But reading the transcript of that interview further you realise that his Austrian-school views on monetary policy leads him to predict Armageddon as a result of his interpretation of the recent conduct of the US Federal Reserve (quantitative easing) and the US Treasury (budget deficits and debt). My reading of his views lead me to conclude that his appointment to that role can only end up creating negative outcomes for the unemployed.<\/p>\n
His views (Austrian extremist) and those of the mainstream of my profession share common ground which is now the base upon which macroeconomic policy is being made. The common ground is:<\/p>\n
- \n
- Persistent budget deficits will stifle growth because they push interest rates up and crowd out private enterprise.<\/li>\n
- Persistent budget deficits and quantitative easing will lead to inflation with a risk of hyperinflation.<\/li>\n
- Persistent budget deficits ultimately lead to government insolvency where debt holders are left stranded.<\/li>\n<\/ul>\n
They also raise issues of inefficient use of resources when deployed by the government and loss of incentive to private enterprise through taxes etc. which I will leave alone today.<\/p>\n
As background for today’s blog you might like to read – Budget deficit basics<\/a> and the suite of blogs – Deficit spending 101 – Part 1<\/a> – Deficit spending 101 – Part 2<\/a> – Deficit spending 101 – Part 3<\/a>.<\/p>\n
Paul’s elevation to influence was the subject of a recent eulogy by well-known Austrian-school commentator and author Tom Mullen who had the audacity to claim that – Austrian Economics Is Scientific (Keynesianism Is Not)<\/a> – in an article he wrote in February 2011.<\/p>\n
I was reminded of this when I read French financial commentator Erwan Mah\u00e9’s May 2011 Newsletter (entitled Thaler’s Corner<\/em>) which I received by E-mail today. The title of his May offering is The huge and highly dangerous Austrian School experiment!<\/em>.<\/p>\n
Mah\u00e9 correctly indicates that governments everywhere have fallen prey to the fears about public debt and deficits that are being whipped up by conservatives who demonstrate little understanding of how poorly the empirical world maps into their theories – hence his conclusion that it is a “huge and highly dangerous … experiment”.<\/p>\n
He cites the rising influence of the Tea Party in the US (“fuelling popular hysteria about unsustainably high government deficits”); the harsh fiscal contraction in the UK which have turned a growing economy back into a near-recessed, going backwards economy; the anti-growth German fiscal rules that have now been embedded in their Constitution and which the French government is now under pressure to replicate; “The slew of austerity plans in eurozone peripheral nations, which will guarantee that they remain in a deep recession characterised by persistently high unemployment for a long time to come”; the refusal of the Bank of Japan to use its capacity to finance the reconstruction while the Japanese government is seeking to raise taxes despite the nation being locked into a recessed\/deflationary cycle for the last two decades.<\/p>\n
It is a very insightful article and touches on many of the main themes of Modern Monetary Theory (MMT) which I traverse regularly in this blog.<\/p>\n
So I thought today I would consider some of these themes in brief with some empirical evidence to help. Why empirical evidence? Answer: Apparently, Tom Mullen (and Ron Paul) think we need it to decide which views are to be considered worthy of the eye of policy makers.<\/p>\n
Mullen wrote:<\/p>\n
\nAnyone who has taken a basic chemistry class in high school remembers how you prove or disprove a theory. You conduct experiments to determine whether the predictions that your theory makes are correct. For example, your theory might predict that mixing two colorless chemicals in a test tube will result in the mixture turning blue. To prove it, you must not only conduct the experiment once, but over and over again, yielding the same result. If your test tube turns blue under the same conditions every time, you have proven your theory. If not, your theory is considered invalid and a new one must be formulated …<\/p>\n
Imagine that you are back in your high school chemistry class lab, conducting experiments. In the row behind you, an Austrian economist is testing his theory. The test tube turns blue one time after another, just as he predicted it would. In the row ahead, a Keynesian economist is testing his theory. His test tube turns a different color every time and then finally explodes, lighting his beard on fire. Which one would you deem the better scientist? Which one would you bet your life savings upon in the next experiment? If you wish to take the scientific approach, listen to the Austrians.\n<\/p><\/blockquote>\n
In between the two pieces quoted is a rail against “Keynesians” – like “Austrian economists like F.A. Hayek predicted the Great Depression when the Keynesians said that the economy was fine”. As an historical note, there were no Keynesians at the onset of the Great Depression. This historical reinvention by Mullen permeates his whole article and his book – A Return to Common Sense: Reawakening Liberty in the Inhabitants of America.<\/p>\n
Let’s also ignore the fact that in sophistical research centres, social science is not conducted at all remotely like a chemist would explore a “controlled” experiment. Social science has no control and we don’t test theories in any crude Popperian manner. That doesn’t mean we do not seek to develop theories that a tentatively adequate representations of the reality we are interested in.<\/p>\n
Yes, I know all reality is relative but we will stay modernist here for today.<\/p>\n
A tentatively adequate representations is conditioned on the data and if we find the data doesn’t accord with what we might have “predicted” then we have to reconsider our representations. But we are not testing truth. We cannot do that because we wouldn’t know what the truth was if we found it. It is better to consider all our representations, models, conjectures etc as being false but better or worse in terms of capturing the patterns around us.<\/p>\n
So if we use long historical data sets and consistently observe one set of relationships then we might be comfortable with theoretical positions that are based on that set of relationships. If we fail to observe (ever) a relationship then any body of theory that predicts that relationship is not likely to be helpful.<\/p>\n
What about the claim that the rise in public debt in the UK or the US or Japan is going to end up in the insolvency of their respective national governments?<\/p>\n
Remember that in the mid-1990s conservative economists (including Austrian-schoolers) were predicting this about Japan. Sixteen years later no default, no insolvency, no loss of private debt market access.<\/p>\n
When have the governments of the UK, the US, or Japan defaulted because they have run out of money? Answer: never. Reasonable conclusion based on the body of evidence: there is no default risk for sovereign nations that issue their own currency and do not borrow in foreign currencies.<\/p>\n
So proposition number one that dominates the “debt is bad” lobby has no empirical backing and should be disregarded.<\/p>\n
What about the hyperinflation argument? Which one do you want to read about first, the deficit or the monetary base relationship with inflation?<\/p>\n
The Austrians, in particular, as continually warning that the monetary base expansion in the US will cause hyperinflation. They consider the quantitative easing which has seen the balance sheets of the central banks in Britain, the US and Japan (among others) expand significantly in recent years to be the source of an impending disaster.<\/p>\n
As Mahe points out these central bank measures are just an:<\/p>\n
\n“asset swap” in investors’ balance sheets between bonds and cash, which end up in the Fed in the form of surplus reserves. In any case, these reserves are useless for commercial banks and do not create more lending (“loans create deposits”!). For that to occur, there needs to be “real credit demand”, which meet the credit requirements stiffened considerably since 2007.\n<\/p><\/blockquote>\n
Austerity programs by national governments, which will surely worsen the already excessive unemployment, have no authority. They have convinced us that that quantitative easing in some way puts more spending power into the hands of consumers and thus fuels inflation. An asset swap among savers is not inflationary.<\/p>\n
Please read my blog – Quantitative easing 101<\/a> – for more discussion on this point.<\/p>\n
As Mah\u00e9 points out if the central bank started meeting the Treasury deficit by “real money creation” – which should be taken to mean the central bank crediting private bank accounts on behalf of the Treasury – then that could be inflationary:<\/p>\n
\n… to the extent that the other inflation factors are present (absence of output gap, inflation expectations, etc.).\n<\/p><\/blockquote>\n
Any spending private or public will be inflationary if the other factors are present. It is spending that carries an inflation risk not the monetary operations that may be associated with it.<\/p>\n
The data used here comes from the official sources. I realise some of the extreme Austrian-schoolers go into denial when it comes to data and claim that there is a conspiracy by the governments around the world to produce spurious data to cover their tracks. At that level of irrationality I give up.<\/p>\n
The first graph shows the relationship between the monetary base and inflation using quarterly seasonally-adjusted data from January 1959 to April 2011. The monetary data is from the US Federal Reserve – Table 1: Aggregate Reserves of Depository Institutions<\/a> and the Consumer Price Index<\/a> data is from the US Bureau of Labor Statistics.<\/p>\n
![\"\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2011\/05\/US_Money_Base_Inflation_1959_2011.jpg\" "\\"US_Money_Base_Inflation_1959_2011\\"")
<\/a><\/p>\n<\/div>\nThe black line is a simple linear regression. If anything the relationship is negative – when the base expands, annual inflation falls although I wouldn’t want to hang anything on a simple linear regression. I could draw the same graph using lags and leads of the variables (to take into account the argument that the inflation pressure builds up over time) with the same result.<\/p>\n
The reasonable conclusion based on the body of evidence is that there is no systematic relationship between the monetary base and the annual inflation rate in the US. I could also draw all the graphs I present here for other advanced nations with similar outcome.<\/p>\n
So for mainstream economists and Austrians who are locked in to the Quantity Theory of Money and the money multiplier there is no evidence to support these theoretical “beliefs”. They are artifacts of religious doctrine only.<\/p>\n
Please read my blog – Building bank reserves is not inflationary<\/a> – for further discussion.<\/p>\n
The next graph considers the relationship between the budget deficit (as a per cent of GDP) and the annual inflation rate in the US from 1931 to 2010. The annual CPI data comes from the US Bureau of Labor Statistics (it is their annual series equivalent of the quarterly data used in the previous graph) and the The US Office of Management and Budget provide historical budget data<\/a> back to 1930.<\/p>\n
The black line is a simple regression although I don’t wish to push the authority of that regression. It is just an indicator that has to be considered.<\/p>\n
Again, I could lag the data to the same effect. I would get the same result for other advanced nations.<\/p>\n
![\"\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2011\/05\/US_annual_inflation_budget_deficits_1930_2010.jpg\" "\\"US_annual_inflation_budget_deficits_1930_2010\\"")
<\/a><\/p>\n<\/div>\nI will come back to an important point about why the graphs look like this later.<\/p>\n
What about the relationship between budget deficits and interest rates?<\/p>\n
It is clear that at any point in time, there are finite real resources available for production. New resources can be discovered, produced and the old stock spread better via education and productivity growth. The aim of production is to use these real resources to produce goods and services that people want either via private or public provision.<\/p>\n
So by definition any sectoral claim (via spending) on the real resources reduces the availability for other users. There is always an opportunity cost involved in real terms when one component of spending increases relative to another.<\/p>\n
However, the notion of opportunity cost relies on the assumption that all available resources are fully utilised.<\/p>\n
Unless you subscribe to the extreme end of mainstream economics which espouses concepts such as 100 per cent crowding out via financial markets and\/or Ricardian equivalence consumption effects, you will conclude that rising net public spending as percentage of GDP will add to aggregate demand and as long as the economy can produce more real goods and services in response, this increase in public demand will be met with increased public access to real goods and services.<\/p>\n
If the economy is already at full capacity, then a rising public share of GDP must squeeze real usage by the non-government sector which might also drive inflation as the economy tries to siphon of the incompatible nominal demands on final real output.<\/p>\n
However, the argument against budget deficits is about their alleged impact on interest rates and the concept of financial crowding out which is a centrepiece of mainstream macroeconomics textbooks. This concept has nothing to do with “real crowding out” of the type noted above.<\/p>\n
The financial crowding out assertion is a central plank in the mainstream economics attack on government fiscal intervention. At the heart of this conception is the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking.<\/p>\n
The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.<\/p>\n
At the heart of this erroneous hypothesis is a flawed viewed of financial markets. The so-called loanable funds market is constructed by the mainstream economists as serving to mediate saving and investment via interest rate variations.<\/p>\n
This is pre-Keynesian thinking and was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving. So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.<\/p>\n
So saving (supply of funds) is conceived of as a positive function of the real interest rate because rising rates increase the opportunity cost of current consumption and thus encourage saving. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises.<\/p>\n
Changes in the interest rate thus create continuous equilibrium such that aggregate demand always equals aggregate supply and the composition of final demand (between consumption and investment) changes as interest rates adjust.<\/p>\n
According to this theory, if there is a rising budget deficit then there is increased demand is placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates to “clear” the loanable funds market. This chokes off investment spending.
\nSo allegedly, when the government borrows to “finance” its budget deficit, it crowds out private borrowers who are trying to finance investment.<\/p>\nThe mainstream economists conceive of this as the government reducing national saving (by running a budget deficit) and pushing up interest rates which damage private investment.<\/p>\n
Please read the trilogy of blogs – Deficit spending 101 – Part 1<\/a> – Deficit spending 101 – Part 2<\/a> – Deficit spending 101 – Part 3<\/a> – for more detailed explanation.<\/p>\n
The basic flaws in the mainstream story are that governments just borrow back the net financial assets that they create when they spend. Its a wash! It is true that the private sector might wish to spread these financial assets across different portfolios. But then the implication is that the private spending component of total demand will rise and there will be a reduced need for net public spending.<\/p>\n
Further, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. But government spending by stimulating income also stimulates saving.<\/p>\n
Additionally, credit-worthy private borrowers can usually access credit from the banking system. Banks lend independent of their reserve position so government debt issuance does not impede this liquidity creation.<\/p>\n
Mah\u00e9 also thinks the crowding out idea is “stupid” because:<\/p>\n
\n… a hike in a country’s budget deficit automatically creates wealth of private-sector economic agents!\n<\/p><\/blockquote>\n
Budget deficits do this in two main ways: (a) they push up private savings; and (b) they push up corporate profits.<\/p>\n
First, when the government net spends it increases demand and national income. Private saving is a function of income growth. This saving is held as deposits in the banking system or is invested in financial assets such as government bonds. As above – it is a wash with respect to government borrowing its own spending back.<\/p>\n
If the saving sits in the banking system as excess reserves then there is downward pressure on interest rates. I explain that in the deficit trilogy – Deficit spending 101 – Part 1<\/a> – Deficit spending 101 – Part 2<\/a> – Deficit spending 101 – Part 3<\/a>.<\/p>\n
Second, Mah\u00e9 also invokes the Kaleckian profits equation that shows that after-tax corporate profits) are equal to private capitalist consumption, investment, budget deficits, trade surpluses less employee savings.<\/p>\n
I explain how this works in this blog – Why budget deficits drive private profit<\/a>.<\/p>\n
But what about the relationship between interest rates and budget deficits? We can consider the treasury yields and the corporate bond rates.<\/p>\n
The US Treasury provide Daily Treasury Yield Curve Rates<\/a> back to 1990. The US Federal Reserve also provides historical data – Selected Interest Rates (Daily) – H.15<\/a> – which has Corporate Bond Rates for AAA- and BBB-rated debt back to 1976.<\/p>\n
The deficit data is from the OMB as before.<\/p>\n
First, the following graph shows the relationship between the US budget deficit and 5-year and 10-year Treasury bond yields from 1990 to 2010. The black lines are the respective simple linear regression relationships.<\/p>\n
The reasonable conclusion based on the body of evidence is that there is no systematic relationship between the US federal deficit and the long-term bond yields in the US. I could also draw all the graphs I present here for other advanced nations with similar outcome.<\/p>\n
![\"\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2011\/05\/US_deficits_bond_yields_1990_2010.jpg\" "\\"US_deficits_bond_yields_1990_2010\\"")
<\/a><\/p>\n<\/div>\nWhat about the corporate bond rate? The following graph shows there is no relationship between the two either.<\/p>\n
![\"\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2011\/05\/US_deficits_corporate_bond_yields_1976_2010.jpg\" "\\"US_deficits_corporate_bond_yields_1976_2010\\"")
<\/a><\/p>\n<\/div>\nConclusion<\/strong><\/p>\n
Clearly, simple graphical eyeballing is not conclusive proof of anything. But after a relatively long career of examining data one gets a good feel for relationships between economic variables.<\/p>\n
My experience tells me that if a simple graph doesn’t support a relationship more sophisticated econometric analysis will not help much. The latter provides more precision and has sampling properties that might console a researcher but if a simple chart cannot find anything then further modelling is unlikely to be worth pursuing.<\/p>\n
The first thing I do when I examine data (prior to econometric analysis) is to plot the series involved.<\/p>\n
But when considering the economics of these relationships you have to understand the context. Budget deficits are endogenous balances – that is, largely beyond the control of governments and hence driven by private spending and saving decisions. The stronger the private spending, the lower will be the budget deficit (typically).<\/p>\n
So when budget deficits rise significantly – as they have in recent years – we know that this is because private spending is so weak and output growth is contracting or weak.<\/p>\n
Central banks tend to react to these circumstances by cutting interest rates and any demand pressure on inflation subsides (or causes deflation). Private borrowing falls despite the reduced interest rates because there is not enough aggregate demand (spending) to justify investment by firms or longer-term commitments to debt by households.<\/p>\n
These cyclical swings drive the relationships that we observe in the graphs I have presented. It is no surprise that budget deficits are associated with lower inflation, lower interest rates and lower investment. The causality is through the income-generating system. All these economic indicators are sensitive to the business cycle.<\/p>\n
The problem with the mainstream body of thought is that they largely deny these linkages and so miss the reality.<\/p>\n
The other problem is that policy makers listen to their twisted versions of the way the system works. Just a few charts would show the governments why they should disregard the mainstream of my profession.<\/p>\n
Digression: Oh Dear<\/strong><\/p>\n
Private lives are just that.<\/p>\n
But I thought this little headline on the ABC News site this morning was an overstatement:<\/p>\n
![\"\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2011\/05\/IMF_boss_in_prison.jpg\" "\\"IMF_boss_in_prison\\"")
<\/a><\/p>\n<\/div>\nI suppose operational might include imposing harsh pro-cyclical policy regimes onto nations that need growth more than anything.<\/p>\n