that Cochrane thinks that Greece holds lessons for the US:
These events have important lessons for the U.S. Our government cannot forever borrow and spend 10 percent of gross domestic product each year, with an impending entitlements fiasco, to boot. Sooner or later, we will have to fix our finances, too. Europe’s experience is a warning that austerity – – a program of sharp budget cuts and (even) higher tax rates, but largely putting off “structural reforms” for a sunnier day – – is a dangerous path.
At which point you realise that John Cochrane thinks that the opportunity set available to governments is the same irrespective of whether the government issues its own currency or uses a foreign currency. As noted above a currency-issuing government cannot be compared to a member state in the EMU.
The fact that John Cochrane overlooks that fact, disqualifies him, in my opinion, from having any further input into this debate.
The only important lesson for the US that comes from the Euro crisis is that a nation should maintain its currency-sovereignty and float the currency it issues.
The US government can spend 10 per cent of GDP each year forever should that be consistent with the saving intentions of the households and the investment choices of business firms, along with the external balance – and the aim of achieving full employment. There would never be a financial impediment stopping the US government from doing that.
Whether the private sector chose to keep lending to the US government is immaterial. My guess is that the US government will never find itself with a failed bond tender. But the point is that it doesn’t have to borrow to spend and could with some political gymnastics alter regulations etc which frustrate its currency sovereingty.
Such options are not available to an EMU nation who would have to change the underlying monetary system rather than alter some accounting arrangements.
John Cochrane then constructed his commentary of the failure of austerity in terms of an attack on what he calls “the Keynesians” but his presentation is an exercise in verballing. The views he purports to be “Keynesian” is fairly unrepresentative of any of the opponents of fiscal austerity.
Please read my blog – Those bad Keynesians are to blame – for more discussion on how the term Keynesian has been used over the last 80 years.
John Cochrane says that “the Keynesians” claim a “Lack of “stimulus” is the problem” and:
They claim that falling output in Europe is a direct consequence of declining government spending. Yes, 50 percent of GDP spent by the government is simply not enough to keep their economies going. They — and the U.S. — just need to spend more. A lot more.
First, MMT does “claim that falling output in Europe is a direct consequence of declining government spending” in the context of a prior period of massive escalation in private debt and a reality where the non-government sector is unwilling to return to that sort of spending growth.
Second, given the private sector spending propensities at present it is clear that the Eurozone-wide government spending to GDP ratio of just over 50 per cent (see Eurostat data on public finances) is insufficient to “keep their economies going”.
There is nothing sacrosanct about that ratio. Whether total government spending less taxation (the deficit) is adequate depends on the size of the output gap left by the private spending decisions.
If there is an output gap remaining then clearly someone needs to spend more in that economy. Spending equals income equals growth. Some sector has to spend more to generate growth.
At present, that spending support must come from government given the reluctance of the non-government sector to step up to the plate.
John Cochrane then further exposes his lack of credibility to comment on macroeconomic issues. He asks:
Where will the money come from? Greece, Spain and Italy simply cannot borrow any more. So, say the Keynesians, Germany should pay. But even Germany has limits. The U.S. can still borrow at remarkably low rates. But remember that Greece was able to borrow at low rates right up to the moment that it couldn’t borrow at all. There is nobody to bail out the U.S. when our time comes. What should we do then?
First, the statement that “Keynesians” think that “Germany should pay” is a gross over-simplification of arguments that support Germany playing a stronger role in the revival of the Eurozone economies.
Typically, the argument is that Germany, by suppressing its own domestic demand and relying on exports to generate its own growth, is undermining the capacity of the southern states to grow in an environment of fiscal austerity.
Most progressives consider that Germany should cease to suppress its own real wages growth and allow German consumers to take an increasing role in driving overall demand in that country. This would have the dual effect of increasing German growth and increasing export growth of its trading partners.
It is hard to construe that argument as suggesting that “Germany should pay”.
Clearly there are those who want Germany to contribute greater funds to the EFSF to allow for more bailouts in the southern states. I would not call that proposal Keynesian.
Second, comparing the US with Greece or any other EMU nation is inapplicable. In the same way, that the ECB can bail out any Eurozone nation that itchooses, the US central bank and the Treasury, together, have unlimited financial resources available to them in the form of US dollars.
The question – “where will the money come from” – is simply a nonsensical enquiry when applied to the US government. Bond markets have closed down the borrowing of some EMU nations simply because they know that these nations have to borrow to cover their deficits as a consequence of the use of a foreign currency.
Equally, the bond markets know that the American government ultimately does not have to borrow because it issues its own currency. The dynamics in that situation of vastly different.
Then John Cochrane moves onto his inflation fear mongering. Curiously, after asking us to think about where the US is ging to get its money from, he provides us with the answer:
The traditional Keynesian answer was: Move on to monetary stimulus.
In other words, the US government has no financial constraint. Nor has the Greek government if “its” central bank was to play the same role as the US Federal Reserve.
But according to Cochrane this role – “monetary stimulus” is equivalent to one that seeks to “Deliberately inflate and devalue”.
As noted above there is not inevitable relationship between a central bank credit bank accounts on instruction from a government running a deficit and inflation.
Cochrane is mimicking the mainstream macroeconomic textbook analysis that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. He fails to elucidate the reader that government spending is performed in the same way irrespective of the accompanying monetary operations.
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.
When a sovereign, currency-issuing government (with a flexible exchange rate) runs a budget deficit, the treasury credits the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.
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 then raises issues for the central bank about its liquidity management. 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 or pay a competitive rate on the excess reserves (which really amounts to the same end).
What would happen if there were bond sales to the private sector? Bank 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 (the Japan solution).
There is no difference to the impact of the deficits on net worth in the non-government sector.
Mainstream economists, such as John Cochrane, would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.
However, the reality is that:
- Building bank reserves does not increase the ability of the banks to lend.
- The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
- 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.
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.
But it is totally fallacious to think that private placement of debt reduces the inflation risk.
I am running out of time today and I want to make one more point from this article.
John Cochrane proposes an alternative route for the US and elsewhere to get out of the crisis. He also thinks that this helps us understand why austerity is failing.
The stimulus explanation is curious for what it omits. Think of Greece.
Is it irrelevant that Greece is 100th on the World Bank’s “ease of doing business” list, behind Yemen; 135th on “starting a business” and 155th on “protecting investors?” Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can’t fire people, that (according to a Greek colleague) you can’t even get a driver’s license without paying a bribe? Does it not matter at all that, as the International Monetary Fund delicately put it in its latest report on Greece, the “structural reform program” aimed at “deeply ingrained structural rigidities in labor, product, and service markets” got nowhere?
Greece was growing before the crisis. Why are all these so-called microeconomic impediments now binding? Would people still spend if they had jobs?
I am not suggesting that clearing out rent-seeking behaviour (say from doctors and lawyers) isn’t a good thing for a nation to pursue – especially when it comes to enhancing equity.
But this process cannot generate growth independent of spending growth.
You really understand John Cochrane’s narrow agenda in this quote:
Keynesians urge devaluation to gain competitiveness. Greek wages have in fact declined about 10 percent to 12 percent, according to the IMF. Yet investment and production aren’t turning around. Greek “demand” needn’t matter — the whole point of the euro area is that Greece can sell to Germany, so long as Greece stays in the euro area. But it isn’t happening.
The fact is that cutting wages is not a sufficient condition to increasing competitiveness. As I have explained before the mainstream rhetoric lures one into thinking that the constraints that the EMU places on member countries mean that the only way that competitiveness can be restored is to cut wages and prices. That is what the dominant theme emerging from the public debate is telling us.
That is what John Cochrane’s is suggesting here.
However, deflating an economy under these circumstance is only part of the story and does not guarantee that a nations competitiveness will be increased.
It is the real or effective exchange rate that determines the “competitiveness” of a nation. This Bank of Japan explanation of the real effective exchange rate is informative.
Movements in the nominal exchange rate and the relative price level (Pw/P) need to be combined to tell us about movements in relative competitiveness.\
The real exchange rate (R) is defined as:
R = (e.Pw/P)
where P is the domestic price level specified in say $AUD, and Pw is the foreign price level specified in foreign currency units, say $US.
The real exchange rate is the ratio of prices of goods abroad measured in $AUD (ePw) to the $AUD prices of goods at home (P). So the real exchange rate, R adjusts the nominal exchange rate, e for the relative price levels.
For example, assume P = $AUD10 and Pw = $US8, and e = 1.60. In this case R = (8×1.6)/10 = 1.28. The $US8 translates into $A12.80 and the US produced goods are more expensive than those in Australia by a ratio of 1.28, ie 28%.
A rise in the real exchange rate can occur if:
- the nominal e depreciates; and/or
- Pw rises more than P, other things equal.
A rise in the real exchange rate should increase our exports and reduce our imports.
A fall in the real exchange rate can occur if:
- the nominal e appreciates; and/or
- Pw rises less than P, other things equal.
A fall in the real exchange rate should reduce our exports and increase our imports.
In the case of the EMU nation we have to consider what factors will drive Pw/P up and increase the competitive of a particular nation.
If prices are set on unit labour costs, then the way to decrease the price level relative to the rest of the world is to reduce unit labour costs faster than everywhere else.
Unit labour costs are defined as cost per unit of output and are thus ratios of wage (and other costs) to output. If labour costs are dominant (we can ignore other costs for the moment) so total labour costs are the wage rate times total employment = w.L. Real output is Y.
So unit labour costs (ULC) = w.L/Y.
L/Y is the inverse of labour productivity(LP) so ULCs can be expressed as the w/(Y/L) = w/LP.
So if the rate of growth in wages is faster than labour productivity growth then ULCs rise and vice-versa. So one way of cutting ULCs is to cut wage levels which is what the austerity programs in the EMU nations (Ireland, Greece, Portugal etc) are attempting to do.
But LP is not constant. If morale falls, sabotage rises, absenteeism rises and overall investment falls in reaction to the extended period of recession and wage cuts then productivity is likely to fall as well. Thus there is no guarantee that ULCs will fall by any significant amount.
Structural reforms are best achieved in an environment of growth when resources that are redundant in one activity can be quickly absorbed into other more productive activities.
In an environment of stagnation, reallocating productive resources is very difficult and attempts to do so, by deliberately generating unemployment, creates massive costs to the economy and to the individuals displaced.
But even with strategies designed to engender resource reallocations across the industry structure that process, does not, in itself, engender growth.
The reallocations can only make sense and be sustained if there is appropriate growth in aggregate demand, targeted to match the new composition of output implied by the change in industry composition.
That is enough for today!