Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
Greetings from Amsterdam where I am spending the next few days talking about what drives spatial changes in unemployment at a Tinbergen Institute regional science workshop. The spatial econometric work that I am outlining tomorrow provides the conceptual framework for the construction of the Employment Vulnerability Index, which received a lot of press earlier in the year. But while I was flying over here I thought about the concept of fiscal sustainability which is now getting a lot of press. So this is the first of a multi-part series on what constitutes a sustainable fiscal policy. Its that time again. Time to debrief!
My motivation for focusing on the topic of fiscal sustainability – although most of my blogs are about this in one way or another – came from the National Journal, which is a discussion site where experts are invited to debate a topic over a period of days. The current topic for debate is “What Is Fiscally — And Politically — ‘Sustainable’?” While the debate on the site is very US-centric, the basic principles apply to all sovereign currencies – that is to any fiat monetary system so it is worthwhile having a read to see the opinions that are expressed. The only qualification that I would make is that most of the discussants are anything but “expert” in this field if their utterings are anything to go by.
In recent weeks the concept of fiscal sustainability has increasingly entered the economic debate again as public deficits rise in response to the spreading real economic crisis. In the US, the central bank chairman Ben Bernanke has defined the concept of fiscal sustainability as:
… as achieving a stable ratio of government debt and interest payments to gross domestic product, and setting tax rates at levels that don’t impede economic growth.
The National Journal claims, however, that “fiscal sustainability is also a political concept. How would you define it? Should federal revenues be expected to stay near historical norms even as government programs bear the brunt of an aging society? Does it matter whether the societal costs of aging are borne publicly or privately?”
So first I thought we should work out what the economic concept of fiscal sustainability is all about. The political concept might be slippery and ideologically laden but in economic terms, when applied to a fiat monetary system – there are some fundamentals that define what constitutes fiscal sustainability, that are typically lost in the hysteria. In fact, the public debate is littered with statements that conflate the political with the economic and all but render the latter construction of the term meaningless.
Sometimes, this conflation is a deliberate device to blur the debate and to allow the proponent of a particular viewpoint to push a line that a full understanding of the economic concepts would not permit. Other times, and probably usually, the conflation is a reflection of plain ignorance.
So what is this concept of a “stable ratio of government debt and interest payments to gross domestic product” about? How is setting “tax rates at levels that don’t impede economic growth” enter the picture? I encourage readers to review my blogs – Size of deficit 101 and Gold standard and fixed exchange rates – myths that still prevail – which provide some of the basic tools for this discussion.
You will soon see that both elements of Bernanke’s definition reflect his lapse back into gold standard reasoning when convertible money and fixed exchange rates were the defining features of the monetary system. Those days are over for most of the world economies and you simply cannot continue to apply the reasoning that was relevant to the former monetary system, which placed clear “financing” restrictions on the national government, to the current fiat monetary system which is characterised by non-convertible currencies and flexible exchange rates.
One of the respondents to the National Journal debate, Gene Steuerle, VP, Peter G. Peterson Foundation, which is a lobby group that seems obsessed with the irrelevant – deficits and debt. If I was the billionaire that set the foundation up in 2008 I would would have donated the money to medical research in search of a cure for cancer or HIV. I am sure the world would have received a better return on the dollars!
Anyway, the commentator immediately reflects his failure to understand that the monetary system has changed. He appeals to the household-government analogy from the outset. He says that a firm or household would never “decide how to spend every additional dollar it planned on making over the next 100 years” meaning that you shouldn’t commit your future revenue until you know what it is. He says:
Bottom line: sustainability is a minimalist goal; we need slack in the budget, measured as future revenues well in excess of today’s commitments as to how those revenues will be spent.
Obviously nonsensical. A sovereign government is nothing like a non-government private sector entity. One issues the currency (under monopoly conditions) and the other uses that currency and cannot get it before the government net spends. Further a sovereign government is not revenue-constrained which means that its future revenue is as irrelevant as its current revenue for decisions about spending. Government spending comes from nowhere. As I noted the other day – spending funds spending – spending funds itself – because the government can always credit bank accounts and add to bank reserves whenever it sees fit.
Hint: Saying a government can always credit bank accounts and add to bank reserves whenever it sees fit doesn’t mean it should be spending without regard to what the spending is aimed at achieving. I will come back to that but it is a clue as to what “fiscal sustainability” means.
A fellow at the neo-liberal American Enterprise Institute, Desmond Lachman, also cannot come to terms with the essence of a fiat monetary system. He told the National Journal that:
The OECD usefully defines a country’s fiscal policy to be sustainable if one can judge that the government might be able to continue servicing its debt without an unrealistically large future correction to the balance of its income and expenditure. Judged by that definition, it would seem that the Obama budget proposal is now raising major issues of fiscal sustainability for the United States.
Note: the US unemployment rate is above 9 per cent and rising. While the expanding deficit is starting to put a floor in the US economy it is still way to small relative to GDP to seriously advance public purpose by reducing unemployment. Where is the mention of this in the conceptualisation of fiscal sustainability?
Hint: advancing public purpose is another component of what “fiscal sustainability” means. You cannot define it in its own accounting terms – some given deficit size relative to GDP or whatever.
But back to Lachman. A sovereign government faces no solvency issues. It also does not have to go through the logic that restricts a household – that logic runs like this – if we spend more than our income now, we have to borrow. To pay the loan back we have to ensure we have revenue (income) in the future. If we borrow too much we will face major corrections in our balance of income and expenditure and we may have to seriously forgo spending later.
That is the logic that the users of the currency have to consider every day. They have to finance every $ they spend and so planning is required to ensure they don’t “blow their credit cards”! But that logic doesn’t apply to a sovereign government. They can spend now (even if they simulataneously issue debt – which I remind you has nothing to do with financing the spending). They can also spend later as well as service and pay back the debt without compromising anything.
Could the debt stocks get so large that they would no longer have any “room to spend” on other things? Note the question is not whether they would no longer have the capacity to spend on other things. The claim is that the debt service payments would become so large that there would not be any further “room” to spend (presumably because the spending gap is full!). First, the leakages from the expenditure system will prevent this from happening – taxes, saving and imports. Second, if for some reason the government didn’t like the position it was in it just stops issuing debt! Full stop.
Lachman goes on to list four “separate but inter-related issues that should now be raising red flags about fiscal sustainability as an issue” in the US. The same issues are raised by deficit nazis everywhere. They are:
- The trajectory of the deficit: How far will the deficit rise and how long will it take to return to surplus?
- The level of the public debt: What percentage of public debt to GDP is acceptable? Conservatives often cite the Maastricht criteria (which forms part of the ridiculous Stability and Growth Pact (SGP) which underpins the Eurozone and guarantees the Euro governments will force persistently high levels of unemployment onto their hapless citizens – all in the name of fiscal prudence mind you. Anyway, Lachman cites the criteria – debt/GDP below 60 percent as the “prudent limit for the public debt”.
- Further major long run budget challenges: the intergenerational furphy which tries to tell us that the “aging of the baby boom generation” will force huge unsustainable deficits and public debt levels onto the future generations and threaten the solvency of the social security and health systems.
- The high proportion of foreign budget financing: Lachman says “It would seem foolhardy to expect foreigners to indefinitely fund large budget deficits especially when they are already voicing concerns about sustainability issues”.
These are the four major issues that define the public debate about the conduct of government fiscal policy. They are all “gold standard” head-in-the-sand conceptions of the alleged constraints that are faced by the sovereign government – whether it be the US or Australia or Japan or most nearly anywhere else.
First, the SGP is a voluntarily-imposed rule imposed on formerly sovereign governments by themselves as a way of garnering the introduction of the Euro. You might like to go back and read my blog – Social security insolvency 101 – to understand the Eurozone dilemma better.
If they were so obsessed with a single currency and a single central bank (ECB) and, therefore, a single monetary policy, then the Eurozone countries should have also voluntarily ceded their fiscal capacities to a single unified body – perhaps the European Parliament. Whichever entity took responsibility for fiscal policy is a separate issue and there are different views about it. The point is that the arrangement they ended up with where the countries retained individual fiscal responsibilities while ceding monetary policy capacity to the ECB was a nonsensical outcome. They then had to artificially constrain their individual fiscal capacity for fear that Italy or Spain would go wild (actually helping their citizens avoid unemployment and poverty but whatever!). That is why the SGP was pushed by the stronger European economies (Germany).
But this 60 per cent rule has no foundation at all in economic theory. It is an arbitrary ratio devoid of economic content. It cannot be represented as “prudent” in any way given its ad hoc nature despite the authority that most economists will claim for it. It is an invention! Moreover, any target public debt/GDP ratio misses the essential point – and that is to ask the question – what is the public purpose being served by net government spending? And why would a government issue debt anyway given it is not revenue-constrained?
Hint: we won’t find a definition of “fiscal sustainability” conceptualised by some level of the public debt/GDP ratio.
Second, to understand the “trajectory of the deficit” you have to understand why the budget balance changes. Two things can drive these changes: (a) the automatic stabilisers work against the dynamics of the business cycle for given policy settings – so when economic activity is plunging downwards, the automatic stabilisers provide stimulus – falling revenue and rising welfare payments – and take the edge of the downturn. The opposite happens when the economy strengthens. Much of the shift in the budget balances around the world at present – that is the shift to large deficits (or in Australia’s case the shift from surplus to deficit) reflects these stabilisers at work; and (b) changes in discretionary policy parameters will also alter the budget balance when the accounting is done. So increasing spending programs neglected by the neo-liberals obsessed with surpluses will increase net spending on top of the impacts of the automatic stabilisers.
Should we be worried about these disretionary changes? It all depends. If the economy is at full capacity (2 per cent unemployment and zero underemployment) then it would not be sensible for the national government to increase its net spending any more and do nothing else because the extra nominal demand will certainly push the economy beyond its real capacity to respond. You then get – you know what (don’t say it too loud – inflation!).
Note I qualified this by saying “and do nothing else”. The national government might decide that it wants to expand the importance of the public sector relative to the private sector in the fully employed economy as a political goal. That would be a perfectly reasonable goal – to expand public goods and services at the expense of private goods and services if it reflected the political sentiment of the day. As an aside, this would be a political choice. There is nothing at all in economic theory that tells us about the desirable size of the public sector in the overall economy despite what the small government lobby would have you believe. Repeat: nothing at all! The optimal size of government is always a political decision (and choice).
Well in that case the government could continue to increase net spending – to command a greater share of the fully employed resources – but at the same time it would have to increase taxes to drain some spending capacity from the private sector. Note the tax rises are not funding the extra public spending which is not revenue-constrained. Rather the taxes are one way the government can take spending capacity from the non-government sector so that it can command a greater usage of the finite resources available.
Note also that this scenario is largely irrelevant if the economy is operating below full capacity.
Hint: fiscal sustainability is directly related to the extent to which labour resources are utilised in the economy. The goal is to generate full employment.
The point is that there is no economic intergenerational crisis unless we run out of real goods and services and the future population is forced to live with less of them. There is no financial constraint on a sovereign government providing adequate social security and health care to future residents. It may be politically difficult to do so if say the younger generations want more reall resources for themselves which would preclude making them available for hip joint replacements. But that is not an economic issue nor a question of public solvency.
Hint: the concept of fiscal sustainability is not defined in terms of any notion of public solvency. A sovereign government is always solvent (unless it chooses for political reasons not to be!).
Fourth, the foreign issue is totally irrelevant. The Chinese government might hold a lot of USD at present and also US Treasury debt instruments. Where did they get the dollars from? The US government! How did they get them? They sold stuff to the US (exports) in greater quantities than the US sold stuff to them (imports). Who gained? US citizens put less (gave up) real goods and services that they could have consumed themselves onto ships and sent them to China than the Chinese put onto ships and sent to the US. More real goods and services net went to the US. Sounds like the US is doing well out of that.
We have to always remember that exports are a cost and imports are a benefit not the other way round! The Chinese (and any foreign entity) wanted to hold US dollar-denominated financial assets as a voluntary choice. Mostly this is to keep the value of their currencies down because they think exporting a lot of their wealth (resources) is good. Well as long as they think giving more real goods and services away net is good they will keep desiring to accumulate USD and other foreign currency financial assets. When they decide not to do that then they will stop exporting as much and the US currency will drop a bit in value and the Americans will have to ship relatively more real goods and services net than they did in the past to China. In other words, the party will be over for the US but this just means marginal adjustments in the scheme of things. The sky will not fall in on the US folk!
Further, how can we say that the Chinese are “financing” the US government spending? The US government, last time I looked (just now!) spend in USD. The monopoly issuer of USD is the US Government. The Chinese Government does not issue USD. It requires the US Government to spend USD before it can get them. It is plainly nonsensical to think otherwise and just goes to show how twisted the neo-liberal logic is.
Conclusion: Lachman doesn’t get it at all.
Hint: the concept of fiscal sustainability will not include any notion of foreign “financing” limits or foreign worries about a sovereign government’s solvency.
End of Part 1
Well that is it for today. Tomorrow, in Part 2 (unless some major data issue strikes!) we will see what others think about this question and move towards a definition of fiscal sustainability that is ground in a thorough understanding of the way the modern fiat monetary system operates.
You can see I had a very nice journey to Europe with my new portable computer battery that lasts 9 hours – seems to be true so far!