Fiscal austerity damages real growth and prolongs the financial downturn

It is unsurprising that my profession has suddenly became enamoured with studies of financial cycles. Up until the GFC mainstream macroeconomics (theories and models) mostly ignored financial markets and banking, thinking that they were largely peripheral to understanding the business cycle. The only linkage between the financial sector and the real economy that was considered was via interest rates – the impact on investment spending and the demand for loanable funds to fund investment impacting back onto interest rates. Even within this limited context, the theories developed were hopelessly deficient and incapable of explaining anything that relates to the real economy. But now – more brash than ever – my profession is busily conjuring up financial markets to fit into their Dynamic Stochastic General Equilibrium (DSGE) models, despite these models being next to useless. In March 2009, Willem Buiter said that DSGE models “excludes everything relevant to the pursuit of financial stability.” More recent research from the BIS (link below in the text) has highlighted some salient facts about the relationship between financial cycles and business cycles. What that research implies is that push for fiscal austerity is without foundation and will not only damage the real economy but will, in the process, prolong the financial downturn and prevent a resolution that could provide the springboard for sustainable growth.

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When 50 per cent youth unemployment is (apparently) protecting the grand kids

Over the last week, a Londoner and a Glaswegian have publicly embarrassed themselves with statements made about the current economic situation. One is an academic historian who hasn’t fully understood history. The other a politician who is seeking to deny the obvious and somehow blur his own culpability in driving the British economy back into a double-dip recession. I guess the smokescreen approach works if yesterday’s Greek vote is anything to go by. I saw a headline in Bloomberg this morning which said that “Greece avoids chaos …”, which prompted me to wonder what chaos might look like if it is not hospitals unable to get access to essential supplies, a government killing its private sector by cutting spending and not paying legitimate bills, and an unemployment rate creeping towards 25 per cent and 50 per cent for youth. The Greeks were bombarded it seems with wilful lies and even then the conservatives on just led the vote count from their main anti-austerity rival. In all the denials and bluster, what I know categorically is that in the real world where we all live – sustaining rates of youth unemployment above 50 per cent – is definitely not protecting the grandchildren.

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Spain bank bailout – fails to address the problem

Its a public holiday in Australia – Queen’s Birthday – so all is quiet. Why the Queen of England is also the Queen of Australia and our Head of State is one of those puzzling things that escape logic. Anyway, for the record, the latest Eurozone development – the request of a 100 billion euro bailout from the Spanish government – does not address the major problem facing the Eurozone – the Euro itself. The intransigence of the EU elites has meant that they are unwilling to reform the poorly designed European monetary system and seem to think that a sequence of band-aid remedies which only buy a little time without addressing the main issue demonstrates leadership. Meanwhile, the real economies deteriorate further and unemployment rises. The current policy proposals that are abroad in the Eurozone, are, in my view, the anathema of leadership.

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We do have a choice – we just need to identify it

I went for a walk at lunchtime through a main shopping area where I am working today. In the past you saw Sale signs twice around twice a year – post Xmas and mid-year. The advertised discounts at this time were modest except for some enticement items that might have been discounted by 30 per cent or so. You may check this out going through archives of Catalogue AU. You rarely saw Closing Down/All Stock must go signs. You rarely saw massive discounts – such as 80 per cent off and the like. Times have changed and there seems to be a permanency to these sales and the discounts are huge. Previously well-to-do shopping strips are now slowly being punctuated with empty shops so the Sale/Closing Down signs are now interspersed with For Lease signs. And Australia is meant to be going through a one-in-a-hundred years mining boom and the Government tells us we are doing so well that they have to undermine aggregate demand by running a surplus to give the economy room to grow even more. The problem is that our political leaders are in denial and continually bombard us with lies to perpetuate their ideological stances which work against the well-being of the majority of citizens. It is clear that the system is failing and that means we have a choice. The problem is that we first have to identify that we have that choice.

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Saturday quiz – May 26, 2012 – answers and discussion

Here are the answers with discussion for yesterday’s quiz. The information provided should help you understand the reasoning behind the answers. If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of Modern Monetary Theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.

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What is “good” at the macro level may well be disastrous at the micro level

I have been reading about the Great Depression lately and comparing the sort of pressures that governments were placed under during that time to cut deficits which were rising on the back of a collapse in economic activity to what is going on today. There are many interesting parallels and déjà vu experiences. That research took me into some literature on the way the governments bow to industry demands as aggregate demand collapses. In turn, that led me to the way the military-industrial complex operates. Which took me into another literature on the role of the military-industrial complex in creating wars to provide markets for their goods – the merchants of death. And so it goes. That is the nature of research – it just takes one on a journey and usually to destinations previously not imagined. But this journey also clarifies some issues that readers regularly write to me about. The relationship between Modern Monetary Theory (MMT) as a macroeconomic framework and issues that issues that lie below the aggregate level – such as distributional issues. There are links clearly (for example, income distribution affects aggregate demand) but in other ways what is “good” at the macro level may well be downright disastrous at the micro level. But in dealing with the disaster at the micro level, we always have to be mindful of the way dealing with that disaster impacts on the aggregates. This is particularly important in considering issues relating to trade. The military-industrial complex is an excellent case study of these challenges. Here are some early thoughts.

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The current and former Treasury boss speak

I was going to write about military expenditure today in the light of large cuts to defense spending that the Australian government made in last week’s Budget and the decision by the Obama Administration to make it easier for American firms to export military equipment (to who knows where!). The concept of the military-industrial complex is interesting and, to some extent, the issues that are being raised by the US decision were discussed during the Great Depression (I have been reading a lot of material from the 1930s lately). While some might (from a micro perspective) conclude that reducing spending on the military is a good thing (less violence etc) they also have to be mindful of the macro perspective which considers a $ spend on a tank to be equivalent in its impact on aggregate demand as a $ spent on public education – well nearly. But I will write about that tomorrow. There were two interesting interventions into the public debate in Australia yesterday from the current Treasury boss and the recently departed Treasury boss which have general application everywhere. While they are current I thought I would consider these general points today.

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The ECB cannot go broke – get over it

CNBC’s Head of News, one Patrick Allen produced this article (May 10, 2012) – European Central Bank Leveraged Like Lehman – which several readers E-mailed to me suggesting that there was a problem that had to be addressed and would prevent the ECB funding member state deficit increases in pursuit of growth. The only problem I am afraid to say is the “author” doesn’t know much about the subject that he is writing about. This, sadly, in a general problem out there in commentary land. The article was in fact reporting the views of one Satyajit Das who gets a lot of airtime on national radio in Australia and elsewhere but perpetuates many of the mainstream myths about the way the monetary system operates and its limits and propensities. Das mixes factual statements (which I agree with) with causalities and reasoning (which I do not agree with). The journalists then build their stories based on an uncritical precising of so-called experts like Das and the myths then spread. Let us be absolutely clear. There is no meaningful comparison between the ECB and Lehman or any central bank and any private bank. Further, the ECB cannot go broke.

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Saturday quiz – April 14, 2012 – answers and discussion

Here are the answers with discussion for yesterday’s quiz. The information provided should help you understand the reasoning behind the answers. If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of Modern Monetary Theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.

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A fiscal collapse is imminent – when? – sometime!

Sometimes I wonder how it is that a bright person can stick to a story for so long when the evidential record is so contrary to the predictions that their story keeps forcing them to make. Then again the predictions are often couched in terms of “might” and “We don’t know what will trigger such a wave of selling” (don’t know!) and “interest rates would shoot up” (would!) and “if the number of people trying to sell them surges” (if) and “inflation would erode” (would! again). So nothing concrete – just a series of assertions. So such a person is never really confronted with the reality that they know “shite” (a word I read in a book by an Irish author I have just finished – In the Woods by Tana French – recommended). This sort of denial is an overwhelming characteristic of the mainstream of my profession. I would love to be proved wrong if private households and firms do turn out to be Ricardian and fiscal austerity leads to a boom with full employment. I would abandon my MMT leanings within a flash and get on the prosperity bandwagon. Why is it that the mainstream, which has the dominant influence on policy makers – and therefore get to see their theories applied in the real world – not adopt a similar position. The predictive capacity of their paradigm is next to zero!

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IMF struggling with facts that confront its ideology

I haven’t a lot of time today (travel) but I thought the latest offering of the IMF was interesting. In their latest World Economic Outlook (April 2012 – which will be released in full next week) they provided two advance chapters – one – Chapter 3 – Dealing with Household Debt – demonstrates just how schizoid this organisation has become. They are clearly realising that their economic model is deeply flawed and has failed to predict or explain what has been going on over the last five years. That tension has led to research which starts to get to the nub of the problem – in this case that large build-ups of debt in the private domestic sector (especially households) is unsustainable and leads to “significantly larger contractions in economic activity” when the bust comes. They also acknowledge that sustained fiscal support is required to allow the process of private deleveraging to occur in a growth environment. But then their ideological blinkers prevent them from seeing the obvious – that sustained fiscal deficits are typically required and that in fiat monetary systems this is entirely appropriate when . Which then leads to the next conclusion that they cannot bring themselves to make – the Eurozone is a deeply flawed monetary system that prevents such fiscal support and should not be considered an example of what happens in fiat monetary systems. Some progress though!

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A nation cannot grow without spending

On Saturday (March 24, 2012), the Sydney Morning Herald published an article by University of Chicago economist John Cochrane – Austerity or stimulus? What’s needed in the US is structural reform. Earlier, on Thursday (March 22, 2012), Bloomberg published an Op Ed by Cochrane – Austerity or Stimulus? What We Need Is Growth. Different title but same article. However, the title, in each case, conveys a very different message to the reader. In either case, though, the content is the problem. A nation cannot grow without spending.

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UK Budget reveals what is really going on

The British government brought down their 2012 Budget yesterday. I haven’t had time to fully digest all the detail yet and I am not yet fully conversant with all the discussion papers that underpinned the official budget documents. My experience tells me that one usually finds some really interesting points that are hidden in the fine print of some of the less obvious government documents. Sometimes these points are “game makers”, which really expose the ideological slant of the budget. Not that you have to do much digging in this budget to determine what agenda the British government is now pursuing. The “bond markets are about to close us down” rhetoric is giving way now to Thatcherite “trickle down” stories. This budget is trying to sell the “puppy” that if more real income is transferred to the rich then they will ensure, through their enhanced enterprise, that the poor (which cedes real income) will eventually be better off. That is a variant on the “fiscal contraction expansion” myth.

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Flawed macroeconomic models lead to erroneous conclusions

I get a lot of queries about the difference between fixed and flexible exchange rates in terms of the options that each present a sovereign, currency-issuing government. I considered this question several times in the past. Many of those questions are pitched in terms of the basic macroeconomic framework for an open economy that appears in most mainstream macroeconomics textbooks, particularly those written in the 1970s, 1980s and 1990s. I am referring here to the Mundell-Fleming model which has been the mainstream staple for many years. The modern textbooks still teach these models but the exposition has evolved although remains deeply flawed. It seems that this conceptual framework is still used to make public comments along the lines that the US government is facing insolvency and that the euro remains the best monetary organisation for Europe. Those conclusions are as flawed as the model that spawns them. Flawed macroeconomic models lead to erroneous conclusions.

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Questions and Answers 3

This is the third Q&A blog where I try to catch up on all the E-mails (and contact form enquiries) I receive from readers who want to know more about Modern Monetary Theory (MMT) or challenge a view expressed here. It is also a chance to address some of the comments that have been posted in more detail to clarify matters that seem to be causing confusion. So if you send me a query by any of the means above and don’t immediately see a response look out for the blogs under this category (Q&A) because it is likely it will be addressed in some form here. It is virtually impossible to reply to all the E-mails I get although I try to. While I would like to be able to respond to queries immediately I run out of time each day and I am sorry for that.

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Athens burned, while I played Sudoku

Today, I am back in Greece. Yesterday, there was a confidential in-house “Staff Note” leaked from the Institute of International Finance, which purported to estimate the costs of a disorderly default on Greek government debt. Most of the paper was about ECB and related “contingent liabilities” which summed to around €1 trillion. However, once you understand the nature of those “contingent liabilities” in the context of the capacity of the ECB as the currency-issuer in the EMU and compare them with the real losses being endured by the Greek economy and its people, then you soon realise that the Greek government should reintroduce its own currency immediately. The European elites, however, are too busy playing Sudoku to appreciate that, ultimately, their ideologically-motivated austerity will not only impoverish Greece, but will also cause their whole monetary system to collapse.

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Look after the unemployment, and the budget will look after itself

There was a Wall Street Journal article (March 5, 2012) – The High Cost of the Fed’s Cheap Money – which is full of statements like “could eventually lead to an economic calamity” etc. The WSJ article basically rehearses a confused form the old supply-side tradition of the pre-Great Depression era where the claim was that “supply creates its own demand” (so-called Say’s Law) which was shorthand for the proposition that flexible prices and interest rates would ensure that whatever was supplied would be purchased. The same sort of arguments were used in a recent lecture to Harvard EC10 students by the Director of the US Congressional Budget Office. It is extraordinary that these myths, which were part of the body of economic theory that led the world into the current crisis, still have currency. They should start by understanding what Keynes meant when he said “Look after the unemployment, and the budget will look after itself”.

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Standby for the third Greek bailout

I suppose I have to write something about the extraordinary deal that emerged out of Brussels yesterday. I tweeted at the time that the “Latest EU Bailout will not end the uncertainty. Greece will not be able to withstand a decade of repressive economic policies”. The ABC National News last night introduced the bailout in terms of “finally resolving the uncertainty” and then proceeded to interview an analyst who outlined why the deal will increase uncertainty. This is the state of confusion among the media commentators who are bullied by the Troika to mouth is the official rhetoric but who must also realise that the projections underpinning the approach are deeply flawed and that the situation in Greece will continue to deteriorate. The reality is that this “deal” only buys some more time. In the meantime, the real situation in Greece will continue to worsen. Standby for the third Greek bailout.

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The Greek elite – prefers to eat its children

I am travelling for most of today and so haven’t much time to write a blog. I am typing this on the train to Sydney airport. The press has been increasingly highlighting the on-going Greece situation. What is important to note is that the neo-liberals are no longer honey-coating the fiscal austerity in terms of “fiscal contraction expansion”. The Greek finance minister is now saying that the Greeks have a choice between disaster and total disaster. Other are juxtaposing sacrifice with chaos. I have noted that in recent months that a lot of commentators have been asserting that an exit would be a disaster – far worse than the current “disaster” of 4 years recession and more to come. But rarely do you read any coherent analysis of what might happen should Greece exit the Eurozone. My view is that while the dislocation would be intense and costly it would, in the longer-term, be less costly than the current alternative – which is persistent recession for the foreseeable future and a savage erosion of real living standards, especially for the next generation. As on commentator put it over the weekend (full quote provided later) – the current austerity approach with “deep structural inequalities and its rigid adherence to a failed economic ideology, protects neither democracy nor human rights. Stiff-necked and punitive, it prefers to eat its children

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Stimulus, stimulus, stimulus – a fact is not an exaggeration

I’ve been travelling for most of today (now back in Newcastle) which has cut the time available to write anything. So this will be a relatively short blog and focuses on the way in which my profession is always trying to reconstruct economic issues when they find some policy proposition uncomfortable. The vehicle to demonstrate this phenomenon is an article published by Bloomberg (February 10, 2012) – Sachs Says Krugman Is ‘Crude Keynesian’. It summarised the radio interview (mp3 link – running for nearly 15 minutes) with Columbia University’s Jeffrey Sachs. The latter is well-known for providing advice to the old Soviet economies, which led to the massive transfer of public wealth to the private oligarchs via privatisation. Under Sachs’ guidance, the so-called “shock therapy”, hastily imposed deregulation, privatisation and the abandonment of price controls (on rent etc) on the previously planned economies – with disastrous consequences. In the Bloomberg interview, Sachs is highly critical of “macro” interpretations of the current problems – claiming that the major challenges are all micro in origin.

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