Real wages in Greece rose during the Euro period leading up to the crisis because the rate of growth in earnings outstripped its low labour productivity growth.

The answer is False.

The question requires you to understand what determines the real wage and what the relationship between earnings and labour productivity growth is. When economists do not specify the unit you should always assume they are talking in nominal terms. So the reference to the “rate of growth of earnings” is in terms of the monetary unit which is the common understanding that people would have of the term.

In terms of the logic of the question, that would also be the only sensible interpretation.

The real wage is defined as the purchasing power equivalent on the nominal wage that workers get paid each period. To compute the real wage we need to consider two variables: (a) the nominal wage (W) and the aggregate price level (P).

We might consider the aggregate price level to be measured by the consumer price index (CPI) although there are huge debates about that. But in a sense, this macroeconomic price level doesn’t exist but represents some abstract measure of the general movement in all prices in the economy.

Macroeconomics is hard to learn because it involves these abstract variables that are never observed – like the price level, like “the interest rate” etc. They are just stylisations of the general tendency of all the different prices and interest rates.

Now the nominal wage (W) – that is paid by employers to workers is determined in the labour market – by the contract of employment between the worker and the employer. The price level (P) is determined in the goods market – by the interaction of total supply of output and aggregate demand for that output although there are complex models of firm price setting that use cost-plus mark-up formulas with demand just determining volume sold. We shouldn’t get into those debates here.

The inflation rate is just the continuous growth in the price level (P). A once-off adjustment in the price level is not considered by economists to constitute inflation.

So the real wage (w) tells us what volume of real goods and services the nominal wage (W) will be able to command and is obviously influenced by the level of W and the price level. For a given W, the lower is P the greater the purchasing power of the nominal wage and so the higher is the real wage (w).

We write the real wage (w) as W/P. So if W = 10 and P = 1, then the real wage (w) = 10 meaning that the current wage will buy 10 units of real output. If P rose to 2 then w = 5, meaning the real wage was now cut by one-half.

The relationship between the real wage and labour productivity relates to movements in the unit costs, real unit labour costs and the wage and profit shares in national income.

The wage share in nominal GDP is expressed as the total wage bill as a percentage of nominal GDP. Economists differentiate between nominal GDP ($GDP), which is total output produced at market prices and real GDP (GDP), which is the actual physical equivalent of the nominal GDP. We will come back to that distinction soon.

To compute the wage share we need to consider total labour costs in production and the flow of production ($GDP) each period.

Employment (L) is a stock and is measured in persons (averaged over some period like a month or a quarter or a year.

The wage bill is a flow and is the product of total employment (L) and the average wage (w) prevailing at any point in time. Stocks (L) become flows if it is multiplied by a flow variable (W). So the wage bill is the total labour costs in production per period.

So the wage bill = W.L

The wage share is just the total labour costs expressed as a proportion of $GDP – (W.L)/$GDP in nominal terms, usually expressed as a percentage. We can actually break this down further.

Labour productivity (LP) is the units of real GDP per person employed per period. Using the symbols already defined this can be written as:

LP = GDP/L

so it tells us what real output (GDP) each labour unit that is added to production produces on average.

Nominal GDP ($GDP) can be written as P.GDP, where the P values the real physical output.

Now if you put of these concepts together you get an interesting framework. To help you follow the logic here are the terms developed and be careful not to confuse $GDP (nominal) with GDP (real):

• Wage share = (W.L)/$GDP
• Nominal GDP: $GDP = P.GDP
• Labour productivity: LP = GDP/L
• Real wage: w = W/P

By substituting the expression for Nominal GDP into the wage share measure we get:

Wage share = (W.L)/P.GDP

In this area of economics, we often look for alternative way to write this expression – it maintains the equivalence (that is, obeys all the rules of algebra) but presents the expression (in this case the wage share) in a different “view”.

So we can write as an equivalent:

Wage share – (W/P).(L/GDP)

Now if you note that (L/GDP) is the inverse (reciprocal) of the labour productivity term (GDP/L). We can use another rule of algebra (reversing the invert and multiply rule) to rewrite this expression again in a more interpretable fashion.

So an equivalent but more convenient measure of the wage share is:

Wage share = (W/P)/(GDP/L) – that is, the real wage (W/P) divided by labour productivity (GDP/L).

I won’t show this but I could also express this in growth terms such that if the growth in the real wage equals labour productivity growth the wage share is constant. The algebra is simple but we have done enough of that already.

That journey might have seemed difficult to non-economists (or those not well-versed in algebra) but it produces a very easy to understand formula for the wage share.

Two other points to note. The wage share is also equivalent to the real unit labour cost (RULC) measures that Treasuries and central banks use to describe trends in costs within the economy. Please read my blog – Saturday Quiz – May 15, 2010 – answers and discussion – for more discussion on this point.

Now it becomes obvious that if the nominal wage (W) and the price level (P) are growing at the pace the real wage is constant. And if the real wage is growing at the same rate as labour productivity, then both terms in the wage share ratio are equal and so the wage share is constant.

The wage share was constant for a long time during the Post Second World period and this constancy was so marked that Kaldor (the Cambridge economist) termed it one of the great “stylised” facts. So real wages grew in line with productivity growth which was the source of increasing living standards for workers.

The productivity growth provided the “room” in the distribution system for workers to enjoy a greater command over real production and thus higher living standards without threatening inflation.

Since the mid-1980s, the neo-liberal assault on workers’ rights (trade union attacks; deregulation; privatisation; persistently high unemployment) has seen this nexus between real wages and labour productivity growth broken. So while real wages have been stagnant or growing modestly, this growth has been dwarfed by labour productivity growth.

The following blogs may be of further interest to you:

• The origins of the economic crisis
• The fiscal stimulus worked but was captured by profits

Question 2:

Quantitative easing aims to stimulate aggregate demand by reducing long-term investment rates whereas deficit spending aims to stimulate aggregate demand via tax cuts or direct public spending. Both policies ultimately work by increasing the net financial assets held by the non-government sector.

The answer is False.

Quantitative easing involves the central bank buying assets from the private sector – government bonds and high quality corporate debt. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserves.

So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank).

The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop.

But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

How these opposing effects balance out is unclear but the evidence suggests there is not very much impact at all.

Fiscal policy adds net financial assets to the non-government sector by way of contradistinction to quantitative easing.

The following blogs may be of further interest to you:

• Money multiplier and other myths
• Islands in the sun
• Operation twist – then and now
• Quantitative easing 101
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• Deficit spending 101 – Part 1
• Deficit spending 101 – Part 2
• Deficit spending 101 – Part 3

Question 3:

In last week’s 2012-13 Budget, the Australian government indicated that it aimed to achieve a budget surplus of 0.1 per cent of GDP in the next financial year. The aim underpins a massive fiscal shift from a budget deficit of around 3 per cent of GDP in 2011-12. If the actual budget outcome remains in deficit at the end of the next financial year the Australian government will be rightly considered not to have gone hard enough on its fiscal austerity plans.

The answer is False.

The actual budget deficit outcome that is reported in the press and by Treasury departments is not a pure measure of the fiscal policy stance adopted by the government at any point in time. As a result, a straightforward interpretation of movements in the actual outcome is difficult.

Economists conceptualise the actual budget outcome as being the sum of two components: (a) a discretionary component – that is, the actual fiscal stance intended by the government; and (b) a cyclical component reflecting the sensitivity of certain fiscal items (tax revenue based on activity and welfare payments to name the most sensitive) to changes in the level of activity.

The former component is now called the “structural deficit” and the latter component is sometimes referred to as the automatic stabilisers.

The structural deficit thus conceptually reflects the chosen (discretionary) fiscal stance of the government independent of cyclical factors.

The cyclical factors refer to the automatic stabilisers which operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.

In times of economic decline, the automatic stabilisers work in the opposite direction and push the budget balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).

The problem is then how to determine whether the chosen discretionary fiscal stance is adding to demand (expansionary) or reducing demand (contractionary). It is a problem because a government could be run a contractionary policy by choice but the automatic stabilisers are so strong that the budget goes into deficit which might lead people to think the “government” is expanding the economy.

So just because the budget goes into deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.

To overcome this ambiguity, economists decided to measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the budget balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.

As a result, 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. As I have noted in previous blogs, the change in nomenclature here 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 construction of the budget balance that would be realised if the economy was operating at potential or 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.

This framework allowed economists to decompose the actual budget balance into (in modern terminology) the structural (discretionary) and cyclical budget balances with these unseen budget components being adjusted to what they would be at the potential or full capacity level of output.

The difference between the actual budget outcome and the structural component is then considered to be the cyclical budget outcome and it arises because the economy is deviating from its potential.

So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the budget balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.

If the budget is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual budget outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual budget outcome is presently.

So you could have a downturn which drives the budget into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.

The question then relates to how the “potential” or benchmark level of output is to be measured. The calculation of the structural deficit spawned a bit of an industry among the profession raising 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.

As the neo-liberal resurgence gained traction in the 1970s and beyond and governments abandoned their commitment to full employment , the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see my blogs – The dreaded NAIRU is still about and Redefing full employment … again!.

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.

The estimated NAIRU (it is not observed) became the standard measure of full capacity utilisation. If the economy is running an unemployment equal to the estimated NAIRU then mainstream economists 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.

Typically, the NAIRU estimates are much higher than any acceptable level of full employment and therefore full capacity. The change of the the name from Full Employment Budget Balance to Structural Balance was to avoid the connotations of the past where 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 which are benchmarked using the NAIRU or some derivation of it – which is, in turn, estimated using very spurious models. This allows them to compute the tax and spending that would occur at this so-called full employment point. But it severely underestimates the tax revenue and overestimates the spending because typically the estimated NAIRU always exceeds a reasonable (non-neo-liberal) definition of full employment.

So the estimates of structural deficits provided by all the international agencies and treasuries etc all conclude that the structural balance is more in deficit (less in surplus) than it actually is – that is, bias the representation of fiscal expansion upwards.

As a result, they systematically understate the degree of discretionary contraction coming from fiscal policy.

The only qualification is if the NAIRU measurement actually represented full employment. Then this source of bias would disappear.

So the fact that the budget deficit is rising might actually indicate that the fiscal austerity program is more contractionary that the Government initially estimated and the automatic stabilisers (loss of tax revenue etc) are more than offsetting the discretionary cuts in net public spending.

The following blogs may be of further interest to you:

• A modern monetary theory lullaby
• Saturday Quiz – April 24, 2010 – answers and discussion
• The dreaded NAIRU is still about!
• Structural deficits – the great con job!
• Structural deficits and automatic stabilisers
• Another economics department to close

Question 4:

Modern Monetary Theory (MMT) brings an understanding of the way central banks purchase and sell government bonds to manage liquidity in the overnight cash markets and thus sustain their target rate of interest. MMT also leads to the conclusion that a central bank could still increase interest rates even if the US government instructed it to directly purchase treasury debt to facilitate the national government’s budget deficit.

The answer is True.

The question hinges on an unstated condition which relates to whether the central bank is offering a support rate on overnight reserves held with it by the private banks.

So what is the explanation?

The central bank conducts what are called liquidity management operations for two reasons. First, it has to ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. Second, it must maintain aggregate bank reserves at a level that is consistent with its target policy setting given the relationship between the two.

So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.

Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also can set a support rate which is paid on commercial bank reserves held by the central bank (which might be zero).

Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan and the US have typically not offered a return on reserves until the onset of the current crisis.

If the support rate is zero then persistent excess liquidity in the cash system (excess reserves) will instigate dynamic forces which would drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.

The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.

In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.

Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.

The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.

So the fundamental principles that arise in a fiat monetary system which are relevant here are as follows.

• The central bank sets the short-term interest rate based on its policy aspirations.
• Government spending is independent of borrowing which the latter best thought of as coming after spending.
• Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
• Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.
• The “penalty for not borrowing” is that the interest rate will fall to the bottom of the “corridor” prevailing in the country which may be zero if the central bank does not offer a return on reserves.
• Government debt-issuance is a “monetary policy” operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.

Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.

Further, the idea that governments would simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.

In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.

However, as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary unless it is prepared to offer a support rate to the banks for excess reserves held. In the absence of that offer, once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.

The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation under these circumstances (no support rate). The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.

The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.

However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.

The following blogs may be of further interest to you:

• The consolidated government – treasury and central bank
• Saturday Quiz – May 1, 2010 – answers and discussion
• Understanding central bank operations
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• Deficit spending 101 – Part 1
• Deficit spending 101 – Part 2
• Deficit spending 101 – Part 3

Question 5 – Premium question

In Year 1, the economy plunges into recession with nominal GDP growth falling to minus -1.0 per cent. The outstanding public debt is equal to the value of the nominal GDP and the nominal interest rate is equal to 1 per cent (and this is the rate the government pays on all outstanding debt). The inflation rate is stable at 1 per cent per annum. The government’s primary budget balance records a deficit equivalent to 1 per cent of GDP and the public debt ratio rises by 3 per cent. In Year 2, the government pushes the primary budget deficit out to 2 per cent of GDP and in doing so stimulates aggregate demand and the economy records a 4 per cent nominal GDP growth rate. All other parameters are unchanged in Year 2. Under these circumstances, the public debt ratio will rise but by an amount less than the rise in the budget deficit because of the real growth in the economy.

The answer is False.

The question relates to the key parameters and relationships that determine the dynamics of the public debt ratio. An understanding of these relationships allows you to debunk statements that are made by those who think fiscal austerity will allow a government to reduce its public debt ratio.

While Modern Monetary Theory (MMT) places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue, the mainstream debate is dominated by the concept.

The unnecessary practice of fiat currency-issuing governments of issuing public debt $-for-$ to match public net spending (deficits) ensures that the debt levels will rise when there are deficits.

Rising deficits usually mean declining economic activity (especially if there is no evidence of accelerating inflation) which suggests that the debt/GDP ratio may be rising because the denominator is also likely to be falling or rising below trend.

Further, historical experience tells us that when economic growth resumes after a major recession, during which the public debt ratio can rise sharply, the latter always declines again.

It is this endogenous nature of the ratio that suggests it is far more important to focus on the underlying economic problems which the public debt ratio just mirrors.

The mainstream framework begins with the flawed analogy between the household and the sovereign government such that any excess in government spending over taxation receipts has to be “financed” in two ways: (a) by borrowing from the public; and/or (b) by “printing money”.

Neither characterisation is operationally necessary in a fiat monetary system.

The basic analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.

However, in the mainstream framework for analysing these so-called “financing” choices the government budget constraint (GBC) is the central organising idea. The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:

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.

However, this is merely an 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 corrected added and subtracted.

So in terms of MMT, the previous equation is just an ex post accounting identity that has to be true by definition and has not real economic importance.

But for the mainstream economist, the equation represents an ex ante (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).

Further, in mainstream economics, money creation is erroneously 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.

This is called debt monetisation and you can find out why this is typically not a viable option for a central bank by reading the Deficits 101 suite – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3.

Anyway, the mainstream claims 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 to be generally preposterous because economies that are constrained by deficient demand (defined as demand below the full employment level) respond to nominal demand increases by expanding real output rather than prices. There is an extensive literature pointing to this result.

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.

But the mainstream claim that because inflation is inevitable if “printing money” occurs, it is unwise to use this option to “finance” net public spending.

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”.

Neither proposition bears scrutiny – you can read these blogs – Will we really pay higher taxes? and Will we really pay higher interest rates? – for further discussion on these points.

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.

A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.

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. The following equation captures the approach:

So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the real GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.

The real interest rate is the difference between the nominal interest rate and the inflation rate. Real GDP is the nominal GDP deflated by the inflation rate. So the real GDP growth rate is equal to the Nominal GDP growth minus the inflation rate.

This standard mainstream framework is used to highlight the dangers of running deficits. But even progressives (not me) use it in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn.

Many mainstream economists and a fair number of so-called progressive economists say that governments should as some point in the business cycle run primary surpluses (taxation revenue in excess of non-interest government spending) to start reducing the debt ratio back to “safe” territory.

Almost all the media commentators that you read on this topic take it for granted that the only way to reduce the public debt ratio is to run primary surpluses.

MMT does not tell us that a currency-issuing government running a deficit can never reduce the debt ratio. The standard formula above can easily demonstrate that a nation running a primary deficit can reduce its public debt ratio over time.

Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.

So the real interest rate in our example is 0 (nominal interest rate = 1 minus inflation rate =1) which then leads to the conclusion that that the proposition presented is false.

A growing economy can absorb more debt and keep the debt ratio constant or falling. From the formula above, if the primary budget balance is zero, public debt increases at a rate r but the public debt ratio increases at r – g.

The following Table simulates the two years in question. To make matters simple, assume a public debt ratio at the start of the Year 1 of 100 per cent (so B/Y(-1) = 1) which is equivalent to the statement that “outstanding public debt is equal to the value of the nominal GDP”.

Also the nominal interest rate is 1 per cent and the inflation rate is 1 per cent then the current real interest rate (r) is 0 per cent.

If the nominal GDP is growing at -1 per cent and there is an inflation rate of 1 per cent then real GDP is growing (g) at minus 2 per cent.

Under these conditions, the primary budget surplus would have to be equal to 2 per cent of GDP to stabilise the debt ratio (check it for yourself). So, the question suggests the primary budget deficit is actually 1 per cent of GDP we know by computation that the public debt ratio rises by 3 per cent.

The calculation (using the formula in the Table) is:

Change in B/Y = (0 – (-2))*1 + 1 = 3 per cent.

The data in Year 2 is given in the last column in the Table below. Note the public debt ratio has risen to 1.03 because of the rise from last year. You are told that the budget deficit doubles as per cent of GDP (to 2 per cent) and nominal GDP growth shoots up to 4 per cent which means real GDP growth (given the inflation rate) is equal to 3 per cent.

The corresponding calculation for the change in the public debt ratio is:

Change in B/Y = (0 – 3)*1.03 + 2 = -1.1 per cent.

So the growth in the economy is strong enough to reduce the public debt ratio even though the primary budget deficit has doubled.

It is a highly stylised example truncated into a two-period adjustment to demonstrate the point. In the real world, if the budget deficit is a large percentage of GDP then it might take some years to start reducing the public debt ratio as GDP growth ensures.

So even with an increasing (or unchanged) deficit, real GDP growth can reduce the public debt ratio, which is what has happened many times in past history following economic slowdowns.

Stimulating real growth (that is, in Y) is the most constructive way of reducing the public debt ratio when there is unemployment.

But the best way to reduce the public debt ratio is to stop issuing debt. A sovereign government doesn’t have to issue debt if the central bank is happy to keep its target interest rate at zero or pay interest on excess reserves.

The discussion also demonstrates why tightening monetary policy makes it harder for the government to reduce the public debt ratio – which, of-course, is one of the more subtle mainstream ways to force the government to run surpluses.

In Chapter 8, he talks about the song – Brother, Can You Spare a Dime? – which he said “was the so-called anthem of the Depression, a transcendent expression—if such a thing is possible—of the hopeless disillusionment of the 1930s.”

The lLyrics are memorable:

They used to tell me I was building a dream, and so I followed the mob,
When there was earth to plow, or guns to bear, I was always there right on the job.
They used to tell me I was building a dream, with peace and glory ahead,
Why should I be standing in line, just waiting for bread?

Once I built a railroad, I made it run, made it race against time.
Once I built a railroad; now it’s done. Brother, can you spare a dime?
Once I built a tower, up to the sun, brick, and rivet, and lime;
Once I built a tower, now it’s done. Brother, can you spare a dime?

Once in khaki suits, gee we looked swell,
Full of that Yankee Doodly Dum,
Half a million boots went slogging through Hell,
And I was the kid with the drum!

Say, don’t you remember, they called me Al; it was Al all the time.
Why don’t you remember, I’m your pal? Buddy, can you spare a dime?

Once in khaki suits, gee we looked swell,
Full of that Yankee Doodly Dum,
Half a million boots went slogging through Hell,
And I was the kid with the drum!

Say, don’t you remember, they called me Al; it was Al all the time.
Say, don’t you remember, I’m your pal? Buddy, can you spare a dime?

Before we go on – enjoy the original Bing Crosby version (10″ 75rpm version released on November 19, 1932 and was number 1 in the charts for 2 weeks) – its Friday, after all – the weekend beckons – but remember for all the unemployed workers victimised by the state terrorism of austerity – there is no weekend because there is no week.

Perhaps you could just put the work tools down for a moment and sing-a-along.

And if Bing isn’t your thing, have a listen to the great version by Tom Waits.

The song is about the unemployed men during the Great Depression who “built the nation” etc and are now without work – abandoned by the state which they built and defended.

I think of Marx when I listen to this song. In his rejection of the Classical arguments put by J.B. Say and David Ricardo that there could not be an overproduction crisis (that is, deficient aggregate demand leaving unsold goods and services), Marx said that at times of aggregate demand failure as inventories rise the workers are:

… less than ever supplied with grain, shoes, etc., to say nothing of wine and furniture.

Here Marx makes a crucial distinction that resonates into the modern debate. Overproduction has nothing much to do with absolute needs. The debate is not about whether production can outstrip needs. It is only needs with capacity to pay that count! And when aggregate demand falls short, firms lay off workers and the unemployed who “made the stuff” no longer have access to it because they lose their incomes.

Thomas Frank notes that in 2009 “someone posted Rudy Vallee’s recording” of the song on YouTube and:

… immediately people began to share their reactions to that wrenching bit of Depresssiana ..

He gives some examples of the comments which included:

This song speaks to the failures of Keynesian Economics. Public spending on infrastructure to stimulate the slowing economy – it has never worked and never will. It turns recessions into depressions like it did in the 30′s, and like it is doing now …

Call your reps and tell them NO to the proposed “stimulus”.

The lyricist (Yip Harburg) was a socialist and blacklisted by the McCarthy purges.

But now, as Thomas Frank observes – in this period of conservative revisionism:

… it is evidently possible to listen to …. [the song] … and hear it as a call for a purified form of free-market economics, as a warning against public works projects, maybe as an endorsement of the Hoover administration, even … That conservatives are the rightful heirs to Depression culture. That the songs and books and movies of the thirties abound with lessons on the wisdom of markets and the follow of government …

The thirties, as we know them in the Internet age, are very different from the thirties we know from the canonical literature of the time or the standard histories of the period. To Google nearly any aspect of the first two Roosevelt administrations is to encounter almost immediately the obsessive loathing for the New Deal felt by conservative entertainers and liberatarian economists.

He cites a growing literature which claims that it provers “over and over again that the New Deal was not necessary, did not help, and very probably made the Depression worse”.

It is clear from this literature that “Yip Harburg was bemoaning government meddling when he wrote “Brother, Can You Spare a Dime?” What else was there to bemoan?”

Later in Chapter 8, Thomas Frank notes that the “ultimate act of thirties usurpation is Ayn Rand’s thousand-page 1957 novel, Atlas Shrugged“, which decribes the struggle of “group of business leaders fighting big-government oppression”.

The book is set in the Great Depression and follows a strike of the “noble producers who are unfairly oppressed” but the strikers are the capitalists who stand in contradistinction to the rest of us – the parasites who “use government to mooch and freeload on the labors of the virtuous capitalist”.

Rand claims that the “workers didn’t build America … businessmen did”. The hero, an entrepreneur named John Galt said at one stage:

We’ve heard it shouted that the industrialist is a parasite, that his workers support him, create his wealth, make his luxury possible – and what would happen if they walked out? Very well. I propose to show to the world who depends on whome, who supports whome, who is the source of wealth, and makes whose livelihood possible and what happens to whom when who walks out.

So the “captains of industry” (and more recently, the Wall Street banksters) are the “great victims … who have contributed the most and suffered the worst injustice in return.” John Galt declares himself “the defender of the oppressed, the disinherited, the exploited – and when I use those words, they have, for once, a literal meaning.”

Atlas Shrugged is a bible for the conservatives who loathe the “looting government” and the parasitic workers. It allows the conservatives to reconstruct all history in terms of the corrupt and misguided government policies inflicting untold misery on the true wealth producers – the capitalist (entrepreneur).

An economic crisis always becomes the fault of governments trying to help the parasites. In announcing the strike, John Galt says:

We have seen a proud, strong country fall to her knees. Her people have become slovely, inept and irresponsible. We do not see any morality in working hard for the benefit of those who choose not to. We do not see any moral value in contributing to a society that seeks to rule, rather than govern, and steal from the Producers to give them who are Looters and Moochers. We hereby [sic] withdraw our Producing abilities, from a society that is unworthy of such contributions.

You, who would damn us, for a pursuit of success, for aspiring to our greatest human potential; yet who depend on our contributions to a society which you leach [sic] from ..

Incredible really.

Thomas Frank systematically demolishes the social theory implicit in Atlas Shrugged.

But for my purposes today I was thinking about all this as part of my current study of the Great Depression and the similarities in conservative narratives at that time in relation to what we have to put up with now.

I read an extraordinary delusional Bloomberg Op Ed yesterday (May 17, 2012) – Supply-Siders’ Case for Austerity Carries No Shame – by conservative journalist Amity Shlaes.

She teaches (at least that is what they call it) as an adjunct in the economics program at the New York University Stern School of Business. Add that to your list of programs to avoid if you would like an education rather than an indoctrination.

She is one of a growing number of conservatives that have taken it as their life work to re-examine history and present new interpretations – aka making stuff up.

The conservatives have long attacked the socialist nations (especially during the Cold War) for their revisionism – inventing new history when the actual history is inconvenient.

This is what they are now doing themselves.

In this Bloomberg article, Shlaes claims that there is no shame in pushing for “budget cuts instead of growth” and the Republicans should learn that their fear of the political backlash of advocating austerity is “exaggerated. And that the austerity concept is misunderstood”.

So the conservative putsch in spades!

She claims that:

Growth happens more easily when people believe that government is, and will remain, small. Austerity makes government smaller. Sometimes you have to have austerity first, so that you have trust, and growth can come later.

There is no empirical evidence to support the claim that economies with “small” government grow more easily, more quickly, or deliver bigher per capita income. There is good evidence to the contrary although the empirical terrain of this sort of econometric modelling is riddled with measurement disputes and technical shortcomings with respect to the different between causality and correlation.

For example, several studies find negative correlations between government spending as a proportion of total spending and growth. But more deeper analysis reveals that the causality flows the opposite way via the automatic stabilisers – so when the economy grows slows the proportional size of goverment rises and vice versa.

She then claims that the US “nightmare” is that it “fears replicating: Europe”. I note in her public bios she lists no formal qualifications in economics despite being an adjunct professor of economics ant Stern. It shows. Where is the evidence that the US fears it will become like Europe?

Why would it? It issues its own currency and bond markets no that. The bond markets also know that the EMU member states do not issue their own currency and thus face solvency risk and are acting accordingly.

No rational person who understood the slightest thing about the difference between the two monetary systems in question would have the slightest fear that she claims.

She claims that the Euro crisis is:

… a crisis of trust. First, markets and individuals trusted European governments when they said their budgets balanced over the long run. Stable governments with balanced budgets would leave the economy some room to grow and realize the advantages of a new continent-wide currency. Then the observers realized the governments were lying. Restoring trust is harder than killing it.

Which doesn’t bear any resemblance to the facts of the crisis that we are witnessing in our own time. Firstly, balanced budgets do not leave room for an economy to grow. The ensure that the private domestic balance (the difference between income and spending) will replicate the external balance. So a current account deficit will be a private domestic deficit of the same proportion of GDP.

Whether that situation is conducive to growth depends on a number of factors. But it is likely that such a situation will be unsustainable in the medium-term because it requires the private domestic sector to be accumulating increasing volumes of debt to sustain growth in demand – the private deficit in that case being the only positive contributor to real growth.

I glean that Shlaes hasn’t the slightest understanding of these macroeconomic balances and how they interact and just adopts the mantra – balanced budgets are good as an ideological statement without knowing what that means.

Her solution to the Euro crisis is also bizarre but mainstream:

The simplest way for European governments to restore voter and market trust is to cut national budgets dramatically.Even by half.

The “even by half” reflects deep scientific calibration.

But she would oversee a massive increase in unemployment, further poverty and, most likely, rising deficits due to the automatic stabilisers. Before “her government” could absorb all that it would be stormed by angry mobs intent on overthrowing her despotic regime.

The twisted logic she brings to journalism is exemplified in this tract:

Such deep cuts, however, are deemed politically impossible. The Europeans will do just about anything to avoid seriously reducing their budgets, including raise tax rates, so they can get more revenue on paper. These tax increases are the kind of austerity that supply-siders have historically deplored. It’s true that higher taxes deter activity, but partly because they give license for larger government by supplying cash for future spending.

So “budgets” are not a balance but spending, which reflects the bias of the conservatives.

Further, tax rate increases deter activity but do no necessarily deliver more “cash for future spending” – because at lower levels of activity, the volume of tax revenue at the given rates may easily (and probably would be) much lower.

Shlaes likes to market herself as an historian. She claim in this article that austerity would push unemployment up:

But there is also evidence that long-term unemployment will be just as bad if the U.S. doesn’t cut the budget in the short term. That evidence is called the 1970s.

I was mystified by this bit of historical invention as I am very familiar with the behaviour of long-term unemployment in the US.

You might like to read this US Bureau of Labor Statistics publication – A glance at long-term unemployment in recent recessions – published in January 2006. It analyses the behaviour of long-term unemployment for the recessions in the 1970s, 1980s, comparing them to the downturns in the US economy in the 2000s (but clearly excluding the current crisis).

The Report says:

In November 1975, the share of persons jobless for more than half a year peaked at 2.1 percent of the labor force, 8 months after the end of the 1973-75 recession.2 In June 1983, 7 months after the official end of the 1981-82 recession, the long-term jobless rate peaked at 3.1 per cent, the highest recorded in the post-World War II era. Although the downturn of 1990-91 more closely resembled that of the mid-1970s in terms of the magnitude of the long-term unemployment rate – just over 2 percent in October 1992 – the rate did not peak until 19 months after the official end of the recession (March 1991). Following the 2001 downturn, the long-term jobless rate peaked at 1.4 percent in September 2003, 22 months after the official end …

The most obvious reason for the slow improvement in long-term unemployment followingthe two most recent contractions was the relatively slower pace of job growth. Following each of the recessions of the mid-1970s and early 1980s, employment rose by 1.5 percent within a year. In contrast, employment was virtually unchanged in the year following the 1990-91 and 2001 recessions. As shown in the accompanying table, even by the time long-term unemployment had started to decline, employment had risen by 1.0 percent or less. Also, in contrast to the recessions of the mid-1970s and early 1980s, the employment-to-population ratio continued to decline far longer following the recessions of 1990-91 and 2001.

The fiscal response in 1974 (that is, the annual fiscal shift) towards deficit was substantial (from $US6,135 million to $US53,242 million) which helped the economy recover relatively quickly. The response of long-term unemployment reflected that.

Schlaes regularly revises history. In her recent book – The Forgotten Man – she does some reinvention about the New Deal. Thomas Frank considers this book and says that:

The larger object of Shlaes’ 2007 book … is to document the conservative article of faith that Rooesevelt’s New Deal did not help the nation recover from the Depression. The author uses two measurements of the national economy to accomplish this goal: the Dow Jones Industrial Average and unemployment numbers. The first metric had little to do with the economy as average people experienced it; the second metric is actually rigged against Roosevelt – Shlaes counts people who held temporary government jobs as having been unemployed. The author thereby makes a mystery of the enthusiasm for FDR felt by the millions of people who were saved by jobs with the WPA. As for the standard yardstick of economic well-being – GDP growth – Shlaes does not even mention it atall.

One the chance that anyone gives a damn about what actually happened in the thirties, here are the numbers. GDP shrank dramatically from 1929 to 1933, then abruptly reversed course in the year after Roosevelt took office . “Real GDP increased 11% in 1934, 9% in 1935, and 13% in 1936″, writes the economist Christina Romer – and those percentages … dwarf the growth levels of the eighties, nineties and zeroes”.

Conclusion

The conservatives have only one recourse to attempting to match the facts with their erroneous theories about fiscal policy. They have to reconstruct the facts – a process that includes leaving important facts out and focusing on irrelevant correlations; fabricating facts; using definitions that no-one else would consider reasonable and then blurring the definition – and more.

They should be disregarded. The lessons of history are firmly supportive of the view that when non-government spending growth lapses, growth can be engendered with an increased contribution from government net spending. It is a proposition that is glaringly obvious in concept and stands the test of time.

The conservatives hate that reality. So instead – make an alternative up.

Saturday Quiz

The Saturday Quiz will be back tomorrow – a few tricks are planned.

That is enough for today!

Thus a CAD signifies the willingness of the citizens to “finance” the local currency saving desires of the foreign sector. MMT thus turns the mainstream logic (foreigners finance a nation’s CAD) on its head in recognition of the true nature of exports and imports.

Subsequently, a CAD will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the CAD gets squeezed down to zero. This might be painful to a nation that has grown accustomed to enjoying the excess of imports over exports. It might also happen relatively quickly. But at least we should understand why it is happening.

Further to this understanding, MMT turns the focus of trade around from the normal mainstream view that CADs are a problem which should be eliminated.

First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.

This doesn’t mean that there is not the possibility that severe distributional shifts (in costs and benefits) might occur on a microeconomic level within a nation undergoing a change in patterns of trade. So workers in manufacturing belts might lose their jobs because imported goods become cheaper and consumers (including the same workers who lose work) voluntarily choose to purchase the cheaper (and in some cases, higher quality) products.

While this process is painful appropriate government policy can help to alleviate the costs of adjustment and engender an environment where the workers transit into other uses. Structural adjustment is always painful though and is best achieved at times of full capacity.

Further, even if a growing trade deficit is accompanied by currency depreciation, the real terms of trade are moving in favour of the trade deficit nation (its net imports are growing so that it is exporting relatively fewer goods relative to its imports).

Second, CADs reflect underlying economic trends, which may be desirable (and therefore not necessarily bad) for a country at a particular point in time. For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.

A current account deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in flows in the financial account. While it is commonly believed that these must eventually be paid back, this is obviously false.

As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets will remain in demand.

However, if a country’s spending pattern yields no long-term productive gains, then its ability to service debt might come into question.

Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase ability to service the associated debt. Roughly speaking, this means that growth of GNP and national income exceeds the interest rate (and other debt service costs) that the country has to pay on its foreign-held liabilities. Here we need to distinguish between private sector debts and government debts.

A lot of people think that this analysis only applies to the US because its currency is also seen as the “reserve currency” in the world so will always be in demand for a multitude of uses. However, the sovereignty of the US in its own currency is intrinsic to its monopoly issuance status not to the fact that its currency is used by other nations.

Further, a national government can always service its debts so long as these are denominated in domestic currency, which it issues under monopoly conditions. In the case of national government debt it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.

In the case of private sector debt, this must be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. These are rough but useful guides.

Note, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.

Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.

The general trade point is that in a macro sense, exports are a cost to a nation (foregone use locally) and imports deliver benefits. The motivation to trade then is to gain access to goods and services that are not available locally (in terms of quantity and/or quality).

However, there are other dimensions to this rather simple “macro” perspective that are also interesting and challenging. It could be that an export delivers broader costs that are not considered in the immediate circumstances of the exchange. We think of trade transactions as voluntary exchanges between parties which are presumably motivated by each side of the bargain making assessments about the use value of their acquisition.

We think that a nation that runs current account surpluses (such as China) is depriving their people of access to goods and services in return for financial claims on foreign nations.

Please read my blog – Modern monetary theory in an open economy – for more discussion on thow MMT considers the open economy.

But it goes deeper than that.

There was a Fortune Magazine article (February 24, 2011) – America’s hottest export: Weapons – which documented how a large order from Saudi Arabia – for 84 F-15 fighter jets – allowed a failing production line in St Louis, Missouri to remain in business.

This story is part of a larger arms export drive promoted by the US Defense Department. Fortune write that in October 2010:

… the Department of Defense … announced an arms package worth some $60 billion … It was the biggest overseas arms sale in recent memory, and it extended the life of the production line through 2018 … The Department of Defense last year told Congress of plans to sell up to $103 billion in weapons to overseas buyers, a staggering rise from an average of $13 billion a year between 1995 and 2005 …

The story quotes two arms industry experts who said that “Obama is much more favorably disposed to arms exports than any of the previous Democratic administrations … [and] … There’s an Obama arms bazaar going on”.

The article notes the risk in an all-out military exports strategy which seems to have been the hallmark of the Obama era:

… supplying some nations with advanced weaponry is a risky strategy, especially as the Middle East, which is teeming with American-made arms, crackles with the sparks of regime change. While the U.S. sells weapons only to its allies, power can shift quickly — just look at Tunisia and Egypt. Even Saudi Arabia, with its 86-year-old monarch, could see a change in leadership. When friends become foes, arms exports become a liability. The government sold dozens of F-14 fighter jets to Iran in the 1970s before the Shah was deposed. Since then the U.S. has systematically destroyed F-14 parts to keep them out of Iran’s hands.

This sort of trend tends to accelerate during a severe economic downturn. The arms export contracts “support thousands of high-paying, highly skilled manufacturing jobs” in the nation and that reality helps to hide from the electorate other more sinister motivations that national governments might have.

Fortune Magazine says that the Presidential imperative is motivated not by jobs but by “U.S. alliances … America’s broader role in the world”.

But there is more to it than that. Enter the military-industrial complex – which has been described in the 1995 article by Robert Higgs, aptly titled – World War II and the Military-Industrial Congressional Complex – as the monolith that led the US to sacrifice “much of its potential dynamism as the massive commitment of resources to military R&D diverted them from the civilian opportunities being pursued with great success in Japan, Germany, and elsewhere”.

The Fortune article notes that:

Defense contractors like Boeing are notorious for spreading their manufacturing outlets across the country to curry political favor … But its heart beats in Arlington, Va., which is where it gets its lifeblood — government spending. There, executives in crisp suits walk alongside uniformed servicemen. Many of those officers will leave the military and walk straight into corporate gigs … The industry does 80% to 90% of its business with the Pentagon.

One of the insights from the WikiLeaks cables is that in all “backdoor dealings with other nations, American officials acted as de facto pitchmen for U.S.-made weapons. The cables call this marketing process ‘advocacy’.”

In a Washington Post article a few weeks ago (May 3, 2012) – Obama plan would ease weapons export rules – we read that the:

The Obama administration is crafting a proposal that could make it easier to export firearms and other weapons to certain countries in an effort to boost sales for U.S. companies, increase trade and improve national security …

Apparently, two US federal government departments – the Department of Homeland Security and the Justice Department – “have expressed concerns that the changes in the export rules could make it easier for drug cartels and terrorists to obtain weapons and make it harder to stop firearms trafficking”.

This insidious symbiosis between the governments and the military is nothing new.

In a famous speech in 1961 – Military-Industrial Complex Speech the outgoing US President
Dwight D. Eisenhower claimed that the basic purposes of America:

… have been to keep the peace; to foster progress in human achievement, and to enhance liberty, dignity and integrity among people and among nations … [but that] … Progress toward these noble goals is persistently threatened by the conflict now engulfing the world. …

He warned that while a “vital element in keeping the peace is our military establishment” the emerging “conjunction of an immense military establishment and a large arms industry is new in the American experience” and “we must not fail to comprehend its grave implications”.

These are:

… the acquisition of unwarranted influence, whether sought or unsought, by the military industrial complex … endanger our liberties or democratic processes.

He urged the US to consider “(d)isarmament, with mutual honor and confidence” as “a continuing imperative” and that “we must learn how to compose differences, not with arms, but with intellect and decent purpose.”

Then we go back to the 1930s. During the Great Depression the arms industry was struggling under the weight of a government intent on cutting the burgeoning budget deficit that had risen on the back of a collapse in economic activity and the fall in tax revenue.

In 1934, the US Senate set up the – Special Committee on Investigation of the Munitions Industry (aka The Nye Committee after the chairperson Gerald Nye, a Republican with liberal tendencies).

The US Senate Archive tells us that:

Although World War I had been over for 16 years, the inquiry promised to reopen an intense debate about whether the nation should ever have gotten involved in that costly conflict … The so-called “Senate Munitions Committee” came into being because of widespread reports that manufacturers of armaments had unduly influenced the American decision to enter the war in 1917. These weapons’ suppliers had reaped enormous profits at the cost of more than 53,000 American battle deaths. As local conflicts reignited in Europe through the early 1930s, suggesting the possibility of a second world war, concern spread that these “merchants of death” would again drag the United States into a struggle that was none of its business. The time had come for a full congressional inquiry.

The hearings lasted 18 months and more than 200 witnesses were called (including robber barons J.P. Morgan, Jr., and Pierre du Pont).

The Committee aim was to eliminate the influence of the military industry in political decision making by “nationalizing the arms industry”.

The Preliminary Report is available HERE. The Committee was terminated for political reasons before it had a chance to finish its work.

Among the findings released we read:

1. “The Committee finds, under the head of sales methods of the munitions companies, that almost without exception, the American munitions companies investigated have at times resorted to such unusual approaches, questionable favors and commissions, and methods of “doing the needful” as to constitute, in effect, a form of bribery of foreign governmental officials or of their close friends in order to secure business.”

2. “The committee accepts the evidence that the same practices are resorted to by European munitions companies, and that the whole process of selling arms abroad thus, in the words of a Colt agent, has “brought into play the most despicable side of human nature; lies, deceit, hypocrisy, greed, and graft occupying a most prominent part in the transactions.”

3. “The committee finds such practices on the part of any munitions company, domestic or foreign, to be highly unethical, a discredit to American business, and an unavoidable reflection upon those American governmental agencies which have unwittingly aided in the transactions so contaminated.”

4. “The committee finds, further, that not only are such transactions highly unethical, but that they carry within themselves the seeds of disturbance to the peace and stability of those nations in which they take place.”

5. “The committee elsewhere takes note of the contempt of some of the munitions companies for those governmental departments and officials interested in securing peace, and finds here that continual or even occasional corruption of other governments naturally leads to a belief that all governments, including our own, must be controlled by economic forces entirely.”

6. “The committee finds, under this head, that there is no record of any munitions company aiding any proposals for limitation of armaments, but that, on the contrary, there is a record of their active opposition by some to almost all such proposals, of resentment toward them, of contempt for those responsible for them, and of violation of such controls whenever established, and of rich profiting whenever such proposals failed.”

The Committee gained access to private correspondence – for example in relation to a proposal after WW1 to “control the international traffic in arms” a “Colt licensee in Belgium wrote”:

It is, of course, understood that our general interest is to prevent the hatching up of a new agreement plan “under such a form” … “that it may be accepted by the governments of all the countries who manufacture arms and munitions of war.”

The intercepted letter also proposed methods of “lengthening the controversies” and suggestions to “wear out the bodies occupied with this question.”

The rest of the Report is gruelling reading. It was tabled in the US Senate, 74th Congress, 2nd session, February 24, 1936.

What about the other side of the arms deals? The import side?

An Al-Jazeerah editorial (published April 18, 2011) – Dictators Squandering the Arab Wealth – considered the impact in Saudi Arabia of the massive US sales to them reported by the Fortune Magazine.

The editorial said that:

The ongoing Arab youth uprisings have underscored the depth of political oppression and economic hardship that the majority of the Arab people have experienced. More importantly, the uprisings have brought to the surface the reality that resources and wealth in the Arab world are seldom utilized to serve the people. Unapologetically, Arab rulers consider their nations’ wealth as their own property; their personal bank accounts and those of the states are one and the same.

This fact, along with the governments’ willingness to engage in brutality against those who oppose them, has deepened dependency on superpowers. The latter has become the norm, and transparent and sound economic decisions have been forfeited. Subsequently, national wealth is wasted and priorities are set irrespective of national needs and whether or not resources are directed toward productive growth.

I love Al-Jazeerah because they don’t mince words.

While the “Arab oil-rich states have accounted for “50% of foreign military sales signed between 2006 and 2009″, Al-Jazeerah notes that:

The Arab states have no actual use for the more sophisticated type of weapons and these weapons are, therefore, stored in warehouses to rust. Furthermore, national military officers have limited access to them. However, weapons which have domestic application are used by Arab rulers to repress their own citizens … While buying sophisticated weapons helps in recycling oil money to the advantage of the superpower, Arab resources have been diverted to these unproductive sectors thereby threatening economic development and endangering the welfare of future generations.

I have previously written about the Eurozone armaments trade and how that is an intrinsic element in the imbalances that have arisen since the Eurozone was established. Please read my blog – The value of government – for more discussion on this point.

The German magazine Der Spiegel carried a photo of a big U boat on November 11, 2010 carrying a Greek flag and said that:

Modernste U-Boote mit Brennstoffzellentechnik: Trotz Finanzkrise haben etwa die Griechen insgesamt sechs Boote der Klasse 214 bei den deutschen Howaldtswerken (HDW) geordert, die zu ThyssenKrupp Marine Systems gehören.

Meaning? These state-of-the-art U-boats (submarines) are equipped with fuel cell technology : Despite the financial crisis, the Greeks have ordered a total of six boats of the Class 214 from the German company HDW, which is owned by ThyssenKrupp Marine Systems.

The Greek government (when they had one) was being coerced at the time by the Germans into seriously cutting back their social spending but at the same time were still buying very expensive arms from the Germans.

The Euro madness is characterised by a strong Germany exporting to weaker nations a lot of military trash while at the same time demanding the same nations who buy their exports to cut government spending (but presumably not on goods that the Germans sell).

The Spiegel article (November 11, 2010) – Kanonen für die Konjunktur said that:

Vor den Deutschen rangieren in der Rangliste der Waffenhändler nur noch die USA und Russland; hinter ihnen die von hiesigen Rüstungsmanagern beneideten Franzosen und Briten. Nach Berechnungen des anerkannten Stockholmer Friedensforschungsinstituts SIPRI lag der deutsche Weltmarktanteil zwischen 2005 und 2009 bei elf Prozent. Den wiederum größten Anteil an Kriegswaffen made in Germany erhielten demnach die Türkei (14 Prozent), Griechenland (13 Prozent) und Südafrika (zwölf Prozent). Im Jahr 2008 etwa erlaubte die Bundesregierung die Ausfuhr von Rüstungsgütern im Wert von fast sechs Milliarden Euro.

Translation: “Germany ranks third in the world behind the US and Russia in world sales of armaments. According to data available from the acknowledged Stockholm Peace Research Institute, the German share of the world market over 2005-2009 averaged eleven percent. The largest buyers of military equipment made in Germany were Turkey (14 percent of total sales), Greece (13 percent) and South Africa (twelve percent). In 2008, the federal government allowed military equipment worth almost six billion euros to be exported”.

One commentator, reacting to the Washington Post story (cited above) – Our Guns and Butter Economy – (May 11, 2011) raised the essential question:

Should we simply say that any exports — no matter their moral, ethical, environmental or health implications — are inherently good?

The neo-liberal view propounded by the IMF and the World Bank and to which most advanced nations have bought into constructs export-led growth as the desirable pattern for nations to follow.

They conclude that it is job-creating and allows governments to run surpluses if net exports are strong enough. Of-course, it is a deeply flawed strategy from a macroeconomic perspective.

Apart from the fact that only some nations can be in trade surplus (because there has to be offsetting deficits), the push for fiscal austerity undermines the capacity of nations to import (which, in turn, undermines the exporter’s revenue).

But below the macroeconomic perspective, is a seedy micro world of armaments, corruption, crime, bribery, and misery. The Nye Committee exposed that 80 odd years ago. Not a lot has changed except it has become more institutionalised.

The article concludes that:

… America has become the true “Lord of War,” as the arms dealer motto goes. We are the leading arms supplier to the developing world and we are responsible for the majority of all weapons sales across the globe. Yes, we are so committed to selling instruments of death to the rest of the planet that military industries have almost tripled their share of the U.S. economy in just a decade.

The question that citizens have to ask is aptly summarised by the author (one David Sirota) – ”

Should we simply say that any exports – no matter their moral, ethical, environmental or health implications – are inherently good? Does “necessity” really mean that “stuff” for stuff’s sake must be the basis of our export economy?

MMT provides no answers to that question and when we say that exports are a cost and imports are a benefit we are talking in terms of the $-spending flows only which drive output and employment (somewhere).

Another layer of analysis has to be entered into to understand the micro (distributional, externalities etc) costs and benefits of trading patterns.

But at the macroeconomic level, MMT does allow us to understand that if we are horrified at the micro level about this insidiously dangerous military-industrial complex and want to cut it back and eliminate its influence then we should not cast that in terms of deficit cutting – if there is excess capacity remaining in the economy.

The US currently spends about 4.8 per cent of GDP on the military (see the Stockholm International Peace Research Institute database).

That is a lot of spending that needs to be reallocated.

I notice Australian progressives are applauding the big cuts to defense spending in the 2012-13 Budget last week – as a victory for peace activism etc. But the micro decision might be good but the macro decision to pursue a surplus is bad.

Progressives have to understand the macroeconomics perspective at the same time they promote what many will consider a valid micro perspective.

Conclusion

The general point is that it is easier being a macroeconomist because all these issues are submerged below the aggregates. We worry about economic and employment growth overall.

Further our understanding of the relative costs and benefits of traded goods and services doesn’t extend to considerations of the external effects – the geo-political effects etc – of certain items of trade.

That is not a shortcoming but a division of labour. For those who advocated at the sub-macro level – it is crucial that they understand that hacking into military budgets, however desirable, has macroeconomic implications which need to be considered. The latter domain is where MMT fits in.

I am travelling today so I have to stop.

Total aside

A while ago I did an interview for the Business Review Weekly. The result was this article – Rock Star Economists – published May 17, 2012.

Take it as you like.

That is enough for today!

He outlined where the Treasury forecasts made in the 2011-12 Budget had failed to materialise (mostly excessive optimism regarding export growth – predicted 6.5 per cent against probably actual of 4 per cent – taking 1 per cent of total real GDP growth one you take into account the fact that imports will probably be higher than expected).

In relation to the planned fiscal austerity that the Government announced (to get the budget back into surplus despite a slowing economy), he said:

… let me make some general comments about the impact of discretionary fiscal policy on the macro-economy.

I have to admit that I am intrigued by the arguments put forward by a number of commentators on this issue. Obviously, it is not a new issue, with people arguing strenuously in recent years that the fiscal stimulus injected during the GFC had no impact on economic activity. For consistency, those same people presumably argue that that any fiscal consolidation must also have no impact on the macro-economy … [after some theoretical discussion and consideration of evidence he concluded] … In short, the standard Mundell-Fleming theory appears to hold under a specific set of conditions, but when these conditions are relaxed discretionary fiscal policy has significant real effects, and to suggest otherwise risks a triumph of ideology over experience.

So the Australian Treasury clearly thinks that the fiscal multipliers are “positive and sizeable” which runs in contradistinction to what a large number of the academic economists think. But then the latter are ruled almost entirely by ideology and refuse to adjust their position when the facts dictate otherwise.

In that context, the Treasury boss acknowledged that his Department was consistent in its view and thus knew that last week’s Budget will have “a contractionary effect on activity”. The question is how much of an effect.

Last week, the Government announced one of the largest single-year fiscal shifts in our history which amounts to 3.1 per cent of GDP in 2012-13. The Treasury boss correctly noted that the final impact (via the multipliers) depends on various factors including the (avoided) leakage from the domestic spending system (via imports).

In his analysis of the size of the real GDP contraction that the budget austerity will cause he repeated the Government’s mantra that the economy was close to full employment and growing around trend and concluded from that:

There are also those who argue that returning the budget to surplus in 2012-13 is a political gesture and there would be no great harm in delaying this by a year or so.

The problem with this argument is that if it’s not appropriate to restore the structural budget position when we have low unemployment and the economy is expected to grow at around trend, when will it be appropriate?

My first observation is that there is no necessity for the budget to be in surplus if the economy was growing on trend. Depending on the behaviour of the external sector and the private domestic sector, the structural budget position at “trend growth” could be a surplus or deficit (of varying magnitudes) or even a balance.

So for a nation with a current account deficit of say 2 per cent of GDP, and the private domestic sector spending exactly what it earns (S = I) and therefore not building indebtedness overall, the appropriate government balance would be a deficit of 2 per cent even if trend growth was being achieved.

In other words, the a particular budget balance should not be the target of policy because it is determined by both government spending and tax plans and the strength of private spending. The latter determines how much tax revenue the government earns for a given tax structure. There is nothing sacrosanct about a budget surplus in isolation from what is happening in non-government sector.

The Budget estimates for 2012-13 – which take into account the dramatic fiscal shift are interesting.

The following Table is taken from the Budget papers and shows the Treasury estimates for the next financial year and some back-casting. Note that the 2011-12 figures (for the 2012-13 Budget) are estimates made in last week’s Budget of what this year will be – when it is finished on June 30, 2012. The far right column tells you what the Treasury thinks is going to happen in the forthcoming 2012-13 financial year.

We thus know that they are forecasting exports to grow by 4.5 per cent and imports to grow by 7.5 per cent. Once you consider the secondary income transfers that are added to the trade balance to generate the Current Account – they are always negative and large – then it is clear that the Treasury is assuming a significant drain on real GDP growth coming from the external sector, mining boom (and record terms of trade for our primary commodities) notwithstanding.

From Budget Paper No. 1 .which presents the main Economic Outlook (Statement 2) we learn that:

The current account deficit is expected to widen to 4¾ per cent of GDP in 2012-13 and 6 per cent of GDP in 2013-14. This largely reflects the forecast shift of the trade balance from surplus in 2011-12 to deficit in both 2012-13 and 2013-14 because of a strong rise in resources investment-related imports and the expected decline in the terms of trade.

That is a significant aggregate demand drain from the economy and will have to offset by growth in private spending given that public spending will also be a fiscal drag on growth.

The Treasury believe that the strong growth in imports “predominantly reflects the larger-than-expected business investment growth … resources investment is very import intensive, and the shift towards investment for LNG projects makes it even more so”.

From Budget Paper No. 1 .which presents the main Economic Outlook (Statement 2) we learn that “Household consumption is expected to grow 3 per cent in both 2012-13 and 2013-14″ and “New business investment growth is expected to be a strong 12½ per cent in 2012-13″.

Overall, given their relative weights in total private final demand growth is expected to be 5 per cent in 2012-13.

The Budget also estimates Private Final Demand to grow at 5 per cent about slightly slower than at present. Public Final Demand is forecast to grow at -0.5 per cent in 2012-13 down from 11.5 per cent (estimated) for this financial year.

So if you you start thinking about that from a sectoral balances perspective the arithmetic is curious (not that the information above is in sectoral balance form).

But we can do some inference drawing on other information.

In 2011-12, the Treasury believe that the current account deficit will be 3 per cent of GDP and the budget deficit will be 3.0 per cent of GDP. For 2012-13, they are projecting a budget surplus of 0.1 per cent of GDP in 2012-13 and a current account deficit of 4.75 per cent of GDP.

We can infer what the estimate of the private domestic balance is (relationship between private spending aind income) from the sectoral balances view of the national accounts:

Private domestic balance (S – I) = Government balance (G – T) + Net Exports (X – M)

where S = total household saving, I is business investment, G is government spending, T is government tax revenue, X is exports and M is imports.

The following Table captures the implied sectoral balances for 2011-12 and 2012-13 – inferring the private domestic balance from the other two pieces of information (which is how it is generally done given the difficulty in estimating total private savings).

While it is difficult to be exact in this regard (given the data presented is not presented in a way that is conducive to computing sectoral balances) we know from the expenditure side of the National Accounts (last published for the December 2011 quarter), that the Private Gross fixed capital formation ratio (per cent to GDP) averaged 21.4 per cent in calendar year 2011.

The Household saving ratio (from disposable income) averaged 9.7 per cent (and so if we computed that ratio out of GDP it would be lower).

Given that knowledge, it is hard to believe that the private domestic balance this current financial year will come out zero. That would infer a much larger contribution to real GDP from the public sector given the behaviour of net exports.

Further the implied shift in private behaviour as the current account grows and the budget retreats (by 3.1 per cent of GDP) is dramatic and relies on massive investment growth, which I do not think will occur.

Then you look at Figure 5 from Budget Paper No. 1, which shows the estimated contributions to real GDP growth for 2011-12, 2012‑13 and 2013‑14. Household consumption is estimated to maintain a constant contribution of about 1.8 percentage points each year. Business investment is estimated to add about 2.25 percentage points to next year’s real GDP growth, while net exports will be firmly negative. Curiously, the government sector is estimated to make a near zero contribution to growth despite the Treasury admitting that the fiscal shift will reduce growth. That doesn’t add up.

But summing the contributions of household consumption and business investment in 2012-13, we get about 4 per cent real GDP growth. The overall Treasury estimate for real GDP growth is 3.25 per cent for 2012-13, which means the negative contributions from net exports and government must be estimated to be around 0.75 percentage points.

Given the current account deficit is estimated to be of the order of 4.75 per cent of GDP – the arithmetic is rather curious.

My second observation is that trend growth might not be the optimal benchmark if the economy has been operating at levels of activity for many years, which are patently well below full employment. Over the last three decades, government policy has deliberately maintained a state of the entrenched labour underutilisation.

So using the trend rate of growth associated with this historical period as the policy goal is to adopt a somewhat diminished aspiration and deliberately waste the potential of a certain proportion of the willing and available labour force.

My third observation is one I continually try to keep alive in the national debate in my media appearances. While the Treasurer and his paid officials (like the Treasury boss) maintain the mantra that the economy has recovered to trend growth and the Treasury clearly chooses to support that lie in the official Budget papers, the fact is that the Australian economy is nowhere near trend growth.

The ABS broad labour underutilisation rate is at 12.5 per cent at present, thousands are leaving the workforce for lack of opportunity, 38 odd percent of our teenagers who want to work are idle and inflation is falling significantly.

This level of labour wastage cannot be consistent with the Non-Accelerating Inflation Rate of Unemployment (NAIRU) – even if that concept had any policy relevance.

I can identify hundreds of thousands of jobs that would fill unmet community and environmental need in Australia at present, which would be suitable for even the most unskilled workers to be offered. The problem is that government refuses to assume its ultimate responsibility as the currency-issuer for full employment.

A casual examination of recent real GDP growth also supports my viewpoint that the economy is no where near trend..

The following graph is taken from ABS National Accounts data (latest available December quarter 2011) and shows the annual rate of real GDP growth since the March quarter 2000 to the December quarter 2011 (blue bars). The red line is the average growth rate (3.5 per cent) for the 20-quarters before the recent crisis impacted (September 2003 to September 2007). This is normally considered to be trend growth.

The Australian economy started slowing in the March 2008 quarter and has not gone close to achieving the growth rate that was enjoyed in the 5 year period before the crisis. The pace of growth was gathering on the back of the fiscal stimulus in the December 2009 to June 2010 quarters but then fell away as the fiscal stimulus was withdrawn.

Private domestic spending growth remains subdued and the pursuit of the fiscal surplus is now introducing serious drag on the growth rate.

The economy is nowhere near is past trend. The Treasury has a current trend estimate of 3.25 per cent which is about the average growth of the period from March quarter 2000. Even with this more subdued growth trend forecast (a period which included two major downturns as you can see from the graph), the Australian economy is nowhere near trend performance and is now moving away from that benchmark.

Please read my blog – The myths that abound in Federal Budget Papers – for more discussion on this point.

But the interesting part of the Speech was the Section entitled “Could fiscal consolidation take too much out of the economy?”, which was in reference to the various statements by commentators in the past week, including myself, that the fiscal retreat was not only unnecessary given the subdued nature of private spending.

He said that:

The impact of fiscal consolidation on economic activity, whether discretionary changes or through the operation of the automatic stabilisers, is much more nuanced than implied by simply looking at the magnitude of the fiscal consolidation — around 3.1 per cent of GDP in 2012-13.

He noted that the “economic impact of fiscal consolidation” was also influenced by the composition of the final spending and taxation – and specifically said that “a decision to reduce outlays in total but also to redistribute them in favour of those with high marginal propensities to consume would be less contractionary, and perhaps even stimulatory, than an across-the-board cut”.

This is in reference to the supposed “Robin Hood” Budget which saw some cash and other benefits to lower and middle-income earners being provided while the top-end-of-town lost some benefits.

But with the contribution to real GDP from private consumption estimated to be relatively constant over the next two budget years (see the previous graph) it is hard to see how the redistributive nature of the budget will provide significant offsets to the large cuts in the deficit.

The Melbourne Age article today (May 16, 2012) – Treasury bullish on economy – written by Peter Martin provided some more clues to the way Treasury is thinking.

The Age reports that:

In answers to questions at the annual Australian Business Economists lunch in Sydney, Dr Parkinson said taking the budget from a $44.4 billion deficit to a $1.5 billion surplus amounted to a fiscal contraction of 3.1 per cent of GDP.

But much of the money saved would not have been spent in Australia anyway. It would have gone overseas on defence equipment and foreign aid. And other decisions in the budget moved spending and concessions from people not likely to spend, to people keener to consume.

I note that the Government is achieving austerity, in part, my imposing austerity on some of the poorest nations in our region through the withdrawal of a significant volume of foreign aid. I found that part of the Budget particularly obnoxious. The Government alleges it is the party to look after the “battler”. Hypocrites!

This information though tells us that the drain on growth from the external balance would have been much larger than it already is forecast to be. This should ne understood in relation to the constant claims that we are living through a one-in-a-hundred years mining boom. What most people don’t understand is that the exports themselves are not driving growth. It is the investment spending that the Government is banking on to drive growth although by their own admissions a significant volume of that spending is associated with imports.

The cuts in defence spending were going to be the main motivation for today’s blog given that I have been reading about the Nye Committee which delivered a very damning report in 1934 on military spending in the US. But that will wait for tomorrow.

The Age article then quoted the Treasury boss:

We haven’t modelled this formally, so there’s no point looking for it under freedom of information … But the macroeconomic effect of the fiscal contraction is probably less than a per cent of GDP. That’s a ballpark figure – 1 per cent of GDP. The fiscal consolidation is 3.1 per cent of GDP, the economic contraction is 1 per cent. This does not mean the fiscal consolidation is not real. The outlays to GDP share will step below 24 per cent and stay there for the next four years. It will be the longest period of outlays below 24 per cent since the late 1970s and early 1980s.

I found the comment that they hadn’t modelled the leakages to domestic demand formally quite surprising. So the entire fiscal contraction is being done on the “back of an envelope” and they have a ballpark figure.

Further, try tallying the “the economic contraction is 1 per cent” as a result of the budget contraction (that is, the government impact on real GDP) with the earlier data I presented about contributions to growth. The estimates of the current account drain and the fiscal drain on real GDP Growth implied by all of this are not consistent with the other estimates.

My view is that when they are also acknowledging in the forward estimates that the unemployment rate will rise over the next year as a result of the contraction and there is a very real risk that their growth estimates will be overly optimistic (meaning more unemployment), that the salaries of the Treasury boss and his management should also be “ballpark figures” and be tied to the forecast error. I predict they would take severe wage cuts over the next year should that be the case.

Former Treasury Boss talks about the Eurozone

The most recently departed Treasury head, Ken Henry was interviewed on the ABC 7.30 Report last night (May 15, 2012) – Former Treasury Head slams Euro and sees Aussie boon.

He spoke of the thinking that led to the 2008 and 2009 fiscal stimulus packages (while he was still in charge) and he said that he told the Government:

… that there was no point in going in soft. If you were going to use fiscal policy to avoid a recession, you should throw a lot at it. Secondly, that although there is a temptation to think that it would be highly desirable to having something concrete, maybe even literally concrete to show for your fiscal stimulus long after the period of crisis has past, an infrastructure project for example, that is almost impossible to roll that out in a timely fashion, to roll out sufficiently to avoid a recession. So, the advice was the best thing you can do in the time available is to provide cash to households. And then the third bit of the advice was, if you think you need to do it, the quicker you do it the better, don’t wait. Don’t wait until you see the whites of the eyes. Do it. Do it early.

This is the advice that all governments should get from their Treasury departments. The former boss said he summarised his advice to government as “Go Hard, Go Early and Go to Households”.

The second stimulus package which concentrated on infrastructure was heavily criticised for being poorly planned, rorted by private contractors and construction firms and so very wasteful.

There was truth in all of that. But here the essential point about macroeconomics (which is also relevant to my discussion tomorrow about military spending), in the words of the former Treasury boss, is that:

… when you’re putting money out the door so to speak, and I know this is difficult for people to understand, it sounds counterintuitive, but actually if it’s fiscal stimulus the most important thing is to get the money out the door. But how the money is, whether the money is in some sense wasted because there’s overcharging or whatever, of course it’s an important point but from a macroeconomic perspective it’s very much second order, maybe even third order.

There is a lot in this interview but I thought his comments on the Eurozone crisis were very pertinent.

… I’ve never seen how the Euro would work, I’ve never seen how it could be expected to work without a general fiscal union. People in Australia understand that without our system of horizontal fiscal equalisation, without fiscal transfers from one state to another state, this federation would simply not hang together, there’s no way it would have hung together in the way it has without that system of fiscal transfers amongst jurisdictions. People understand that. People in Europe have not understood that and they need to understand it, the question is – whether it’s too late? That’s the question.

The interviewer (who is prone to neo-liberal thinking) then tried to claim that the Euro leaders “certainly understood it with the Maastricht treaty didn’t they? They understood they had to have some kind of fiscal union if they were going to have monetary union?”.

Which were extraordinarily ignorant questions to ask. The Stability and Growth Pact were the anathema of a properly empowered fiscal capacity at the “federal” level. The SGP was an ideological contrivance to deliberately limit the spending capacity of the member states. It provided no capacity to address asymmetric aggregate demand shocks across the regional space.

The Treasury boss replied:

… what the stability and growth pact in the Euro was designed to do was prevent governments like the Greek government from taking the easy way out and Greece did take the easy way out. So let me explain that. Here’s the issue: if you have two countries that share the same currency and they have different rates of productivity growth, the only way to make that hang together, there are two ways: one is a fiscal transfer from a high productivity growth country to a low productivity growth country. So that’s one plan, that’d be a fiscal union, if you don’t have that then the only other way to make it hang together is for the low productivity growth country to go on a fiscal expansion.

He then claim that Greece did not take the hard decisions and improve productivity growth and “that the Greek government” ran “an expansionary fiscal policy in order to try to retain something approximating full employment in this low productivity growth country” and that caused the meltdown.

Which raises the question of Spain and Ireland – they were in budget surplus leading up to the crisis?

The essential point is that a nation that surrenders its currency sovereignty and adopts a foreign currency then has to fund its deficit spending irrespective of the state of its productivity growth.

When the crisis hit the Eurozone member states, the aggregate demand collapse was so large and the reaction by the Euro leaders so poor (imposing austerity rather than supporting growth), that the bond markets were no longer prepared to fund some of the rising deficits. If the nations had their own currencies then the crisis would have remained a real one (high unemployment etc) which could have been remedied rather quickly by deprecation and domestic demand stimulus.

Instead, the flawed design of the EMU guaranteed it would become a sovereign debt crisis – that is, a test of solvency of the member states.

Conclusion

I have run out of time today. Tonight we all tune in for another edition of the Euro crisis.

In the next 12 months we will see how robust the Australian economy is. My estimate is that it won’t be as strong as the Treasury estimate and the Budget will remain in deficit courtesy of the automatic stabilisers. This time next year you will be able to tell me that I am wrong. I hope I am.

That is enough for today!

Economic growth reached 3.1% in 2011 and was due to increasing private consumption as well as investment. The forecast for 2012–2017 assumes that gradual economic recovery will continue with 2.6% growth in 2012. Positive growth is expected throughout the forecast period, though changes to the planned large scale industrial investments may affect the forecast. Economic growth will be driven by investment and consumption.

This could be Greece’s future. It is a graph taken from the Spring 2012 Economic Forecast.

Compare that to this characterisation of the Greek tragedy. I thought this was a pretty stark piece of work from Greek cartoonist Dimitris Hantzopoulos. The title of the graphic – ΤΗΣ ΗΜΕΡΑΣ means The Day.

If your geography is lagging, here is a hint:

The weekend before last, the Greeks voted to end austerity – a categorical call at the recent election. But there is confusion among the electorate because the majority also want to keep the Euro. This is an education gap – they cannot feasibly keep the Euro under current (or perceived future) conditions and avoid the painful austerity.

Further, even if they get beyond this crisis in some sort of battered shape – much poorer and with yawning social divisions – it is only a matter of time before the next business cycle swing hits them and the aftermath or vestiges of the current malaise will quickly multiply with the new strife as aggregate demand collapses again.

The EMU as it is current structured – without a credible supra-national fiscal authority with the clear mission to defend regions that are suffering from asymmetric demand shocks (positive or negative) – cannot handle a sizeable business cycle swing. A monetary system that is incapable of meeting the challenges of such swings in aggregate demand is not a reasonable basis for organising complex economies – if the prosperity of all citizens is the goal.

So if Greece wants to end austerity and use its productive base to restore growth then it has to abandon the Euro.

It seems that the political machinery of the elites in Greece (and outside) is however manoeuvring to spit in the face of the electorate and to impose some sort of technical panel to govern the country.

The recent election has ended in an impasse – such is the polarisation of the vote as the support for the main right and left middle-class parties collapsed. The Greek people might not understand the intricacies of the monetary system tyranny that is being imposed on them but they were clear on one thing – they wanted an end to the Troika-led austerity.

There can be no doubt about that. The guess is that a new election will consolidate that view even further and the two main parties will see further loss of support. There would be hope of some sort of coalition opposed to austerity which did not include Golden Dawn. But correct me if I am wrong – I am hardly an expert on Greek politics.

The Euro elites, of-course, are currently issuing all sorts of warnings and the Greek elites from President down to the leaders of the two main parties (so abysmally defeated at the recent election) are now conspiring to implant a government of technocrats and politicians. The Greek people clearly resented the installation of Lucas Papademos (under pressure from the Troika) when the elected Prime Minister indicated he would take the last bailout to a popular vote.

They should take a lesson out of the Iceland book.

Iceland soon learned that when your government is selling you out its only recourse is to get the titular head (president) to intervene. That is what happened in Iceland when the President intervened in 2010 – in line with the mood of the population – and refused to sign legislation passed by an out-of-touch government intent on big-noting itself on the world stage by pushing for EMU admission in spite of the obvious harm that would do to the nation.

The President of Iceland vetoed an act of parliament which would have seen the nation “repay” £3.4bn to Britain and the Netherlands. This repayment was in relation to the amount that the British and Dutch governments paid out in 2008 to their citizens who had deposits in a private Icelandic bank which collapsed during the height of the global financial crisis.

At present, the press hysteria is reaching new heights with all sorts of dire warnings for the Greek people if they dared leave the Eurozone and abandon Germany to Spain and Italy (and Ireland) and soon other nations.

At the time the Icelandic President intervened the press also rose to hysteric heights. The jingoistic British press made all sorts of threats against their tiny northern neighbour.

The Icelanders however were vehement and resentful that the British government had used the UK anti-terrorist act to freeze all Icelandic assets in the UK in late 2008. It was that move that was the final nail in the Icelandic banks’ solvency.

The Icelandic population considered the deal their parliament has agreed to was not in their interests and not their responsibility and they realised that the motivation of Iceland’s politicial leaders was, in fact, to walk the EMU stage, which the overwhelming proportion of the population remain opposed to.

The same could now be said about the Greek population. They have voted resoundingly to reject the imposition of austerity on them.

The Dutch and British governments bailed their own citizens out after they allowed Icesave to operate under the Passport system. They then tried to cadge the money back from the Icelandic government – there were claims that under European law there is a sovereign guarantee of deposits (that is unclear – there is no requirement of a state guarantee).

Further, they claim Iceland is being discriminatory (against European law) in that it bailed its own citizens out but refused to bail out the foreigners (also unclear). The Dutch and the Brits will not go to an independent court to let these matters be decided impartially. The reason – they would probably lose their bullying capacity to pressure Iceland to pay up.

All the same sorts of statements are being made about the Greeks – legal threats, economic threats – all vapid if the Greek government takes back control of its currency and lets it depreciate.

The problem the citizens of Iceland faced was that the Icelandic Parliament, seemingly wanting to appease those who would block its proposed entry into the EMU (Britain has been making threats), finally agreed to repay the loans. You can read more about what the people think via the In Defence home page.

It is clear that the citizens did not approve of this deal and the vast majority do not want to go over to the Euro (that is, enter the EMU). This people protest which has gathered strength in 2009 and provided the President’s with his motivation to protect the national interest. It was only the second time in the 66-year history of Iceland as a republic that the titular head has exercised this power.

Recall the national TV address the President’s made when he announced his decision to the nation. His official declaration said that after the parliament passed the law to repay the loan he:

… has received a petition, signed by about a quarter of the electorate, calling for the Act to be subjected to a referendum. This is a far larger proportion of the electorate than the criterion that has been referred to in declarations and proposals from the political parties.

Public opinion polls indicate that the overwhelming majority of the nation is of the same opinion. In addition, declarations made in the Althingi and appeals that the President has received from individual Members of Parliament indicate that the majority of the Members are in
favour of holding such a referendum …

It is the cornerstone of the constitutional structure of the Republic of Iceland that the people are the supreme judge of the validity of the law …

Now the people have the power and the responsibility in their hands.

Contrast that to what has been happening in Greece.

When the incumbent Prime Minister George Papandreou indicated he would put the earlier bailout plan to a referendum the Troika had him removed post haste. The Germans are even suggesting that Greece should retain its unelected Prime Minister indefinitely (that is, avoid the upcoming elections) in the same way that the Italians are suspending a democratic vote until 2013 at least.

It is true that Iceland had its own currency and Greece chose to use a foreign currency. The fact that Iceland has its own currency has given it tremendous leverage over the international financial markets. Greece has no such leverage. Iceland could default on foreign currency-denominated debts and let its currency depreciate.

The Greeks have to change their entire monetary system, which adds complexities – all of which are tractable.

For Iceland, the crisis imposed massive real costs on the nation but the benefits became obvious relative quickly. A more rapid return to growth was guaranteed. Greece is now in its fifth year of recession (Depression) with no end in sight.

On February 17, 2012 the rating agency Fitch upgraded Iceland’s rating and said:

The restoration of Iceland’s Long-term foreign currency rating to investment grade reflects the progress that has been made in restoring macroeconomic stability, pushing ahead with structural reform and rebuilding sovereign creditworthiness since the 2008 banking and currency crisis … Iceland has successfully exited its IMF programme and gained renewed access to international capital markets. A promising economic recovery is underway …

While I treat these ratings agency assessments with a grain of salt, they do reflect the way the bond markets think. The point is that Iceland has a place in the world that the EMU nations would envy right now.

While the Icelandic government certainly didn’t go on a fiscal spree and allowed net exports to reap the advantages of the massive depreciation, the government also didn’t scorch the economy with austerity. They have allowed growth to build its tax revenue rather than exacting harsh tolls on its citizens.

As the Spring 2012 forecast shows – private consumption and investment is now driving growth – as confidence returns – unemployment is falling, real wages are rising and aggregate demand is stable.

All of that was predictable. Modern Monetary Theory (MMT) shows that a sovereign government is never revenue constrained because it is the monopoly issuer of the currency. Which means it always has the capacity (given real resources) to improve domestic growth and employment irrespective of what is happening in the private economy and the external sector.

Moreover,a floating currency allows fiscal and monetary policy to concentrate on domestic policy without the need to engage in “official intervention” (central bank transactions in the foreign exchange market) to stabilise a given parity.

It means that external imbalances do not have to be resolved via dramatic domestic deflation (attacks on working conditions).

Here is some graphical evidence which helps support this narrative.

Real GDP growth comparison – Greece and Iceland

The following graph is constructed using the latest quarterly National Accounts data from Iceland and Greece (from their respective national statistical agencies). It compares real GDP growth (seasonally adjusted and in annual terms) from the March-quarter 2005 to the December-quarter 2011 in both nations.

There is only one conclusion – the nation that has so far resisted the European neo-liberal elites and demonstrated leadership from the top is on the way to recovery from a larger shock than Greece faced. That nation – which has increasingly bowed to the unreal demands of the same elites even to the point of installing an unelected technocrat-central-banker to the Presidency – is sinking.

I am not suggesting Iceland is all brights lights. Far from it. But it is in control of its currency and has allowed the flexibility inherent in that control to play out to its advantage (exchange rate movements, central bank interest rate setting capacity, and fiscal support).

Nominal and Real Exchange Rates

The following graph uses data available from the Central Bank of Iceland and show the USD, Euro and Broad Trade Index exchange rates against the Krona (monthly average, mid-rate) from January 2000 to May 2012.

You can read about the Broad Trade Index – HERE – but suffice to say it represents a weighted exchange parity based on the trading proportions of its partners. The Central Bank of Iceland regularly update the currencies in the “basket”, which is used to calculate the Index as trading patterns change.

In 2011, Iceland’s major trading partners were EU27 (66 per cent of total trade), Norway (6.5 per cent), United States (6.2 per cent), Brazil (4.1 per cent), and China (3.1 per cent) (Source).

The depreciation in the Icelandic currency against the major world currencies during the crisis has been dramatic. The same sort of adjustments would quickly happen in Greece should it exit the Eurozone and restore its own currency sovereignty.

But note that the depreciation is finite! Those who claim that nations which run counter to the sentiments of the financial markets will experience a currency collapse and never recover fail to understand the dynamics of an exchange rate crisis. Sure enough, major depreciations occur.

But historically, the parities stabilise and begin to improve once the structural adjustments that the depreciation brings (changing terms of trade, changing industry composition etc) start to occur.

Consider the following graph which shows the real exchange rate (that is, the nominal rate adjusted for relative price inflation). Movements in the nominal exchange rate and the relative price level (Pw/P) need to be combined to tell us about movements in relative competitiveness. The real exchange rate captures the overall impact of these variables and is used to measure our competitiveness in international trade.

The nominal parity can also be adjusted for unit labour costs. I show both in the following graph.

Please read my blog – Saturday quiz – January 28, 2012 – answers and discussion (Answer to Question 2) – for more discussion on the derivation of the real exchange rate.

The rapid drop in the real exchange rate gave Iceland a massive boost in international competitiveness. It is the same boost that Greece would get if it leaves the Eurozone. As long as it can isolate the real income effects of the exchange rate plunge – it will be finite and growth will return almost immediately.

Notice that the two ways of computing the real exchange rate – the CPI (broad inflation) and ULC (labour cost) measures – move together. This tells you that the labour costs were indeed contained as the price of imports rose in the face of the rapid nominal exchange rate depreciation. This allowed the increase in competitiveness to “stick” (using the jargon of my profession).

The EMU nations are trapped and cannot exploit the flexibility of a sovereign currency. The only adjustment to the external balances is then domestic deflation which imposes a recession bias. Adding fiscal austerity at the same time is the reason Greece’s National Accounts are in such an appalling shape.

For a government to pursue public purpose they have to have control of their own currency and that means it must float.

Inflation

What about inflation? Many commentators claim that flexible exchange rates are dangerous because they will result in accelerating inflation. The claim is only partially true and forgets to take into account the internal (substitution away from imports) and external (improvement in export competitiveness) adjustments that occur when the terms of trade change – especially when they are as drastic as depicted in the graphs above.

The following graph is from the Central Bank of Iceland and shows you what happened to the annual inflation rate in Iceland between 2000 and 2012.

It is clear that there was a spike in inflation (the annual rate went from 3.4 per cent in August 2007 to the peak of 18.6 per cent in January 2009 as the Krona depreciated. Since the economy resumed growth, the inflation rate has averaged around 4 per cent per annum.

There is no evidence to support the view that the large depreciation has created an unstable high inflation environment. Most of the import cost impacts have been well-managed and are through the system now.

Depreciation is likely to have long-term implications for the price level if domestic (non-traded) wages and prices chase each other up in a profit-margin-real wage resistance spiral.

If the nation is prepared to take the real income loss that is involved in the depreciation – which is generally finite – then the parity adjustment works in its favour (increasing competitiveness).

Real Wages

Statistics Iceland also publish a Real Wage Index which is shown in the following graph (from January 2005 to March 2012). It peaked at 120.2 in January 2008 and then reached a trough in May 2010 at 103.9 (down 13.6 per cent on the peak). It has now recovered some of the loss and in March 2012 was standing at 112.1 (down 6.7 per cent on the peak).

This is a predictable pattern. The exchange rate depreciation erodes the real wage as import price rise.

The nominal wage index continued to grow in Iceland throughout the crisis although the rate of growth slowed appreciably in 2008 and 2009. This point goes to an important aspect of the dispute between Keynes and the Classical writers who urged wage cuts during the Great Depression. It also bears on what is happening in other economies as the austerity mavens push large nominal wage cuts onto workers as part of the so-called structural adjustment.

Keynes noted that workers would resist real wage cuts if they were delivered via cuts in money wages but would tolerate them if they were induced by general inflation. The rationale was that the former would disturb relativities while the latter impacted on the wage structure more or less uniformly.
But there is another reason why preserving nominal wages growth is important.

Most of our contractual commitments are denominated in nominal units ($ or whatever currency is applicable). So when real wages are being cut by rising inflation (in this case by a depreciating exchange rate) but nominal wages are preserved, workers can then make adjustments to the composition of their spending without, in the first instance, undermining their capacity to meet their weekly contractual liabilities (for example, their mortgage payments).

Attacking nominal wage levels, more readily undermines the capacity of workers to meet these nominal contractual obligations and opens the possibility for further instability (credit collapse etc).

Compare the real wages trajectory in Iceland with this story from Athens News (April 27, 2012)Real wages tumble by 25% as tax burden soars in 2011. We read that in Greece:

The Paris-based think tank said real wages before tax fell in 18 of its 34 members during 2011, with by far the sharpest annual cuts taking place in Greece, where gross salary earnings fell by 25.3 percent …

In absolute figures, the OECD annual Taxing Wages report said that average gross income declined from 20,457 euros in 2010 to 15,729 euros in 2011, which is equivalent to real reduction of 25.3 percent, taking into account a 3 percent rate of inflation.

Conclusion

The Greek President should show the same sort of leadership that Iceland’s titular head demonstrated when he blocked the machinations of the scheming politicians there who were intent on playing along with the European elite cabal.

The fact that Iceland also maintained their own currency allowed them to restore growth and confidence relatively quickly, notwithstanding the massive recession they encountered.

Greece is stuck in austerity with no way out. It can only grow in a robust manner and sustain that growth if it leaves the Eurozone. It should declare a bank holiday next Monday (making the declaration sometime over the weekend), default on all Euro-denominated debt, and renegotiate from the strength of its own currency.

It might also start printing tourist maps in German to cater for the swarm of northerners who would take advantage of the terms of trade shift.

Politics in the Pub

For those that live locally (I am in Newcastle at present), I am giving a talk at the Monthly Politics in the Pub gathering tonight on the Eurozone crisis.

The evening starts at 18:30 at the Station Hotel, Hamilton (just near the railway gates).

That is enough for today!

Merkel had campaigned on the issue of the “thrifty” Christian Democrats versus the “ever more debt” leftist parties (Social Democrats and Greens) – see story in Sydney Morning Herald (May 14, 2012) – Merkel’s austerity push rejected in bellwhether state.

Over the weekend, I read a few articles about last week’s Australian labour force data release which kept emphasising how the economy must be in good shape because unemployment fell. The commentators forgot to mention that nearly all of the decline in unemployment was due to the participation rate falling (people dropping out of the labour force because of the lack of jobs).

So the data actually was not an indicator of “good news”, but probably the opposite, depending on how much confidence we can place in the accuracy of the employment data at the moment.

Please read my blog – Australian labour market – converting unemployment into hidden unemployment – for more discussion on this point.

The Barro Op Ed also still manages to conclude one thing when the actual data he refers to tells us that exactly the opposite is the reality.

Barro claims that there are renewed called for more fiscal stimulus in the face of a move back to recession in key nations but:

Curiously, this plea for more fiscal expansion fails to offer any proof that Organization for Economic Cooperation and Development (OECD) countries that chose more budget stimulus have performed better than those that opted for more austerity. Similarly, in the American context, no evidence is offered that past U.S. budget deficits (averaging 9% of GDP between 2009 and 2011) helped to promote the economic recovery.

There is a plethora of evidence.

Over the crisis I wrote a series of blogs examining some of the evidence. There is too much evidence in favour of the “stimulus worked” view to capture in my blogs.

Here are some in chronological order:

• Fiscal stimulus effects …
• What else but a fiscal stimulus?
• Stimulus package continues to boost Australian economy
• Fiscal stimulus and the construction sector
• The fiscal stimulus worked but was captured by profits
• US fiscal stimulus worked – more evidence
• The lesson for the Europeans is that the US fiscal stimulus worked

I have also written many blogs about the deteriorating state of the Eurozone economies and then the UK (after the May 2010) election.

Where fiscal austerity has been deliberately imposed the economies have slowed and unemployment has risen.

Barro though thinks there are important exception which challenge the “stimulus works” view:

Two interesting European cases are Germany and Sweden, each of which moved toward rough budget balance between 2009 and 2011 while sustaining comparatively strong growth—the average growth rate per year of real GDP for 2010 and 2011 was 3.6% for Germany and 4.9% for Sweden. If austerity is so terrible, how come these two countries have done so well?

Note the loose language – “toward rough budget balance”. From where? How? What does “rough” mean?

But an examination of the data reveals that this statement is untrue.

The Statistics Sweden Public Finances data (up to 2009, supplemented with Eurostat data up to the end of 2011 allows us to see what has been happening to the budget outcome in Sweden and Germany.

The following graph shows the budget deficits (-) for Sweden and Germany as a per cent of GDP from 2000 to 2011. You note that Germany was an early violator of the fiscal rules imposed by the Stability and Growth Pact.

As I discussed in this blog – The hypocrisy of the Euro cabal is staggering – the Germans violated the SGP for several years from 2001 to 2005. If they hadn’t have maintained the level of fiscal stimulus (above that permitted under the Treaty) then their economy would have probably fallen into recession during that period.

But in relation to Barro’s claims, it is far fetched indeed to claim that either Sweden or Germany were running a balanced budget during the downturn.

The following graph shows the evolution of the budget deficits (-) as a per cent of GDP for Sweden and Germany from 2000 to 2011.

For Germany, the budget deficit went from a 0.1 per cent of GDP surplus in 2008 to deficits of 3.2 per cent in 2009, and 4.2 per cent in 2010. This is an enormous fiscal shift over three fiscal years.

In the case of Sweden, the budget surplus declined from 3.6 per cent of GDP in 2007 to 2.2 per cent in 2008 and the into deficit of 0.9 per cent of GDP in 2009.

By any stretch of imagination, a 4.5 per cent swing in the fiscal stance in two years is a very expansionary change.

The point is that it is not only the actual budget balance that matters when we are appraising the direction of fiscal policy (expansionary or contractionary). A shift from a budget surplus of 3.6 per cent to a deficit of 0.9 per cent of GDP is likely to be highly expansionary in the context of what else is happening in the economy (private domestic sector and external balances).

So the “two interesting case studies” provided by Barro work against his argument.

Barro then claimed that:

The OECD countries most clearly in or near renewed recession—Greece, Portugal, Italy, Spain and perhaps Ireland and the Netherlands—are among those with relatively large fiscal deficits. The median of fiscal deficits for these six countries for 2010 and 2011 was 7.9% of GDP. Of course, part of this pattern reflects a positive effect of weak economic growth on deficits, rather than the reverse. But there is nothing in the overall OECD data since 2009 that supports the Keynesian view that fiscal expansion has promoted economic growth.

The size of the deficit tells you two things. First, the discretionary position of the government with respect to spending and taxation policies. Second, the state of non-government spending, given that the automatic stabilisers work in a counter-cyclical manner pushing the budget towards or into deficit in a downturn as tax revenue declines with private activity.

Barro hints at that without explaining it when he says that “part of this pattern reflects a positive effect of weak economic growth on deficits, rather than the reverse”. Why did he not then make the next valid conclusion?

Which is – that the large deficits in many of the Euro nations have come because the scale of collapse in non-government spending and the resulting real GDP gaps have been so large. Further, the European nations have much stronger automatic stabilisers as a result of their more generous welfare states.

The more you move north – into Scandinavian economies – the more generous these provisions tend to be. So while the Swedish government provided for some more infrastructure spending by way of discretionary stimulus and some income tax cuts the nation’s welfare system – quickly sustained the incomes of those who lost jobs.

But the larger the collapse in non-government spending the larger will be the budget shift towards or into deficit (other things equal). To then claim that the states with poor growth rates have the highest deficit ratios which allows us to conclude that there is a negative relationship between fiscal stimulus and real GDP growth is to blur the obvious impact of the automatic stabilisers.

The facts are that the Eurozone nations have been imposing harsh austerity – discretionary budget cuts which have undermined the growth prospects of their nations. But the budget deficits in some cases have been growing despite the austerity because the declining growth has further undermined the tax revenue.

A close examination of the Eurozone situation substantiates that conclusion.

Next up, Barro invokes Japan as his next example and says:

Once a comparatively low public-debt nation, Japan apparently bought the Keynesian message many years ago. The consequence for today is a ratio of government debt to GDP around 210%—the largest in the world.

This vast fiscal expansion didn’t avoid two decades of sluggish GDP growth, which averaged less than 1% per year from 1991 to 2011. No doubt, a committed Keynesian would say that Japanese growth would have been even lower without the extraordinary fiscal stimulus—but a little evidence would be nice.

Japan resumed growth after its monumental property market collapse on the back of a fiscal stimulus. The conservatives derailed that growth in 1997 when they forced the government to increase sales taxes to get the “budget back in balance”. The evidence is clear. The nation double-dipped and remained sluggish until a renewed fiscal stimulus was introduced.

Barro finally claims that:

Looking forward, there is a lot to say on economic grounds for strengthening fiscal austerity in OECD countries.

The economic grounds being?

There was an interesting speech made on January 20, 2009 by the Deputy Governor of the Sveriges Riksbank – Svante Öberg: Sweden and the financial crisis – which considers the way in which Sweden was reacting to the onset of the global financial crisis.

He discussed the usual ways in which central banks reacted – “The central banks have primarily contributed by adding large amounts of liquidity via loans against collateral to the bank” – “guarantees and capital injections to minimise the risk of further bankruptcies in the banking sector” etc, and noted that:

Sweden is a small and open economy with extensive foreign trade and a financial market that is well integrated with the international markets. Sweden’s dependence on the outside world has increased over time. This means that a global financial crisis combined with a severe international economic downturn has a substantial impact on the Swedish economy.

The Swedish banks were tightly regulated after the financial meltdown in the early 1990s and the extent of risky debt was significantly reduced.

Some of the specific developments the Deputy Governor outlined were:

1. “the Riksbank’s balance sheet for the second half of 2008 has increased from SEK 200 billion at the end of June to SEK 700 billion at the turn of the year. The loans from the Riksbank together with Swedbank’s borrowing under the government’s guarantee programme mean that the State provided or guaranteed more or less all of the banking sector’s borrowing in the last few months of 2008.”

2. “The Swedish National Debt Office, Finansinspektionen and the Government have also acted to safeguard the functioning of the Swedish financial system and to mitigate the effects of the crisis on the real economy. The National Debt Office has acted to meet the dramatic increase in demand for treasury bills. Extra auctions have been held in order to issue larger volumes of short-term treasury bills than normal. By the turn of the year, the National Debt Office had issued more than SEK 190 billion in treasury bills over and above the regular loan programme”.

3. “Sweden is also pursuing an expansionary fiscal policy in order to counter the downturn in economic activity.”

Building on the earlier analysis, and supplementing the budget data with detailed quarterly and annual National Accounts data, available from Statistics Sweden we can add some more insight into what was going on in Sweden during the crisis.

I would note that the presentation of the Statistics Sweden National Accounts data is not particularly user friendly. That is, it requires some manipulation to get it into a time series format for analysis.

The following graph shows the evolution of the budget deficit (% of GDP) and real annual GDP growth (per cent) for Sweden from 2000 to 2011. So as noted above the plunge in real GDP growth saw the budget surplus decline from 3.6 per cent of GDP in 2007 to 2.2 per cent in 2008 and the into deficit of 0.9 per cent of GDP in 2009.

This was a mixture of discretionary and strong automatic stabiliser effects. But taken together and as noted above, a 4.5 per cent swing in the fiscal stance in two years is a very expansionary change.

The following graph shows the quarter-by-quarter (annualised) real GDP growth rate since the March-quarter 2005 in Sweden to the December-quarter 2011. The fiscal stimulus began in 2009 and continued into 2010. One could argue in the light of real GDP slowing that the Swedes were in too much of a hurry to get back into surplus.

The following graph is taken from the national accounts data and shows real GDP growth (from March-quarter 2007 to the December-quarter 2011) in annualised terms (per cent) and the stacked columns show the percentage point contribution to that real growth from private consumption, private investment (not including inventories), government (consumption and capital) and net exports.

The pattern is very clear. Private spending was driving strong growth leading up to the crisis and there was a small contribution from the government sector. While exports growth was strong, the income leakage from imports was stronger and so the overall contribution form net exports was negative.

As the crisis began to erode exports, the rising unemployment saw private consumption and investment emerge as negative contributions to real GDP growth.
Throughout this period, the government contribution to real GDP growth remained positive and the strong impulse from the automatic stabilisers helped private consumption to recover fairly quickly.

As investment continued to languish, undermining growth, the government sector supported growth right through 2009 and 2010.

As the government started to contract its contribution and the impact of the world downturn has had a negative impact on exports, private consumption and investment is stalling and the economy is heading south again.

Further assisting the Swedish economy during the crisis was the fact that Sweden refused to join the Eurozone and the currency flexibility has worked in its favour of the course of the crisis.

The following graph shows the movement in the Swedish Kronor-Euro exchange rate since January 1, 2004 (monthly averages). The data is available from the Swedish Riksbank.

At the onset of the crisis there was a movement away from the Krona and the exchange rate depreciated against the Euro. It has since recovered it original parity as Eurozone growth stalled and the Swedish economy resisted a major downturn. The Swedish krona also fell sharply against the US dollar.

Both movements improved the competitiveness of Swedish exports and offset to some extent the decline in the volume demand.

In 2009, the Deputy Riksbank Governor said that (article linked to above):

The financial crisis has also affected the Swedish krona. However, the Riksbank’s assessment is that the weakening of the krona is temporary and primarily a result of the financial crisis. In times of financial turbulence investors tend to turn to the larger currencies, which are regarded as “safer”. The result of this flight to quality is that smaller currencies like the Swedish krona weaken … During a normal economic downturn it may be an advantage that the currency depreciates in this way and thus dampens the downturn.

But as the real GDP and contributions graph (above) shows, the Swedish economy is now becoming caught up once again in the austerity mania in the rest of Europe. The government generally adopts a conservative approach to the budget and as exports, private consumption and investment become contractionary influences on real GDP growth, they will have to inject more stimulus to keep growth positive.

On November 16, 2011 – the Swedish National Financial Management Authority (ESV) issued this briefing – Public finances still close to balance despite sharp for Sweden – we read that:

After two years of strong expansion, demand and growth are now slowing down sharply. Swedish GDP is stagnating and is forecast to rise by just 0.1 percent in 2012.

The growth outlook is weak for both the euro area and the US in the coming years, and low global demand affects Sweden through weaker exports. Household consumption will also be low, as expectations about both personal finances and the whole economy have deteriorated drastically. Moreover, household wealth has fallen with share prices.

The report tells us that in 2009 and 2010 there were deficits but the government “expected to produce a surplus of 0.4 percent of GDP this year”. However, the “sharp slowdown in the economy in 2012 means that general government net lending will deteriorate again next year to give a deficit of 0.3 percent of GDP”.

Conclusion

For more on the fantasy world that Robert Barro lives in (academically) – please read the blog – Pushing the fantasy barrow. His predictions have failed to materialise over the course of his academic career.

While this blog is not a definitive analysis of either Germany or Sweden and their response to the financial crisis. But even a cursory examination of the basic facts provides information that runs counter to the Barro obsession that deficits are bad and austerity is good.

I am also not suggesting that all is well in Sweden (nor Germany). But to say they demonstrate the case that stimulus has been proven to be ineffective is false and not supported by the most obvious facts.

That is enough for today!

The non-government sector are wealthier when a government issues bonds by the government to match its budget deficit.

The answer is False.

This answer relies on an understanding the banking operations that occur when governments spend and issue debt within a fiat monetary system. That understanding allows us to appreciate what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

In this situation, like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

• Building bank reserves does not increase the ability of the banks to lend.
• The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
• Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk.

You may wish to read the following blogs for more information:

• Why history matters
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• The complacent students sit and listen to some of that
• Saturday Quiz – February 27, 2010 – answers and discussion

Question 2:

Ignoring any reserve requirements, a central bank will eliminate any need to conduct open market operations to ensure its target policy rate is achieved each day by paying a positive interest rate on overnight reserves.

The answer is False.

Mainstream macroeconomics textbooks tells students that monetary policy describes the processes by which the central bank determines “the total amount of money in existence or to alter that amount”.

In Mankiw’s Principles of Economics (Chapter 27 First Edition) he say that the central bank has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system” and the second “and more important job”:

… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).

How does the mainstream see the central bank accomplishing this task? Mankiw says:

Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.

This description of the way the central bank interacts with the banking system and the wider economy is totally false. The reality is that monetary policy is focused on determining the value of a short-term interest rate. Central banks cannot control the money supply. To some extent these ideas were a residual of the commodity money systems where the central bank could clearly control the stock of gold, for example. But in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.

The theory of endogenous money is central to the horizontal analysis in Modern Monetary Theory (MMT). When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply.

As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 (Currency plus bank current deposits of the private non-bank sector plus all other bank deposits from the private non-bank sector) is just an arbitrary reflection of the credit circuit.

So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.

Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans. The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base (bank reserves) as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

With this background in mind, the question is specifically about the dynamics of bank reserves which are used to satisfy any imposed reserve requirements and facilitate the payments system. These dynamics have a direct bearing on monetary policy settings. Given that the dynamics of the reserves can undermine the desired monetary policy stance (as summarised by the policy interest rate setting), the central banks have to engage in liquidity management operations.

What are these liquidity management operations?

Well you first need to appreciate what reserve balances are.

The New York Federal Reserve Bank’s paper – Divorcing Money from Monetary Policy said that:

… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

So the central bank must ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. But, equally, it must also maintain the bank reserves in aggregate at a level that is consistent with its target policy setting given the relationship between the two.

So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.

Many countries (such as Australia and Canada) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like the US and Japan have historically offered a zero return on reserves which means persistent excess liquidity would drive the short-term interest rate to zero.

The support rate effectively becomes the interest-rate floor for the economy. If the short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.

So the issue then becomes – at what level should the support rate be set? To answer that question, I reproduce a version of the diagram from the FRBNY paper which outlined a simple model of the way in which reserves are manipulated by the central bank as part of its liquidity management operations designed to implement a specific monetary policy target (policy interest rate setting).

I describe the FRBNY model in detail in the blog – Understanding central bank operations so I won’t repeat that explanation.

The penalty rate is the rate the central bank charges for loans to banks to cover shortages of reserves. If the interbank rate is at the penalty rate then the banks will be indifferent as to where they access reserves from so the demand curve is horizontal (shown in red).

Once the price of reserves falls below the penalty rate, banks will then demand reserves according to their requirments (the legal and the perceived). The higher the market rate of interest, the higher is the opportunity cost of holding reserves and hence the lower will be the demand. As rates fall, the opportunity costs fall and the demand for reserves increases. But in all cases, banks will only seek to hold (in aggregate) the levels consistent with their requirements.

At low interest rates (say zero) banks will hold the legally-required reserves plus a buffer that ensures there is no risk of falling short during the operation of the payments system.

Commercial banks choose to hold reserves to ensure they can meet all their obligations with respect to the clearing house (payments) system. Because there is considerable uncertainty (for example, late-day payment flows after the interbank market has closed), a bank may find itself short of reserves. Depending on the circumstances, it may choose to keep a buffer stock of reserves just to meet these contingencies.

So central bank reserves are intrinsic to the payments system where a mass of interbank claims are resolved by manipulating the reserve balances that the banks hold at the central bank. This process has some expectational regularity on a day-to-day basis but stochastic (uncertain) demands for payments also occur which means that banks will hold surplus reserves to avoid paying any penalty arising from having reserve deficiencies at the end of the day (or accounting period).

To understand what is going on not that the diagram is representing the system-wide demand for bank reserves where the horizontal axis measures the total quantity of reserve balances held by banks while the vertical axis measures the market interest rate for overnight loans of these balances

In this diagram there are no required reserves (to simplify matters). We also initially, abstract from the deposit rate for the time being to understand what role it plays if we introduce it.

Without the deposit rate, the central bank has to ensure that it supplies enough reserves to meet demand while still maintaining its policy rate (the monetary policy setting.

So the model can demonstrate that the market rate of interest will be determined by the central bank supply of reserves. So the level of reserves supplied by the central bank supply brings the market rate of interest into line with the policy target rate.

At the supply level shown as Point A, the central bank can hit its monetary policy target rate of interest given the banks’ demand for aggregate reserves. So the central bank announces its target rate then undertakes monetary operations (liquidity management operations) to set the supply of reserves to this target level.

So contrary to what Mankiw’s textbook tells students the reality is that monetary policy is about changing the supply of reserves in such a way that the market rate is equal to the policy rate.

The central bank uses open market operations to manipulate the reserve level and so must be buying and selling government debt to add or drain reserves from the banking system in line with its policy target.

If there are excess reserves in the system and the central bank didn’t intervene then the market rate would drop towards zero and the central bank would lose control over its target rate (that is, monetary policy would be compromised).

As explained in the blog – Understanding central bank operations – the introduction of a support rate payment (deposit rate) whereby the central bank pays the member banks a return on reserves held overnight changes things considerably.

It clearly can – under certain circumstances – eliminate the need for any open-market operations to manage the volume of bank reserves.

In terms of the diagram, the major impact of the deposit rate is to lift the rate at which the demand curve becomes horizontal (as depicted by the new horizontal red segment moving up via the arrow).

This policy change allows the banks to earn overnight interest on their excess reserve holdings and becomes the minimum market interest rate and defines the lower bound of the corridor within which the market rate can fluctuate without central bank intervention.

So in this diagram, the market interest rate is still set by the supply of reserves (given the demand for reserves) and so the central bank still has to manage reserves appropriately to ensure it can hit its policy target. If there are excess reserves in the system in this case, and the central bank didn’t intervene, then the market rate will drop to the support rate (at Point B).

So if the central bank wants to maintain control over its target rate it can either set a support rate below the desired policy rate (as in Australia) and then use open market operations to ensure the reserve supply is consistent with Point A or set the support (deposit) rate equal to the target policy rate.

The answer to the question is thus False because the simple act of paying interest on reserves does not necessarily eliminate the need for open market operations. It all depends on where the support rate is set. Only if it set equal to the policy rate will there be no need for the central bank to manage liquidity via open market operations.

The following blogs may be of further interest to you:

• Understanding central bank operations
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary

Question 3:

Ignoring any reserve requirements, bank reserves will be higher than otherwise if the central bank pays a positive return on overnight reserves held by the commercial banks equal to its current policy rate.

The answer is True.

This question was clearly related to the Question 2 and so some of the essential information required to understand the answer here is presented there.

The payment of a positive return on overnight reserves equal to the current policy rate will significantly reduce interbank activity. Why? Because the banks will not have to worry about earning non-competitive returns on excess reserves. When there are excess reserves in the system, which means the level of reserves is beyond that desired by the banks for clearing purposes, the banks which hold excesses seek to lend them out on the interbank (overnight) market.

In the absence of a support rate (positive return on overnight reserves) and any central bank liquidity management operations (open market purchases in this case), the competition in the interbank market will drive the market rate of interest down to zero on overnight funds. It should be noted that these transactions between the banks will not eliminate a system-wide excess reserve situation.

The competition will redistribute the excess between banks but will not eliminate it. A vertical transaction between the government and non-government sectors is the only way such an excess can be eliminated.

Please see the suite of blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3 – for a detailed explanation of the difference between vertical transactions (between the government and non-government sectors) and horizontal transactions (between non-government entities).

Clearly, the central bank loses control of its monetary policy setting in this case (unless the target is a zero short-term interest rate) unless it steps in and eliminates the excess reserves by selling government debt to the banks. This provides the banks with an interest-bearing financial asset in exchange for the zero-interest bearing reserves.

Once the central bank offers a support rate the situation changes If the support rate on overnight reserves is set equal to the current policy rate then the banks have no incentive to engage in interbank lending. Some banks may still seek overnight funds in the interbank market if they are short of reserves but in general activity in that market will be significantly reduced.

Further, the opportunity cost of holding excess reserves is eliminated and so the banks have less need to minimise their holdings of reserve balance each day.

Any bank with reserves in excess of their short-term perceived clearing house requirements will still earn the market rate of interest on them.

As a consequence, the incentive to lend these funds is substantially reduced. Banks would only participate in interbank market if the rate they could lend at was above the market rate and below the central bank penalty rate.

So in this case, banks will tend to hold more reserves than otherwise to make absolutely sure they never need to access the discount window offered by the central bank which carries the penalty.

The following blogs may be of further interest to you:

• Understanding central bank operations
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary

Question 4:

When a country runs a small current account deficit and the private domestic sector is saving overall, the government budget balance will always be in deficit.

The answer is True.

This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances.

Refreshing the balances – we know that from an accounting sense, if the external sector overall is in deficit, then it is impossible for both the private domestic sector and government sector to run surpluses. One of those two has to also be in deficit to satisfy the accounting rules.

The important point is to understand what behaviour and economic adjustments drive these outcomes.

The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.

From the sources perspective we write:

GDP = C + I + G + (X – M)

which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

From the uses perspective, national income (GDP) can be used for:

GDP = C + S + T

which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.

Equating these two perspectives we get:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero. The sectoral balances derived are:

• The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
• The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
• The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.

A simplification is to add (I – S) + (X – M) and call it the non-government sector. Then you get the basic result that the government balance equals exactly $-for-$ (absolutely or as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances).

This is also a basic rule derived from the national accounts and has to apply at all times.

So what economic behaviour might lead to the outcome specified in the question?

If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative – that is net drain of spending – dragging output down. The reference to a “small” external deficit was to place doubt in your mind. In fact, it doesn’t matter how large the external deficit is for this question.

Assume, now that the private domestic sector (households and firms) seeks to save overall, which is a different thing to saying that households save out of disposable income.

Households can save out of disposable income but the private domestic sector may still be spending more than income if investment flow is larger than the flow of saving, and vice versa.

So assume that the private domestic sector is succesful in spending less than its overall income. Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income and firms might cut back investment spending.

The immediate impact is that aggregate demand will fall and inventories will start to increase beyond the desired level of the firms.

The firms will soon react to the increased inventory holding costs and will start to cut back production. How quickly this happens depends on a number of factors including the pace and magnitude of the initial demand contraction. But if the households persist in trying to save more and consumption continues to lag, then soon enough the economy starts to contract – output, employment and income all fall.

The initial contraction in consumption multiplies through the expenditure system as workers who are laid off also lose income and their spending declines. This leads to further contractions.

The declining income leads to a number of consequences. Net exports improve as imports fall (less income) but the question clearly assumes that the external sector remains in deficit. Total saving actually starts to decline as income falls as does induced consumption.

So the initial discretionary decline in consumption is supplemented by the induced consumption falls driven by the multiplier process.

The decline in income then stifles firms’ investment plans – they become pessimistic of the chances of realising the output derived from augmented capacity and so aggregate demand plunges further. Both these effects push the private domestic balance further towards and eventually into surplus

With the economy in decline, tax revenue falls and welfare payments rise which push the public budget balance towards and eventually into deficit via the automatic stabilisers.

If the private sector persists in trying to increase its saving ratio then the contracting income will clearly push the budget into deficit.

So we would have an external deficit, a private domestic surplus and a budget deficit.

The following blogs may be of further interest to you:

• Barnaby, better to walk before we run
• Stock-flow consistent macro models
• Norway and sectoral balances
• The OECD is at it again!

Question 5 – Premium Question:

Various governments are imposing austerity budgets on their economies. In Britain and the US, even “progressives”are supporting cutting net spending but prefer to focus on tax increases while the “conservatives” are recommending spending cuts and privatisation. In terms of the initial impact on national income, which policy option will be more damaging – a tax increase which aims to increase tax revenue at the current level of national income by $x or a spending cut of $x?
(a) Tax increase
(b) Spending cut
(c) Both will be equivalent
(d) There is not enough information to answer this question

The answer is Spending cut.

The question is only seeking an understanding of the initial drain on the spending stream rather than the fully exhausted multiplied contraction of national income that will result. It is clear that the tax increase increase will have two effects: (a) some initial demand drain; and (b) it reduces the value of the multiplier, other things equal.

We are only interested in the first effect rather than the total effect. But I will give you some insight also into what the two components of the tax result might imply overall when compared to the impact on demand motivated by an decrease in government spending.

To give you a concrete example which will consolidate the understanding of what happens, imagine that the marginal propensity to consume out of disposable income is 0.8 and there is only one tax rate set at 0.20. So for every extra dollar that the economy produces the government taxes 20 cents leaving 80 cents in disposable income. In turn, households then consume 0.8 of this 80 cents which means an injection of 64 cents goes into aggregate demand which them multiplies as the initial spending creates income which, in turn, generates more spending and so on.

Government spending cut

A cut in government spending (say of $1000) is what we call an exogenous withdrawal from the aggregate spending stream and this directly reduces aggregate demand by that amount. So it might be the cancellation of a long-standing order for $1000 worth of gadget X. The firm that produces gadget X thus reduces production of the good or service by the fall in orders ($1000) (if they deem the drop in sales to be permanent) and as a result incomes of the productive factors working for and/or used by the firm fall by $1000. So the initial fall in aggregate demand is $1000.

This initial fall in national output and income would then induce a further fall in consumption by 64 cents in the dollar so in Period 2, aggregate demand would decline by $640. Output and income fall further by the same amount to meet this drop in spending. In Period 3, aggregate demand falls by 0.8 x 0.8 x $640 and so on. The induced spending decrease gets smaller and smaller because some of each round of income drop is taxed away, some goes to a decline in imports and some manifests as a decline in saving.

Tax-increase induced contraction

The contraction coming from a tax-cut does not directly impact on the spending stream in the same way as the cut in government spending.

First, imagine the government worked out a tax rise cut that would reduce its initial budget deficit by the same amount as would have been the case if it had cut government spending (so in our example, $1000).

In other words, disposable income at each level of GDP falls initially by $1000. What happens next?

Some of the decline in disposable income manifests as lost saving (20 cents in each dollar that disposable income falls in the example being used). So the lost consumption is equal to the marginal propensity to consume out of disposable income times the drop in disposable income (which if the MPC is less than 1 will be lower than the $1000).

In this case the reduction in aggregate demand is $800 rather than $1000 in the case of the cut in government spending.

What happens next depends on the parameters of the macroeconomic system. The multiplied fall in national income may be higher or lower depending on these parameters. But it will never be the case that an initial budget equivalent tax rise will be more damaging to national income than a cut in government spending.

Note in answering this question I am disregarding all the nonsensical notions of Ricardian equivalence that abound among the mainstream doomsayers who have never predicted anything of empirical note! All their predictions come to nought.

You may wish to read the following blogs for more information:

• Spending multipliers

Of-course, Walter Bagehot was an early editor of The Economist magazine which had been started by this father-in-law. He wrote the now-famous book – Lombard Street in 1873, which explored banking and finance in an international setting.

Serious students of monetary economics would not cite Bagehot in the context of the lender of last resort role of the central bank as Das has done. Bagehot derived the advice from an earlier writing of Henry Thornton (The Paper Credit of Great Britain), which is the essential starting point for these types of discussions.

In Lombard Street, Bagehot essentially argued for increasing the “reserve” held at the Bank of England. He was a conservative and was writing during the period when the central bank was constrained by the 1844 Peel Act (the so-called Bank Act), whih held that the Bank could only issue new bank notes by holding physical stocks of gold against the issue.

At the time, the the so-called Bank of England note was the dominant instrument of credit in private transactions. The Bank Act acted like a straitjacket on commerce because there was limits on the amount of credit that could be extended at any point in time.

The Peel act did not limit “cheques” though and progressively, the “joint stock banks” grew and the modern credit-creation role of banks (on receipt of security) developed.

Further, in Lombard Street, Bagehot was, in fact, analysing the collapse of one bank in Lombard Street, London (which caused a panic in 1866). What Bagehot advised was that the central bank in reducing panic should not make advances by which the “the Bank will ultimately lose” but he also noted (quoting from Chapter 7):

The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business …

The same could not be said in the banking sector of the Eurozone at present. The crisis is not an isolated case of one or two bad banks, but a whole sector poisoned by deregulation and greed.

The CNBC article building on Das’s arguments wrote that:

The European Central Bank is indebted to the hilt and is beginning to look like one of the banks it has done so much to save … Having subsidized the European banking industry with its 1 trillion euro ($1.29 trillion) long-term refinancing operation (LTRO), funds that were distributed at well below market prices, the central bank is leveraged to levels Bear Stearns and Lehman Brothers might have felt comfortable with in early 2007.

This is like comparing a household to a treasury (given that the central bank is part of the consolidated government sector). Please read my blog – The consolidated government – treasury and central bank – for more discussion on this point.

Quoting an array of leverage ratios and other ratios which are applicable to non-government institutions and households (the users of the currency) is a waste of time when considering the central bank which issues the currency.

No meaningful analogies can be drawn and it is surprising that these so-called experts do not understand that.

The CBNC article though persists, quoting Das (as above) in relation to the ECB:

It is supported by it own capital (scheduled to increase to 10 billion euros) and the capital of euro zone central banks (80 billion euros). This equates to a leverage of around 38 times …

To which someone who really understands all this says – “So what?”.

A private bank needs capital – clearly because there are prudential regulations requiring that – but because it can become insolvent. It has not currency-issuing capacity in its own right.

While the ECB has an elaborate formula for determining how capital is from the national member banks (for example, see Annual Report 2011) – at an intrinsic level, it has no need for capital. It could operate forever with a balance sheet that if held by a private bank would signal insolvency.

The point is that there are no comparable concepts for a currency issuer and a currency user in terms of solvency. The latter is always at risk of insolvency the former never.

I have previously considered the leaked (confidential report) from the Institute of International Finance – Implications of a Disorderly Greek Default and Euro Exit.

That Repor claims that most profound issue relating to the Greek bailouts is the “increased involvement of the ECB in supporting the euro area financial system” which “would lead to significant losses and strains on the ECB itself” and the Greek government defaulted in a disorderly fashion:

When combined with the strong likelihood that a disorderly Greek default would lead to the hurried exhort of Greece from the Euro Area, this financial shock to the ECB could raise significant stability issues about the monetary union.

Given the political developments in Greece at present the instability relating to the “bailouts” is increasing. If the new elections give the Syriza the largest number of seats, which a Poll yesterday predicted, then the small little economy of Greece has renewed weight in Euro-politics, as long as the leaders of the party and the coalition it might be able to string together do not get seduced by the fine food and drink provided at the next EC Summit and strike a deal with the Germans etc.

But talk of a “financial shock to the ECB” is cheap, meaingless talk. It doesn’t mean a thing.

The ECB is the currency-issuer of the Euro. It can never run out of Euros.

Willem Buiter noted in his 2008 Discussion Paper – Can Central Banks Go Broke? – that in “the usual nation state setting” there is a unique “national fiscal authority” (treasury) which “stands behind a single national central bank”. He concludes in this situation that:

There can be no doubt … the fiscal authorities are, from a technical, administrative and economic management point of view, capable of extracting and transferring to the central bank the resources required to ensure capital adequacy of the central bank should the central bank suffer a severe depletion of capital in the performance of its lender of last resort and market maker of last resort functions.

So can a central bank go broke? Answer: Yes.

Willem Buiter provides the qualification that is essential:

… the central bank can always bail out any entity – including itself – through the issuance of base money – if the entity’s liabilities are denominated in domestic current and nominally denominated (that is, not index-linked). If the liabilities of the entity in question are foreign-currency-denominated or index-linked, a bail-out by the central bank may not be possible.

Which is the standard Modern Monetary Theory (MMT) definition of a risk-free sovereign government – one that only issues liabilities in its own currency. If the consolidated government sector – the central bank and the treasury – issue liabilities (for example, take on debt) – that is denominated in a foreign currency, then insolvency becomes a possibility.

What about the Eurozone, where there is no fiscal authority? In the Eurozone, the pecking order is that the member state treasuries are deemed to guarantee
their own national central banks which “own” the ECB and which provide lender of last resort facilities to their own banking systems. There is no fiscal authority backing the ECB but despite all the legal niceties (complexities) involved in how the national central banks might carry out their lender of last resort duties, the reality is that the ECB is the ultimate lender of last resort in the EMU.

The other point to note (which is made by Buiter) is that it :

… is not necessarily the case that a central bank goes bankrupt even if its equity capital is completely depleted by its engagement in unorthodox monetary policies. The reason is that there are differences between central banks and commercial banks and a static visual inspection of the central bank balance sheet does not convey a complete picture.

Why is that?

Consider the US Federal Reserve which could easily buy all the outstanding US federal government if it wanted to and if the Federal Reserve lost capital it could simply issue new currency to replenish it.

The same logic goes for the ECB – it alone creates the Euro currency. It can never go bankrupt.

While the mainstream economists would consider this to be dangerously inflationary if the central bank acted in this way the point is that at least that observation (erroneous or not) takes the debate beyond the inane level of insolvency.

I also think the evidence is pretty much in that there are no inflationary pressures emerging – some four years into the crisis and after a period of massive balance sheet building by the central banks.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

So the argument that the the argument that the ECB is exposing itself to credit risk (buying up dodgy assets) and could go broke is erroneous.

Please read my blogs – The US Federal Reserve is on the brink of insolvency (not!) and Better off studying the mating habits of frogs – for more discussion on this point.

So why do these characters still rattle on about central bank insolvency?

I think that the claims are really being driven by those who their paranoia about so-called “central bank independence”. Please read my blog – Central bank independence – another faux agenda – for more discussion on this point.

The neo-liberals claim that the ECB has breached its charter of independence. They continually quote the June 15, 1998 comment from the then ECB President Wim Duisenberg, which was made during an interview published by Der Spiegel in the article – Der Euro wird Weltwährung:

Es gibt keine Zentralbank der Welt, die von der Politik so unabhängig ist wie die Europäische Zentralbank

That is – “There is no central bank in the world that is as independent from politics as the European Central Bank”. Not only was the construct of the ECB political – its austerity focus etc – but the appointments to the Board from inception were dominated by Euro politics.

But the critics of the ECB appeal to the Statute of the European System of Central Banks (ESCB) and of the European Central Bank (for example, http://www.ecb.int/ecb/legal/pdf/en_statute_2.pdf”>Article 7 says that:

When exercising the powers and carrying out the tasks and duties conferred upon them by the Treaties and this Statute, neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Union institutions, bodies, offices or agencies, from any government of a member state or from any other body.

The critics then list the number of developments where the ECB has compromised its independence.

For example, they say that the ECB’s Securities Markets Program (SMP) – established on May 14, 2010 which involves the ECB buying bonds from governments which the bond markets will not lend to at reasonable rates – but the purchasing is via the secondary market from banks who took the primary issue, violates the no-bailout clause in the ECB Statutes.

They point to Article 21.1, Protocol (No 4) of the Statute of the European System of Central Banks and of the European Central Bank, which says:

… overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

The conclusion is that the SMP is a violation of the “intent” of the rules. I agree. But at least the ECB has had the sense to realise that without the SMP Greece and probably other member states would be totally insolvent by now (the appalling 70 per cent Greek haircut notwithstanding).

The SMP is ensuring that yields on precarious public debt issues are being kept down. The participants in the primary issuing market know that the ECB will operate rather vigorously in the secondary market when required.

Please read my blog – S&P ≠ ECB – the downgrades are largely irrelevant to the problem – for more discussion on this point.

The point is that the “rules” which established the EMU (and the role of the ECB) were ideological and based on the spin of the day that the business cycle was dead and that no recession could be bad enough to upset the financial system and cause governments to grossly violate the Stability and Growth Pact fiscal rules.

Please read my blog – The Great Moderation myth – for more discussion on this point.

I won’t go on to discuss the LITR. But the same arguments are presented.

The problem is that elements in the ECB appear to buy into the myths and recently they have been making subscription calls to the national member states to add capital to prevent an inflationary outbreak which they claim would follow a “printed money” solution to their capital losses.

Conclusion

The dominance of inapplicable concepts, reasoning and understandings blocks any meaningful progress being made in the crisis at present.

These erroneous narratives lead to policy developments which have continued to make the crisis worse.

Saturday Quiz

The Saturday Quiz will be back sometime tomorrow.

That is enough for today!