It’s Wednesday and also a holiday period, so just a few things today. First, I discuss a research paper that has concluded that central bankers have been using the wrong model for years which has resulted in flawed estimates of the state of capacity utilisation, and, in turn, created excessive unemployment. Second, we have a…
The piper will call if surpluses are pursued …
News Limited is still (mis)leading the way on the deficit-debt attacks. In another appalling piece of misrepresentation and erroneous reasoning, The Australian ran a story from its economics chief, Michael Stutchbury today entitled Now comes time to pay the piper. This newspaper has really excelled in recent months in the lengths it has gone to mislead and lie to its readers on matters relating to the macroeconomy and the conduct of fiscal policy. There will be a piper to pay – that I agree – but it will be because the federal budget deficit is not large enough right now rather than because it is too high.
First, some background. In Saturday’s Fairfax papers, the Australian PM released his 6098 words essay outlining how this Federal Government has chosen to continue the abandonment of full employment and impose huge costs from the cyclical downturn on the most disadvantaged workers and their families in our communities. Cruddy … to say the least. I plan to write separately about this essay. But in this blog I am just mentioning it because Stutchbury builds on it.
The PM’s essay starts by detailing what he claims are the cause of the current financial crisis. The usual suspects – “living beyond our means” (tell that to the millions who are starving around the World and the unemployed who cannot get a job) – the “long, debt-fuelled shopping spree” – “skyrocketing asset prices” (the Australian Government’s own central bank – the RBA – berated anyone (like me) who dared say in the 1990s that the debt build up was being backed by increasingly volatile assets) – “Weak financial regulation” – etc.
Then you read this extraordinary statement:
The final layer of the house of cards was the huge volume of money funnelled from China, Japan and the Middle East to Western banks and governments. Cheap savings from the East flooded into the West to finance ballooning deficits. From 1999 to 2006 the US current account deficit more than tripled, from $US63.3 billion to $US214.8 billion, balanced by huge surpluses in other countries, especially China.
This erroneous reasoning is fast becoming entrenched as another of those “self-evident” neo-liberal truths. You know the type of statement they just expect you will accept without question and when you dare ask them to explain it they look down with disdain as if you are some sort of cretin or something. The trouble is that they cannot even explain it themselves in a way that is consistent with the way the modern monetary system operates.
First, in each of the budget deficit countries (where the currency is not convertible and the exchange rate flexible), the national government is not revenue constrained. So the concept of “financing” net government spending is inapplicable. Households need to finance their spending – sovereign governments do not.
Second, these so-called ballooning deficits are all denominated in the currency of issue in the respective countries. Take the US as an example. The US Government spends in $US. It does so by crediting bank accounts (using electronic delivery systems) or writing cheques. The US dollar is the sole creation of the US Government just as the Chinese Government, for example, is the sole issuer of the Yuan. So it would be impossible for the Chinese to finance US Government spending in US dollars.
So what this twisted logic is trying to get to is the story that the Chinese trade surpluses with the US (for example), generate holdings of US dollars which are then used, in part, to buy US Treasury bonds. The mistake is then made that these bond sales by the US Government provide it with increased capacity to run deficits. Accordingly, as the trade surpluses grow, so do the Chinese holdings of US bonds and hence they have been increasingly unwriting the “over-consumption” of the US Government.
Well wrong … and wrong.
I have dealt with the trade issue previously – see my blog Debt is not debt! – where I explain the following statements:
- exports are a cost – we have to give something real to foreigners that we could use ourselves – there is an opportunity cost borne by us.
- imports are a benefit – they represent foreigners giving us something real that they could use themselves but which we benefit from having. The opportunity cost is all theirs!
- So, on balance, if we can persuade them to send more ships filled with things than we have to send them in return (net export deficit) then that is a net benefit to us. I abstract here from the valid arguments that say we cannot measure welfare in a material way.
- If we run a current account deficit with China (using Australia and China as an example) then the Chinese are giving up more real things than they get from us. So the current account deficit “finances” their desire to accumulate net financial claims denominated in $AUDs. The standard incorrect conception is that the foreigners finance our profligate spending patterns. In fact, our trade deficit allows them to accumulate these financial assets (claims on us). We gain in real terms – more ships full coming in than leave! – and they gain in terms of achieving their desired financial portfolio. Win-win.
- If they change their desire to accumulate financial assets in our currency then they will become unwilling to allow the “real terms of trade” (ships going and coming with real things) to remain in our favour. Then we have to adjust our export and import behaviour accordingly. If this transition is sudden then some disruptions can occur. In general, these adjustments are not sudden.
These statements lead to the following juxtaposition:
Neo-liberal myth: Australian consumers have to borrow $billions from foreigners to keep consuming
Modern money reality: Australian consumers are funding $billions in foreign savings (accumulation of $AUD-denominated financial assets by foreigners).
It is through this route that foreigners can gain access to the domestic currency and, in turn, use that currency to purchase things denominated in it (including financial assets).
In the blog (Debt is not debt!) I provide a transaction-by-transaction analysis of the implications of all of this.
The point of importance in the context being discussed here is that this build-up of US or Australian Government debt in the hands of foreigners presents no particular problems to the US or Australian economy quite apart from the fact that the debt was voluntarily issued in the first place and of no consequence to the ability of the respective governments to spend (in their own currencies) whenever they chose.
To really understand how the public component of the “national debt” is paid off you have to understand the operational mechanisms. Most commentators (and politicians etc) who make statements about these sorts of things haven’t the slightest conception of how the accounting transactions actually unfold.
What we call money and what we refer to as Government debt are really just numerical entries that appear in the government accounting structure. If a commercial bank buys a government bond (on behalf of the Chinese Government) then the monetary system records the following impacts.
When the government bond is sold to the bank, the Government debits the commercial bank’s account with the Government (used to transact government bond sales and purchases) – that is, reduces the amount in that account. Simultaneously, the Government credits the commercial bank’s bond asset account held with the Government for the same amount – recording that the bank now holds $x worth of government bonds.
These transactions are just electronic adjustments to numbers in the accounting system. One number down (the debit) the other up (the credit). Nothing real is transferred (other than a piece of paper telling the commercial bank that it holds some bonds now – that is, an official receipt is provided).
The transaction provides the government with no greater capacity to spend. Anytime it wants to spend it just credits whatever relevant bank account it wants in the private sector) to signify it has spent $AUD.
Now think about bond repayment day – the day the bond matures and its face value and interest has to be paid in full. What happens? Well the sky doesn’t fall in that is for sure. The government doesn’t ring the children of the past up and demand they pay money back to cover the public spending their parents enjoyed in the past. That is for sure – the kids of the past don’t have to cough up.
What happens is so ridiculously simple that you wonder what the fuss is all about. The Australian Government would once again make two electronic adjustments to the accounts – one up and one down.
They would debit (reduce) the commercial bank’s bond asset account held with the Government by the value of the bonds being repaid. They would credit the commercial bank account held at the Government to record bond issue sales by the same amount. Once done – two keystrokes – the debt is repaid – nothing real changes hands (except for another bit of paper sent by the Government to the Chinese representatives that they no longer hold the bonds).
Interest payments are similarly handled – nothing real is involved.
So it is this context that we should try to work out what Stutchbury, Economics editor for The Australian is on about in his latest commentary.
He starts of with the usual call to hysteria. How many different ways they can contrive to scare the hell out of us is surely becoming a challenge to them. They are not up to it clearly because it is the same message every time. So trying to encapsulate the message from our PM in his essay, Stutchbury says:
HIGHER interest rates and rising unemployment. “Increased economic pain” and “unpopular budget cuts”. “Additional financial pressure on many families” and even “sacrifice”.
The stunning rhetorical retreat to austerity has been forced by the reality that Labor has run out of rope – and money – in trying to protect working families from the global recession.
Hell on Earth it seems is coming.
It is true that the Australian Government might have run out of rope – we would have to check with the relevant inventory clerk who maintains the records to see if their rope stocks have been depleted. I wouldn’t care to speculate. I doubt that this will give them very few problems though because with sales flat in the boating industry I am sure there is plenty of rope out there that the Government can purchase if it actually needs some.
And the point is – of-course – that the national government can buy whatever is currently for sale at any time there is stuff for sale. So it might have run out of rope but it can never “run out of money”.
A sovereign government which issues its own currency – can never run out of that currency.
I guess what Stutchbury is trying to do is put pressure on the Government to “voluntarily” impose spending limits on itself. That is quite a different thing to saying that the government has reached its financial spending limit. There is no financial limit on a sovereign government.
Note here I use the term “financial limit”. This is a logical construct. A household (or a private firm) clearly has a financial limit beyond which its spending cannot go (because it runs out of saving; sells all other assets; cannot borrow anymore etc). But the government could go on spending forever if it was stupid enough to drive nominal spending (aggregate demand) beyond the economies real capacity to increase output – and then drive it further into inflation and then hyper-inflation. It could do that which makes it different to a household.
The operational limit is the real capacity of the economy. A sensible fiscal policy will ensure that aggregate spending laps up against that real capacity. That is the way to ensure high levels of employment are achieved and sustained.
Stutchbury clearly doesn’t understand or chooses to deliberately mislead his readers about this.
He then outlines the ways in which we have so far we avoided the worst of the global recession (which I have some agreement with).
But then he says by way of warning that:
Partly because the budget and interest rate stimulus has been so front-loaded, Australia could be one of the few economies where the first half of 2009 will be stronger than the second half.
The economy could still go backwards over the rest of the year before picking up next year.
The imminent problems we face are (quotation marks denote Stutchbury):
1. “Lower contract prices for iron ore and coal exports” which will hit us in the coming months (I agree).
2. “With no more cash handouts and unemployment trending higher, family incomes, and hence consumer spending, will be squeezed” (I agree).
3. “Young homebuying couples could be exposed if one of them loses their job” (I agree).
4. “With Canberra removing the first-home buyers subsidy, that could prick the emerging bubble in lower-end housing prices, leaving some couples in a financial jam” (I agree).
So what do we conclude from those dangers? For anyone trained in macroeconomics, these imminent problems will manifest quite obviously in falling aggregate demand – falling spending for goods and services. It is obvious that output will fall in the face of declining spending if nothing further is done to offset the decline.
Here we go back to the Krudd essay. The PM says:
… the Government’s strategy to return the budget to surplus will involve some painful and unpopular decisions that will affect many Australians. As the private sector was in retreat last year, the Government acted responsibly to step in and stimulate the economy through an expansion of the budget. But in the recovery phase, the opposite will be true as the Government appropriately withdraws while the private sector expands.
First, the automatic stabilisers (rising tax revenue and falling welfare outlays) will ensure that the budget deficit is reduced if the national economy recovers as private spending rises. The Australian Government doesn’t have to do anything for that to happen.
Second, will the economy exhibit any substantial recovery. Those 4 imminent problems outline above (the rising unemployment being the most alarming) will undermine private spending which will, in fact, drive the budget deficit higher via the same automatic stabilisers working in reverse (falling tax revenue and rising welfare payments).
While the $77 odd billion federal intervention has helped to put a floor under the downturn – as its impact dissipates and the four imminent problems start asserting themselves – Stutchbury is correct – we are heading for a worse second-half than the first-half.
Remedy? The last thing the Government should do now is start “cutting” its net spending to fulfill some grossly ill-informed strategy to get back into surplus. What all this is telling us is that another stimulus package is desperately required and this time it should be 100 per cent targetted at direct public sector job creation in green areas of activity. The Federal Government should not allow one single person to be added to the jobless queue.
They have the fiscal capacity to achieve that goal. The fact they are talking cut-backs now and listening to the squawk from the journos like Stutchbury – that they have “run out of money” – is testament to their desire to allow unemployment to rise and allow long-term unemployment to become entrenched.
The federal government chooses the unemployment rate – if it rises then the government has chosen it to rise. There is nothing more clear than that in macroeconomics. It can always employ idle labour productively given its fiscal capacity. With so much idle labour available at present (and rising) the purchase of all of it by government would place no inflationary pressures on the economy. We are way off reaching an inflationary gap position.
So when I read the heading “Time to pay the piper” I thought about it in this way. The piper will we pay is that associated with the rising unemployment and lost opportunities to create public spaces and replenish the planet using the idle labour left abandoned by deficient private sector spending (as they scurry to save and reduce the precarious nature of their balance sheets) and failed policy settings in the past (the obsessive surpluses).
We will pay that piper in lost opportunities to defend the standards of living of the workers who become and remain unemployed – of the workers who are enduring rising underemployment only if the federal government abandons their responsibilities to use its fiscal capacity responsibly. Responsibly means to increase the deficit to offset the declining private spending.
When non-government sector spending is contracting – then there is only sector left to remedy the problem – you guessed it – the government sector via increasing budget deficits.
This Post Has 10 Comments
After 7 straight years of ever increasing federal budget surpluses, I imagine that the private sector must not have been all that far from reaching the limits of it’s capacity to continue growing through running down savings and running up debt, had the GFC not hit first.
So we’re already running close to the edge I suppose. I wonder how long it will take for a return to surplus to push us over from this point.
Trying to run a surplus now with the private saving ratio rising quickly would cause a rapid contraction. There is no way they can run 11 years of them with the amount of private debt already in the system.
The thing that struck me about the Rudd essay was the failure to link public sector surpluses with rising private indebtedness.
His economic advisors seem to have forgotten the simple circular flow of income models from Macroeconomics 101?
I’m also seeing hints of Steven Keen in Rudd’s analysis.
I’m look forward to your in depth take on the essay when it arrives.
‘So it would be impossible for the Chinese to finance US Government spending in US dollars.’
I believe they can and they have been. When US is running a trade account deficit to China, more US dollars are going to Chinese businesses than YUAN to america. The US dollars are then converted to the YUAN. However, instead of getting fair exchange rates, whereby the YUAN should appreciate vs the USD after prolonged deficits(making chinese goods more expensive(less competitive) and thus balancing the trade deficit, the CHinese government intervenes and performs what is widely know as sterilisation with the influx of USD. Simply put they forcibly exchange a set amount of YUAN for all the USD based on government determined ‘pegged’ values ie. they accept USD and just magically credits the business accounts with YUAN. This creates inflation but it also keeps chinese goods ridiculously cheap overseas and therefore creating more manufacturing jobs in china.
So now the chinese government is sitting on loads ( hundreds of billions of USD ), they can either spend it through buying assets like foreign resources, companies or BUY US TREASURIES. The very bonds that the US government is selling to fund their balloning budget.
The key here is that the chinese are running these surpluses and manipulating their currency because it keeps their GDP growing really fast and creating a lot of jobs by being the manufacturing hub of the world and not because they love the US or that they think the US bonds are a great fiancial asset.
It’s not good for the US to run up a huge deficit because the bonds(IOU) also carry a coupon which needs to be serviced. It’s like a mortgage or any other loan. Sure the US government can simply roll over the bonds by making more bonds. BUt is the really wise to be paying interest on the interest.
‘A sovereign government which issues its own currency – can never run out of that currency.’
That’s true. But they can really screw up the value of 1 unit of currency and the Rating of the countries’ debt, making government funding really really expensive.
Please point out anything u disagree with what i just wrote
1. Governments can screw up the value of their own currency – agree. But only if they act in extreme ways. Continuous budget deficits per se are not such extreme events depending on the saving desires of the non-government sector.
2. ratings agencies are irrelevant to a sovereign government – just ask Japan which over the last 15 or so years has had multiple downgrades, huge deficits, huge debt issuance, zero interest rates, deflation.
3. Sovereign governments do not have to borrow a cent!
The Chinese government cannot finance US government spending which is in US dollars.
Further, if the US government didn’t borrow a cent what do you think would happen to its outlays? Well they would still be out there buying stuff.
All the rest of your analysis is okay but doesn’t make the point you want it to.
Bill, I see that Sinclair Davidson argues that following the premiers plan, GDP growth and employment swiftly began to recover in Australia as government expenditure was slashed by 20%. He (as I expect you are aware) also argues that the new deal stalled and slowed recovery in the US. He presents a series of graphs as “evidence” although he does not give the source. I did not understand his argument that the new deal hampered recovery, as he presents one graph supposedly proving that it did – after he has already presented another graph showing rapid US recovery in the period immediately after the new deal was enacted!
I can post a link if you like, but what’s your take on this? It seems counter-intuitive to me that slashing government spending by 20% could kick start a seriously stalled economy into growth. Unless there is more to the story that he is not telling – which I have no doubt is the case.
Some more digging seems to suggest that overseas creditors demanded that expenditures be cut in order for Australia to continue recieving finance.
So they cut expenditure in order to get money which they then spent?
There was no fiat monetary system back in those days so they couldn’t simply issue currency at will.
What I’m reading here seems to say that they briefly flagellated the country in order to satisfy creditors in order to get more money to spend, which would hardly be indicative of proof that fiscal strangulation led to recovery.
I’ll keep researching.
No. It’s like searching for a needle in a haystack. Thousands of volumes of parliamentary records and other stuff.
But if Davidson is correct that Australia began a v-shaped recovery soon after government spending was slashed then I am curious to know why, since I subscribe to the veiw that the opposite should be the case.