Sometimes everything comes together in unintended ways. That has happened to me this week. I…
GIGO … that process or mechanism that we are beguiled by what amounts to nothing. GIGO emerges out of highly specialised and technical structures that bright minds create. It occupies hours of time that might be spent finding a cure for cancer or making renewable energy instantly viable on a wide-scale. GIGO keeps our most disadvantaged citizens in states of joblessness and poverty for no reason other than we think it is something. GIGO ravages the developing world and leads to wars, terrorism and other pathologies. Something has to be done about it.
Today I started out reading this Bloomberg story – Obama Weighs Spending to Stem Job Cuts Without Second Stimulus, which reported that:
… the White House is balancing rising concern about unemployment and a budget deficit the Congressional Budget Office estimates will total $1.6 trillion for 2009, and $1.4 trillion in 2010 … In considering the measures, the administration has to reconcile two potentially contradictory missions: combating rising unemployment through government intervention and the need to hold deficits down.
This report was just a rehash of the White House Press Secretary Robert Gibbs’ press conference the day before. In relation to a question “Has the President’s feeling about a second stimulus plan changed from skepticism to a little bit more willingness?”, Gibbs told the press:
… No, I think we’ve said all along that there were no plans for that; that we’re focused on, I think as many are, as we meet about half of the Recovery Act money being spent, and we’re focused on the implementation of a piece of legislation that has clearly cushioned the blow in terms of people that are either jobs created or jobs saved, as well as economic activity, that has lessened the pothole that our economy fell into.
But it didn’t start the day off very well. By that I mean the construction that rising unemployment and rising deficits are contradictory missions. Where do we start with that?
It is clear that the political forces and the poor economic advice the US President is getting is setting up these false trade-offs. It used to be that the trade-off that policy makers feared was the so-called Phillips curve trade-off between inflation and unemployment (and on which I wrote my PhD thesis). These twin evils had to be somehow balanced at a sustainable mix.
This whole literature morphed into the very unsavoury neo-liberal concept of the NAIRU (underpinned by an even more unsavoury concept called the natural rate of unemployment) and economists started to argue that the government could do nothing about unemployment really but let the market forces work. If the government tried to intervene and reduce unemployment it would cause inflation.
It is all sophistry but it dominates policy thinking.
But now we are getting more brazen – the trade-off now is unemployment and budget deficits – both evil evidently. The link, I guess is that the budget deficits are alleged to be inflationary. But then we also know they are evil in other ways – for example, they lead to child abuse (they have to pay the debt back) and tax oppression.
Anyway, it is sad that the US is not capable of seeing through this cant. They will have high unemployment until either the budget deficit rises again (so another stimulus is needed) or in some magical way investment and consumption recovers very quickly and/or they persuade the rest of the world to buy their goods and services in huge quantities. None of those non-government remedies are likely in the near future so … bad luck if you are unemployed in the US.
I also read that the Californian government is in a zig zag about welfare and is slashing and burning what safety nets they have in place. Not much of the sunny state left I concluded.
Then I turned to home and was confronted by more of the same. I decided that today was about GIGO … again.
The Federal Opposition leader gave an extended interview last night on the ABC 7.30 Report. In reply to a question from the presenter “I imagine first that you’d like to talk about interest rates because they’ve just gone up. Are you going to say it’s the Government fault?”, Turnbull said:
Well certainly it bears out the criticism we made at the beginning of the year that the Government’s fiscal stimulus, its borrowing and spending, was too big and poorly targeted and that it would inevitably result in interest rates being higher than they otherwise would be. And I noticed that Warwick McKibbin, who’s probably our most distinguished economist, at least in international reputation and of course a member of the Reserve Bank board, made pretty much the same point in a submission to the Senate today.
So, there’s – I don’t think there’s any doubt that the criticisms we made at the beginning of the year that the Government was borrowing and spending too much and spending it in a poorly targeted fashion have been borne out by the rise in rates today. Because there’s the Reserve Bank saying it’s got to withdraw the monetary stimulus, it’s got to start tightening monetary policy, and of course the problem is that the Government is still expanding fiscal policy. So what the Government’s doing is working against the Reserve Bank.
Scary. People believe it though. The RBA put up interest rates because it said growth was returning and it had to align them once more with a neutral level – and it would take a while to get back to that. Their reasoning is errant but that was discussed in yesterday’s blog.
Any growth whether driven by investment, leveraged consumption, net exports or net government spending would have invoked the same response from the RBA given they are pavlovian in nature these days and have models that tell them that inflation rises when output rises and so interest rates have to rise to stop inflation rising. Not much more sophisticated than that I am afraid.
So in effect, given this institutional machinery any growth would cause interest rates to rise.
Further, one can hardly say the size of the stimulus is over the top given that we have GDP growth still skidding along the bottom, real net national disposable income minus 3.2 per cent between June 2008 and June 2009 and labour underutilisation still rising and around 14.5 per cent at present (latest data comes out tomorrow).
So what about the most distinguished economist in Australia. I wonder how you win that title? The submission Turnbull was referring to was a tawdry bit of sophistry submitted to the Senate Economics Reference Committee which has been enquiring into whether the stimulus was too large and whether it should be withdrawn earlier than planned.
Just to remind everyone, this enquiry was forced through Senate by The Greens, who were concerned with the size of the government’s deficit and debt build-up – as I have noted previously – displaying their impeccable neo-liberal macroeconomic credentials and allowing the Senate to wheel out a trail of mainstream economists who say nothing but get press saying nothing.
When you next speak to a member of The Greens remind them that their national body is allowing the worst neo-liberal myths to get centre-stage each day in the media as a consequence of them forcing this enquiry onto the Senate.
So the submission in question was from Warrick McKibbon who is a professor of economics at ANU and an appointee of the previous conservative goverment on the RBA Board. In case you are wondering how the most distinguished economist.not! in Australia concludes these things you might like to know the following.
McKibbon gave evidence based on his G-Cubed macroeconomic model which sounds flash until you understand how it works. It is a smokescreen which generates zero knowledge about how our economy actually operates and what might happen as a result of policy changes. In technical jargon it is “an intertemporal general equilibrium model of the world economy” which means in English, it makes stuff up.
The specification is explained in an article by McKibbin and Wilcox in 1999 edition of Economic Modelling, Volume 16, pages 123-148. I don’t recommend reading it – a total waste of time. I waste time like this every day – that’s my job. But for the non-economist – take a walk in the sun instead.
Here is how it describes household behaviour:
Households maximize an intertemporal utility function subject to a lifetime budget constraint, which determines the level of saving, and firms choose investment to maximize the stock market value of their equity.
So we are alleged to know everything about everything for our lifetimes now! We know how much income and wealth we will have over our lifetime and when we will get it. We know all the evolutions of GDP over our lifetime because this determines the level of saving in each period. I am glad we are so enlightened.
Here is what the model says about the labour market:
.. wages will be equal across sectors within each region, but will generally not be equal between regions. Long run wages adjust to move each region to full employment … [there is] … short-run unemployment if unexpected shocks cause the real wage to be too high to clear the labor market.
A sector is an industry and a region is broadly a country in this model. Last time I looked there was a wage structure that had existed for as long as data goes back and the wage differentials across the sectors bore no relation to any so-called “compensating differentials” that mainstream economists try to use to explain why there are high and low wages.
Given we haven’t seen anything remotely like full employment in the last 35 years in Australia – I wonder when the long run adjustments are going to deliver us nirvana.
Further, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour unable to find a buyer at the current money wage. In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns. Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending. Real wage cuts (if you could adminster them) would probably increase the desire to save rather than reduce it. So cutting real wages will not reduce unemployment. Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.
Then we turn to the government sector in the model:
… agents will not hold government bonds unless they expect the bonds to be paid off eventually and accordingly impose the following transversality condition … Thus, the current level of debt will always be exactly equal to the present value of future budget surpluses … The implication … is that a government running a budget deficit today must run an appropriate budget surplus at some point in the future. Otherwise, the government would be unable to pay interest on the debt and agents would not be willing to hold it. To ensure that … [the model is intertemporally consistent] … we assume that the government levies a lump sum tax in each period equal to the value of interest payments on the outstanding debt. In effect, therefore, any increase in government debt is financed by consols, and future taxes are raised enough to accommodate the increased interest costs.
This is enough to give a modern monetary theorist a heart attack except that I ride a bike a lot and have also been confronted with this arrant rubbish all my professional life – so I view it as a comic prose rather than anything serious. I take the sanguine view that at least McKibbon has a job and that is something to be happy about!
But you easily see what is going on. As a matter of construction, the G-Cubed “say nothing about anything” model is going to run scenarios and conclude that budget deficits will drive taxes up. But in reality this is just McKibbon concluding that because he built the model to do that. And the old rule applies … garbage in, garbage out or GIGO (an acronym I like somehow).
So just reflect on this construction of the government and non-government sector transactions if you can bear it.
It is trivial to assume that you won’t buy a bond unless you expect to be paid back. Fine. Given there is no insolvency risk for a sovereign government that issues its own currency it is reasonable to assume the government will credit your bank account on the date the bond matures and you will rip up your bit of paper (telling you that you own a bond).
What is this “transversality condition”? We read from Econterms that:
The transversality condition limits solutions to an infinite period dynamic optimization problem. Intuitively, it rules out those that involve accumulating, for example, infinite debt. The transversality condition (TC) can be obtained by considering a finite, T-period horizon version of the problem of maximizing present value, obtaining the first-order condition for nt+T, and then taking the limit of this condition as T goes to infinity.
It means nothing that is germane to real life. It assumes we know everything out into the future and can discern economic conditions out there in time space and make decisions now that will maximise the outcomes over our lifetimes. I am sure you are all good at doing that. I get up each morning and consult the vector of prices and quantities in 2020 just to make sure all my plans today are optimal.
If we added up all the budget deficits and all the budget surpluses we would not find any particular correspondence in present value terms.
A sovereign government could (and in most cases should) run permanent deficits around some trend growth path and allow the automatic stabilisers to push the fiscal balance up and down to ensure full employment.
If it could persuade the rest of the world to buy all our exports and reduce the quantity of imports sufficiently to drive growth from the external sector sufficiently to generate full employment then it could get away with running a surplus. This would not only deprive its own citizens (us) of the use of our resources but would also deprive us of the benefits of getting more real goods and services from abroad than we ship away from our shores. Remember exports are a cost and imports are a benefit (in narrow material terms).
So, the only other way we could run some “compensating” surpluses would be to squeeze the non-government sector of liquidity and then the only way growth could occur would involve the increased indebtedness of the non-government sector. That is not sustainable.
And if the non-government sector didn’t take on increasing levels of debt but instead tried to defend their saving ratio, then the economy would melt down due to a collapse of aggregate demand (the fiscal drag from the surpluses reinforcing the spending gap left by the non-government saving) and before we could open our eyes the fiscal balance would be back in deficit via the automatic stabilisers.
The deficit would rise to match the non-government saving all brought into equality by the contracting income adjustments (attenuated a little by the net spending add coming from the rising deficits).
So even if the government was feverishly trying to implement G-Cubed down there in Canberra or anywhere else the income adjustments in the economy would be declaring their efforts and the “knowledge” provided by G-Cubed to be irrelevant to anything real.
And finally we come to interest rates. G-Cubed has a standard neo-classical money demand function applies – so people hold more cash if income rises (transactions motive) and less if interest rates rise (speculative motive). Interest rates are then determined by the intersection of a (downward-sloping) money demand curve and money supply. We learn that the:
… supply of money is determined by the balance sheet of the central bank and is exogenous.
Exogenous means determined as a policy parameter from outside the system and not influenced by the state of the system – that is the level of economic activity or anything else.
Accordingly, if GDP rises, there is an excess demand for money and interest rates have to rise to ration if off because the money supply function is given (vertical line).
This is the standard IS-LM type model that our poor students are subjected to in undergraduate macroeconomics and from which few ever recover. It is the model (more or less) that is in every mainstream text book (but will not make an appearance in the textbook Randy Wray and myself are writing on MMT).
The conclusion that is driven by the model is that budget deficits which generate growth will drive interest rates up. GIGO.
The trouble is that the model has no correspondence with the fiat monetary system we live in nor the institutional arrangements of government that adminster the monetary system. It is not just a matter of degree – there is no correspondence at all.
The extant money supply in our system is endogenously determined by the credit creation process conducted by the commercial bank leveraging on the net financial assets (high powered money) created by the government.
In the real world, the central bank has no control over the money supply except that it controls the price of the reserves it adds to the system to support the leveraging of the commercial banks.
Further, the central bank has total control over its target interest rate … no-one else sets it. The thinking of the central bank board may have some Taylor rule operating which explains their poor decision making but they still have discretion. The short-term interest rate is not market-determined.
So in the evidence that McKibbon gave he submitted a recent paper (available at the link I provided above) and concluded that:
… The fiscal stimulus and accompanying borrowing, causes real interest rates to rise over what they would otherwise be … there will be competition by government and the private sector over scarce funds for either private investment or to finance fiscal deficits …
And there you have it. This is what Turnbull was relaying to the innocent public last night on the 7.30 Report – a public he aspires to lead as PM. He is polling about as low as an Opposition ever has which is probably of some consolation.
But now you know that if you establish a model where all the results you want to support are produced as a matter of the structure of the model … the appeal to the rigor of the model is somewhat limp … to say the least.
If you have finite loanable funds and competing users then of-course the price rationing system will push the price up for the marginal user. Does this say anything about the real world … nothing of any importance or relevance. Why? Because there is not a finite supply of loanable funds in a fiat monetary system where credit creation renders the money supply endogenous and spending generates its own saving.
Further, the government provides the reserves (via the deficit) which are given back to them in return for the bits of paper call a government bond. The government just borrows back the currency it has spent. It is stupid behavour and is driven largely by ideology (that government spending is dangerous) but that is exactly what it does.
Any modelling that pretends the government competes for a finite pool of pre-existing saving is not worth the computer disk it is stored on.
As an aside, you might also read in his evidence to the Senate Committee that:
… we do not have infrastructure spending in the model so that the fiscal responses here are assumed to be spending on goods and services and not government investment in physical capital. Expenditure on infrastructure would likely also stimulate medium to long run supply in the model and therefore change the extent to which there is crowding out over time.
In other words, the model is incapable of estimating the supply responses that accompany the infrastructure spending and overestimate the “crowding out” even within the twisted logic of the model.
And finally, I read something in his specification paper that gave me hope. On page 146 you read that:
G-Cubed could, however, be improved in several areas.
Yes, true, press the delete button on the directory that is storing the model files.
The problem is that the deficit-hysteria crowd applaud new mining contracts (such as the $50 billion Gorgon gas project off the Western Australian coast) and never say we need less mining contracts because private debt will be too high or inflation will run out of control or that higher interest rates will wreck our kids futures.
This is quite apart from the arguments about whether we should aim to just dig deep holes in our landscape and ravage indigenous areas. Those characters who hate government direct job creation policies and attempt to demean them by referring to them as digging a hole and filling it in again … never acknowledge that that is all mining companies do anyway.
And then you have The Greens, who called the Senate Committee because they think we need lower deficits and less public debt (for all the neo-liberal reasons) but also hate mining. So presumably they are then content with a system that has endemic unemployment. They would not admit to that but haven’t the capacity to argue anything different because their macroeconomic position is inconsistent with full employment.
MMT allows you to see through all these inconsistent arguments and present scenarios based on different policy perspectives which are stock-flow consistent and ground in the operational realities of the monetary system not some tomfoolery like GIGO-Cubed.
That is why it is important to understand it – and then you can impose whatever ideology you like on it.
But then if you politically bully the government to reduce its deficit by discretionary cutbacks at a time the non-government sector is attempting to increasing its saving ratio then will have to accept the increasing labour underutilisation rate. Politically, you may want to achieve that outcome … but you would not be able to deny the causality and your intent.
The problem is that denial is the hallmark of the mainstream of the profession I am part of. That is all they really have to offer.
The “wannabee who could never be” ex treasurer resigned today – this is no loss to the national political scene.
Labour Force data is out at 11.30. I also gave a brief interview today for tomorrow morning ABC Radio National Breakfast show about youth unemployment and what the government should do about it. You might be interested in that.