When New is Old and just another exercise in denial

There is now a so-called “New View of fiscal policy”, which, in fact, is not all that different to the “Old View” although the proponents are hell-bent on convincing us (and presumably themselves) otherwise. The iterative bumbling along of mainstream economists, dammed by reality but steeped in denial, continues. The latest iteration comes from the Chairman of the US Council of Economic Advisors, one Jason Furman, who was supervised in his doctoral studies by Greg Mankiw at Harvard. He is also “closely linked to Robert Rubin” a classic “Wall Street insider” who was Treasury secretary under Bill Clinton and a gung-ho deregulator with a seedy past (in January 2009, he was named by Marketwatch as one of the “10 most unethical people in business”). Please see – Being shamed and disgraced is not enough – for more on Rubin. Furman’s lineage is thus not good. Furman supports free trade, social security private accounts and Wal-Mart’s labour practices which allows it to offer such low prices (for junk!) (Source). Furman is part of the core ‘Democrat neo-liberal establishment’, which received its comeuppance in last week’s Presidential election. His views on fiscal policy should come as no surprise then.

On November 2, 2016, Furman published an Op Ed on the Voxeu.org site – The New View of fiscal policy and its application – which asserts that the GFC has led to the “landscape of the fiscal policy debate” changing “over the past decade, with academics and international organisations moving away from an ‘Old View’ of fiscal policy as ineffective”.

He outlined:

… the five principles of a ‘New View’ of fiscal policy, which increasingly appreciates that expansionary fiscal policy is effective in a world of persistently low interest rates, low growth, and strong international linkages.

‘Scuse me while I kiss the sky!

To cope with what is to come, let’s take a little time out (3 minutes 20 to be exact) to enjoy one of the best guitar players of all time singing about being disassociated from reality.

I guess I should be happy that the mainstream are giving ground and finally recognising that fiscal policy is an effective policy tool after teaching students and advising politicians for three or more decades that it was not to be used to stabilise the fluctuations in the non-government spending cycle.

But when the concessions are so qualified and the rationale really just a restatement of the prior flawed theories then you can understand why I turn to Jimi Hendrix to sustain myself through the day!

Furman is correct in stating what the Old View claimed:

• Discretionary fiscal policy is dominated by monetary policy as a stabilisation tool because of lags in the application, impact, and removal of discretionary fiscal stimulus.
• Even if policymakers get the timing right, discretionary fiscal stimulus would be somewhere between completely ineffective (the Ricardian view) or somewhat ineffective with bad side effects (higher interest rates and crowding-out of private investment).
• Moreover, fiscal stabilisation needs to be undertaken with trepidation, if at all, because the biggest fiscal policy priority should be the long-run fiscal balance.
• Policymakers foolish enough to ignore (1) through (3) should at least make sure that any fiscal stimulus is very short-run, including pulling demand forward, to support the economy before monetary policy stimulus fully kicks in while minimising harmful side effects and long-run fiscal harm.

The point is fails to make is that the “Old View” never had any veracity. It constructed reality in a particular way to satisfy the ideological preference by mainstream economists against active fiscal interventions to maintain full employment.

It was in the interests of the elites to create a theory of the economy that allowed unelected and mostly unaccountable central bankers to take over macroeconomic policy – even though the mainstream construction of what they were doing was inapplicable to a modern monetary economy – for example, they claimed monetary policy was about controlling the money supply.

Please read my blogs – Money multiplier and other myths and Money multiplier – missing feared dead – for more discussion on this point.

It was in their interests to claim that increasing fiscal deficits would increase interest rates and damage the spending prospects for firms seeking to invest (the crowding out hypothesis) because it provided a powerful political point that would extend the coalition against deficits (excluding government handouts to business).

But there has never been any validity to those claims.

The ‘financial crowding out’ hypothesis, which is a central plank in the mainstream economics attack on government fiscal intervention.

At the heart of this conception is the classical theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. You will still find major mainstream textbooks teaching this stuff.

The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

At the heart of this erroneous hypothesis is a flawed viewed of financial markets. The so-called loanable funds market is constructed by the mainstream economists as serving to mediate saving and investment via interest rate variations.

This is pre-Keynesian thinking and was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving. So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

So saving (supply of funds) is conceived of as a positive function of the real interest rate because rising rates increase the opportunity cost of current consumption and thus encourage saving. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises.

Changes in the interest rate thus create continuous equilibrium such that aggregate demand always equals aggregate supply and the composition of final demand (between consumption and investment) changes as interest rates adjust.

According to this theory, if there is a rising fiscal deficit then there is increased demand is placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates to ‘clear’ the loanable funds market. This chokes off investment spending.

So allegedly, when the government borrows to ‘finance’ its fiscal deficit, it crowds out private borrowers who are trying to finance investment. The mainstream economists conceive of this as the government reducing national saving (by running a fiscal deficit) and pushing up interest rates which damage private investment.

The analysis relies on layers of myths which have permeated the public space to become almost self-evident truths. This trilogy of blogs will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3

The basic flaws in the mainstream story are that governments just borrow back the net financial assets that they create when they spend. Its a wash! It is true that the private sector might wish to spread these financial assets across different portfolios. But then the implication is that the private spending component of total demand will rise and there will be a reduced need for net public spending.

Further, they assume that savings are finite and the government spending is financially constrained which means it has to seek ‘funding’ in order to progress their fiscal plans. But government spending by stimulating income also stimulates saving.

The Ricardian Equivalence myth has been used recently in the crisis to justify the harsh austerity inflicted on Eurozone nations. It was claimed that the private sector was deliberately not spending because of government deficits as they were ‘saving’ to pay for future tax increases to pay back the deficits.

There has never been any empirical support provided for this hypothesis. When governments cut spending and push up unemployment that places a further break on non-government spending.

I discuss the Ricardian Equivalence nonsense in detail in these blogs – Pushing the fantasy barrow and The fantasy Barro(w) is still being pushed.

Finally, there has never been a valid case made for establishing “the biggest fiscal policy priority” to be “long-run fiscal balance.” This fiscal rule has never been justified.

The reality is that the fiscal balance should be whatever is required, given non-government overall saving desires, which includes the state of external balance, to achieve full employment.

I explain that in this blog – The full employment fiscal deficit condition – for more discussion on this point.

So the “Old View” was always flawed and deeply so.

The “New View” outlined by Furman is just a rescue attempt to keep the underlying credibility of ‘Old View’ economists intact after it was exposed for what it is during the GFC.

Furman lists five aspects of this so-called “New View”:

1. Furman writes: “fiscal policy is often beneficial for effective countercyclical policy as a complement to monetary policy.”

Note – fiscal policy is still seen as a “complement”. Monetary policy is still seen as being useful but constrained now in effectiveness by the low interest rate regimes.

Modern Monetary Theory (MMT) economists differ here. We say that monetary policy is typically ineffective and totally unsuited to the task of maintaining full employment and price stability.

If it works at all, it maintains price stability by creating mass unemployment.

Please read my blog – Monetary policy has to work hand-in-glove with fiscal policy to be effective – for more discussion on this point.

Fiscal policy should be the primary counter-stabilisation policy tool. Nothing in the last 30 years has changed that conclusion.

2. Furman writes: “discretionary fiscal stimulus can be very effective and in some circumstances can even crowd in private investment. To the degree that it leads to higher interest rates, that may be a plus, not a minus.”

The current literature finds that “fiscal expansion can have large positive effects” thus negating many research articles that claimed that cutting deficits was expansionary even when non-government spending was weak.

The fact is that prior studies have always been dramatically flawed in one way or another and should never have been seen as representing reliable knowledge.

However, Furman thinks the ‘newly discovered’ effectiveness of fiscal policy is because “monetary policy is constrained” and “will not partially offset fiscal policy through interest-rate or exchange-rate channels”.

This is just a version of the “Old View” with some assumptions altered. However, fiscal policy has always been effective in stimulating output. It was just a wall of lies hiding behind bizarre economic theories (such as Ricardian Equivalence) to advance the ideological attack on government activism.

Expanding deficits actually puts downward pressure on interest rates through their effects on bank reserves. The trilogy of blogs noted above explains that in detail. The “Old View” was never right.

3. Furman writes: “fiscal space is larger than generally appreciated because stimulus may pay for itself or may have a lower cost than headline estimates would suggest and countries have more space today than in the past.”

I have provided extensive critiques of the mainstream concept of “fiscal space” in the past. The mainstream believe that currency-issuing governments will run out of money if bond markets baulk at purchasing their debt instruments. That will happen, so it goes, if deficits are too large or public debt to high.

The idea is nonsensical. A sovereign government is never revenue constrained because it is the monopoly issuer of the currency. It does not need to ever borrow funds from the non-government sector.

Such a government can never run out of money.

The only reason it continues to issue debt etc is to provide corporate welfare to the elites who demand every dollar of bond they can get their grubby hands on and because the elites know they can use the ‘debt’ argument to further their attacks on government spending when they want to.

If governments used their currency-issuing capacity to spend without issuing matching debt to the non-government sector then one of the most powerful politico/ideological avenues to attack government spending would be lost. Not to mention the on-going corporate welfare in the form of a risk-free annuity in which to park liquidity in uncertain times.

The only relevant meaning to the term fiscal space is constructed in terms of available of real resources. A currency-issuing government can always purchase anything that is for sale in the currency it issues, including all unemployed labour.

So if there is mass unemployment – there is fiscal space.

That means that increasing deficit spending can be accomplished without pushing nominal spending to the point where aggregate demand outstrips the real capacity of the economy to respond to it real terms (by producing more output). In that sense, fiscal space is about the available real capacity to be brought into productive use without accelerating inflation.

Please read the following introductory suite of blogs – Fiscal sustainability 101 – Part 1 – Fiscal sustainability 101 – Part 2 – Fiscal sustainability 101 – Part 3 – to learn how Modern Monetary Theory (MMT) constructs the concept of fiscal sustainability.

4. Furman writes: “more sustained stimulus, especially if it is in the form of effectively targeted investments that expand aggregate supply, may be desirable in many contexts … Sustained fiscal policy may be necessary because the global economic climate is showing symptoms of persistently inadequate demand dragging on growth and inflation … fiscal spending creates future fiscal space through increasing government revenue and reducing the debt-to-GDP ratio.”

Furman falls back into the “Old View” mentality – that fiscal space is a financial issue that relates to currency-issuing governments running out of money.

But there is an incredible arrogance about all this “New View” stuff. Until the “Old View” came along in the 1980s (about), it was just a pile of notions that had been repudiated logically and empirically during the 1930s. Its comeback in the 1980s was not due to any theoretical breakthrough or empirical validation.

It was just a reflection of the shifting ideology towards neo-liberalism and disdain for government-induced full employment.

The dominant view after the Great Depression up until the mid-1970s, early 1980s, clearly understood that continuous government deficits were necessary to allow income support for non-government saving overall.

Continuous deficits in the Keynesian period:

(a) Sustained higher real GDP growth rates than have been the norm since the neo-liberal era (“Old View”) began.

(b) Reduced income inequality instead of the rising inequality now (which even the IMF considers undermines growth).

(c) Lower unemployment rates and virtually zero underemployment and hidden unemployment.

(d) Higher real wage and productivity growth.

(e) Higher private saving rates.

Suddenly to rediscover the need for ‘sustained stimulus’ as if this is new is just historically blind.

The reason that fiscal surpluses were possible in the recent period (where they were achieved) was largely due to the atypical non-government behaviour, characterised by the credit binge, which led to the GFC.

Now the non-government sector is trying to resume more typical behaviour, the need for continuous fiscal deficits is clear. There is nothing “New” about that to anyone who understands how the macroeconomy operates (and has always operated).

5. Furman writes: “there may be larger benefits to undertaking coordinated fiscal action across countries … Fiscal expansions can have large positive spillovers, especially when they are internationally coordinated.”

Fiscal policy expansion in one nation can stimulate exports in other countries, inasmuch as it stimulates domestic income growth, which feeds into import spending.

We always knew that. There is nothing “New” about that insight.

Conclusion

I think I will just go and listen to more Jimi Hendrix – cue up Voodoo Child!

That is enough for today!

(c) Copyright 2016 William Mitchell. All Rights Reserved.