What is “good” at the macro level may well be disastrous at the micro level

I have been reading about the Great Depression lately and comparing the sort of pressures that governments were placed under during that time to cut deficits which were rising on the back of a collapse in economic activity to what is going on today. There are many interesting parallels and déjà vu experiences. That research took me into some literature on the way the governments bow to industry demands as aggregate demand collapses. In turn, that led me to the way the military-industrial complex operates. Which took me into another literature on the role of the military-industrial complex in creating wars to provide markets for their goods – the merchants of death. And so it goes. That is the nature of research – it just takes one on a journey and usually to destinations previously not imagined. But this journey also clarifies some issues that readers regularly write to me about. The relationship between Modern Monetary Theory (MMT) as a macroeconomic framework and issues that issues that lie below the aggregate level – such as distributional issues. There are links clearly (for example, income distribution affects aggregate demand) but in other ways what is “good” at the macro level may well be downright disastrous at the micro level. But in dealing with the disaster at the micro level, we always have to be mindful of the way dealing with that disaster impacts on the aggregates. This is particularly important in considering issues relating to trade. The military-industrial complex is an excellent case study of these challenges. Here are some early thoughts.

MMT leads to the understanding that a Current Account deficit (CAD = exports minus imports plus net income flows) can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the CAD. This desire leads the foreign country (whichever it is) to deprive their own citizens of the use of their own resources (real goods and services) and net ship them to the country that has the CAD, which, in turn, enjoys a net benefit (imports greater than exports). A CAD means that real benefits (imports) exceed real costs (exports) for the nation in question.

Thus a CAD signifies the willingness of the citizens to “finance” the local currency saving desires of the foreign sector. MMT thus turns the mainstream logic (foreigners finance a nation’s CAD) on its head in recognition of the true nature of exports and imports.

Subsequently, a CAD will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the CAD gets squeezed down to zero. This might be painful to a nation that has grown accustomed to enjoying the excess of imports over exports. It might also happen relatively quickly. But at least we should understand why it is happening.

Further to this understanding, MMT turns the focus of trade around from the normal mainstream view that CADs are a problem which should be eliminated.

First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.

This doesn’t mean that there is not the possibility that severe distributional shifts (in costs and benefits) might occur on a microeconomic level within a nation undergoing a change in patterns of trade. So workers in manufacturing belts might lose their jobs because imported goods become cheaper and consumers (including the same workers who lose work) voluntarily choose to purchase the cheaper (and in some cases, higher quality) products.

While this process is painful appropriate government policy can help to alleviate the costs of adjustment and engender an environment where the workers transit into other uses. Structural adjustment is always painful though and is best achieved at times of full capacity.

Further, even if a growing trade deficit is accompanied by currency depreciation, the real terms of trade are moving in favour of the trade deficit nation (its net imports are growing so that it is exporting relatively fewer goods relative to its imports).

Second, CADs reflect underlying economic trends, which may be desirable (and therefore not necessarily bad) for a country at a particular point in time. For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.

A current account deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in flows in the financial account. While it is commonly believed that these must eventually be paid back, this is obviously false.

As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets will remain in demand.

However, if a country’s spending pattern yields no long-term productive gains, then its ability to service debt might come into question.

Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase ability to service the associated debt. Roughly speaking, this means that growth of GNP and national income exceeds the interest rate (and other debt service costs) that the country has to pay on its foreign-held liabilities. Here we need to distinguish between private sector debts and government debts.

A lot of people think that this analysis only applies to the US because its currency is also seen as the “reserve currency” in the world so will always be in demand for a multitude of uses. However, the sovereignty of the US in its own currency is intrinsic to its monopoly issuance status not to the fact that its currency is used by other nations.

Further, a national government can always service its debts so long as these are denominated in domestic currency, which it issues under monopoly conditions. In the case of national government debt it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.

In the case of private sector debt, this must be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. These are rough but useful guides.

Note, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.

Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.

The general trade point is that in a macro sense, exports are a cost to a nation (foregone use locally) and imports deliver benefits. The motivation to trade then is to gain access to goods and services that are not available locally (in terms of quantity and/or quality).

However, there are other dimensions to this rather simple “macro” perspective that are also interesting and challenging. It could be that an export delivers broader costs that are not considered in the immediate circumstances of the exchange. We think of trade transactions as voluntary exchanges between parties which are presumably motivated by each side of the bargain making assessments about the use value of their acquisition.

We think that a nation that runs current account surpluses (such as China) is depriving their people of access to goods and services in return for financial claims on foreign nations.

Please read my blog – Modern monetary theory in an open economy – for more discussion on thow MMT considers the open economy.

But it goes deeper than that.

There was a Fortune Magazine article (February 24, 2011) – America’s hottest export: Weapons – which documented how a large order from Saudi Arabia – for 84 F-15 fighter jets – allowed a failing production line in St Louis, Missouri to remain in business.

This story is part of a larger arms export drive promoted by the US Defense Department. Fortune write that in October 2010:

… the Department of Defense … announced an arms package worth some $60 billion … It was the biggest overseas arms sale in recent memory, and it extended the life of the production line through 2018 … The Department of Defense last year told Congress of plans to sell up to $103 billion in weapons to overseas buyers, a staggering rise from an average of $13 billion a year between 1995 and 2005 …

The story quotes two arms industry experts who said that “Obama is much more favorably disposed to arms exports than any of the previous Democratic administrations … [and] … There’s an Obama arms bazaar going on”.

The article notes the risk in an all-out military exports strategy which seems to have been the hallmark of the Obama era:

… supplying some nations with advanced weaponry is a risky strategy, especially as the Middle East, which is teeming with American-made arms, crackles with the sparks of regime change. While the U.S. sells weapons only to its allies, power can shift quickly — just look at Tunisia and Egypt. Even Saudi Arabia, with its 86-year-old monarch, could see a change in leadership. When friends become foes, arms exports become a liability. The government sold dozens of F-14 fighter jets to Iran in the 1970s before the Shah was deposed. Since then the U.S. has systematically destroyed F-14 parts to keep them out of Iran’s hands.

This sort of trend tends to accelerate during a severe economic downturn. The arms export contracts “support thousands of high-paying, highly skilled manufacturing jobs” in the nation and that reality helps to hide from the electorate other more sinister motivations that national governments might have.

Fortune Magazine says that the Presidential imperative is motivated not by jobs but by “U.S. alliances … America’s broader role in the world”.

But there is more to it than that. Enter the military-industrial complex – which has been described in the 1995 article by Robert Higgs, aptly titled – World War II and the Military-Industrial Congressional Complex – as the monolith that led the US to sacrifice “much of its potential dynamism as the massive commitment of resources to military R&D diverted them from the civilian opportunities being pursued with great success in Japan, Germany, and elsewhere”.

The Fortune article notes that:

Defense contractors like Boeing are notorious for spreading their manufacturing outlets across the country to curry political favor … But its heart beats in Arlington, Va., which is where it gets its lifeblood — government spending. There, executives in crisp suits walk alongside uniformed servicemen. Many of those officers will leave the military and walk straight into corporate gigs … The industry does 80% to 90% of its business with the Pentagon.

One of the insights from the WikiLeaks cables is that in all “backdoor dealings with other nations, American officials acted as de facto pitchmen for U.S.-made weapons. The cables call this marketing process ‘advocacy’.”

In a Washington Post article a few weeks ago (May 3, 2012) – Obama plan would ease weapons export rules – we read that the:

The Obama administration is crafting a proposal that could make it easier to export firearms and other weapons to certain countries in an effort to boost sales for U.S. companies, increase trade and improve national security …

Apparently, two US federal government departments – the Department of Homeland Security and the Justice Department – “have expressed concerns that the changes in the export rules could make it easier for drug cartels and terrorists to obtain weapons and make it harder to stop firearms trafficking”.

This insidious symbiosis between the governments and the military is nothing new.

In a famous speech in 1961 – Military-Industrial Complex Speech the outgoing US President
Dwight D. Eisenhower claimed that the basic purposes of America:

… have been to keep the peace; to foster progress in human achievement, and to enhance liberty, dignity and integrity among people and among nations … [but that] … Progress toward these noble goals is persistently threatened by the conflict now engulfing the world. …

He warned that while a “vital element in keeping the peace is our military establishment” the emerging “conjunction of an immense military establishment and a large arms industry is new in the American experience” and “we must not fail to comprehend its grave implications”.

These are:

… the acquisition of unwarranted influence, whether sought or unsought, by the military industrial complex … endanger our liberties or democratic processes.

He urged the US to consider “(d)isarmament, with mutual honor and confidence” as “a continuing imperative” and that “we must learn how to compose differences, not with arms, but with intellect and decent purpose.”

Then we go back to the 1930s. During the Great Depression the arms industry was struggling under the weight of a government intent on cutting the burgeoning budget deficit that had risen on the back of a collapse in economic activity and the fall in tax revenue.

In 1934, the US Senate set up the – Special Committee on Investigation of the Munitions Industry (aka The Nye Committee after the chairperson Gerald Nye, a Republican with liberal tendencies).

The US Senate Archive tells us that:

Although World War I had been over for 16 years, the inquiry promised to reopen an intense debate about whether the nation should ever have gotten involved in that costly conflict … The so-called “Senate Munitions Committee” came into being because of widespread reports that manufacturers of armaments had unduly influenced the American decision to enter the war in 1917. These weapons’ suppliers had reaped enormous profits at the cost of more than 53,000 American battle deaths. As local conflicts reignited in Europe through the early 1930s, suggesting the possibility of a second world war, concern spread that these “merchants of death” would again drag the United States into a struggle that was none of its business. The time had come for a full congressional inquiry.

The hearings lasted 18 months and more than 200 witnesses were called (including robber barons J.P. Morgan, Jr., and Pierre du Pont).

The Committee aim was to eliminate the influence of the military industry in political decision making by “nationalizing the arms industry”.

The Preliminary Report is available HERE. The Committee was terminated for political reasons before it had a chance to finish its work.

Among the findings released we read:

1. “The Committee finds, under the head of sales methods of the munitions companies, that almost without exception, the American munitions companies investigated have at times resorted to such unusual approaches, questionable favors and commissions, and methods of “doing the needful” as to constitute, in effect, a form of bribery of foreign governmental officials or of their close friends in order to secure business.”

2. “The committee accepts the evidence that the same practices are resorted to by European munitions companies, and that the whole process of selling arms abroad thus, in the words of a Colt agent, has “brought into play the most despicable side of human nature; lies, deceit, hypocrisy, greed, and graft occupying a most prominent part in the transactions.”

3. “The committee finds such practices on the part of any munitions company, domestic or foreign, to be highly unethical, a discredit to American business, and an unavoidable reflection upon those American governmental agencies which have unwittingly aided in the transactions so contaminated.”

4. “The committee finds, further, that not only are such transactions highly unethical, but that they carry within themselves the seeds of disturbance to the peace and stability of those nations in which they take place.”

5. “The committee elsewhere takes note of the contempt of some of the munitions companies for those governmental departments and officials interested in securing peace, and finds here that continual or even occasional corruption of other governments naturally leads to a belief that all governments, including our own, must be controlled by economic forces entirely.”

6. “The committee finds, under this head, that there is no record of any munitions company aiding any proposals for limitation of armaments, but that, on the contrary, there is a record of their active opposition by some to almost all such proposals, of resentment toward them, of contempt for those responsible for them, and of violation of such controls whenever established, and of rich profiting whenever such proposals failed.”

The Committee gained access to private correspondence – for example in relation to a proposal after WW1 to “control the international traffic in arms” a “Colt licensee in Belgium wrote”:

It is, of course, understood that our general interest is to prevent the hatching up of a new agreement plan “under such a form” … “that it may be accepted by the governments of all the countries who manufacture arms and munitions of war.”

The intercepted letter also proposed methods of “lengthening the controversies” and suggestions to “wear out the bodies occupied with this question.”

The rest of the Report is gruelling reading. It was tabled in the US Senate, 74th Congress, 2nd session, February 24, 1936.

What about the other side of the arms deals? The import side?

An Al-Jazeerah editorial (published April 18, 2011) – Dictators Squandering the Arab Wealth – considered the impact in Saudi Arabia of the massive US sales to them reported by the Fortune Magazine.

The editorial said that:

The ongoing Arab youth uprisings have underscored the depth of political oppression and economic hardship that the majority of the Arab people have experienced. More importantly, the uprisings have brought to the surface the reality that resources and wealth in the Arab world are seldom utilized to serve the people. Unapologetically, Arab rulers consider their nations’ wealth as their own property; their personal bank accounts and those of the states are one and the same.

This fact, along with the governments’ willingness to engage in brutality against those who oppose them, has deepened dependency on superpowers. The latter has become the norm, and transparent and sound economic decisions have been forfeited. Subsequently, national wealth is wasted and priorities are set irrespective of national needs and whether or not resources are directed toward productive growth.

I love Al-Jazeerah because they don’t mince words.

While the “Arab oil-rich states have accounted for “50% of foreign military sales signed between 2006 and 2009”, Al-Jazeerah notes that:

The Arab states have no actual use for the more sophisticated type of weapons and these weapons are, therefore, stored in warehouses to rust. Furthermore, national military officers have limited access to them. However, weapons which have domestic application are used by Arab rulers to repress their own citizens … While buying sophisticated weapons helps in recycling oil money to the advantage of the superpower, Arab resources have been diverted to these unproductive sectors thereby threatening economic development and endangering the welfare of future generations.

I have previously written about the Eurozone armaments trade and how that is an intrinsic element in the imbalances that have arisen since the Eurozone was established. Please read my blog – The value of government – for more discussion on this point.

The German magazine Der Spiegel carried a photo of a big U boat on November 11, 2010 carrying a Greek flag and said that:

Modernste U-Boote mit Brennstoffzellentechnik: Trotz Finanzkrise haben etwa die Griechen insgesamt sechs Boote der Klasse 214 bei den deutschen Howaldtswerken (HDW) geordert, die zu ThyssenKrupp Marine Systems gehören.

Meaning? These state-of-the-art U-boats (submarines) are equipped with fuel cell technology : Despite the financial crisis, the Greeks have ordered a total of six boats of the Class 214 from the German company HDW, which is owned by ThyssenKrupp Marine Systems.

The Greek government (when they had one) was being coerced at the time by the Germans into seriously cutting back their social spending but at the same time were still buying very expensive arms from the Germans.

The Euro madness is characterised by a strong Germany exporting to weaker nations a lot of military trash while at the same time demanding the same nations who buy their exports to cut government spending (but presumably not on goods that the Germans sell).

The Spiegel article (November 11, 2010) – Kanonen für die Konjunktur said that:

Vor den Deutschen rangieren in der Rangliste der Waffenhändler nur noch die USA und Russland; hinter ihnen die von hiesigen Rüstungsmanagern beneideten Franzosen und Briten. Nach Berechnungen des anerkannten Stockholmer Friedensforschungsinstituts SIPRI lag der deutsche Weltmarktanteil zwischen 2005 und 2009 bei elf Prozent. Den wiederum größten Anteil an Kriegswaffen made in Germany erhielten demnach die Türkei (14 Prozent), Griechenland (13 Prozent) und Südafrika (zwölf Prozent). Im Jahr 2008 etwa erlaubte die Bundesregierung die Ausfuhr von Rüstungsgütern im Wert von fast sechs Milliarden Euro.

Translation: “Germany ranks third in the world behind the US and Russia in world sales of armaments. According to data available from the acknowledged Stockholm Peace Research Institute, the German share of the world market over 2005-2009 averaged eleven percent. The largest buyers of military equipment made in Germany were Turkey (14 percent of total sales), Greece (13 percent) and South Africa (twelve percent). In 2008, the federal government allowed military equipment worth almost six billion euros to be exported”.

One commentator, reacting to the Washington Post story (cited above) – Our Guns and Butter Economy – (May 11, 2011) raised the essential question:

Should we simply say that any exports — no matter their moral, ethical, environmental or health implications — are inherently good?

The neo-liberal view propounded by the IMF and the World Bank and to which most advanced nations have bought into constructs export-led growth as the desirable pattern for nations to follow.

They conclude that it is job-creating and allows governments to run surpluses if net exports are strong enough. Of-course, it is a deeply flawed strategy from a macroeconomic perspective.

Apart from the fact that only some nations can be in trade surplus (because there has to be offsetting deficits), the push for fiscal austerity undermines the capacity of nations to import (which, in turn, undermines the exporter’s revenue).

But below the macroeconomic perspective, is a seedy micro world of armaments, corruption, crime, bribery, and misery. The Nye Committee exposed that 80 odd years ago. Not a lot has changed except it has become more institutionalised.

The article concludes that:

… America has become the true “Lord of War,” as the arms dealer motto goes. We are the leading arms supplier to the developing world and we are responsible for the majority of all weapons sales across the globe. Yes, we are so committed to selling instruments of death to the rest of the planet that military industries have almost tripled their share of the U.S. economy in just a decade.

The question that citizens have to ask is aptly summarised by the author (one David Sirota) – ”

Should we simply say that any exports – no matter their moral, ethical, environmental or health implications – are inherently good? Does “necessity” really mean that “stuff” for stuff’s sake must be the basis of our export economy?

MMT provides no answers to that question and when we say that exports are a cost and imports are a benefit we are talking in terms of the $-spending flows only which drive output and employment (somewhere).

Another layer of analysis has to be entered into to understand the micro (distributional, externalities etc) costs and benefits of trading patterns.

But at the macroeconomic level, MMT does allow us to understand that if we are horrified at the micro level about this insidiously dangerous military-industrial complex and want to cut it back and eliminate its influence then we should not cast that in terms of deficit cutting – if there is excess capacity remaining in the economy.

The US currently spends about 4.8 per cent of GDP on the military (see the Stockholm International Peace Research Institute database).

That is a lot of spending that needs to be reallocated.

I notice Australian progressives are applauding the big cuts to defense spending in the 2012-13 Budget last week – as a victory for peace activism etc. But the micro decision might be good but the macro decision to pursue a surplus is bad.

Progressives have to understand the macroeconomics perspective at the same time they promote what many will consider a valid micro perspective.

Conclusion

The general point is that it is easier being a macroeconomist because all these issues are submerged below the aggregates. We worry about economic and employment growth overall.

Further our understanding of the relative costs and benefits of traded goods and services doesn’t extend to considerations of the external effects – the geo-political effects etc – of certain items of trade.

That is not a shortcoming but a division of labour. For those who advocated at the sub-macro level – it is crucial that they understand that hacking into military budgets, however desirable, has macroeconomic implications which need to be considered. The latter domain is where MMT fits in.

I am travelling today so I have to stop.

Total aside

A while ago I did an interview for the Business Review Weekly. The result was this article – Rock Star Economists – published May 17, 2012.

Take it as you like.

That is enough for today!