When ‘new’ is really old and doesn’t get us very far – latest BIS paper

It takes a while for the mainstream organisations in economics, banking and finance to start to realise that the framework they use cannot explain the actual events in the real world, without serious revision. The problem though, is that the overall framework is flawed and the typical ‘response to anomaly’ approach, which changes a few assumptions to get ‘novel results’ is inadequate because it leaves one blind to all the possible policy solutions. The latest example is the Bank of International Settlements paper – Indebted Demand (released October 19, 2021) – which was written by three economists from Princeton, Harvard and Chicago Booth, respectively. They now recognise that rising inequality and massive household debt is a major problem for economic growth and macroeconomic stability. But, in maintaining ‘conventional’ assumptions about the government sector, they miss the vital linkages in the story, that Modern Monetary Theory (MMT) economists have been providing for the last 25 or so years. Whether these responses to anomaly represent progress or different variations in a flawed ‘chess’ strategy is a matter of opinion. My thought is they are a largely a waste of time, although marginally, they demonstrate that elements of mainstream macro theory that were considered core elements a decade ago are no longer sustainable.

The BIS paper authors think they have come up with something new, although if they had read the literature they would know that Modern Monetary Theory (MMT) economists have been talking about the phenomena they identify since the 1990s.

In attempting to reduce the hysteria about government debt that dominates the mainstream, MMT economists shift the attention to the public debt held by the currency-users (households, firms etc).

While mainstream economists, especially those who seek public attention with wild claims, come up with solvency thresholds (remember the 80 per cent threshold from the spreadsheet twins Reinhardt and Rogoff), MMT economists point out that the non-government sector balance sheets can reach a state of precarity, which then impacts back on private spending growth and output and employment levels.

We have been writing about the impacts of excessive private credit growth for decades.

It was obvious that governments could temporarily pursue austerity programs and introduce fiscal drag into the system as they chased fiscal surpluses if they could manage the politics of that anti-social policy strategy.

However, if the strategy to retrench the public sector was to avoid creating a major economic recession, then the government had to rely on an explosion of private credit growth to maintain household consumption spending as the fiscal squeeze was undermining it.

The strategy to suppress real wages growth over the last few decades also relied on credit growth sustaining household consumption spending.

Governments achieved that state through the financial market deregulations of the 1980s and 1990s and the lax prudential oversight that marked this period.

Remember Gordon Brown’s ‘light touch regulation’, which was, in fact, no oversight at all as the Financial Services Authority was compromised by the pressure placed on it to go lax.

The former chair of the FSA, Adair Turner, said on the release of the official report on the collapse of the Royal Bank of Scotland – The FSA’s report into the failure of RBS (October 16, 2012) – that:

In the years before the crisis we allowed the development of a financial system which was taking too many risks, in some cases doing activities that were socially useless, which had a set of remuneration structures that allowed people to make very large amounts of money …

These regulative lapses allowed the growth of non-government debt to provide cover for the fiscal austerity in terms of maintaining expenditure flows, but, eventually, it was the stock changes – the balance sheet effects – that would undermine the whole fiasco.

MMT economists wrote about this in the 1990s.

We pointed out that a growth strategy that was based on trying to record fiscal surpluses would ultimately squeeze non-government expenditure once the balance sheets became too precarious – loaded up with debt.

The increasing precariousness of the balance sheets meant that small changes in the economic and financial environment – such as a rise in unemployment, a rise in interest rates, or some other small shift – would trigger a sequence of defaults and bankruptcies, that would then feed into the real economy from the financial markets and cause a major recession.

The Global Financial Crisis was the demonstration of that sort of causality.

The point that MMT teaches us, which is not found in mainstream economics, is that fiscal policy is instrumental in creating the funding for the savings desires of the non-government sector.

If we decompose the non-government sector into the external sector and the private domestic sector, then for a typical nation that runs an external deficit, the only way the private domestic sector can save overall is if there is a fiscal deficit.

It is impossible for any other outcome to occur.

So the fiscal deficit creates the spending growth that the external deficit and the private domestic saving aspirations undermines.

In this way, national income can continue to grow and be compatible with the leakages from the income-expenditure system that the external deficit and the private domestic sector saving creates.

In that sense, the income growth arising from the fiscal injection, provides the ‘funding’ or ‘finance’ to permit the private domestic sector to save overall, and, reduce debt exposure.

During the GFC, many of the leading mainstream economists attempted to deny all of this.

Remember the extraordinary – Interview with Eugene Fama – with the New Yorker’s John Cassidy (January 13, 2010).

Fama is an economist at the University of Chicago and is most known for his work promoting the so-called – Efficient markets hypothesis – which asserted that financial markets are driven by individuals who on average are correct and so the market allocates resources in the most efficient pattern possible.

Fama told John Cassidy that the financial crisis was not caused by a break down in financial markets and denied that asset price bubbles exist.

He claimed that the collapse in housing prices was nothing to do with the escalation in sub-prime mortgages but rather:

What happened is we went through a big recession, people couldn’t make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it. As a consequence, we had a so-called credit crisis. It wasn’t really a credit crisis. It was an economic crisis.

Fama asserted that “the financial markets were a casualty of the recession, not a cause of it”.

The point was that the idea that financial market imbalances could generate economic recession was denied.

That was a common belief among mainstream macroeconomists.

The standard New Keynesian macroeconomic model – taught to students around the world, and dominant in policy circles – didn’t even have a financial sector specified, such was the belief in the efficient markets hypothesis.

And in the GFC, the attention was on public debt, with all the crazy predictions of impending insolvency, escalating bond yields and interest rates etc, that were common at the time.

So now we have the BIS paper – Indebted Demand (released October 19, 2021, but finalised on January 24, 2021).

The paper’s conjecture is that:

1. “Rising debt and falling rates of return have characterized advanced economies over the past 40 years” – they make no initial distinction between household and government debt.

They pose the questions: “How did the twin phenomena of high debt levels and low rates of return come to be? What are the implications of high debt levels and low rates of return for the evolution of the economy and macroeconomic policy-making?”

The fact that they ask these indicates a mainstream thought process is lying beneath the enquiry.

2. They think their paper provides a “new framework to tackle these difficult questions” – which might be “new” to mainstream thinkers but pretty common place for an MMT economist.

Their framework is based on:

… how rising income inequality and the deregulation of the financial sector can push economies into a low rate-high debt environment. Traditional macroeconomic policies such as monetary and fiscal policy turn out to be less effective over the long term in such an environment. On the other hand, less standard policies such as macro-prudential regulation, redistribution policy, and policies addressing the structural sources of high inequality are more powerful and long-lasting.

Effectively, borrowers are bigger spenders than lenders.

When “large debt levels weigh negatively on aggregate demand”, the interest payments to lenders to not lead to offsetting spending gains.

So “demand is depressed due to elevated debt levels” which the authors term “indebted demand”.

This is their so-called “new framework”.

Here is something I wrote – Balance sheet recessions and democracy (July 3, 2009) – twelve years ago.

Here is an earlier paper from 2002 – Fiscal Policy and the Job Guarantee – written with Warren Mosler and published in the Australian Journal of Labour Economics (5(2), June, 243-60).

The implications of the phenomena the BIS authors have ‘discovered’ is that:

… shifts or policies that boost demand today through debt accumulation necessarily reduce demand going forward by shifting resources from borrowers to savers; therefore, such shifts or policies actually contribute to persistently low interest rates … a rise in top income shares in the model shifts resources from borrowers to savers, pushing down interest rates due to savers’ greater desire to save.

They claim that monetary policy designed to deal with the fall in aggregate demand, create a vicious cycle of low interest rates, rising debt, and falling demand – so a “debt trap” occurs.

The income distribution and profit models of – Michał Kalecki – for examples, which were standard in the Post Keynesian literature after the 1930s, all assumed that income distribution would impact on aggregate spending.

The mainstream New Keynesian models all ignored that literature.

So it is interesting to see New Keynesian economists finally ‘discover’ it.

It is also interesting to see mainstream economists conclude that “An increase in income inequality … unambiguously reduces long-run equilibrium interest rates and raises household debt”, and, in turn, reduces aggregate spending and income generation overall.

Who would have thought?

And the BIS authors conclude that “Financial deregulation … unambiguously reduces long-run equilibrium interest rates and increases household debt”, and, in turn, reduces aggregate spending and income generation overall.

Gosh! Revelations.

The paper examines what all this means for fiscal and monetary policy.

This is where the wheels fall off.

They note that there has been a considerable rise in government debt and that:

… a rise in government debt exerts upward pressure on interest rates

I won’t detail their depiction of government in their model.

Suffice to say they “introduce a standard government sector into the economy” and “government spending is treated here as purchases of goods that are either wasted, or – which is equivalent” … a technical construct.

They claim that governments are financially constrained and issue debt to cover spending over taxation.

They incorporate the typical “crowding out” arguments to conclude that increased:

Tax-financed government spending and fiscal redistribution reallocate resources from the saver to a “spender”, which is either the government – in the case of government spending – or the borrower – in the case of redistribution. Such resource reallocation would raise aggregate demand were it not for an increase in interest rates.

So the “new framework is just the old one (“the model predicts conventional short-run effects of debt-financed fiscal stimulus programs”).

I have already mentioned how monetary policy exacerbates the situation – lowering interest rates, pushes up household debt, which then causes aggregate demand to fall, etc, etc.

The only policies they believe allows an economy to escape the ‘debt trap’ are “unconventional”:

For example, redistributive tax policies, such as wealth taxes, or structural policies that are geared towards reducing income inequality generate a sustainable increase in demand … One-time debt forgiveness policies can also lift the economy out of the debt trap, but need to be combined with other policies, such as macroprudential ones, to prevent a return to the debt trap over time.

So whether this sort of paper represents progress is moot.

One could conclude, as I do, that the authors have identified a major flaw in mainstream macroeconomics (absence of income inequality mechanisms in influencing aggregate spending) but then play with the standard mathematical gymnastics and conventional assumptions about government and households to grind out a convenient result.

And in doing so, they really get nowhere.

They cannot explain why the large expansion in fiscal deficits, variously in different countries at different times, have been associated with declining yields on the government debt.

They ignore the obvious role of central banks in controlling bond yields and hence related interest rates in the relevant ‘maturity range’, preferring to construct the low interest rates as somehow due to market responses to an excess of saving among high end lenders.

They fail to present any understanding of how the biases in fiscal policy, beginning the 1980s, towards surplus, squeezed the liquidity of the non-government sector, which was instrumental in the overall build-up in private debt stocks.

They fail to present any understanding of how wages suppression and the distribution of national income towards profits pressured households into increased indebtedness, in order to maintain household consumption expenditure growth.

If they had have constructed the government sector in MMT terms, rather than ‘conventional’ terms, the results they produce for fiscal policy would not hold.

It is true that the financial market deregulation is a causal factor in the increased household debt since the 1980s.

But, we also have to understand that in the context of flat wages growth and the fiscal surplus bias to get the whole picture, which, in turn, provides knowledge of the path out of the ‘debt trap’.

What the BIS paper doesn’t tie together is that the New Keynsian reliance on monetary policy to stabilise aggregate spending was accompanied by the obsession with fiscal surpluses.

The latter obsession created an overwhelming fiscal drag which squeezed households – the tax liability remained as government spending injections fell in relative (and sometimes absolute) terms.

So households were not only borrowing to the hilt under the new slack introduced in to the financial markets as the casino was opened up to all, but they were also being squeezed to borrow more to maintain their existing consumption expenditure, as wages growth flattened and governments were trying to run surpluses.

In that context, the reliance on monetary policy to address the downward pressures on aggregate spending, forced interest rates lower and lower until, now, we have negative short term rates in some jurisdictions.

It is all tied together, and the BIS authors do not see that because they maintain a ‘conventional’ model of government.

Conclusion

As the title of this post indicates – we don’t get very far with this paper.

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.