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If we don’t, it won’t and won’t need to …

The New York Times Editorial on October 2 was bitter-sweet – Wanted: Leadership on Jobs. Bitter because of the topic. Sweet because a leading newspaper is finally focusing on real issues in this crisis. It followed a devastating month of labour force data in the US which should be the clarion call for immediate intervention and a ramping up of budget deficits. Although Australia has not deteriorated as much as the US, our labour market is in a parlous state and, in my view, justifies a third stimulus package.

On October 2, the US Bureau of Labor Statistics released the latest payrolls data with the headline:

Nonfarm payroll employment continued to decline in September (-263,000), and the unemployment rate (9.8 percent) continued to trend up … The largest job losses were in construction, manufacturing, retail trade, and government.

Construction, manufacturing and retail normally lose jobs in a downturn but government? They should be dramatically expanding employment right now.

The BLS also report that since the downturn began in December 2007, December 2007, an extra 7.5 million people have become unemployed and now 9.8 per cent of the willing labour force is without work.

The following graph shows the history of the unemployment rate in the US since 1948 and apart from the 1982 recession the current downturn is the worst from the labour market perspective.


It is in this context that the NYT editorial said:

By every meaningful measure, the weak job market deteriorated further in September. Federal stimulus spending has prevented an even worse decline. But that is cold comfort for the tens of millions of working men and women for whom conditions are bleak and getting bleaker, and for the millions more who are destined to lose their jobs – or to have their hours and compensation cut – in the months and years to come.

The Editorial calls for Congress to legislate for emergency income support for the unemployed and demanded that the President “flesh out … [his] … commitment to ensure that economic recovery does not leave middle-class and low-income families behind”.

The Editorial goes on to document the damage of the rising unemployment. Arthur Okun referred to unemployment as the “tip of the iceberg” and underneath the water was the reduced labour force participation rates, the falling productivity, the failure to integrate new entrants and the static wages. He talked about the upgrading effects associated with running the economy at higher pressure. Higher skilled workers no longer compete for the low skill jobs (because there are more jobs for everyone) and a series of mobility transitons occur.

In this vein Arthur Okun and others argued that all boats rise on a high tide. This justified their position that it was important for governments to maintain the economy at high-pressure through the use of fiscal and monetary policy. Considerable research has been undertaken in the USA connecting economic growth, job creation, employment quality, and earnings distributions. Okun argued that growth brought productivity improvements, increasing labour force participation rates, occupational upgrading, and rising average earnings for the most disadvantaged in the labour market. Rates of poverty declined and there was a narrowing of the earnings distribution.

A book I published in 2001 was called Unemployment: the tip of the iceberg (you can still get it cheap via CofFEE if you are interested – a few dollars only these days). Here are some photos of the Book Launch of that book. The book covers all these issues.

These submerged costs are what the NYT Editorial is talking about. It said:

The combination of a rising unemployment rate and a quickening pace of labor-force dropouts is especially worrisome … A shrinking labor force represents a tremendous waste of talent and potential, a loss of value that will not be entirely retrievable. Widespread joblessness among men is particularly devastating for the economy and many families, because men tend to earn more than women and to have jobs offering health insurance … The real work, however, lies ahead. Economic recovery will not automatically replace the jobs that have been lost so far in this recession. Nor will higher levels of learning and skill – necessary as they are – magically create jobs, especially in the numbers that are needed.

So it is time that governments addresses this aspect of the downturn with direct fiscal responses. Even in Australia where we are crowing about having escaped the worst of it we have 14.5 per cent of our willing labour resources underutilised; virtually static real wages, unemployed facing real benefit cuts because the government is acting maliciously towards them; rock-bottom productivity performance; falling participation rates; and not remotely enough jobs to go round.

Now is the time to intervene and initiate widespread public sector job creation. This should be the centrepiece of the third stimulus package in Australia. The deficit has to go at least another 2-3 per cent of GDP yet before any impact on the stock of labour wastage will occur.

Perhaps if Obama leads, we will (as usual) follow. Better going down that track than following them into Iraq.

So after all that, what do you think of this statement?

The big error of the current discussion is to confuse the budget balances of individuals and companies with the government budget balance, which needs to be in deficit so long as attempted savings exceed perceived investment opportunities. Gordon Brown more or less understands this, and I wish he would use his talents to explain such fundamentals instead of stirring up an outdated class war.

A modern monetary theorist could certainly have written the first sentence. But not the second.

This was, in fact, the conclusion to leading Financial Times columnist Samuel Brittain’s latest article in that newspaper on October 1, 2009 which carries the title A cool look at the current deficit hysteria.

First a note about this conclusion. We should discount immediately any commentator, theorist, article that draws even the most tenuous link between the budget of a household or private organisation and the budget of the national government, which issues its own currency. There is no such link – the household uses the fiat currency that is issued and the government issues the currency.

The former has to finance all their spending in advance whereas the latter is never revenue-constrained and can spend at will (as long as their are things available to purchase). Note this statement is not the same as saying it should spend at will. The correct statement is that it can but should only spend what is necessary. Think back to Samuel Brittain’s quote above – it needs to net spend “so long as attempted savings exceed perceived investment opportunities” … which is a little inaccurate in itself but trying to say that the non-government’s net desire to save has to be “financed” by government or else contractionary income adjustments will bring the place undone.

I received an very long E-mail the other day telling me that this distinction that modern monetary theory (MMT) makes is wrong. The writer (a non-economist) had taken a lot of time to write to me but in vain. The analysis presented was completely erroneous. He is the specific point on the household-government analogy which the writer says is valid:

Households do not *as a matter of principle* have to prefinance their spending. Indeed even in practice I sometimes obtain my lunchtime sandwich from the nice dinner lady *before* going to the cash machine.

Sorry, the dinner lady is just extending credit. She would not do that if she thought you had no funds in the cash machine. The funds you are “borrowing” (implicit credit) were not generated by your past spending.

The writer then goes on:

Similarly, given an extant financial system with money in the accounts of most participants, the government does not need to credit private accounts before taxing. It seems to me that you have set up an artificial initial condition (the state of there being no existing unit of exchange) to produce a necessary temporal series of events (government creating currency and distributing about the system). You then infer a causal implication. I don’t see this as valid. The system you have laid out is causally symmetric in principle and no fundamental distinction between government spending and private spending exists save the ability for government to print or destroy the unit of exchange. I am unclear exactly what you mean by “the source of” private spending. If you mean to infer a relationship of causal priority, I’m not clear there is one, beyond the trivial fact that government supplies the paper and legal framework of the currency. You might just as well say that government spending cannot occur until taxes are collected. Of course, neither is strictly true (or false).

Similarly means “in a like style or manner” which means the claim is false. There is nothing like or similar about the government spending. This is a common confusion. Attempting to discern the underlying principles of the system and the causation by observing the system as a whole.

To really understand the mechanics you have to go back to first principles.

Yes, there is a stock of net financial assets in the government’s currency already in the system. How did they get there? They are the accumulated deficits of the past. The non-government sector cannot create these net financial assets. So just because there is already a capacity to pay taxes in the non-government sector at the start of today means that on that particular day if there was no government spending the taxes could be paid. Surely true … the wherewithal would come from past deficits.

But if the government kept running surpluses (if it could – and it couldn’t) then the stocks of net financial assets in the non-government sector would fall and disappear and that sector would be unable to pay its tax obligations. That is one of the dynamics that budget surpluses introduce – a squeeze on the capacity of the non-government sector to pay taxes.

And if we go back in time – as a quest for first principles – it is clear that on day 1 when the government introduced the currency – that it could not have collected any taxes in that currency prior to spending it. That is, there were no prior accumulations of net financial assets in that currency because there had been no prior deficits.

I also would never say that “government spending cannot occur until taxes are collected”. That statement could never describe a fiat monetary system.

Warren Mosler and I had a little chat about this and he gave me a US example which shows that even once the system is functioning, the operational arrangements still, more or less, require the government to spend first before collecting revenue.

He was referring to a US arrangement which goes like this. When the US Treasury issues and sells securities (for example, 20 billion worth). they get paid for them on the 15th of the month. On that day the Treasury simply let’s it’s balance increase at the Federal Reserve, say by the same $20 billion. On that same day, for all practical purposes, there never used to be $20 billion available in the private sector to make payment. The cash in circulation and in everyone’s mattress and pockets isn’t available, and the banking system never used to have that much in their accounts at the Fed.

So what the Fed had to do was loan the banks the $20 billion in balances they needed to buy the securities from the Treasury. In other words, the government had to spend first before it could borrow, because the funds simply weren’t there. More recently the Fed has gone out and bought about $2 trillion in securities from the private sector, paying for them by increasing the balances those banks have at the Fed by the same $2 trillion. This ‘advanced purchase’ of securities from the private sector by the government gave the private sector they then used to buy new securities from the Treasury.

This is exactly how the monetary system in this context works.

It means categorically that the government cannot collect taxes or borrow, for all practical purposes, until it first spends or lends the funds to the banking system.

So overall the logic by the E-mail sender is plain wrong. Spread the word to all.

The E-mail went on:

Certainly, the condition of there being no taxable units of exchange prior to a government crediting accounts has never occurred – government fiat has always been exchanged into an existing system of currency.

My advice is to study history. There are numerous examples of new fiat currencies being created where none existed before.

But that aside, no matter the origin, once the government starts taxing in a non convertible currency it can only spend if the tax is sufficient to result in people who are willing to sell real goods and services in exchange for that currency. You can deny this but not beat it!

The E-mail went on:

… Taxation does indeed withdraw spending power from the private sector, but it *does* also increase the buying power of the state.

Sounds logical doesn’t it – it would have been a good True/False question in the Saturday quiz. Answer: false.

Taxation does increase the buying power of the state but not because the state has ‘more currency’ than before and can thus spend more. The state doesn’t have to finance its spending ever. The reason it increases the “buying power” is because the taxation increases the demand for state spending. The non-government sector has to cover its tax bill before it does anything else.

Anyway, the things that come in on the E-mail. What will life be like when Google Wave is the rage. I signed up yesterday and am waiting for my first wave interaction.

After that digression, we go back to Brittain.

Second, what about Brittain’s the class war argument? It has been a common in recent years for the neo-liberals to announce that the old way of thinking – left-right, workers-capitalists, and all those old-fashioned vestiges the the class wars are irrelevant now – in this new era of competition and individualism.

The previous conservative federal government announced when it sold off the national telecom (Telstra) that everyone was becoming a shareholder now (well not me! why buy something that we already owned?). The story of that privatisation is covered in this blog – Macroeconomics get lost in the kitchen cupboard – it was a disaster for the nation.

Anyway, the calls that the class war are over are not new. In 1959, Harold Macmillan, then the British prime minister famously declared the notion of a class war to be absurd and thorougly “last week” whereupon he immediately appointed some earls, a duke, and a marquess to his cabinet to demonstrate it.

One of the reasons that the neo-liberals are so down on government deficits has nothing to do with their knowledge of how they function in relation to the monetary system. Rather they want less public goods and more private goods. They want deregulation and privatisation because it wrecks trade unions that defend the workers’ interests and provides public services to the poor who would otherwise be at the behest of the bosses. They hate the idea of full employment because it forces them to be continually structuring the wage offer to be attractive to the workers who have choices.

So behind all the sophistry about the damage that deficits cause and the need for less regulation is … ladies and gentlemen … the class war.

The battles to preserve the profit share and expand it drive the macrodynamics in the absence of strong fiscal policy leadership. In the last 30 years national governments have moved away from mediating the class struggle to actively promoting the interests of capital at the expense of the working class. The persistence of high unemployment and rising underemployment (due to the obsession with budget surpluses), static real wages growth (due to deregulation of wage setting systems) and the declining quality of public services (as public set cutbacks demanded) all are evidence of this. We cover this topic in depth in our recent book Full Employment Abandoned: Shifting Sands and Policy Failures.

Back to Brittain who actually writes some good articles and you can read them from his Home Page, a week or so after they come out in the FT.

Brittain writes in his current article that:

The British political classes are going through one of their occasional bouts of masochism, with party leaders vying with each other on the theme of who can cut public spending faster and more effectively. Spice is added by talk of leaks and secret plans; and ideology by arguing about the balance between tax increases and spending curbs. My own bottom line is that all this is in response to a largely imaginary budget crisis. If we have a normal economic recovery the red ink will diminish remarkably quickly. If we don’t, it won’t and won’t need to.

I think the last two sentences are examples of lovely prose. They tell us that the non-government sector can reduce any deficit they think is too large by simply spending more themselves. All this nonsense from the conservatives and their sycophantic economic analysts who get wheeled out in the press to proclaim nothing more than their vested interests and ignorance. If they don’t like the size of the deficit … then get over it or spend more.

But if they don’t do that then “it won’t and won’t need to” – beautiful statement. So if the non-government sector wants to maintain a reduced rate of spending growth then the deficit has to remain to ensure, first, that the excess capacity (including the high rates of labour underutilisation) is brought back into use, and, second, that once the economy is growing again, to ensure that the growth in capacity is productively deployed on an on-going basis.

It is as simple at that.

But Brittain is also a deficit dove. He worries about Debt/GDP ratios at the end of the day. He says

The ratios themselves, as projected by the International Monetary Fund, show Britain well below the US and only slightly above France and Germany … Debt ratios of this size are historically far from unprecedented. In the early Victorian period the ratio was nearly 200 per cent and almost reached that level again in the early 1920s. In 1956 it was just under 150 per cent.

So nothing to worry about because they are not that large. Well there is nothing to worry about anyway!

One of the things that surprised me the most last week about the debate was the incapacity of many commentators to realise that all their dreams were unattainable.

It was common to say all debt has to fall and the private sector has to save more. MMT will immediately tell you that these desires are incommensurate under current institutional arrangements (where governments voluntary issue debt $-for-$ when they net spend).

The causation is:

1. The private sector desires to spend less and increase their saving ratio – they start saving – to the debt-deflationists this is good.

2. They then start paying down their debts – to the debt-deflationists this is good – that objective seems to be possible.

3. Until income contracts because aggregate demand falls and the private sector notices their savings actually dropping – to the debt-deflationists this is bad.

4. So the solution is for governments to net spend to fill the aggregate demand left by the private saving. Income grows, saving grows, private debt falls, but because of the institutional arrangements – public debt rises – to the debt-deflationists this is bad.

You get the point. They can’t have everything and an understanding of MMT would tell them that straight away and save them the angst of pursuing inconsistent aspirations.

The thing we need is for more private saving and debt reduction financed by the public deficits. The public debt build up is a largely irrelevant sideshow.

It was a public holiday in NSW today but there was no rest for the wicked! But now its time to rest. More tomorrow, unless something else comes up.

This Post Has 16 Comments

  1. Now we have the economist joining the fray with some sensible takes on deficits:

    Ironic that just as THE SUN, premier UK tabloid declares ‘labour’s lost it’ and formally backs the tories for the upcoming general election on a platform of slash and burn, the mainstream financial press (economist, FT, even WSJ), are coming out significantly in favour of ongoing deficits.

    That sounds like an odd kind of class war to me, kind of oddly inverted. The tories appear to be targetting the lowest common denominator here in the hope that by so doing they can get away with populism and scaremongering and avoid addressing the economics. They continue to as you put it, think they can have everything.

    Certainly a political crisis approaches, as it always must do when the dominant ideology becomes incompatible with reality.

  2. Dear scepticus

    Yes a good insight. Thanks for the Brittain article – I had read it and had it stored away.

    best wishes

  3. No probs. Duncan weldon’s blog I linked to above is a nice source of UK commentary in line with MMT, and seems to be pretty good in terms of an ongoing summary of the debate in the press.

    I do hope labour can achieve a seeming impossible task – break the link in the average voters mind between household and national finances. There must be, somwhere on the web the kind of very simple explaination of this issue that avoids all monetary jargon and makes this point in such a way that confused voters can understand it and engage with the logic.

  4. “It was common to say all debt has to fall and the private sector has to save more. MMT will immediately tell you that these desires are incommensurate under current institutional arrangements (where governments voluntary issue debt $-for-$ when they net spend).”

    Isn’t it possible for savings to increase in real terms because of deflation without the government running additional deficits?

    (There is a slight problem with deflation if all the savers are located in China, but from a pure MMT point of view, the non-government savings should increase in real terms, unless I’m missing something.)

  5. On that chart Bill – it is obvious that the WW2 to 1975 period was not remotely as successful at creating very low unemployment in the US as it was here.

    Did they not advance full employment as deliberate government policy as we did?

  6. Picking up on Warren Mosler’s example, another frame for illustrating this is the case of a central bank with a zero reserve requirement (e.g. Canada). When the government issues bonds in such a system, the system has no reserves to pay for them (except for a small operating buffer). When the system purchases the bonds, it becomes “short” reserves, i.e. with an overdraft position at the central bank, which then converts to discount window borrowing, unless some alternative form of government monetary provision is made to increase reserves (i.e. spending or asset acquisition). When the monetary provision is in the form of a loan, we can say that loans create deposits (reserve deposits, used to pay for the bonds), similar to the horizontal case. In all cases, vertical expenditure or asset acquisition creates the deposits required to purchase the bonds.

    The dependence of the required deposit creation on prior government spending or lending activity isn’t exactly a temporal ordering requirement, in the sense that the bond payment, initial overdraft, and effective credit provision are all more or less simultaneous from an operational perspective. But it is a conditional ordering in the sense that the bond payment can’t be made without such a credit facility being in place to begin with.

    The process works the same way for the payment of taxes in a zero reserve system. The default form of government “financing” for the tax payment is the central bank’s loan of the reserves required to make the tax payment. That loan can be repaid with reserves that are subsequently or instead created by government spending or additional forms of asset acquisition.

    The case of a zero reserve system can then be generalized to the case of a non-zero reserve system by equating the zero reserve case to the amount of reserve adjustment that the central bank would make in a non-zero system, in order to “finance” system bond or tax payments, and at the same time keep the level of reserves unchanged, at its desired target level.

    The current case of the massive excess reserve position of the US Federal Reserve is quite unique. As you say, a secondary consequence of the Fed’s credit crisis balance sheet expansion is that it has effectively “prefunded” the reserves required for the system to purchase new bonds or pay taxes in an amount equal to the excess reserve level. This type of prefunded position is the result of unique circumstance, and not a general requirement in order to make those kinds of payments.

  7. Good points, JKH. I personally like to think of the zero reserve system as the general case, assuming the target rate is set above the remuneration rate (though this latter assumption isn’t a general case of its own . . .I go with “0 is the natural rate” for that). Then add things like buffers due to payments uncertainty and potential of penalized overnight overdrafts, inability to perfectly offset changes to cb’s balance sheet, and RR.


  8. Dear Lefty

    True. In the 1960s, for example, there was a huge literature that developed out of the US about structural unemployment – this is where the segmented labour market literature came from and this led to studies of discrimination (against blacks, women and minorities) and regional decay arising from de-industrialisation.

    best wishes

  9. As I understand it, MMT posits that government has two powerful tools; the power to print and spend fiat money, and, completely independently, the power to lend at an interest rate of its choosing, some of that fiat money into the private economy. It took a while, but I agree with both of these key points. The question then is how best to use these powers? I like your notion that govt. should buy (employ) labor, starting at the low end. There are two variables, two masters to serve, if you will. There is employment, and there is inflation, or price stability. Two independent input variables, fiat money spending rate, and interest rates should suffice to control these two output variables. My question then is “Who do you lend to?”. If interest rates are pre-ordained by the given constraints of full employment and price stability, how is money allocated to projects in the private sector. If the answer is “the banks”, this is a non-answer, the new question just becomes “Which banks?”.
    I offer one possible answer. Give money to those entities with a proven track record of paying the most taxes. Seed financing could go to the young with no history, youth being a good excuse for having no history, but increasing amounts of capital would go to successful entities defined by their tax payments, presumably proportionate to and so indicative of their future earnings success. This allocation function/problem will matter for growth, innovation, etc. It has to be dealt with IMO.

  10. Dear Peter

    Clearly if the price level is falling (deflation) all nominal aggregates rise in real terms. But I don’t think that helps the argument much.

    best wishes

  11. Dear Bill and all,

    I am beginning to understand the logic of Modern Monetary Theory. And it’s starting to make sense to me. But in all the analyses I have read (and I don’t mean only here, but in other blogs, as well), I have a nagging sensation that something is missing.

    I am an old marxist and I am aware of all the criticisms (some of them probably quite justfified and well founded) that marxism has received. So, maybe I suffer from a deformed way of understanding reality.

    My question is: who benefits from all these wrong decisions? Because it’s pretty obvious who the losers are. Is this just a case of neoclassical economists’ incompetence?

  12. Dear Marco

    Old marxists still have a place! When thinking about MMT it is important to know what it is intending to theorise about and apply itself too and what other tools you might need in addition to it to investigate particular concerns. It is clear there are very systematic distributional consequences and patterns along class and other lines that result from applying macroeconomic policies in one way or another.

    MMT will give you a clue about what things to look for – asset positions, etc but doesn’t define, for example, class boundaries or which unit of analysis below the macroeconomic sectors – might present interesting results.

    I have my own views on those matters but they require separate (but consistent) reasoning.

    As an aside: Victor will write another guest blog in the coming weeks about why the bosses enjoy unemployment.

    best wishes

  13. To elaborate, defenders of the status quo now argue that they “deliver the goods” to society by allocating resources where they will do the most good. Their recent track record is abysmal, and this, more than anything else, has opened a door for MMT to walk through, hopefully into the sunshine of a brave new world. You must therefore have a counterargument to their “we allocate capital better” assertion. As I understand it, the capital allocation function is currently driven by interest rates which provide a price signal to the banking and investment community. The Fed “brings the punchbowl”, interest rates decline, evermore risky and perhaps stupid ventures make sense, they get funded, a few succeed, some become the “Googles” of tomorrow, and life goes on. The Fed “Takes away the punchbowl”, rates climb (I appreciate you think this is backwards), investment disappears, and we have a recession. My concern is, under your regime, this manic behavior will cease. Clearly, this is a good thing, but mania does potentially have its uses. “Stupid” investment, driven by super low interest rates, can arguably lead to “Googles” being created. In this context, how does the brave new world of stable, predictable, non manic, interest rates prescribed by MMT jive with the need for a little bit of nutty behavior?

  14. “Clearly if the price level is falling (deflation) all nominal aggregates rise in real terms. But I don’t think that helps the argument much.”

    It doesn’t if one assumes that the non-govt sector desires to increase its savings in order to reach a nominal target. It can’t do that without the government increasing its deficit.

    But if the non-government sector desires to reach a real target (“N years of expenses”, say), it can do so. Once this savings level is reached, spending will resume.

  15. Dear Bill,

    Your perspective on class war is an interesting one and seems largely equivalent to Marx’s, without appealing to surplus-value notions and the Labor Theory of Value.

    In Marx’s view, the interests of workers and capitalists are inherently antagonistic, because of the existence of surplus-value. In your view, are the interests of workers and capitalists inherently antagonistic? Or is there a possible intermediate arrangement?

    I mean, during the 1940s and up to the 1970s it appeared that Keynesianism had managed to “tame” the wildest and most brutal manifestations of capitalism, without discarding it entirely. In simple terms: it appeared that Keynes had saved capitalism from itself.

    I even vaguely remember some old Soviet-block economists claiming that capitalism was not necessarily self-destructive, largely based on this.

    And then, suddenly, seemingly out of the blue, came the Thatcher and Reagan era and the old bad times came back again with a vengeance: now the resulting crisis is not merely a socio-economic one, but an environmental one as well.

    It may be that the two old German guys were right about the inherent tendency of capitalism to self-destroy, after all. But I am not as optimistic as they were about the final outcome: it is not clear to me that there is a way to either tame capitalism a second time around, or to replace it altogether with something better, before it’s too late.



    PS: Sorry for the apocalyptic detour.

  16. Dear Brad

    I have been thinking about your interesting comment for the last few days. I am unsure the “nutty” behaviour has anything much to do with interest rate movements. That thesis would have to be proven. I think it is more driven by non-monetary concerns which is not to say the outcomes do not become commercialised in time. The linux development is the example I am most familiar with.

    I think a stable monetary environment with a high pressure economy (where jobs were easier to find for all) would encourage people to take some time out and “invent”. I was young when Australia had true full employment and all we wanted to do was play guitars … never thought about a career … because jobs were easier to come by. So all that time my mother described as a waste was sort of your nutty behaviour. I think people are less risk-taking now because it is harder (and more costlier) to take time out like that.

    best wishes

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