Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
Today I decided that there is another macroeconomics research unit that needs to be closed down. My decision was reached after I read the latest paper from the Bank of International Settlements – The future of public debt: prospects and implications – which confirms that the Monetary and Economic Department of that organisation is publishing deficit terrorist literature. The paper is so bad that I am sorry I read it. I may avoid BIS publications altogether in the future. But if I apply that reasoning I am going to be back to reading Stieg Larsson novels and there are only three of them and I have already read them!
One economics department closes that shouldn’t
The title of this blog is a double-entendre and relies on the sometimes imprecise nature of English. You may not know this but the University of Notre Dame in the US has been trying to get rid of any semblance of non-mainstream economics at their institution. In 2003, as a first step, they forcibly split the economics department into two separate departments.
On the one hand, the Economics & Policy Studies Department, which is a liberal social science outfit and describe themselves as “Committed to values and socio-economic justice. Open to alternative theories and approaches. Interested in devising effective policies. Providing students with solid training in economics that matters”
And on the other hand, the The Department of Economics and Econometrics, the latter describing itself as “a neoclassical economics department committed to rigorous theoretical and quantitative analysis in teaching and research”.
My description of the latter is that they undertake erroneous and misleading research and teaching and are irrelevant to anything important facing the world.
You can read about the struggles at the University HERE.
Anyway, the final chapter is now being played out and the university has announced that the heterodox department has been closed. You can read about it from David Ruccio’s blog – he is a professor in the department being closed. He writes:
Readers should know that the implications of the decision are much broader than the fate of ECOP faculty. It shows how university governance has dramatically changed, at Notre Dame and elsewhere, in undermining faculty and student input. The basic idea is, they should shut up and tend to their “own affairs” (teaching, churning out publications, and studying) and let the administration go about its work in remaking the university. It also shows how closed the discipline of economics remains – even after the crises of capitalism that have called into question every facet and dimension of mainstream economics, from basic theory to policy recommendations. Finally, it shows how fragile and threatened academic freedom is, at Notre Dame and throughout higher education in the United States.
So Vale liberal thinking.
While another economics department should be closed
But I have identified one “economics department” that should be closed. The BIS authors, noted in the introduction, identify themselves for dismissal almost immediately – their language gives them away. This document is being held out as a piece of research from the BIS yet you read descriptive terminology such as “an explosion of public debt” and “enormous future costs” and “increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways” as samples of hyperbole that riddle the document.
If I was given this paper to referee for a reputable academic journal (a task I do often) I would reject it immediately because of the emotional narrative. And that would be irrespective of the argument and case being made – which also happens to be deplorable.
You have to ask what is an explosion of public debt? When does an increase in public debt explode? What is the comparison between a bomb going off and a rise in nominal public debt liabilities?
You have to ask what are enormous future costs when the paper is talking purely in terms of financial flows which are performed by sovereign governments at zero marginal cost – being electronic in nature. The government is not revenue-constrained and does not have to sacrifice anything other spending desires to ensure the debt is serviced and repaid. There are real resource implications which only really become binding when the economy reaches full employment. Then some choices have to be made.
Further, the rise in public debt didn’t “finance” any government spending for the sovereign governments. It is the other way around – the governments just borrowed back what they had net spent. This is not just a play on words. It is a crucial aspect of understanding how the currency works and interacts with the monetary system via government and non-government sector transactions. Clearly the BIS staff don’t understand that and should resign immediately.
Finally, after misleading their readers with erroneous references to “financing”, the authors go one step further and want us to believe that the stimulus responses which led to the rise in public debt were examples of the “extravagant ways” of governments. The implication is that extravagance is bad and so the stimulus interventions were bad (and thus wasteful and indulgent) and the rest of the nonsensical logic follows.
What do they think would have happened if there had not been a substantial stimulus? Why not acknowledge that the debt increase is just the manifestion of the portfolio diversification opportunity provided by the government to the non-government sector – that is, exchanging a zero interest reserve balance for an interest-bearing risk-free bond?
Even their own narrative is inconsistent. In the opening sentences they say:
Governments were forced to recapitalise banks, take over a large part of the debts of failing financial institutions, and introduce large stimulus programmes to revive demand.
Forced doesn’t sound like extravagant!
This is not to say that I agree with the composition of the fiscal packages in different countries and we have to be careful to differentiate true fiscal interventions from essentially reserve additions via the quantitative easing. You cannot add those two together as fiscal policy changes.
As is commonplace among these sorts of articles/commentaries (I won’t call this a research paper for obvious reasons noted above), the authors have a clear agenda but realise that the basic facts – those nuisances – are not particularly consistent. So they have to workaround the facts but cannot really ignore them.
So before launching into their agenda they are forced to make some obvious references:
Should we be concerned about high and sharply rising public debts? Several advanced economies have experienced higher levels of public debt than we see today. In the aftermath of World War II, for example, government debts in excess of 100% of GDP were common. And none of these led to default. In more recent times, Japan has been living with a public debt ratio of over 150% without any adverse effect on its cost. So it is possible that investors will continue to put strong faith in industrial countries’ ability to repay, and that worries about excessive public debts are exaggerated. Indeed, with only a few exceptions, during the crisis, nominal government bond yields have fallen and remained low. So far, at least, investors have continued to view government bonds as relatively safe.
But of-course this isn’t consistent with their agenda and so the facts quickly give way to the speculation and poor economics.
They claim that “bond traders are notoriously short-sighted” and will eventually realise that in “the face of rapidly ageing populations … the path of pre-crisis future revenues was insufficient to finance promised expenditure”. They then conclude that:
… the question is when markets will start putting pressure on governments, not if. When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways? …
It follows that the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely. Failure to do so will raise the chance of an unexpected and abrupt rise in government bond yields at medium and long maturities, which would put the nascent economic recovery at risk.
First, bond speculators are not investors they are speculators. Investment has a special meaning in economics – the addition to the productive capital stock.
Second, apart from in some selected EMU nations, there is no likelihood in the near future – that period which will cover the early recovery period – of bond yields rising even under current issuance arrangements. The only thing that will put the nascent (teetering on double dip) recovery at risk is the sort of policies the BIS are advocating – that is, immediate fiscal retrenchment.
I have several triggers which tell me that a writer doesn’t know much about the way the monetary system works or doesn’t want to tell their readers about the nuances because it would weaken (destroy) their argument. One of these triggers appears in this paper in Table 1 – the comparison of the public debt situation in Greece, Ireland and Italy with that prevailing in the UK and the USA.
For example, they say:
A key fact emerging from the table is that over the past three years public debt has grown rapidly in countries where it had remained relatively low before the crisis. This group of countries includes not only the United States and the United Kingdom but also Spain and Ireland.
This so-called “key fact” is a meaningless comparison. The EMU nations have a financial problem, the other nations (USA and the UK) do not. Simple as that. All nations share the real problem that the recession has brought – low income growth, high unemployment etc. But the solvency and debt-servicing problems in this case are confined to the EMU nations.
The BIS staff must know that so why do they persist in conflating these non-applicable pairs? My bet is they know everyone is focused on Greece and is assuming things are bad there so linking them in the same paragraph allows them to leave the reader to conclude that things are bad in the USA and the UK as well. This is just deception.
But their argument becomes clear:
… unless action is taken almost immediately, there is little hope that these deficits will decline significantly in 2011. Even more worrying is the fact that most of the projected deficits are structural rather than cyclical in nature. So, in the absence of immediate corrective action, we can expect these deficits to persist even during the cyclical recovery.
The reality is that the deficits will likely rise if immediate austerity strategies are introduced.
But more importantly, their assertion that the projected deficits are mostly “structural” is unproven and severely tainted by the flawed methods and assumptions they use to decompose the structural from the cyclical.
I wrote a primer on this topic of structural deficits in this blog – Structural deficits – the great con job!. The conclusion is that whenever you hear to term “structural deficit” coming from a mainstream economist you can conclude the measures are deliberately skewed to suit their ideological pre-occupations. You might also like to read the blog – Structural deficits and automatic stabilisers – for more discussion on this point.
The essence is this. The federal budget balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. One might assume that it is reasonable to conclude that when the budget is in surplus the fiscal impact of government is contractionary (withdrawing net spending) and if the budget is in deficit the fiscal impact is expansionary (adding net spending).
However, things are more complicated than that. We cannot conclude that changes in the fiscal impact reflect discretionary policy changes because there are automatic stabilisers operating. To see this, the most simple model of the budget balance we might think of can be written as:
Budget Balance = Revenue – Spending.
Budget Balance = (Tax Revenue + Other Revenue) – (Welfare Payments + Other Spending)
We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the Budget Balance are the so-called automatic stabilisers
In other words, without any discretionary policy changes, the Budget Balance will vary over the course of the business cycle. When the economy is weak – tax revenue falls and welfare payments rise and so the Budget Balance moves towards deficit (or an increasing deficit). When the economy is stronger – tax revenue rises and welfare payments fall and the Budget Balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.
So if the budget goes into deficit we cannot necessarily conclude that the Government is seeking to expand the economy.
To overcome this uncertainty, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. The change in nomenclature is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation.
The Full Employment Budget Balance was a hypothetical construct of the budget balance that would be realised if the economy was operating full employment. In other words, calibrating the budget position (and the underlying budget parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.
So a full employment budget would be balanced if total outlays and total revenue were equal when the economy was operating at total capacity. If the budget was in surplus when calibrated to full employment, then we would conclude that the discretionary structure of the budget was contractionary and vice versa if the budget was in deficit when calibrated at full employment.
An industry developed among economists – dealing with lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.
Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s.
Things changed in the 1970s and beyond. At the time that governments abandoned their commitment to full employment (as unemployment rise), the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see my blog – The dreaded NAIRU is still about – for more on this.
The NAIRU became a central plank in the front-line attack on the use of discretionary fiscal policy by governments. It was argued, erroneously, that full employment did not mean the state where there were enough jobs to satisfy the preferences of the available workforce. Instead full employment occurred when the unemployment rate was at the level where inflation was stable.
NAIRU theorists then invented a number of spurious reasons (all empirically unsound) to justify steadily ratcheting the estimate of this (unobservable) inflation-stable unemployment rate upwards. So in the late 1980s, economists were claiming it was around 8 per cent. Now they claim it is around 5 per cent. The NAIRU has been severely discredited as an operational concept but it still exerts a very powerful influence on the policy debate.
Further, governments became captive to the idea that if they tried to get the unemployment rate below the NAIRU using expansionary policy then they would just cause inflation. I won’t go into all the errors that occurred in this reasoning. In my recent book with Joan Muysken – Full Employment abandoned we consider these debates in considerable detail. But the point is that the NAIRU is an concept devoid of operational meaning.
But the mainstream never let some facts get in the way – and still measure full capacity utilisation by the NAIRU. So if the economy is running an unemployment equal to the estimated NAIRU then these clowns concluded that the economy is at full capacity. Of-course, they kept changing their estimates of the NAIRU which were in turn accompanied by huge standard errors. These error bands in the estimates meant their calculated NAIRUs might vary between 3 and 13 per cent in some studies which made the concept useless for policy purposes.
But they still persist in using it because it carries the ideological weight – it underpins the neo-liberal attack on government intervention.
So they changed the name from Full Employment Budget Balance to Structural Balance to avoid the connotations of the past that full capacity arose when there were enough jobs for all those who wanted to work at the current wage levels. Now you will only read about structural balances.
And to make matters worse, they now estimate the structural balance by basing it on the NAIRU or some derivation of it – which is, in turn, estimated using very spurious models. The estimates are always far above what a true full employment state would be. This means their estimates of when the economy reaches “full capacity” also underestimate potential output.
Armed with these measures, they then compute the tax and spending that would occur at this so-called NAIRU level of activity. But it severely underestimates the tax revenue and overestimates the spending (because it is still contaminated by the automatic stabilisers).
But the important point is that the flawed methodology leads them to conclude that the true “structural balance” (read: full employment surplus) is more in deficit (less in surplus) than it actually is.
They thus systematically understate the degree of discretionary contraction coming from fiscal policy. As a consequence they will always claim that discretionary fiscal contraction has to occur well before the automatic stabilisers (coming from the renewed growth) have exhausted. This means they are always exerting a deflationary bias into economies which explains why unemployment rates have been persistently high in almost all advanced nations for the last 35 years.
RR pops up again
A second trigger I have noted that tells me immediately that a commentator/writer is a crook is if they quote Reinhart and Rogoff (RR) on public debt defaults and apply it to all nations without qualifying whether they are talking about public debt denominated in domestic currency as opposed to public debt denominated in foreign currencies.
The authors do invoke the erroneous RR analysis without qualification. Their analysis falls in a heap as a consequence. Please read my blog – Watch out for spam! – for more discussion on why RR should be largely ignored.
To bring further add “gravity” to the situation the authors claim:
Many countries have a clear deficit bias.
This conclusion is drawn by charting fiscal positions in the advanced nations since the 1970s. Not surprisingly, there were deficits interspersed with periods of surplus as governments, driven by free market ideology, attempted to follow the neo-liberal logic that told them surpluses represented saving. In all our known fiscal history, every time governments have pursued surpluses, recessions have followed. I exclude nations with strong external positions from this conclusion.
However, if they had charted the same countries since 1945, the “bias” towards deficits would have been even more apparent. Which just signifies that the private sector has mostly had a bias towards saving over the same period. For countries with external deficit positions (most), the budget surpluses always coincided with private domestic deficit positions.
That is, the private sector was increasing their indebtedness and as we have seen, categorically, that is an unsustainable growth strategy.
I wondered why the authors failed to present the whole picture – that the public deficits were supporting the private surpluses (saving) and net wealth accumulation and the public surpluses were associated with the opposite?
They are either too blinkered or too devious in intent to realise these national accounting relationships. I could have written their paper in exactly the opposite way – any time public debt is mentioned I would have emphasised the positive impact on private wealth stocks etc. It really matters that people understand these sectoral associations that underpinning Modern Monetary Theory (MMT).
The mainstream always fail to bring the whole picture together and thus end up arguing inconsistent positions – like we need to run down debt levels every where even though we are running an external deficit. You can do that but only at the expense of a global depression and ultimately significant increases in public debt as the automatic stabilisers strike with a vengeance.
Unless of-course you also advocate, as I do, that the government abandons the gold standard hangover of issuing debt $-for-$ to match its net spending position. It is totally unnecessary – has no implications for anything important – and just gives people the jitters for no reason!
If that wasn’t bad enough
The BIS authors then get onto “long-term fiscal imbalances” and launch into the ageing population terror campaign. They say:
More worryingly, the current expansionary fiscal policy has coincided with rising, and largely unfunded, age-related spending (pension and health care costs). Driven by the countries’ demographic profiles, the ratio of old-age population to working-age population is projected to rise sharply … Added to the effects of population ageing is the problem posed by rising per capita health care costs.
This leads us to the obvious conclusion that any assessment of the government fiscal situation based on a short-term perspective is incomplete and at best misleading. A key question is to what extent such accrued liabilities should be reflected in debt estimates. Concerns about both fiscal sustainability and intergenerational equity demand that the accumulated net discounted value of all future revenues and expenditure commitments scheduled in current laws be added to the current debt stock. Currently, however, there is no unique source providing such estimates.
But not to be worried by the lack of such estimates they choose to quote highly flawed studies that show the “present value of unfunded liabilities arising from ageing – is very large.” This is a totally irrelevant observation.
I have written about this non-debate often. Please read my blog – Another intergenerational report – another waste of time – for a starting point to further discussions on this point.
Any “financial” estimates of likely trends in budget balances are largely irrelevant. I guess their relevance lies in the fact that they will provide work for some economics graduate. But this is just “make work” and nothing more than boondoggling. Anyone who is employed to do this sort of work is not in a real job. That assessment pretty much applies to most of the financial sector!
Anyway, as the population ages different types of real goods and services are required. Less primary school buildings and more aged care facilities. These sort of compositional shifts in public provision.
The only questions that are important in this debate are:
1. Will there be enough real resources available in the future to build aged care facilities (perhaps via refurbishing schools spaces)?
2. Will the younger generation support politically (via the ballot box) governments using these real resources to provide such facilities?
End of story! I never see analysis of these questions yet they are the only issues that matter.
If there are real resources available for purchase then the government will always be able to purchase them subject to having a political mandate to do so.
Rising dependency ratios matter because productivity has to increase to ensure there are enough real goods and services provided to meet the growing demand. That tells you that it is paramount that governments spend now to educate its population to the highest levels possible and be prepared to provide high quality public infrastructure to support production.
That sort of vision for the public sector is the anathema of what the “fiscal austerity camp” represents.
… it just gets worse
Next stop is the interest rate explosion that is about to happen which will cause:
… the debt ratio will explode in the absence of a sufficiently large primary surplus.
At which point the governments either stop allowing the bond markets to determine yields – that is, use their capacity to control the yield curve or, better still, abandon the practice of issuing debt.
Why will yields spike dangerously so that real interest rates exceed real output growth rates? There is no answer to this question provided. They just assert it is going to happen and we are regaled with some graphs that compare Greece and other EMU countries to the US, Australia, Japan etc.
I wonder how long we will have to wait for Japan to explode? They have been carrying debt levels almost twice that specified by RR as being the insolvency (defaulting) threshold for twenty years to date … and nothing has happened. BIS authors on this topic – nothing!
Moreover any attempted return to large primary surpluses would help to ensure that the real interest rate was above the growth rate as economies collapsed again.
They then engage in a pictorial exercise which provides their debt projections. They are irrelevant and dangerous given the position that the authors hold (that is, economists working for the BIS).
For example, they argue that the average primary balance required to stabilise the public debt/GDP ratio at the 2007 level would have to be 11.8 per cent for Ireland, 10.1 per cent for Japan, 10.6 per cent for the United Kingdom and 8.1 per cent for the United States.
Even if the nations followed their 10 or 20 year projections, we would be back in a deeper mess than we have been in over the last few years.
Why are they so hung up?
The BIS authors close by stating what they believe the problems of public debt ratios are.
First, “higher risk premia and increased cost” via bond market assessments (as evidenced by rising CDSs). Answer: ban most of this speculative activity and use the central bank to control the yield curve if that is a worry.
They then say that:
… a second risk associated with high levels of public debt comes from potentially lower long-term growth. A higher level of public debt implies that a larger share of society’s resources is permanently being spent servicing the debt. This means that a government intent on maintaining a given level of public services and transfers must raise taxes as debt increases.
This is a typical maintream argument that is based on the false notion that taxes are used to finance government spending. But they are clearly conflating financial transactions between the government and non-government sector with the use of real resources. That conflation is misleading and likely to be erroneous.
For example, in the UK and the US, in particular there have been huge build-ups in bank reserves with virtually zero impact on aggregate demand. The transactions have altered financial portfolios but not engaged very many real goods and services.
Similarly, debt servicing by government doesn’t take any real resources away from the non-government sector. It adds income which can be used to purchase real goods and services. But the meagre act of crediting a bank account as the government pays its servicing obligations doesn’t imply “that a larger share of society’s resources is permanently being spent servicing the debt”.
Whether governments raise taxes in the future depends on the state of aggregate demand. They may or may not. But it will have very little to do with the public debt situation.
Thirdly, we get hit with the “crowding out” argument:
The distortionary impact of taxes is normally further compounded by the crowding-out of productive private capital. In a closed economy, a higher level of public debt will eventually absorb a larger share of national wealth, pushing up real interest rates and causing an offsetting fall in the stock of private capital.
The government borrows back what it has spent. There is no finite pool of saving. Saving expands with income and income responds to aggregate demand which government net spending adds to.
There is no systematic relationship ever been found between real interest rates and budget deficits that stands up to scrutiny.
The only crowding out that matters is whether there are real goods and services available. If they are fully utilised then if the governments wants to increase its command on them they have to deprive the non-government sector. That is crowding out!
More likely government deficits that support growth “crowd-in” private resource usage via increased demand and improved confidence.
Finally, the BIS authors tell us that:
The existence of a higher level of public debt is likely to reduce both the size and the effectiveness of any future fiscal response to an adverse shock. Since policy cannot play its stabilising role, a more indebted economy will be more volatile.
The only things that limit the capacity of fiscal policy to respond to a negative shock are the availability of real goods and services to purchase and the political climate that the government faces. Neither of these limitations are “financial”. A government could spend whatever it wanted to irrespective of its past fiscal history.
Will someone write to the BIS and ask that these authors be sacked for poor work standards and misleading the public? Thanks.
That is enough for today!