{"id":20465,"date":"2012-08-01T18:23:33","date_gmt":"2012-08-01T08:23:33","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=20465"},"modified":"2012-08-01T18:23:33","modified_gmt":"2012-08-01T08:23:33","slug":"the-non-existent-but-remarkable-austerity-depreciation-mechanism","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=20465","title":{"rendered":"The non-existent but remarkable austerity-depreciation mechanism"},"content":{"rendered":"

\t\t\t\tThe conservative lobby (often dominated by Austrian school types) are increasingly running the narrative that neither monetary or fiscal stimulus can engender growth as nations wallow in stagnation. Their rejection of the use of fiscal stimulus – aka spending of one sort or another – would appear to be in denial of the basic macroeconomic rule – one person’s spending is another person’s income – or in a sectoral sense – government spending equals non-government income. Their arguments against monetary policy have some resonance with my own views. But, for example, is any one really going to argue that if the government hired all the unemployed and paid them a stable wage (in excess of any income support they might be receiving) that the shops would not experience rising sales, which, in turn, would stimulate rising orders to suppliers and increased production and higher growth. Are they really saying that all stimulus spending leaves the shores via net exports? While historical evidence is often cited, when one digs further it becomes clear that the evidential basis of the anti-government claims cannot be substantiated. And – the arguments reduces to a rather crude expression of their dislike of government activity.
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\nMost recently there was a Bloomberg Op Ed (August 1, 2012) – Ben Bernanke Could Lose for Same Reason as Olympic Sailor<\/a> – by that so-called historian Amity Shlaes. I last wrote about Ms Shlaes in this blog – When conservatives reinvent history to suit themselves<\/a>. She is a selective interpreter of history – to say the least.<\/p>\n

In her recent book – The Forgotten Man<\/em> – she sought to refute the obvious fact that FDR’s New Deal policy substantially reduced unemployment. She purports to show that unemployment did not fall under the major public works programs that were part of the Federal stimulus efforts in the early 1930s.<\/p>\n

The only problem is that she deliberately counted the people who were in the job creation programs (that is, working for a wage) as being unemployed.<\/p>\n

She also declined to include the most obvious statistic that economists deploy to measure economic growth – real GDP growth – in her analysis.<\/p>\n

Of-course on both counts – Real GDP grew rapidly in 1934, 1935 and 1936 – and unemployment fell as the idle workers were absorbed into productive employment by the New Deal work programs. But Ms Shlaes decided to ignore all of that and along the way fudge the jobless numbers to boot.<\/p>\n

In the Bloomberg article, she chooses to publicise “some research “pulled together” by two economists at the Bush Institute<\/a> (where she works). There is very little information available about the Bush Institute but the identities that have publicly linked themselves to it would suggest it is a hive of free market zealots who spent their time crafting “evidence” to support their anti-government ideology.<\/p>\n

When I clicked the link in the Shlaes article to see what the book was about I received this message from Firefox (see following graphic), which I took to be some new fangled filter that Firefox has skilfully weaved into its code to protect visitors accessing dangerous and\/or fraudulent material. I can’t be sure about that but I was grateful for the relief.<\/p>\n

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I had previously read the paper – Household expenditure cycles and economic cycles, 1920 – 2010<\/em> – that presumably fed into this book. You can download a version of it HERE<\/a>. I would not bother though – it is 1.1mb and its file size bears no relation to its quality.<\/p>\n

Ms Schlaes reports that the faith that Ben Bernanke appears to have in monetary policy as a viable counter-stabilisation policy tool is mis-placed. Her argument is based on:<\/p>\n

\n… the conclusion about the central bank drawn by two economists, the Nobel Memorial Prize winner Vernon Smith and Steven Gjerstad, after a review of the 11 U.S. recessions since World War II and as well as crises abroad.\n<\/p><\/blockquote>\n

So really she is parroting their argument which is that “basic premise at the Fed” that along with fiscal policy the central bank “navigates the economy like a ship through something called the business cycle, and that the North Star is data on business investment, such as a measure called ‘gross fixed investment’ (spending on plants, machinery or roads)” is false.<\/p>\n

The reason this premise is false (and we are taking their interpretation of the central bank’s thinking without question for the moment) is because “business investment isn’t the North Star to measure progress”.<\/p>\n

Instead, in rejecting the term “business cycle” they argue that the real driver of economic fluctuations is “purchases of new single and multifamily homes” – which is what the paper I referred you to is all about.<\/p>\n

In the paper they write:<\/p>\n

\nAlthough expenditure on new housing units is not a large component of GDP – which may explain its limited role in typical macroeconomic accounts of recessions – it is volatile, it has declined before ten of eleven post-war recessions and the Great Depression, it has rarely declined substantially without a recession following soon afterward,3 and the extent of its decline emerges as a good predictor of the depth and duration of the recession that follows.\n<\/p><\/blockquote>\n

So their first complaint is that business investment is not a leading indicator of economic activity.<\/p>\n

They then claim that monetary policy is not a powerful counter-stabilising policy tool. They write:<\/p>\n

\nWe also argue that there are two conditions in which monetary policy is deprived of much of its power: both conditions are present in the aftermath of the recent recession. First, accommodative monetary policy primarily affects new residential construction, and therefore a saturated housing market has only a muted response to monetary easing. Second, when household balance sheets are damaged in the aftermath of a serious housing bubble and collapse, households remain unresponsive to accommodative monetary policy as their focus turns to de-leveraging rather than borrowing for new housing assets or durable goods. In extreme cases the net flow of mortgage funds turns negative: this occurred in both the Great Depression and the Great Recession.\n<\/p><\/blockquote>\n

I have no problem with this conclusion. Modern Monetary Theory (MMT) does not prioritise the use of monetary policy as a counter-stabilising policy tool because it operates indirectly (that is, does not stimulate spending immmediately); it cannot be easily targetted; and the distributional effects are uncertain (creditors and debtors are impacted differently by interest rate changes).<\/p>\n

Further, the so-called non-standard monetary policy tools such as quantitative easing are based on the false premise that banks are currently not lending because they do not have sufficient liquidity. The claim that by swapping government and other bonds for reserves will lead to more bank lending denies the way banking operates.<\/p>\n

It is also a central MMT tenet that when the non-government sector is deleveraging to restore some sense of security to household balance sheets it is unlikely that the demand for credit will be high and that non-government spending will likely be insufficient to restore growth in any immediate time frame.<\/p>\n

Please read my blog – Balance sheet recessions and democracy<\/a> – for more discussion on this point.<\/p>\n

Ms Schlaes is correct in emphasising that central bankers think they can operate in an effective “countercyclical” manner (that is, against the direction of the private spending cycle) and that “homeowners who owe more than their houses are worth won’t take more loans or spend more money until their budgets look better. So quantitative easing won’t work now”.<\/p>\n

She clearly doesn’t know exactly what quantitative easing is although, to be fair, if one takes an uncritical view of what central bankers say in their hype, one might conclude that it was designed to stimulate lending by making more funds available to banks.<\/p>\n

The more sophisticated understanding of quantitative easing is that it impacts on the economy by reducing long-term interest rates (by pushing up demand for the assets which drives their yields down). This will only be stimulatory if investors perceive that there are profitable returns in the real economy to be made by borrowing at the lower rates.<\/p>\n

The evidence is clear that pessimism over expected revenue streams are outweighing the benefits of lower costs of finance. Further, firms know that they have enough capital in place at present to meet the demands for goods and services coming from the household sector, which itself is being subdued by the huge debt levels, precarious housing market, and the constant threat of unemployment.<\/p>\n

Please read my blog – Quantitative easing 101<\/a> – for more discussion on this point.<\/p>\n

So we can all agree that the emphasis on monetary policy as the vehicle to restore aggregate demand growth is misplaced. I would note that the dominance of monetary policy over fiscal policy is a characteristic of the neo-liberal era.<\/p>\n

Economists managed to convince governments that fiscal policy was ineffective and likely to increase inflation if used to reduce unemployment and that inflation targetting (supported by passive fiscal stances) was the best way to achieve price stability and maximise real GDP growth.<\/p>\n

There was no evidence supporting that mix. It was, in fact, it was a reflection of the neo-liberal hatred for government intervention in the economy and was accompanied by deregulation and other policy initiatives that was justified on the now clearly false claim that self-regulating markets would maximise wealth for all.<\/p>\n

Ms Schlaes then jumps a very wide gap – that is, declines to consider whether counter-cyclical fiscal policy should be the primary policy tool to support growth when private spending is weak – and writes that the belief that “procyclicality is supposed to be lethal” – is refuted by the two economists:<\/p>\n

\nSmith and Gjerstad argue that the best course for recovery seems to be for the government to practice austerity, by reducing spending, even during the recession. In other words, to adopt that dread procyclical position. Additionally, countries should focus on recovery through exports, they say, and allow their currency to depreciate to improve terms of trade for exporters.\n<\/p><\/blockquote>\n

Apparently, the book authors claim that the “austerity-depreciation mechanism is remarkable”.<\/p>\n

So lets dig into this alleged awesome “austerity-depreciation mechanism”.<\/p>\n

First, to understand movements in international competitiveness we have to differentiate several concepts: (a) the nominal exchange rate; (b) domestic price levels; (c) unit labour costs; and (d) the real or effective exchange rate. <\/p>\n

It is the last of these concepts that determines the “competitiveness” of a nation. This Bank of Japan explanation<\/a> of the real effective exchange rate is informative.<\/p>\n

The nominal exchange rate (e<\/em>) is the number of units of one currency that can be purchased with one unit of another currency. Movements in nominal exchange rates provide ambiguous signals about changes in international competitiveness for a nation.<\/p>\n

To determine whether a nation’s goods and services are becoming more or less competitive with respect to goods and services produced overseas you need to know about:<\/p>\n