I have been travelling for most of today so I have to keep this post…
This week’s Economist Magazine (print edition) is running a story Making fiscal policy credible – Bind games, continues the mounting conservative push for governments to return fiscal conduct back to the days before the crisis. The conservatives (except the really loopy ones) are begrudgingly being forced to recognise that the fiscal stimulus packages have saved the World economy from a total disaster. But after taking a deep breath they get back on track with the “debt is bad” “surplus is good” mantra that got us into this mess in the first place.
The article comes with the sub-heading “Can governments bolster confidence that they will act to prevent a debt spiral?” which tells you immediately, by construction, that the article has nothing to disseminate but misunderstandings and worse about the way the fiat monetary system operates.
We can see this article in the context of the latest news from the OECD. They have just released their latest Composite Leading Indicators, upon which they conclude the following:
OECD composite leading indicators (CLIs) for July 2009 show stronger signs of recovery in most of the OECD economies. Clear signals of recovery are now visible in all major seven economies, in particular in France and Italy, as well as in China, India and Russia. The signs from Brazil, where a trough is emerging, are also more encouraging than in last month’s assessment.
The CLI attempts “to indicate turning points in economic activity approximately six months in advance”. The OECD say that the “OECD CLIs are constructed from economic time series that have similar cyclical fluctuations to those of the business cycle but which precede those of the business cycle. Typically movements in GDP are used as a proxy for the business cycle but, because they are available on a more timely and monthly basis, the OECD CLI system uses instead indices of industrial production (IIP) as proxy reference series. Moreover despite their tendency towards higher volatility historical turning points of IIPs coincide well with those of GDP for most OECD countries.”
You can read more about how the CLI is constructed via this Methodology paper.
The following graph is taken from the latest OECD Composite Leading Indicators and is for the overall OECD block of countries. The shaded areas are observed growth cycle downswings (measured from peak to trough) in economic activity.
To provide some comparative analysis I assembled the following graph from the CLI. I took the peak index value prior to the current recession for the representative countries shown and made that the base value (= 100) of a new index and then constructed it to July 2009 (the latest observation). The peaks are: Australia (Nov 2007); Japan (Jan 2007); United Kingdom (August 2007); USA (July 2007); The four big European economies (Sep 2007); China (Mar 2008), and India (Dec 2007).
Apart from being nice to look at, you can see the vastly different response to the downturn across the countries shown. China showed signs that it was coming out of the crisis very quickly whereas the trough for the European-Big-4, India, the UK, and Australia more or less coincide about 6 months after China was turning. The US economy then turned according to this in Month 20 of its downturn, 9 months after China turned (relative to the respective starting points). Japan bottomed out in Month 26 of its downturn. So all of the major economies shown are not indicating that GDP will be growing over the next 6 months.
What I concluded from this graph is that it is clear that the automatic stabilisers and the discretionary stimulii interrupted a very serious event. The size and targetting of the stimulus packages (a separate blog is coming on this issue) are highly related to the shape of the recession trajectories shown by the CLI.
The Economist article also thinks that at the anniversary of the Lehman Brothers collapse:
… the world economy is turning the corner … [but] … Policymakers are cautious and in no hurry to withdraw stimulus.
But with the worst behind us, the Economist claims that:
… officials are under increasing pressure to explain how they will reverse course when the time comes. That task is particularly hard when it comes to the public finances. Fragile economies need support from fiscal policy, but it is harder for finance ministries than central bankers to promise credibly to be strict in future when they are so liberal today.
So you get the drift.
First, the severity of the crisis is measured in this construction by the output cycle rather than the labour market cycle. It is the latter which affects real people and takes longer to resolve. But the mainstream economic emphasis is always on the GDP cycle. Once it has turned and output resumes growth it is time to batten down the policy hatches and get the public budgets back in surplus as soon as possible.
Second, the notion of “policy credibility” is often used by the mainstream as the benchmark but rarely is this notion given any credibility itself. Who are th judges? Well, you can guess. It is the financial markets that matter because apparently they can force higher interest rates on the economy and push a double-dip recession onto all of us. More on that later.
The Economist article then makes the astounding claim that:
Scarcely any rich country has stable public finances. America’s public debt is expected to double as a fraction of GDP by 2018. Britain faces many years of budget deficits and a rising debt burden. There is no end in sight for deficits in the rest of Europe either. An obvious danger of large and persistent deficits is a loss of faith in governments’ ability to cap the rise in debt. If bond markets become concerned that governments could default or inflate away their debts, interest rates would jump, choking off recovery.
There are those amorphous bond markets that have to be satisfied!
What do they mean by stable? The inference is that there is a solvency risk attached to the public debt which regular readers will understand is impossible from a technical sense. A specific government may default voluntarily for political reasons but that has nothing to do with their capacity to service and repay any level of public debt.
Further, there is the imagery that persistent deficits are unstable and will undermine the credibility of the governments in question. We have a recent demonstration that this is nonsensical – Japan. You may also like to read the blog – Japan – up against the neo-liberal machine. Both of these blogs provide modern testimony that persistent deficits are in fact necessary as long as the non-government sector are intent on net saving in the currency of issue.
But taking a longer view of history you may want to read this blog – Some myths about modern monetary theory and its developers, which shows how long-term deficits in the US were never unstable. In Australia, the federal deficits persisted right through the high growth period which supported positive private sector saving ratios. Conversely, the period of budget surpluses was accompanied by increasing private sector indebtedness and dis-saving. The latter period set up the conditions for the current crisis around the world.
What the Economist article fails to acknowledge in its mainstream ranting is that if the non-government sector is to save then the government sector has to run fiscal deficits to finance that saving and maintain high levels of output and employment.
Trying to assess the sustainability of a fiscal position without any reference to the saving intentions of the non-government sector nor the capacity utilisation rate and its impact on the labour market shows how narrow and misguided their analysis is. You might like to read the following blogs to gain a better understanding of how to assess fiscal sustainability – Fiscal sustainability 101 – Part 1, Fiscal sustainability 101 – Part 2 and Fiscal sustainability 101 – Part 3.
In the last of that trilogy I concluded that:
But in defining a working conceptualisation of fiscal sustainability I have avoided … very much analysis of debt, intergenerational tax burdens and other debt-hysteria concepts used by the deficit … [terrorists] … They are largely irrelevant concepts and divert our attention from the essential nature of fiscal policy practice which is to pursue public purpose and the first place to start is to achieve and sustain full employment.
The other question that the Economist article author and all the mainstream analysts have to answer is why didn’t the “bond markets” lose faith in Japan as it was issuing massive amounts of Yen-denominated debt each day to match the huge daily injections of net financial assets (Yen-denominated) via the national budget deficit?
Why didn’t bond markets consider that eventually the deficits would have to be inflated away to overcome solvency issues and why didn’t interest rates junpt as a consequence choking recovery? There was a double-dip late in the 1990s in Japan because the deficit-terrorists forced the government (via political pressure) to cut the fiscal stimulus back. Once the government realised their error, the stimulus was expanded and growth returned. Interest rates stayed zero (overnight) and low (investment instruments) and inflation continued to deflate.
The only danger for countries at present is that they will choke off their recovery by withdrawing the fiscal stimulus packages before the labour market has recovered.
The Economist article then offers some suggestions as to how governments should maintain credibility. They say:
One way to bolster trust would be to put fiscal policy on the same footing as monetary policy, by outsourcing budgetary decisions to independent councils with a mandate to preserve fiscal solvency.
So the maintream economists now want to usurp democracy even further – they the “defenders of freedom” – and place both arms of aggregate policy into the hands of unelected and unnaccountable officials.
You might like to read my blog – Fiscal rules going mad – to see what a disaster this would be.
Further, if you think about this suggestion, it is not just the assault on our democracies that is of concern. It also makes no sense at all. What does “a mandate to preserve fiscal solvency” mean?
An understanding of the fiat monetary system will immediately tell you that this requirement would not define any feasible situation where the deficit should be limited. Why? Because the national government, which issues the currency, is always solvent!
So by failing to recognise that the commentary is meaningless. In reality, the conduct of fiscal policy has some strict limitations for sustainability which I outline in detail in the trilogy of articles linked above.
In short, fiscal policy has to aim to achieve public purpose – full employment – and in doing so, maintain nominal spending growth in the economy in line with the growth in the real capacity of the economy to absorb that expenditure. Otherwise, inflation becomes the problem once employment is maximised.
If the mainstream understood that the debate would become more productive. We would not be calling for cut-backs in government spending unless we were convinced that the spending gap left by non-government saving was approaching a state we might call “over-filled” by public net spending. One way to quickly assess that state is to estimate the extent of labour underutilisation.
Labour underutilisation is high in all countries at present which means there is more room for fiscal expansion not less. Once the private sector spending resumes the automatic stabilisers will reduce the fiscal position anyway.
To see that these processes are already in train, a report in yesterday’s Sydney Morning Herald told us about the Budget windfall from economy. The article by Josh Gordon said:
Australia’s recession-defying economy looks set to deliver the budget a massive $17 billion annual cash windfall, slashing the likely size of the deficit and level of public debt by up to a third … Amid growing optimism about the outlook for the economy, private sector economists predict the Federal Treasury will be forced to sharply upgrade its budget forecasts when it releases updated figures this year.
As if anyone who understands what is going would be surprised by this. The Economist commentator, however, understands very little about these things.
They suggest that if governments do not want to go the sensible path of adopting fiscal rules or hiving off fiscal policy “to technocrats” they could adopt a ” fiscal council … [to] … monitor compliance with a budget-balance target” (such as in Chile, Hungary, and Sweden).
For Chile they “pledge to run a budget surplus of 1% of GDP over the business cycle”, which means that they pledge to drive the non-government sector into deficit of 1 per cent of GDP over the business cycle. This is not a sustainable position to adopt and will soon see the public budget balance back into deficit with rising unemployment to support.
The Economist article then suggests that:
.. procedural rules, such as a cap on public-sector pay growth … or a “pay-go” rule that says new spending schemes have to be funded by tax increases or cuts in other programmes … [are sensible options]
They are in fact nonsensical voluntary contraints imposed by the national governments on their ability to achieve full employment and price stability. These rules bear no relation to the net spending levels that would be required to support non-government saving at high pressure levels.
The Economist article then quotes some mainstream economist who says that “America needs is fiscal projections that say something about how and when deficits will be tamed … That sort of detail would help taxpayers and bondholders to form views about future policy. As with monetary policy, fiscal policy works more effectively when people know what to expect …”
This assessment then leads the Economist to conclude that:
Devising sound rules is tricky. There is no good theory on what is the right level of public debt. Then again, there is no robust research that says a 2% inflation rate is better than 4%, even if that is what many central banks aim for. Overly rigid rules may spur tighter policy in a slump, but allowing for the cycle can leave too much wriggle room, as Britain’s fiscal mess shows. But even imperfect rules, if monitored well, are better than none at all.
There is no credible mainstream macroeconomic theory per se nor credible mainstream macro research that can guide us at all.
The only position that is credible and sustainable in the long-term is that public deficits have to provide the “finance” for non-government saving desires. By doing that government net spending underpins full utilisation of the available real resources subject to private sector spending wishes (claims over resource allocation).
If the national government tries to push against the non-government sector’s desire to save by pursuing surpluses (withdrawing aggregate demand), then the downward income adjustments that will follow will bring private saving in line with planned private spending at increased levels of unemployment. Further, the government sector will be forced into deficit anyway.
The mainstream just don’t get this and impose their foolish ideas on the public debate. Fools never learn though.
The best place to start in this quest is for the national government to immediately soak up all unutilised labour resources (persons and desired hours unsatisfied) by introducing a Job Guarantee. The guarantee would unconditionally offer a public sector job to anyone who could not find one at the minimum wage (and satisfactory working conditions etc). This policy ensures that the government does not compete for resources that the private sector is currently demanding.
Once everyone who wanted to work had a job, the national government could then further expand aggregate demand in whatever ways they had sought a political mandate up to the point of full capacity utilisation.
It is clear that the mainstream has no conception of the appropriate role of government in the fiat monetary system.
From a modern monetary perspective, we should just keep arguing the point that the recession ain’t over until the labour market is back to full employment. Given the past 30 years or so, and the persistent rates of high labour underutilisatin that have been witnessed, it is clear that the neo-liberals have kept most economies in a state of sustained aggregate demand shortage.
This demand-deficiency has morphed from high unemployment into both high unemployment and high underemployment. But whether it is persons-employed or working hours that are in excess supply – it still remains that the conduct of fiscal policy over this period has been anything but sustainable.
The pursuit of budget surpluses have committed a significant number of workers to a live of diminished opportunities just to satisfy the mindless ideologically-driven demands of mainstream economists.
Eventually repeated episodes of budget-surplus induced downturns will teach us what the role of government should always be. But the losses through unemployment and underemployment and lost opportunities are a high price to pay to teach us that the mainstream ideas are inapplicable to the fiat monetary system that we work within.