The deficit and debt debate

The ABC News Online business reporter Michael Janda ran this Opinion piece – Economists tackle the deficit and debt debate today. He interviews three economists – myself, Steve Keen (University of Western Sydney) and Stephen Kirchner (Centre of Independent Studies). The discussion is interesting because it demonstrates how the journalists modify what you say to mean something slightly different (no accusation here that it was designed to skew meaning though) and generates the statistic that two out of three economists do not understand how the modern monetary economy works.

You can hear my interview via the ABC site or HERE. The other interviews are available via the ABC Opinion page.

The reporter says that “It is said that if you put ten economists in a room you will get eleven different opinions.”

In relating this to this week’s national budget he concludes that:

The main bones of contention have been the scale of the deficit, the size of the debt the Government is issuing to fund it, and the accuracy of the Treasury projections that the Government’s plan to get back into surplus rests upon … Many economists and business groups, as well as the federal Opposition, say that the deficit is being allowed to rise too far.

I agree that these are major issues at present. My views on these issues are summarised as such:

1. The scale of the deficit is not something that we should focus on – rather our attention should be on providing a job for everyone who wants to work. The deficit will be whatever that takes.

2. The size of the debt is largely irrelevant and further the debt being issued does not fund the net spending.

3. The amount of effort that has been expended by presumably a host of Treasury economists drawing up structural deficit projections and fixing assumptions so that the deficit becomes a surplus over some politically acceptable time frame is mindboggling. It is such a misguided use of smart people to be focusing on that sort of exercise. As long as the non-government sector desires to save in the currency of issue then the government budget will always be in deficit or else there will be recession. We cannot escape that basic macroeconomic fact! It is not a theory but an exercise in national accounting.

4. The deficit has to fill the spending gap. When the mainstream economists, who constitute the overwhelming majority, claim that the deficit is getting “dangerously large” what benchmark are they assessing it against? I never hear them say anything about the spending gap that is driving the real output and employment losses. Another basic macroeconomic fact is that you will get rising unemployment unless government deficit finances the desire to save. Or that aggregate demand has to be sufficient to meet the nominal value of goods and services currently supplied. If demand is deficient then inventories will rise and firms will cut output and the rest follows. Whether the deficit to GDP ratio that is required to close the spending gap is 4.9 per cent or 10 per cent just tells you about the relative size of the spending gap and the private saving that is responsible for creating it. That should be the focus with the deficit size an accounting artifact.

So then the CIS economist (using that description liberally!), said that:

There’s no question that we were going to go into deficit, and this was necessary to soften the blow from the global economic downturn …. But it is a question of degree, and overall about two-thirds of the deterioration in the budget balance is due to slower economic growth, but about one-third is due to discretionary policy actions which have made that downturn in the budget even worse.

So what? We were going into deficit whether we liked it or not because with the non-government sector seeking to save again, the automatic stabilisers (via taxation receipt losses and rising welfare payments) were pushing it that way.

But how do we deal with the nonsense that discretionary actions (that is, changing budget parameters in an expansionary way) “made that downturn in the budget even worse”? As if the budget deficit is bad when it was “necessary to soften the blow”.

Some economists use the distinction between a cyclical and structural deficit. I don’t use the framework myself because it is usually based on ridiculous assumptions that full employment can be reasonably defined as being when you have around 5 per cent unemployment. But the framework is often used and you can see it in the article in The Australian by Michael Stutchbury today. The question Michael doesn’t ask is what is the full employment level that is being assumed here. Given the analysis is really the Treasury’s rather than his, you can bet that the unemployment rate they considered to represent full employment was about 3 per cent higher than it should have been and would include all the underemployment. Clearly this is not full employment and so all the estimates of structural budget balances are a waste of time.

But back to the point at hand. The structural/cyclical story notes that the budget will vary over the business cycle even if the government leaves all parameters (tax rates, spending ratios etc) unchanged because of the automatic stabilisers. So to focus on a particular budget outcome at some point in the cycle does not really allow you to determine the expansionary/contractionary extent of the discretionary components of fiscal policy. Accordingly, economists say that to measure the discretionary (or structural component) of the fiscal stance you have to calibrate it independent of the business cycle – with the potential capacity being the typical calibration point chosen. So they talk about a full employment budget position. At full employment, the cyclical component is zero and the budget position is all structural. So for balanced budget types (across the cycle) what they are inferring is that the structural budget balance should be zero. All discretionary spending initiatives should be matched by taxation.

I digressed into that for background so that what I say next is more easily understood. When this clown from the CIS talks about the “discretionary policy actions which have made that downturn in the budget even worse” he is referring to these structural elements.

The point being missed is that if you went into the downturn with a budget surplus with high levels of labour underutilisation anyway you were already “under spending” in relation to the spending gap by several percentage points of GDP. The surplus was heavily structural and aided by strong cyclical components. So in the downturn, that discretionary fiscal drag had to be reversed in a signficant manner.

Further, the so-called “structural component” at full employment can never be zero if the private sector desire to save in the currency. Back to that again. In those situations, there always has to be a “structural deficit” (even though I don’t like the terminology) or else production will fall and you won’t be at full employment anymore. Given how far we are away from full employment at present, the deficit is currently well below what it should be.

Anyway, when you read the CIS commentator you see why I told you I used the “economist” description liberally!

Under the heading Stimulus stymied by debt the Reporter then quotes Steve Keen:

We have had far too much debt, more than the system can actually cope with, we therefore can’t get out of this the way we used to get out of it by re-encouraging private lending once more.

I agree that the volume of high risk private sector debt was a major part of this current crisis. But encouraging credit worthy businesses to borrow is still sound. Banks have no current constraints extending credit to these customers. The residual of so-called toxic debt is a separate issue.

The Reporter then concluded that in “Keen’s view, the amount of outstanding private debt is simply too large for the Government to replace with public debt.”

Things seem to be going astray at this point. The current expansionary period is nothing to do with replacing private debt with public debt. Private debt was incurred to “finance” spending by revenue-constrained private sector agents (households and firms). The private debt build-up was matched $-for-$ with asset accumulation because all non-government transactions net to zero in an accounting sense.

Public debt doesn’t finance anything. The Federal Government is not revenue-constrained and can spend when it likes without prior recourse to revenue.

If what Keen is suggesting is that expanding the budget deficit cannot overcome the real downturn then he is wrong. There is no financial crisis so deep that cannot be dealt with by public spending. Here is a link to a paper I wrote on this with a co-author last year. The actual crisis is a real crisis where spending is below potential capacity output. That is exactly what a budget deficit aims to resolve. If the financial crisis (and the “toxic debt”) has impacted on spending so much that the spending gap is huge then that just means the deficit has to be that much larger. It is clear from the December quarter national accounts that household saving is rising dramatically (from a negative level during the debt binge). That is a good indicator that the deficit had to get big!

The Reporter than coaxes Steve into giving his solution to the debt problem which is “for the Government to get rid of the debt by causing higher inflation or by simply cancelling it and nationalising the banking system.” Keen is quoted as saying:

Ultimately, we’re going to see governments changing across either to abolishing debt, or to literally printing money rather than running out debt to finance their spending … We know this crisis was caused by too much debt, how on earth do we think that getting into more debt is going to solve the problem.

Omigosh! Where to start! First of all, they are not “running out debt to finance their spending” – that is plain wrong and reflects a fundamental misconception of central bank operations and the impact of net government spending on bank reserves. Read above!

Second, the alternative conception he is suggesting of “literally printing money” is equally as problematic. Governments do not spend by printing money. I have covered this before in my blog – Quantitative easing 101.

Further, the notion Keen is trying to advance is that deficits which are not matched by debt issuance are inflationary. So the government should run a deficit, not issue debt, print money, drive up inflation, and erode the real value of the private debt until it is worthless – thereby solving the problem. As I said – Omigosh!

Increasing net spending (the deficit) will add to bank reserves as the Government credits bank accounts in return for goods and services provided by the private sector and in consideration of income transfers to that sector. As long as the net spending is adding to aggregate demand and closing the spending gap there is little to fear from inflation. Firms will respond to the spending stimulus by increasing output and employment. Once the economy reaches full employment then nominal demand will exceed the real capacity of the economy to absorb it and then inflation becomes a threat. No sensible government would push the deficit into this zone though. So at the point the deficit becomes inflationary you have already overcome the recession and created full employment!

The Reporter under the heading Deficit, debt ok said that I saw there was “no problem with governments running persistent deficits, and that this has been a more usual state of affairs historically than recent years of budget surplus.”

Correct but deficits are good only when they close non-government spending gaps and underwrite employment. Outside of that there are problems.

The Reporter then says that I noted that “the Government does not need to issue debt to fund its spending because it can create money.”

This is what I actually said:

The Government does not need to fund its net spending. The Government is not like a household – households like my household, if we want to spend we have to find a source of revenue, we are revenue constrained. The federal Government is not revenue constrained, it issues the currency.

There is a subtle difference in that I did not say that the government can create money to fund its spending and therefore doesn’t need to issue debt to fund it! Public debt issuance can never be seen as a source of “funds” – this concept is totally inapplicable to a currency-issuing sovereign government. That government is never revenue-constrained and so spends by crediting bank accounts. It does not spend by “creating money”! That connotation too easily descends into the “printing money” myth.

The Reporter then says that I said “some degree of Government debt also serves a useful role in the economy.”

This is what I actually said:

When the Government does issue debt, it provides us with a safe haven for our savings. The debt repayments and the debt servicing the Government makes provides us with income and allows us to earn income from our savings in a risk free way … It’s something that superannuation funds can invest in much more securely than some of the more high risk assets.
This is actually what I said:

Again a subtle difference. The principle role that debt plays is to be part of the monetary operations of the central bank. As I have explained many times – see the blog Will we really have to pay higher interest rates? – debt issuance drains bank reserves and avoids the interbank competition from driving the overnight rate below the central bank’s target interest rate. The fact that it might have other characteristics that are appealing misses the point about its main function.

The clown from the CIS was then wheeled out juggling something called nonsense. He chimed in with the crowding out claims such that the “federal Government borrowing will make it harder for the private sector to get loans”: He is quoted as saying:

There’s a long-run crowding out effect from government borrowing that will probably persist well after the recovery is underway.

The Reporter then quotes him again saying “This … will blunt the effect of the extra spending that the Government makes by reducing the amount the private sector can borrow to invest in expansion.”

Where do you start with this? Banks will lend funds to any credit worthy customer. They do not have to have the funds in the bank to do this. Remember loans create deposits not the other way around. The banks then add the necessary reserves by borrowing in the markets or from the central bank depending on rates and availability of funds. To construct the world as if there is a finite source of “savings” and if the government uses them all up then the private sector will miss out is laughable. But then clowns make you laugh after all!

There were some other points in the discussion that I have not covered. Some more clown moments but they are periperal to the issues raised here.

So now you know why there is a new statistic – two out of three economists do not understand how the modern monetary economy works

Budget and equity advancements

I also did an interview with Stephen Long for last night’s PM program. You can listen to the MP3 audio of the entire segment from ABC PM program or via CofFEE podcasts.

I was asked to comment on the so-called Robin Hood nature of the Federal Budget and specifically the superannuation and family benefit changes which ostensibly negatively impact on high income earners. Here is the brief interchange taken from the ABC Transcript:

ABC Presenter STEPHEN LONG: But it hasn’t satisfied the critics. Bill Mitchell, Professor of Economics at the University of Newcastle.

BILL MITCHELL: Well look the rort is still there. I mean you can sacrifice now $50,000 depending upon what age at the, at a 15 per cent tax rate instead of your marginal tax rate. So clearly they’ve wound some back there is some loss there for the individuals in those positions, very small number. But not a significant impact upon the Budget either short-term or long-term, and certainly not a major equity revision.

STEPHEN LONG: Professor Mitchell says it’s all tinkering at the margins.

BILL MITCHELL: The way I see it is that if you’re going to stand back and allow unemployment to rise to high end eight per cent by the end of 2011, which is the Government’s ambition, then the equity losses there drown any of the equity gains that you might get from these phased in very small tinkering at the edge of superannuation and private health insurance and things like that. One of the greatest sources of inequity is unemployment and for the Government to bring down a very large budget and not have any direct job creation to soak up the substantial unemployment that they’re going to witness and preside over, is the largest equity loss of the package, I think.

You can also read the Full Segment Transcript if you are interested.

Public Policy lecture on Global Financial Crisis

Tonight we are running the first of three public lectures in Newcastle on the GFC. Professor Randy Wray who I am working with on a number of projects at present is visiting CofFEE at the University and together we will present three lectures over the next three weeks.

All are welcome if you live in Newcastle or can travel.

You can find further information from the CofFEE Page.

For those that cannot travel we will have video and audio podcasts available starting next week.

This Post Has 9 Comments

  1. hi bill

    keen was quoted as saying….

    “drive up inflation, and erode the real value of the private debt”.

    Forgive my ignorance but my understanding was that this is exactly the scenario that central banks were wanting to achieve, the ultimate outcome from their monetarily policy intiatives. stoke a bit of inflation, and everyone’s happy as their debt burden is diminshed by inflation.

    Bernanke, so-called expert on the great depression, fears deflation above anything else. As did his predecessor greenspan. I thought the sequence of events was well rehearsed as they approach their irrational fear of deflation moment…lower interest rates to 0, unconventional monetary policy ie queasing to manipulate the cost of borrowing, keep this up until you generate a bit [but not too much], and have that inflation erode the value of private debt ? everyone can breathe a sigh of relief, central banker reputations are restored, and we can go back to overpaying for a basic human need [housing]

    is this not how they’ve been able to keep households seemingly unconcerned by the levels of debt they have been accumilating in recent years. Keep IR’s low, encourage household sector to take on more debt. have the psychological effect on savers with low IR’s whereby they believe their savings are getting a low rate of return hence invest in asset classes, stoke inflation and subsequent asset price inflation chips away at the ever greater value of household debt which was taken on to keep the ponzi system going..

    The idea over the last few years appears to be encourage housholds to deal with secured debt the way govts. deal with their own debt accumulaiton.Pay the interest only, don’t worry about the principal sum outstanding. Clear distinction being that govts. don’t die or become redundant or suffer ill health.

    IT’s why i believe this whole lowering of the base rate and interest rate manipulaiton in the name of combating the private sectors apparent risk aversion and recent tendency to save more, is infact a giant con to encourage debt accumilation. What kind of a solution to a problem is that ?
    it is argued it’s the only solution where private sector demand has dropped off but is it not like kicking a can down the road.

  2. Dear Bill,

    I found this an intersting post but it no way was I suprised by the CIS or the medias comments. When talking with theses media and CIS clowns I probably would never mention the unemployment or underemployment rate.

    Instead I would be quoting both the number of people wanting jobs or more hours of work with the number of jobs or hours acually available.

    For me those stats demonstrate the reason why governments must run deficits – to fill the spending gap.

    The two out of three statistic is no suprise to me either. We should never argue with idiots because they will drag us down to their level and beat us with experience.



  3. It’s really a shame. Keen is really good on many things – in a way he could be called a “post keynesian fellow traveler” – but he still just doesn’t seem to have a good grasp of reserve accounting. I asked him about it on his blog once, and he seemed to sort of get it, but he claimed that it didn’t really matter from a practical standpoint, since it was politically untenable for governments to run deficits big enough to make up for the collapse of the debt bubble. I was left wondering if he was just talking about what is practically possible (which he may be right about, but which it seems would call for trying to better educate the public, as you are doing) or he truly saw a limit on governement deficits. Very sad, especially from someone who wrote “Debunking Economics”, one of my favorite books…

  4. Dear Jimbo

    Your analysis is pretty much in line with my experience, too.


  5. Dear Jimbo

    I think Steve is a “fellow traveller in the Post Keynesian tradition”. I also think he was among a few of us (in Australia) who foreshadowed that the private debt build-up was going to become ugly eventually. No doubt about that. But I think you have to tie that debt arguments in to a broader understanding of the monetary system with the sovereign Government at the centre of the show adding and draining net assets. You really cannot fully understand the debt binge dynamic unless you also understand it in relation to the fiscal dynamics (specifically, the surplus obsession). That is where Steve and I depart.

    I am also of the view that I am an educator. I am not marketing a concept or appealing to what might be popular or politically practical at a particular point in time. My role is to try to understand the macro system as a totality – not just one part of it – and then communicate that as best I can. I leave it to those who take on the political roles to take the ideas and run with them. But I guess I wrote this particular blog because I am frustrated that so-called progressives keep using terms like “debt funded” or “debt financed” and “print money to generate inflation” and other orthodox neo-liberal terminology when it is plain wrong in technical terms but also incredibly naive in political terms. It makes the progressive task that much harder to pursue when people turn back at me and say “…. well so and so, who is a progressive thinks that debt does fund the deficit” or “if they don’t finance the deficit with debt then they will just be printing money and that is inflationary”. Neither statements are remotely true.

    best wishes

  6. In today’s Australian, Anatole Kaletsky says “A government that borrows in it’s own currency will never default because, in extremis, it can always instruct it’s central bank to print money to pay it’s debts”.

    So he admits that federal government is not revenue constrained. But he does not then ask the next logical question: if federal government can simply issue whatever currency it needs to pay it’s debts as long as they are in it’s own currency – why would they need to go into debt at all?

    Actually, if I have been paying full attention to Bill’s blog, Kaletsky, while on the right track here is somewhat innaccurate because:

    (1) Printing money is a seperate thing to how the government actually spends and,
    (2) The process of issuing fiat (I take it this is what he actually means) is by no means “in extremis” – it occurrs every day.

  7. Dear Lefty

    Good post. The neo-liberal answer to that question is that when a government doesn’t sell bonds, this is inflationary, while a bond sale is not, in their view. My feeling for a number of years has been that the loanable funds view (which is the basis for the neo-liberal position in the previous sentence) is the real problem, as every neo-liberal economist who reads his/her graduate text knows that a government can create its own currency and need never default. In reality, there is no difference in terms of stimulus whether bonds are sold or not; in fact, a bond sale adds an additional interest payment to the original deficit, and is therefore actually more stimulatory.


  8. Part of my continuing caching up process reading the old posts..

    Let’s assume that recessions are the result of a collapse in demand in which the public desires stop spending and increase savings. I believe that a spike in the desire to save is a symptom of something wrong with the macro-economy, and that if government were to fix the underlying cause, then it would not need to keep supplying the public with additional savings.

    I.e. there is a “natural” rate of savings that corresponds to overall productivity, and should be matched by a “natural” government deficit that is a constant (and hopefully declining) share of GDP. I say hopefully declining because if productivity is increasing, then there is less and less need to save. Any additional private sector savings are fictitious, in exactly the same way as the government debt is fictitious. Savings greater than this natural amount cannot be spent. If the government only supplies more income, but does not fix the underlying problem, it is like giving a fictitious cure to a patient and then going to the beach.

    Typically households boost savings because they are not being paid enough. The resulting collapse in demand drives down prices, increasing the share of the average wage to per-capita output.

    Consider the following data from 1790-2006, relating average hourly production earnings to per-capita GDP:

    Historically recessions have a stabilizing effect on income inequality and allow the middle-class to exist, but at a high social cost in terms of economic trauma. Like forest fires, if the government is going to counter recessions with demand-maintenance policies, then it needs to also run controlled burns, to keep the middle class from disappearing.

    The controlled burn consists of recouping the demand subsidies supplied to the private sector from the wealthy. You need these stabilizing forces if you are going to deny workers the one tool that they have to increase their wages relative to output: stop shopping and shrink output. The business sector has first and foremost a responsibility to supply households with adequate wages, and government should only step in and bail out the business sector via demand-boosts in excess of wages paid if the bulk of these subsidies are recouped from the beneficiaries of business profits. Therefore taxes do not “fund” the government’s spending, but taxes are a tool to ensure that wages are kept in line with demand, and that government spending does distort this balance in the name of avoiding output gaps.

    The great moderation and Keynesian demand-maintenance policies do not look good from this historical perspective, as government stepped in to boost worker incomes temporarily — effectively tricking them into resuming to shop — really to borrow — instead of having deflation boost wages in a more lasting manner.

    The one notable exception to this pattern is the period 1945-1963, in which wage shares rose both in good and bad times. That was a time of 90% upper tax rates, excess profit taxes, and strong unions. As these stabilizing mechanisms were dismantled but the demand-maintenance policies remained, the overall result was a huge hit to financial position of the middle class.

    In the same way, in a debt-crisis, the government should not just dribble out deficit spending. All such moneys end up being used to repay debt and are subsidies to lenders and asset holders. First, force a mass debt-restructuring to deal with the underlying problem, and then deficit spend. The parties that *ultimately* benefit from this demand maintenance — those who receive income from debt-repayment — should have their taxes increased by an offsetting amount, so that only the “real” underlying savings remains.

    And this goes for anything else. If the public is saving because they believe their pensions are too low, or their future health-care costs are too high, then the government should boost balance sheets only while putting in place the needed fixes to social programs, so that the private sector savings rate goes back to normal. And it should then recoup that extra spending as the public “pays” for those programs via increased taxes, or in the case of bond sales, the spread between the yield received and nominal GDP growth.

  9. Spending my Saturday night in 2018 reading the archives of Bill Mitchell … time well spent IMO

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