British House of Lords inquiry into the Bank of England’s performance is a confusing array of contrary notions
On November 27, 2023, the Economic Affairs Committee of the British House of Lords completed…
The resurgence of economic orthodoxy is a great example of how declining schools of thought can maintain dominance in the narrative for extended periods of time if the vested interests are powerful enough. In the case of the economics profession, mainstream New Keynesian theory persists because it serves the interests of capital. Recently, the IMF urged the Australian government to engage in ‘fiscal consolidation’ in order to support further interest rate hikes by the RBA aimed at reducing inflation quickly. In general, the IMF is urging nations to engage in fiscal austerity in order to bring their public debt ratios down. The problem is that even their own research shows that these fiscal adjustments on average do not succeed. And, usually, they leave a damaged society where the lower income and disadvantaged cohorts are forced to endure the bulk of the negative effects.
I considered the IMF’s recent input to the Australian policy debate in this blog post – Latest IMF report on Australia is food for uncritical and lazy journalists but garbage nonetheless (November 2, 2023).
It was the IMF just rehearsing standard New Keynesian orthodoxy and in that blog post I discussed the problems with that approach, not the least being that monetary policy does not work in the way that the mainstream claims.
But the IMF is generally advocating what they term ‘fiscal consolidation’, which they sometimes have called ‘growth friendly fiscal consolidation’.
I call it fiscal austerity and there is no such thing as ‘growth friendly’ austerity, which by whichever means is chosen (direct government spending cuts and/or tax increases), means a cut in net government spending.
And the basic rule of macroeconomics is that spending equals output and income, which in turns drives the demand for labour.
So when government net spending falls, output and national income falls and unemployment rises.
The mainstream like to claim that the cuts in government net spending will stimulate private spending through reverse ‘crowding out’ impacts.
They claim that larger fiscal deficits push up interest rates because government place extra demand on finite saving (supply of loans), which then squeezes private investment expenditure – so-called crowding out of private spending by government.
So, according to this narrative the crowding out can be reversed when fiscal deficits are reduced and the borrowing requirement of the government declines.
Howver, crowding out notions suffer from two major shortcomings.
1. Savings are not finite and expand with fiscal deficits, meaning that the extra spending brings forth extra saving.
2. Bank lending is not constrained by reserves – they will extend loans to any credit worthy customer who seeks credit.
And when times are good – such as when economic activity is stimulated by fiscal deficit expansion and private business investment opportunities expand, it is highly likely that access to credit will be eased as banks chase the business of private borrowers.
I wrote about the claim that banks require prior savings (reserves) in order to make loans in these blog posts (among others):
1. Will we really pay higher interest rates? (April 8, 2009).
2. Building bank reserves will not expand credit (December 13, 2009).
Mainstream economists also advocate ‘fiscal austerity’ as a way of reducing the public debt ratio.
The narrative here is that there is some unspecified and fuzzy public debt ratio threshold, beyond which the government faces increased risk of a bond market revolt as investors seek increasingly higher yields to compensate them for the higher risk.
Eventually, so the story goes, the investors refuse to buy the debt and the government is forced to default because it has run out of money.
At that point, the austerity that must be imposed to bring the government ‘finances’ back in line is harsh and the options are limited and so it is recommended to avoid passing that ‘threshold’ governments should engage in a more managed austerity process.
More managed means that the IMF recommends cutting pensions and other social support schemes, selling off public assets, and cutting public service employment.
I have never read an IMF report that recommends defunding the military or cutting expenditure on missiles and weapons bound for Israel or other terrorist regimes.
Some economists have ventured to actually specify the ‘threshold’ – the famous 80 per cent limit that the spreadsheet mavens came up with during the GFC only for the world to discover they had made deliberate errors or errors of incompetence using the data.
And then that threshold was surpassed and nothing much happened, except in the Eurozone where the ECB had to control the bond yields because the bond investors knew correctly that the 20 Member States are using a foreign currency (the euro) and so all debt issued carried credit risk.
But even that exercise proved beyond doubt that the central bank can always control government bond yields at any maturity it chooses, so the whole ‘investor revolt’ story is exposed as ridiculous scaremongering.
And, of course, the ‘threshold’ theory cannot deal with the Japanese case – which is the most accentuated case study that demonstrates categorically that mainstream New Keynesian macroeconomic theory is not fit for purpose.
But don’t mention ‘Japan’ is the way they deal with that.
Or mutter something about ‘different culture’, which in itself doesn’t represent a successful defence, but just throws people off the trail.
I will also comment another day on the current claims that the latest US Treasury bond auction “failed” the other day because yields rose a bit.
Of course, there was no failure.
But I will leave that story for another day.
The elephant in the room, of course, is that most governments do not even need to issue debt in order to run fiscal deficits (spending above taxation revenue).
That elephant is never mentioned in the mainstream analyses because it would blow a lot of the constant story lines apart.
Once people realised that the issuing of public debt is really just a hangover of the fixed exchange rate system which ended for most nations in the immediate period after the gold convertability was abandoned in August 1971, then a substantial part of the orthodox attacks on government spending would cease to have credibility.
The only reason the arguments continue to have traction is because of the mass ignorance of the population.
I was re-reading the April 2023 IMF World Economic Outlook over the weekend to check on a few things and I was reminded that even the IMF’s own research department acknowledges that ‘fiscal consolidation’ does not reduce debt ratios, anyway.
Chapter 3 of that IMF Report entitled – Coming Down to Earth: How to Tackle Soaring Public Debt – discusses this issue.
Economists talk about public debt ratios rather than the level of public debt to ensure they don’t fall into the error of scale.
Obviously, bigger economies have larger debt.
So they scale their analysis (if we can call it that) to the volume of public debt outstanding relative to GDP, the latter being the size of the economy.
It is true that as a result of the pandemic support provided by governments and their insistence on matching public deficit increases with extra public debt, the public debt ratios have risen.
Why should that warrant any concern?
Well, for the IMF:
High public debt ratios are a significant concern for policymakers, particularly in light of tightening global financial conditions, weak economic growth prospects, and a stronger US dollar. The recent rise in sovereign debt holdings of domestic financial institutions, particularly in emerging markets, has further exacerbated the costs of high public debt, including by limiting the resources available for domestic institutions to lend to the private sector and by aggravating the risk of adverse sovereign-bank feedback loops.
So you see all the scare triggers are there and all leading to claims that there are less “resources available for domestic institutions to lend to the private sector”.
Which, as above, is a fiction.
To start, a central proposition of the orthodox macroeconomics is that the currency-issuing government is like a household and thus faces a ‘financial budget constraint’ on its spending.
The framework presented is an accounting relationship linking the fiscal flows (spending, taxation and interest servicing) with relevant stocks (base money and government bonds).
The way the mainstream macroeconomics textbooks build this narrative is to draw an analogy between the household and the sovereign government and to assert that the microeconomic constraints that are imposed on individual or household choices apply equally without qualification to the government.
The framework for analysing these choices is called the government budget constraint (GBC) in the literature.
The GBC is in fact an accounting statement relating government spending and taxation to stocks of debt and high powered money.
However, the accounting character is downplayed and instead it is presented by mainstream economists as an a priori financial constraint that has to be obeyed.
Modern Monetary Theory (MMT) economists consider this to be just an ex post accounting relationship that has to be true if all the stocks and flows are properly accounted for but which carries no particular import other than to measure the changes in stocks between periods.
These changes are also not particularly significant within MMT given that a sovereign government is never revenue constrained because it is the monopoly issuer of the currency.
But mainstream economists shift, without explanation, from an ex post (after the fact) sum that has to be true because it is an accounting identity, to an alleged behavioural constraint on government action.
The GBC literature emerged in the 1960s during a period when the neo-classical microeconomists were trying to gain control of the macroeconomic policy agenda by undermining the theoretical validity of the, then, dominant Keynesian macroeconomics.
There was nothing particularly progressive about the macroeconomics of the day which is known as Keynesian although as I explain in this blog – Those bad Keynesians are to blame (November 5, 2009) – that is a bit of a misnomer.
So the GBC is the orthodox framework for analysing the ‘financing’ choices of government and it says that the fiscal deficit in year t is equal to the change in government debt (ΔB) over year t plus the change in high powered money (ΔH) over year t.
If we think of this in real terms (rather than monetary terms), the mathematical expression of this is written as:
which you can read in English as saying that Fiscal deficit (BD) = Government spending (G) – Tax receipts (T) + Government interest payments (rBt-1), all in real terms.
Within that expression is the ‘primary fiscal balance’, which is government spending less interest payments on outstanding debt minus tax revenue.
However, this is merely an accounting statement.
It has to be true if things have been added and subtracted properly in accounting for the dealings between the government and non-government sectors.
Within the GBC approach, taxes are conceived as providing the funds to the government to allow it to spend.
Further, this approach asserts that any excess in government spending over taxation receipts then has to be “financed” in two ways: (a) by borrowing from the public; and (b) by printing money.
You can see that the approach is a gold standard approach where the quantity of “money” in circulation was proportional (via a fixed exchange price) to the stock of gold that the nation held at any point in time.
So if the government wanted to spend more it has to take money off the non-government sector either via taxation of bond-issuance.
However, in a fiat currency system – which dominates today, the mainstream analogy between the household and the government is flawed at the most elemental level.
The household must work out the financing before it can spend. The household cannot spend first.
The government can spend first and ultimately does not have to worry about financing such expenditure.
Mainstream theory claimed that ‘printing money’ would be inflationary, even though governments do not spend by printing money anyway and all spending carries an inflation risk.
Ignoring that reality, the mainstream claimed that fiscal deficits should be covered by debt-issuance.
But there were negative effects of that ‘financing’ arrangement – the crowding out of private investment mentioned above.
Hence the mainstream typically eschew the use of fiscal deficits, although some of the ‘lite’ New Keynesian voices allow deficits when there is recession.
The change in the public debt ratio is derived from that expression as follows:
The change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.
So a change in the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.
Within this logic, it is clear that a growing economy can absorb more debt and keep the debt ratio constant.
For example, if the primary deficit is zero, debt increases at a rate r but the debt ratio increases at r – g.
Now, can fiscal consolidation reduce this ratio?
Note also that the fiscal balance is made up of two components:
1. The policy parameters chosen by the government – planned spending and tax rates.
2. The state of the economy which means that tax revenue and welfare spending will change over the course of the economic cycle, at the given policy parameters.
So what can happen and usually does is that in an environment of austerity that aims to reduce the fiscal deficit, the opposite ends up happening.
Simply because the austerity kills economic activity such that tax revenue declines and welfare spending rises even if the government plans are for the opposite to occur.
The result – deficits keep rising, GDP growth falls and unemployment rises.
And because government continue to issue debt to match the primary deficit, the numerator of the public debt ratio increases at the same time as the denominator (GDP) decreases and you know what happens.
The public debt ratio rises.
The IMF, after outlining various qualifications to their framework, acknowledge that:
… because such conditions may not always hold, and partly because fiscal consolidation tends to slow GDP growth, the average fiscal consolidation has a negligible effect on debt ratios.
The ‘conditions’ that have to hold – austerity promoting growth via strong reverse crowding out – etc do not typically occur when governments attempt to engineer a deliberate austerity campaign.
But what always happens is GDP growth rates decline.
After considering all the evidence, the IMF conclude:
A broad range of econometric methods, based on well-established methods in the empirical literature, confirm that fiscal consolidations do not reduce debt ratios, on average … Results suggest that, on average, consolidations do not lead to a statistically significant effect on the debt ratio.
Is that clear?
They qualify that by saying that debt ratios can fall when there are cuts to primary fiscal deficits when “the negative effects on output are mitigated”.
If you can conjure up a situation that stimulates growth when there is a harsh cut back in a significant source of expenditure then sure, the public debt ratio can fall because the denominator is increasing faster than the numerator (or the numerator is also falling).
But pigs might fly!
In general though, the public debt ratio is a relatively uninteresting macroeconomic figure and should be disregarded.
If the government is intent on promoting growth, then the primary deficit ratio and the public debt ratio will take care of themselves.
That is enough for today!
(c) Copyright 2023 William Mitchell. All Rights Reserved.