{"id":13991,"date":"2011-03-30T17:11:37","date_gmt":"2011-03-30T06:11:37","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=13991"},"modified":"2011-03-30T17:11:37","modified_gmt":"2011-03-30T06:11:37","slug":"how-are-the-laboratory-rats-going","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=13991","title":{"rendered":"How are the laboratory rats going?"},"content":{"rendered":"

\t\t\t\tI am all done writing letters – at least for today. I forgot to send both. I noted someone mentioned that he had never read any admissions of error from me. True enough. Over the course of my academic career I have made many predictions and none have turned out to be qualitatively wrong (sometimes the quantum us shaky but the direction is correct). But I am not trying to sell tickets for myself. Economists like me who comment regularly on current affairs are always subject to empirical scrutiny. So I am regularly putting my neck on the line – in written word (blog, Op-Eds etc) and speech (presentations, media interviews etc). So far so good. I note that a correct empirical observation doesn’t mean the underlying theoretical explanation which might have motivated the prediction is correct. But it is a lot better than missing the empirical boat altogether and suggests that there is some worth in the theoretical framework being employed. From a personal perspective the current period of economic policy is very shattering (if you share my values about the dignity of work etc). But from an intellectual perspective, as an economic researcher, the current period is very interesting. It is providing us with real world data which directly relates to theoretical statements made by economic schools of thought. So I am keeping a running tally of how the laboratory rats are going? You can judge which theoretical structure you consider useful yourself when thinking about what is happening at present.
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\nGovernments are in full-scale austerity mode at present. Neoliberals claim that governments, like households, have to live within their means. They say budget deficits have to be repaid and this requires onerous future tax burdens, which force our children and their children to pay for our profligacy. They argue that government borrowing (to “fund” the deficits) competes with the private sector for scarce available funds and thus drives up interest rates, which reduces private investment-the so-called “crowding out” hypothesis. <\/p>\n

And because governments are not subject to market discipline, neoliberals claim, public use of scarce resources is wasteful. Finally, they assert that deficits require printing money, which is inflationary.<\/p>\n

But they go further than this. They claim that quite apart from these alleged negative impacts, deficits are not required to achieve the aims of the Keynesians. It used to be considered non-controversial that government deficits could stimulate production by increasing overall spending when households and firms were reluctant to spend. In a bizarre reversal of logic, neoliberals talk about an “expansionary fiscal contraction” – that is, by cutting public spending, more private spending will occur.<\/p>\n

This assertion comes with the fancy name of “Ricardian Equivalence,” but the idea is simple: Consumers and firms are allegedly so terrified of higher future tax burdens (needed, the argument goes, to pay off those massive deficits) that they increase saving now to ensure they can meet their future tax obligations. So increased government spending is met by reductions in private spending-stalemate. But, neoliberals argue, if governments announce austerity measures, private spending will increase because of the collective relief that future tax obligations will be lower and economic growth will return.<\/p>\n

I could provide quotes from leading politicians (from the UK Prime Minister down) and leading economists (Nobel Prize winners and up<\/strong> – ooh, sorry to be so disrespectful) supporting this logic.<\/p>\n

These conservatives, some of whom were direct beneficiaries of bailout packages in the early days of the crisis, tell us that our governments are bankrupt, that our grandchildren are being enslaved by rising public debt burdens and that hyperinflation is imminent. Governments are being pressured to cut deficits despite strong evidence that public stimulus has been the major source of economic growth during the crisis and that private spending remains subdued.<\/p>\n

Austerity will worsen the crisis, because it is built on a lie. Public deficits do not cause inflation, nor do they impose crippling debt burdens on our children and grandchildren. Deficits do not cause interest rates to rise, choking private spending. Governments cannot run out of money.<\/p>\n

But the empirical world is continually spitting out data that allows us to judge the veracity of these claims and counter-claims.<\/p>\n

In that context, the neoliberal narrative has run into some inconvenient facts. Interest rates remain low. In most of the developed world, inflation is falling and where it is rising, it is due energy and food costs rising rather than excessive deficits.<\/p>\n

But what about Ricardian Equivalence?<\/p>\n

Should we not be seeing private sector confidence and spending rising by now – especially in the UK which is now 2 budgets into austerity and in Ireland which has been hacking away in the name of Ricardo since early 2009?<\/p>\n

If you are familiar with the theoretical discussion relating to government budget constraints, debt dynamics etc leading to Ricardian Equivalence then you can now skip down to the section headed “How is this theory stacking up?” The conceptual part of the blog is for those needing a refresher or some more advanced understanding.<\/p>\n

Conceptual framework<\/strong><\/p>\n

The theory in a nutshell is this. Government deficits have to be backed by debt-issuance. In the mainstream framework this is drawn from the government budget constraint (GBC) literature which considers a national government to be like a super-household – that is, facing the same constraints but just bigger in scale.<\/p>\n

I have outlined the logic before but to make sure readers understand it here it is in summary.<\/p>\n

In the mainstream approach, the GBC framework is used to analyses the so-called “financing” choices governments face when spending. The GBC equation says that the budget deficit in year t<\/em> is equal to the change in government debt over year t<\/em> plus the change in high powered money over year t<\/em>. So in mathematical terms it is written as:<\/p>\n

\"gbc\"<\/a><\/p>\n

<\/div>\n

which you can read in English as saying that Budget deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and\/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.<\/p>\n

However, once we strip this off the erroneous theory (that governments are like households and have to “finance” their spending) then the GBC is a n accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been correctly added and subtracted.<\/p>\n

So in terms of Modern Monetary Theory (MMT), the previous equation is just an ex post<\/em> accounting identity that has to be true by definition and has no real economic importance.<\/p>\n

But for the mainstream economist, the equation represents an ex ante<\/em> (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).<\/p>\n

In fact, the mainstream economists know that there is no constraint – what they really want to say is that using ΔH to fund government spending is inflationary and therefore undesirable. They should be more open about that so that we can move beyond it being a debate about constraints and discussing when inflation becomes possible.<\/p>\n

So in mainstream economics, money creation (ΔH) is depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money. The government then spends this money. The reality might be that the treasury would instruct the central bank to credit some bank accounts and some intra-government accounting record would be altered. The accounting is of no interest to us economists in this context.<\/p>\n

The mainstream however claim that if governments increase the money growth rate (they erroneously call this “printing money”) the extra spending will cause accelerating inflation because there will be “too much money chasing too few goods”! Of-course, we know that proposition is only valid if there is full employment of all resources. Most economies are typically constrained by deficient demand (defined as demand below the full employment level) and they respond to nominal demand increases (growth in spending) by expanding real output rather than prices. There is an extensive literature pointing to this result.<\/p>\n

So when governments are expanding deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases. You will also appreciate that the inflation risk comes from the spending – not what accounting gymnastics are performed – that is, whether the government “borrows from itself” (exchanges of accounting information between treasury and the central bank) or borrows from the public (swapping a bank reserve for a bond account).<\/p>\n

These operations neither increase or decrease the risk of inflation associated with the spending. What matter is whether there is spare capacity in the economy to increase production when a spending increase enters the economy. If there is then the inflation risk is low to non-existent. If there isn’t then the inflation risk is high – bond issuance or not!<\/p>\n

But not to be daunted by the “facts”, the mainstream claim that because inflation is inevitable if “printing money” occurs, it is unwise to use this option to “finance” net public spending.<\/p>\n

Hence they say as a better (but still poor) solution, governments should use debt issuance to “finance” their deficits. Thy also claim this is a poor option because in the short-term it is alleged to increase interest rates and in the longer-term is results in higher future tax rates because the debt has to be “paid back”.<\/p>\n

This last claim is the basis of Ricardian Equivalence. I have covered the arguments in detail in the following blogs – Will we really pay higher taxes?<\/a> and Will we really pay higher interest rates?<\/a> and so won’t repeat them here other than to keep context.<\/p>\n

The mainstream textbooks are full of elaborate models of debt pay-back, debt stabilisation etc which all claim (falsely) to “prove” that the legacy of past deficits is higher debt and to stabilise the debt, the government must eliminate the deficit which means it must then run a primary surplus equal to interest payments on the existing debt.<\/p>\n

A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.<\/p>\n

The standard mainstream framework, which even the so-called progressives (deficit-doves) use, focuses on the ratio of debt to GDP rather than the level of debt per se<\/em>. The following equation captures the approach (which can be derived from the GBC is you have mathematical skills):<\/p>\n

\"debt_gdp_ratio\"<\/a><\/p>\n

<\/div>\n

In English, this just says that the change in the debt ratio (the term on the left of the equals sign) is the sum of two terms on the right-hand side of the equals sign which are:<\/p>\n