The tax extreme wealth to increase funds for government spending narrative just reinforces neoliberal framing
Despite the rabble on the Right of politics that marches around driven by conspiracies about…
Zimbabwe is the new Weimar Republic. Not! Zimbabwe is the front-line evidence that shows that government deficits will generate hyper-inflation. Not! Zimbabwe is the demonstration of the folly of a fiat monetary system. Not! Zimbabwe is an African country with a dysfunctional government. Yes!
First we should make sure what we are talking about. The right think that when the workers get a pay rise it is inflation. It is not. The left think that when the corporate sector increase the price of a good or service it is inflation. It is not. It is also not inflation when the exchange rate falls pushing the price of imports up a step. It is also not inflation when the government increases a particular tax (say the GST) by x per cent to some new level.
So while a price rise is an essential pre-condition – a necessary condition – for what we call inflation it is not a sufficient condition. That is, the observation of a price rise will be required to define an episode as being inflationary (at some point) but observing a price rise alone will not be sufficient to categorise the phenomena that you are observing as being an inflationary episode.
Inflation is the continous rise in the price level. That is, the price level has to be rising each period that you observe it. So if the price level or a wage level rises by 10 per cent every month, then you have an inflationary episode. In this case, the inflation rate would be considered stable – a constant rise per period. If the price level was rising by 10 per cent in month one, then 11 per cent in month two, then 12 per cent in month three and so on, then you have accelerating inflation. Alternatively, if the price level was rising by 10 per cent in month one, 9 per cent in month two etc then you have falling or decelerating inflation.
If the price level starts to continuously fall then we call that a deflationary episode.
Hyper-inflation is just inflation big-time!
So a price rise can become inflation but is not necessarily inflation. Many commentators and economists get this basic understanding wrong – often and continually.
Second, it also follows that cyclical adjustments in price levels by firms from what they are currently offering at depressed levels of activity to what the price levels that are defined at their normal operating capacity levels are also not sensible to consider as inflation. When the economy is in poor shape, firms cut prices in an attempt to increase capacity utilisation by temporarily suppressing their profit margins and hence maintain market share. As demand conditions become more favourable the firms start increasing the prices they offer until they get back to those levels that offer them the desired rate of return at normal capacity utilisation. Have you tried hiring hotel accommodation recently in the tourist areas? Big discounts are on offer but they will disappear once the economy improves. It is not helpful to call that inflation.
Responsible fiscal practice
Now at the risk of repeating myself a million times, this is the macroeconomic sequence that defines responsible fiscal policy practice. This is basic macroeconomics and the debt-deficit-hyperinflation hyperventilating neo-liberal terrorists seem unable to grasp it:
1. The sovereign government, which is not revenue-constrained because it issues the currency, has a responsibility for seeing that the workforce is fully employed.
2. Full employment means less than 2 per cent unemployment, zero underemployment and zero hidden unemployment.
3. The sovereign government can purchase any real good or service that is available for sale in the market at any time. It never has to finance this spending unlike a household which uses the currency issued by the sovereign government. The household always has to finance its spending (as do state and local governments in a federal system).
4. The non-government sector typically decides (in aggregate) to save a propoportion of the income that is flowing to it. This desire to save motivates spending decisions which result in the flow of spending being less than the income produced. If nothing else happened then firms would reduce output and income would fall (as would employment) and households would find they were unable to achieve their desired saving ratio.
5. The government sector must in this situation fill the spending gap left by the non-government sector’s decision to withdraw some spending (in relation to its income). If the government does increase its net contribution to spending (that is, run a budget deficit) up to the point that total spending now equals total income then firms will realise their planned output sales and retain current employment levels.
6. The government sector’s net position (spending minus revenue) is the mirror image of the non-government’s net position. So a government surplus is equal $-for-$, cent-for-cent to a non-government deficit and vice versa. So if the non-government sector is in surplus (a net saving position) then income adjustments will render the government sector in deficit whether it plans to be in that state or not. If income is falling in fhe face of rising saving behaviour of the non-government sector and that spending gap is not filled by government net spending then the budget deficit will rise (as income adjustments cause tax revenue to fall and welfare payments to rise). You end up with a deficit but the economy is at a much less satisfactory position than would have been the case if the government had have “financed” the non-government saving desire in the first place and kept employment levels high.
So a responsible government will attempt to maintain spending levels sufficient to fill any saving. You will note I have discussed this in broad aggregates (government – non-government) rather than taking the so-called leakages and injections approach which decomposes the non-government sector into foreign and domestic and considers tax, saving and import leakages against the government spending, investment and export injections. No particularly interesting things emerge at that level of aggregation which are relevant here. We get all the basic insights by keeping it simple.
Getting causality right
If we think about the Weimar Republic for a moment, the problems for them began long before the hyperinflation, which really went off in 1923. Following World War I the reparations payments required under the Versailles Treaty squeezed the German government so badly that they eventually defaulted. The Treaty was just a bloody-minded pay-back by the victors of the war and brought so much subsequent grief to the World in the 1939-1945 War that you wonder what was going on in their heads.
Anyway, for historians, you will recall that the French and Belgian armies then retaliated after the German default and took over the industrial area of the Ruhr – Germany’s mining and manufacturing heartland. The Germans, in turn, stopped work and production ground to a halt. The Germans kept paying the workers in local currency despite limited production being possible and you can imagine that nominal demand quickly started to rise relative to real output which was grinding to a halt. The crunch came when the export trade stalled and the only way the German Government could keep paying their treaty obligations etc was to keep spending. The inflation followed.
But think carefully about the causality here – it was not a normal situation at all where a sovereign government was trying to finance the saving desire of the non-government sector and keep employment and output levels high.
I sketched the following simple diagram to give you an idea of what might go on when a severe supply shock (contraction) occurs. It is not perfect but makes the point (you have to impose your own dynamic motion on the chart). The horizontal axis is real output and full-employment potential output is shown by the vertical green line (inferring no bio-unsustainable production levels!) The vertical axis is spending or demand in real terms. The trick is that the price level is held constant in this diagram. The 45 degree line is the fixed-price aggregate supply curve indicating that firms will supply whatever is demanded at the fixed price up to capacity (Point A). After A, supply capacity would be exhausted and inflation would then enter the picture.
The red line (top) which intersects Point A is the aggregate demand line and shows the current state of spending in the economy at different real income levels. It is upward sloping because consumption rises with national income and it is less than 45 degrees because not all income is consumed (some saving). So it is the sum of all demand components (consumption, investment, net exports and government spending).
If we assume that shangri la prevails then we are initially at Point A. There will be full capacity output, stable prices, some non-government saving and a budget deficit to match.
Now imagine that some dictator comes along and starts taking land off the original farmers (who were productive) and gives it to those who do not understand how to farm or have no real interest in farming, in this primarily agricultural economy. The potential output would steadily contract and I have shown a particular revised potential line (a contraction of the overall capacity of the economy to produce).
If you think about current demand levels in relation to that new dramatically reduced supply potential you quickly see there is a huge excess demand (spending) measured by the gap between Points B and D. But, in fact, as the income levels fall, the economy would actually contract along the top red aggregate demand line (as income falls, so does consumption and saving). At Point C there is still excessive demand (spending) in relation to the new potential capacity.
So demand would have to be reduced downward (red line shifting down) until it intersected the new supply constraint at the 45 degree line at Point D. Point C could theoretically be associated just as much with a budget surplus as a budget deficit – that is, you cannot directly implicate the conduct of fiscal policy with the excess spending automatically or even necessarily.
The upshot is that the price level would be rising in this economy long before it reached Point D from Point A because of the chronic excess spending relative to the dramatically lower capacity.
The hyperventilators out there in debt-deficit hysteria land have been increasing using Zimbabwe as their modern equivalent of the Weimar Republic and as the front-line attack dog in their squawking campaign to get rid of deficits again. The problem is that they clearly have not read much history nor analysed Zimbabwe very well at all.
It is obvious that the nice coloured Zw currency has steadily been debased and replaced by notes with more and more noughts on the end of the 1.
So what went on? The Zimbabwean Government is sovereign in the Zw dollar, although recent decisions to allow US dollars to freely trade within the economy is likely to undermine that sovereignty if tax collections in Zw become difficult to achieve.
In the same way that the Treaty of Versailles was directly responsible for the plight that Germany found itself in during the 1920s, the white racist regime that ruled prior to 1980 and which had broken away from the colonial arrangements with Britain, set up the conditions that are now destroying Zimbabwe. White minority rule in Colonial Africa created such an unfair sharing of land between the whites and blacks that a backlash was always going to occur. The same sort of breakdown will threaten South Africa which is trying to reinvent itself (peacefully) in the post Apartheid era (not very successfully may I add).
Whites who constituted 1 per cent of the population owned 70 per cent or more of the productive land. After the civil war of the 1970s and the recognition of independence in 1980s, Mugabe’s government more or less oversaw relatively improved growth with stable enough inflation outcomes.
In this World Bank Report 1995 you see the data shows that the economic performance was variable but reasonable. The economy underwent a severe drought in 1992-93 which pushed the inflation rate up but it soon came back to usual levels.
The following graph is of GDP growth since independence in 1980 to 2007 (data from IMF). The performance up until about 2000 provided no sign of the disaster that has followed. GDP growth looked to be like many other nations – variable and usually positive except for the harsh drought in 1992-93.
The problems came after 2000 when Mugabe introduced land reforms to speed up the process of equality. It is a vexed issue really – the reaction to the stark inequality was understandable but not very sensible in terms of maintaining an economy that could continue to grow and produce at reasonably high levels of output and employment.
The revolutionary fighters that gained Zimbabwe’s freedom from the colonial masters were allowed to just take over productive, white-owned commercial farms which had hitherto fed the population and was the largest employer. So the land reforms were in my view not well implemented but correctly motivated.
Like the allies after Versailles, you sometimes do not get what you wish for. The whites in Zimbabwe had always been reluctant to share with the majority blacks and ultimately reaped the nasty harvest they sowed.
From an economic perspective though the farm take over and collapse of food production was catastrophic.
Unemployment rose to 80 per cent or more and many of those employed scratch around for a part-time living.
So the land reforms represented the first big contraction in potential output. A rapid demand contraction was required but impossible to implement politically given that 45 per cent of the food output capacity was destroyed.
The situation then compounded as other other infrastructure was trashed and the constraints flowed through the supply-chain. For example, the National Railways of Zimbabwe (NRZ) has decayed to the point the capacity to transport its mining export output has fallen substantially. In 2007, there was a 57 percent decline in export mineral shipments (see Financial Gazette for various reports etc).
Manufacturing was also roped into the malaise. The Confederation of Zimbabwe Industries (CZI) publishes various statistics which report on manufacturing capacity and performance. Manufacturing output fell by 29 per cent in 2005, 18 per cent in 2006 and 28 per cent in 2007. In 2007, only 18.9 per cent of Zimbabwe’s industrial capacity was being used. This reflected a range of things including raw material shortages. But overall, the manufacturers blamed the central bank for stalling their access to foreign exchange which is needed to buy imported raw materials etc.
The Reserve Bank of Zimbabwe is using foreign reserves to import food. So you see the causality chain – trash your domestic food supply and then have to rely on imported food, which in turn, squeezes importers of raw materials who cannot get access to foreign exchange. So not only has the agricultural capacity been destroyed, what manufacturing capacity the economy had is being barely utilised.
Further, goods and services have also been prevented from flowing in via imports because many importers abandon goods at the border when they are hit by exhorbitant import duties.
Taken together, the collapse of production has seen the unemployment rate rise to 80 per cent or more. The rising unemployment has further choked any household income growth and aggregate demand has fallen even further.
As a consequence, GDP growth has been contracting at around 7 or 8 per cent per year and the economy’s potential capacity level has been falling dramatically as investment dries up.
Further, the response of the government to buy political favours by increasing its net spending without adding to productive capacity was always going to generate inflation and then hyperinflation.
But while the hyperinflation was almost inevitable it provides no intrinsic case against a government that is sovereign in its own currency and who runs permanent deficits to pursue full employment – under the guidelines specified above – responsible fiscal management.
When you so comprehensively mismanage the supply side of your economy as the Zimbabweans did the only way to avoid inflation is to severely contract real spending to match the new lower capacity. More people would have starved and died than already have if the Government had have cut back that severely.
But this disaster has nothing much to do with budget deficits as a means to ensure high levels of employment in a growing economy (where capacity grows over time) where the non-government sector also desires to save. A private sector investment boom would have caused the same outcome both in inflation and the political problems of fighting it. So will the hyperventilators also say we should not have net private investment?
The historical context is important to understand because it created the political circumstances which have made the hyperinflation inevitable. But these historical vestiges from the colonial white-rule bear very little relevance to the situation that a modern sophisticated fiat monetary system will face.
So hyperventilate as you like but Zimbabwe does not make a case against the use of continuous budget deficits in defence of full employment.
Bad Governments will wreck any economy if they want to.
A wise government using the fiscal capacity provided to it by a fiat monetary system can engender full employment and equity yet also sustain price stability.