Time for a reality check on debt – Part 1

I am now in the US with a hectic week ahead. At present I am in Florida and for those who haven’t been here just imagine taking a landscape and pouring as much concrete as you can mix over as much of that landscape that you can access. Then once that sets, you build massive high-rise buildings and suburbs that span hundreds of kilometres and you have it. Oh, and plant a few palm trees as you concrete. But then there is surf nearby and before work this morning I am off to check it out. Anyway, in between other things I have been reading the so-called public debt exposition that appears in the latest issue of the The Economist Magazine. It will take a few blogs to work through it but here is Part 1. It might happen that there will be no Part 2 if I get so sick of reading this nonsense.

As a prelude to today’s blog I thought I might share something from a book of fiction that I am currently reading. At present, I am reading the first of the Stieg Larsson trilogy entitled The Girl with the Dragon Tattoo which is recommended. One of the main characters is a sometime financial journalist and author. On page 91 of the book, there is a narrative covering the first chapter of this character’s book (one Mikael Blomkvist), which is an investigation into “the labyrinth of financial journalism”. Blomkvist is cast in the book as character who is on the outside of the mainstream financial commentary and has a significant disregard for the standard way in which his profession functions. The description of the first chapter of Blomkvist’s book goes like this:

… In the last twenty years, Swedish financial journalists had developed into a group of incompetent lackeys who were puffed up with self-importance and who had no record of thinking critically. He drew this conclusion because time after time, without the least objection, so many financial reporters seemed content to regurgitate the statements issued by C.E.O.s and stock-market speculators – even when this information was plainly wrong or misleading. These reporters were thus either so naive and gullible that they ought to be packed off to other assignments, or they were people who quite consciously betrayed their journalistic function …

He compared the efforts of financial reporters with the way crime reporters or foreign correspondents worked. He painted a picture of the outcry that would result if a legal correspondent began uncritically reproducing the prosecutor’s case as gospel in a murder trial, without consulting the defence arguments or interviewing the victim’s family before forming an opinion of what was likely or unlikely …

I thought this had strong parallels with the view I have about economic journalism (with noted exceptions – and I will name names if asked) in Australia. Mostly lackeys who just reiterate the orthodox line with either little understanding and/or an explicit intention to deceive.

It also serves to introduce the latest waste of trees that I have had the misfortune to encounter. I advise no-one to buy the current edition of The Economist magazine which is running a major disinformation campaign in its – Public debt – The biggest bill in history. The July 11, 2009 edition pretends to tell us what the “The right and wrong ways to deal with the rich world’s fiscal mess” are. Well let me just conclude that most of the discussion is easily forgotten. There are a number of articles in the edition on the same theme and I might cover a few of them over the next week or so.

You get the drift of the lead article in the opening sentence:

THE worst global economic storm since the 1930s may be beginning to clear, but another cloud already looms on the financial horizon: massive public debt. Across the rich world governments are borrowing vast amounts as the recession reduces tax revenue and spending mounts – on bail-outs, unemployment benefits and stimulus plans. New figures from economists at the IMF suggest that the public debt of the ten leading rich countries will rise from 78% of GDP in 2007 to 114% by 2014. These governments will then owe around $50,000 for every one of their citizens …

The language is emotional throughout. We read about “this alarming trajectory” – “today’s debt surge” – “today’s borrowing binge” which is occuring “just before a slow-motion budget-bust caused by the pension and health-care costs of a greying population”. We are presented with three solutions to this huge demographic disaster – “Will they default, inflate or manage their way out?” By manage their way out the writer means – running surpluses.

The lead article recognises that “without stimulus the global recession would be deeper and longer” but then gets back on theme (slapped over the hand by the boss I reckon!) concluding that “in the long run today’s fiscal laxity is unsustainable”.

Then it gets down to business. The inevitable descent into defict nazism and hysteria:

Governments’ thirst for funds will eventually crowd out private investment and reduce economic growth. More alarming, the scale of the coming indebtedness might ultimately induce governments to default or to cut the real cost of their debt through high inflation.

So there you have it. The stimulus was necessary but will result in government killing private investment and economic growth and ultimately governments will default or inflate to clear the legacy of their bad ways. The neo-liberal fightback it is called. Re-read my opening about the financial journalists in the fiction I am reading. Problem is that they are alive and well and have jumped out of Larsson’s book to serve up this drivel. Life imitating art!

This is an example of how journalists twist what is going on to promote an argument that does not reflect the essence of what is going in. In the US at present, 10-year Treasury bond yields have risen over the last six months. The scaremongers want you to believe that this is the direct consequence of the deficit “crowding out” private investment by drawing on scarce funds available in the financial markets.

The Economist exposition on debt continually rehearses this argument – ad nauseum. But then at one point, it admits the following:

Much of this rise stems from confidence about economic recovery rather than fiscal alarm.

Which is more the point of what is really going on in financial markets and as you will appreciate has nothing at all to do with the crowding out story. I will return to this point soon.

In the next sentence, the journalist gets back on theme with “eye-popping deficits” and “printing money to buy government bond” and “concerns that America’s debt might eventually be inflated away”.

The futility of government intervention is rehearsed next. The journalist writes that worries about the inflation whether:

… (j)ustified or not, such worries will themselves wreak damage. The economic recovery could be stillborn if interest rates rise too far too fast. And today’s policy remedies could become increasingly ineffective. Printing more money to buy government debt, for instance, might send long-term bond yields higher rather than lower.

First, if the journalist thinks the views may not be justified then why didn’t he (it is a male) outline the alternative views which would underpin the argument that these fears were irrational? Think about the Larsson above – those lackeys who just spread the case for the prosecution.

Second, if he thinks there is a case to be made that the fears are irrational, then why use the language that incites and perpetuates the fears?

Why not start the article with the point that while deficits are rising due to the severity of the crisis, the stimulus will underwrite production and employment, and provide the conditions for firms to develop the confidence necessary to resume investment? Why not say that while some neo-liberals consider the extent of the expansion a worry because the growth in nominal demand may outstrip the real capacity of the economy to absorb it and thus inflation may ultimately result, there is such a huge spending gap across most economies, as evidenced by the parlous rates of capacity underutilisation and rising unemployment that any such fears are irrational?

Paul Krugman’s latest article which I read on the flight over from Zurich yesterday (in the International Tribune) is worth introducing here as an example of an alternative depiction. He starts with:

The debate over economic policy has taken a predictable yet ominous turn. The crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts. For those who know their history, its deja vu all over again – literally.

Krugman then recounts three instances in history where monetary policy was stuck in what economists call a liquidity trap where all people want to hold money no matter how low interest rates go rather than spend. First, between 1933 and 1937 after three years of being stuck in depression the US economy grew rapidly on the back of the fiscal stimulus called the New Deal. He notes that while there was strong growth the economy didn’t go close to achieving full employment in this period. But then the conservatives (fiscal policy haters) mounted a rearguard action and peddled the inflation fears which ultimately forced the central bank to tighten monetary policy and Roosevelt tried to balance the budget. Krugman says that:

Sure enough, the economy slumped again, and full recovery had to wait for World War II.

Second, Japan in the 1990s recessed badly and then after a massive fiscal injection grew again (nearly 3 per cent GDP growth in 1996). The naysayers then emerged from their dirty little holes in the gutters and attacked the deficits and invoked the inflation scare campaign. Same old same old. The political pressure forced the Government to start focusing on the size of the deficit and increased taxes and cut spending dramatically. The inevitable double-dip followed soon after and the Japanese economy moved back into recession.

Krugman then concludes that “here we go again”. He says that the “inflation worryers are harassing the Fed”:

The latest example, Arthur Laffer, he of the curve, warns that the Fed’s policies will cause devastating inflation. He recommends, among other things, possibly raising bank’s reserve requirements, which happens to be exactly what the Fed did in 1936 and 1937.

That move was one of the reasons that the US double-dipped during the Great Depression.

In addition to the attacks on the central bank, Krugman says there is a full frontal assault now being launched on the fiscal side of the stimulus. Some want the fiscal plans to be “cancelled”.

Some, especially in Europe, argue that stimulus isn’t needed, because the economy is already turning around. Others claim that government borrowing is driving up interest rates, and this will derail the recovery.

For example, The Economist special feature; the Financial Times (especially the daily blog of Willem Buiter, who for some strange reason is influential).

Krugman then spends the rest of his Opinion piece providing a “reality check” – which I borrowed for my blog title today!

First, unemployment is very high and rising around the world – “that is, we’re not even experiencing the kind of growth that led to the big mistakes of 1937 and 1997.”

Second, “what about the claim that the Fed is risking inflation? It isn’t”

Mr Laffer seems panicked by a rapid rise in the monetary base, the sum of currency in circulation and the reserves of banks. But a rising monetary base isn’t inflationary when you’re in a liquidity trap. America’s monetary base doubled between 1929 and 1939; prices fell 19 per cent; Japan’s monetary base rose 85 per cent between 1997 and 2003, deflation continued apace.

Which is a good time to bring attention to a recent thoughtful comment from Sean Carmody. Sean wonders whether we have any examples of this level of monetary base expansion post Bretton Woods – that is, after the gold standard, convertible monetary system was abandoned and the fiat monetary system ruled! Yes, clearly. Japan!. In an effort to revitalise growth after their policy-induced double dip (noted above – the policy induced bit was because they moved away from sensible policy settings and conceded to the deficit-debt-inflation hysteria), the Japanese government ran massive deficits, issued massive amounts on Yen-denominated debt (and investors queued up for it!), but kept interest rates at near zero by not draining the full reserve add arising from the deficits with bond issues. In issuing bonds, they left just enough excess reserves in the system to let the interbank competition drive and keep the interest rate at zero. And … all the time this was happening deflation was occuring.

Interestingly, The Economist article admits the policy failure in the Japan of 1997.

A sudden fit of fiscal austerity would be a mistake. Even when economies stop shrinking, they will stay weak. Japan’s experience in 1997, when a rise in consumption taxes pushed the economy back into recession, is a reminder that a rush to fiscal tightening is counterproductive, especially after a banking bust. Instead of slashing their deficits now, the rich world’s governments need to promise, credibly, that they will do so once their economies are stronger.

I will return to this in a moment.

Krugman also considers the rising interest rate scare campaign and says of government borrowing:

All it’s doing is offsetting a plunge in private borrowing – total borrowing is down, not up. Indeed, if the government weren’t running a big deficit right now, the economy would probably be well on its way to a full-fledged depression.

You will note that I depart from Krugman here who is a relatively liberal “deficit-dove”. It is true that the public borrowing is offering safe financial assets to the non-government sector who are generally scared of losing their savings in other private (risky) investment vehicles. The private borrowing is thus providing an alternative to non-interest bearing bank reserves. But the hint in Krugman’s narrative that the borrowing is funding the deficits is clearly not correct. The borrowing is serving a monetary function – interest-rate maintenance. But the point that the net spending (deficits) are saving the real economy is valid and categorical.

Krugman also reiterates the point made above about the rising bond yields at present. He says that:

Oh, and investors’ growing confidence that we’ll manage to avoid a full-fledged depression – not the pressure of government borrowing – explains the recent rise in long-term interest rates. These rates, by the way, are still low by historical standards. They just not as low as they were at the peak of the panic, earlier this year.

So you see how an event (yield rises) that signifies growing confidence in the real economy is reinterpreted (and trumpetted) by the conservatives to signal something bad (crowding out). The reason long-term yields are rising is because investors are diversifying their portfolios again and moving back into private financial assets. The yield is a reflection of the last auction bid in the bond issue. So if diversification is occuring reflecting confidence the demand for public debt weakens and yields rise. Nothing at all to do with a declining pool of funds being soaked up by the binging government!

Further, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Say that out aloud thirty times a day when you get up and before you do anything else. Recite it. Pass it on to your children. Its what astute financial market players (not the lacky journalists) call “a wash”. The funds used to buy the government bonds come from the government!

Once you understand that you immediately see that the crowding out claim is nonsensical in a fiat monetary system. The crowding out logic goes like this. There is allegedly a fixed volume of saving out there which are available for loans and private investors are all competing for the finite funds. The price of loans then reflects the volume relative to demand! Along come the evil, profligate government who muscles in and adds to the competition which drives interest rates up and forces some productive private projects out of the market because the cost of funds becomes prohibitive.

Well there is no finite pool of saving. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.

Luigi Passinetti the famous Italian economist had a wonderful sentence I remember from my graduate school days – “investment brings forth its own savings” – which was the basic insight of Keynes and Kalecki – and the insight that knocked out classical loanable funds theory upon which the neo-liberal crowding out theory was originally conceived.

Krugman sums up his article as follows:

… A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual. These demands should be ignored. It’s much too soon to give up on policies that have, at most, pulled us as few inches back from the edge of the abyss.

Juxtapose this with the line taken by The Economist. They want the policy makers to come out with “clear principles on how deficits will be shrunk; new rules to stiffen politicians’ spines”. They want politicians to “pledge to clean up their public finances by cutting future spending rather than raising taxes.” The push now is for widespread imposition of Maastricht-like rules and “independent bodies” to oversee the conduct of fiscal policy. That is, ceding democratic responsibility to a pack of conservative economists who struggle to see beyond the last first-derivative they took while writing their last academic paper on “When do slave-owners whip their slaves?” The main answer that the paper like all the papers they write provides is: when the marginal benefit exceeds the marginal cost.

This recourse to fiscal rules as a basis for fiscal sustainability violates all the rules that underpin that concept. Please read my three part series on this – Part 1 – Part 2 and Part 3.

The Economist article says;

The next step is to boost the credibility of these principles with rules and institutions to reinforce future politicians’ resolve. Britain’s Conservative Party cleverly wants to create an independent “Office for Budgetary Responsibility” to give an impartial assessment of the government’s plans. Germany is poised to pass a constitutional amendment limiting its structural budget deficit to 0.35% of GDP from 2016. Barack Obama’s team wants to resurrect deficit-control rules … Such corsets need to be carefully designed – and Germany’s may prove too rigid. But experience from Chile to Switzerland suggests that the right budgetary girdles can restrain profligacy.

They seem to be getting kinky – fiscal corsets. In the next blog in this review of the current financial press I will consider these rules and specifically explain why Switzerland’s fiscal brake system is a nonsensical model for us to follow. A reader has asked me to explain the Swiss system and as I was just in Zurich this morning I feel I know all about the place!

More next time … and maybe re-read the introduction and then open any News Limited economic commentary these days! Fiction commenting on fiction.

Saturday Quiz

Coming as usual tomorrow.