Last year it was Reinhart and Rogoff being rammed down our throats as the deficit terrorists were claiming that governments in the advanced nations were on the cusp of defaulting on their sovereign debt. Their book was relentlessly misused by commentators and academics (like Niall Ferguson and others) and even the authors themselves left things ambiguous in interviews. The fact is that their research (if we dare call it that) is applicable to only a narrow set of situations none of them relevant in the contemporary setting. More recently, the deficit terrorists have been holding up a new effigy – a new hero. Another Harvard economist – Alberto Alesina. What is it about that place? Alesina has allegedly provided a solid theoretical case to support the absurd claims by the austerity proponents that cutting the very thing that is supporting growth at present will not damage that growth. He is now the new hero. Well it is another scam job! He chooses to use flawed orthodox textbook models to assert his case without mind to the situational context and other realities. He is no hero but just another mainstream economist seeking celebrity with zero substance to offer and very little else to sell other than a headline.
On June 30, 2010, Business Week carried a story – Keynes vs. Alesina. Alesina Who? – which concluded that:
The bottom line Alesina has provided the theoretical ammunition fiscal conservatives want.
I had read the Alesina paper – Fiscal adjustments: lessons from recent history – and decided it was so poor that I wouldn’t comment on it. But it has come back again in a Wall Street Journal article (July 26, 2010) where it is once again claimed that:
Before the debate over the efficacy the 2009 stimulus is resolved, Congress is turning to whether it’s time to start cutting deficits.
Mr. Alesina says it is: In 107 periods since 1980 when governments cut deficits, doing so tended to quicken economic growth, not slow it
So the press is now running with Alesina’s paper and holding it out as an authority in the same way they misused the recent book by Reinhart and Rogoff entitled This Time is Different. All the deficit terrorists started quoting from this book and it was clear most had not even read it much less understood its limited applicability.
To refresh your memory about Reinhart and Rogoff, here is draft version of This Time is Different that you can read for free.
Of critical importance, quite apart from the other issues that one might have with Reinhart and Rogoff’s analysis (and I have many), one has to appreciate what they are talking about. Most of the commentators do not spell out the definitions of a sovereign default used in the book. In this way they deliberately (or through ignorance – one or the other) blur the terminology and start claiming or leaving the reader to assume that the analysis applies to all governments everywhere.
It does not. On Page 2 of the draft, Reinhart and Rogoff say:
We begin by discussing sovereign default on external debt (i.e., a government default on its own external debt or private sector debts that were publicly guaranteed.)
How clear is that? They are talking about problems that national governments face when they borrow in a foreign currency. So when so-called experts claim that their analysis applies to the “entire developed world”, which many did during 2009 and into 2010, you realise immediately that they are lying or just don’t get it – full stop.
The US government has no foreign currency-denominated debt. Domestic debt owned by foreigners is not remotely like debt that is issued in a foreign currency. Reinhart and Rogoff are only talking about debt that is issued in a foreign jurisdiction typically in that foreign nation’s currency. Japan has no foreign currency-denominated debt. Many other advanced nations have no foreign currency-denominated debt.
It turns out that many developing nations do have such debt courtesy of the multilateral institutions like the IMF and the World Bank who have made it their job to load poor nations up with debt that is always poised to explode on them. Then they lend them some more.
But it is very clear that there is never a solvency issue on domestic debt whether it is held by foreigners or domestic investors.
Reinhart and Rogoff also pull out examples of sovereign defaults way back in history without any recognition that what happens in a modern monetary system with flexible exchange rates is not commensurate to previous monetary arrangements (gold standards, fixed exchange rates etc). Argentina in 2001 is also not a good example because they surrendered their currency sovereignty courtesy of the US exchange rate peg (currency board).
Further, Reinhart and Rogoff (on page 14 of the draft) qualify their analysis:
Table 1 flags which countries in our sample may be considered default virgins, at least in the narrow sense that they have never failed to meet their debt repayment or rescheduled. One conspicuous grouping of countries includes the high-income Anglophone nations, the United States, Canada, Australia, and New Zealand. (The mother country, England, defaulted in earlier eras as we shall see.) Also included are all of the Scandinavian countries, Norway, Sweden, Finland and Denmark. Also in Europe, there is Belgium. In Asia, there is Hong Kong, Malaysia, Singapore, Taiwan, Thailand and Korea. Admittedly, the latter two countries, especially, managed to avoid default only through massive International Monetary Fund loan packages during the last 1990s debt crisis and otherwise suffered much of the same trauma as a typical defaulting country.
Britain has defaulted only once in its history – during the 1930s – while it was on a gold standard. The Bank of England overseeing an economy ravaged by the Great Depression defaulted on gold payments in September, 1931. The circumstances of that default are not remotely relevant today. There is no gold standard, the sterling floats. Britain has never defaulted when its monetary system was based on a non-convertible currency.
A large number of defaults are associated with wars or insurrections where new regimes refuse to honour the debts of the previous rulers. These are hardly financial motives. Japan defaulted during WW2 by refusing to repay debts to its enemies – a wise move one would have thought and hardly counts as a financial default.
But if you consider the “virgin” list – how much of the World’s GDP does this group of nations represent? Answer: a huge proportion, especially if you include Japan and a host of other European nations that have not defaulted in modern times.
Further, how many nations with non-convertible currencies and flexible exchange rates have ever defaulted? Answer: hardly any and the defaults were either political or because they were given poor advice (for example Russia in 1998).
Reinhart and Rogoff don’t make this distinction – in fact a search of the draft text reveals no “hits” at all for the search string “fixed exchange rates” or “flexible exchange rates” or “convertible” or “non-convertible”, yet from a MMT perspective these are crucial differences in understanding the operations of and the constraints on the monetary system.
Further, if you consider the Latin American crises in the 1980s, as a modern example, you cannot help implicate the IMF and fixed exchange rates in that crisis. The IMF pushed Mexico and other nations to hold parities against the US dollar yet permit creditors to exit the country. For Mexican creditors this meant that interest returns sky-rocketed (the interest rate rises were to protect the currency) and the poor Mexicans wore the damage.
It was clear during this crisis that the IMF and the US Federal Reserve were more interested in saving the first-world banks who were exposed than caring about the local citizens who were scorched by harsh austerity programs. Same old, same old.
So that little diversion was a reminder that every time you see someone trying to gain authority in an argument by using the research by Reinhart and Rogoff disregard everything they say.
But now the debate is moving to trying to find justifications for the impossible – trying to defend the nonsensical claim that mass austerity will engender economic growth.
The deficit terrorists have struggled to put two coherent words together by way of a justification for this religious hope. Now they think they can be more confident in their sorties into the public debate courtesy of some very dubious research by Alesina. Another Harvard appointment (Rogoff too) – another dodgy economist to quote.
The Business Week article claims that:
Alberto Alesina is a new favorite of fiscal hawks like former President George W. Bush’s chief economic adviser, N. Gregory Mankiw. A professor of economics at Harvard University, the 53-year-old Italian disputes the need for more government spending to prop up growth and advocates spending cuts instead.
This is Alesina’s hour. In April in Madrid, he told the European Union’s economic and finance ministers that “large, credible, and decisive” spending cuts to reduce budget deficits have frequently been followed by economic growth.
It is one thing to find selective examples of successful austerity (notwithstanding the capacity to misrepresent what actually happened in those examples). But it is another issue to assert that the so-called case studies are relevant today to all countries, especially when all of the countries are pursuing austerity.
Alesina at least recognises that the appeals by the gold bugs and Austrians that we are about to encounter hyperinflation (or large inflations) are unfounded. He says the famous historical inflations :
… do not offer much guidance for today. Large inflations, let alone hyperinflations, are (fortunately) unlikely to be repeated; too much has been learned about their evils.
The problem he seeks to address is how to get growth restored.
In relation to austerity packages his contention is that:
… not all fiscal adjustments cause recessions. Many even sharp reductions of budget deficits have been accompanied and immediately followed by sustained growth rather than recessions even in the very short run. These are the adjustments which have occurred on the spending side and have been large, credible and decisive.
He then outlines his conjecture as to how economic expansion can arise from severe cuts in public net spending.
Theoretically, expansionary effects of fiscal adjustments can go through both the demand and the supply side. On the demand side, a fiscal adjustment may be expansionary if agents believe that the fiscal tightening generates a change in regime that “eliminates the need for larger, maybe much more disruptive adjustments in the future” … Current increases in taxes and/or spending cuts perceived as permanent, by removing the danger of sharper and more costly fiscal adjustments in the future, generate a positive wealth effect. An additional channel through which current fiscal policy can influence the economy via its effect on agents’ expectations is the interest rate. If agents believe that the stabilization is credible and avoids a default on government debt, they can ask for a lower premium on government bonds. Private demand components sensitive to the real interest rate can increase if the reduction in the interest rate paid on government bonds leads to a reduction in the real interest rate charged to consumers and firms … The decrease in interest rate can also lead to the appreciation of stocks and bonds, increasing agents’ financial wealth, and triggering a consumption/investment boom. On the supply side, expansionary effects of fiscal adjustments work via the labor market and via the effect that tax increases and/or spending cuts have on the individual labor supply in a neoclassical model, and on the unions’ fall-back position in imperfectly competitive labor markets.
First, households are alleged to have an advanced understanding of the way the economy works and the future fiscal policy settings. All the evidence from behavioural economics tells us they do not have that understanding nor behave in the “rational” way that is alleged in the the mainstream textbooks. The latter provide the basis of Alesina’s alleged theoretical causation. They have no application to the real world.
Please read my recent blogs – Defunct but still dominant and dangerous and The myth of rational expectations – for more discussion of the extent of rationality of individuals and how mainstream economics is flawed.
But, further, if they did have such an understanding they would quickly scoff at Alesina and point out that governments do not have to raise taxes to “pay back deficits”. There is very little historical evidence to support the fact that governments behave like that. Governments rarely pay down outstanding debt and when they try that by running surpluses a recession soon follows pushing them back into deficit.
Our enlightened households would tell Alesina that the reality – rehearsed countless times in history – is that the reversal of the automatic stabilisers as growth emerges reduces the budget deficits and arrests the rise in the public debt to GDP ratio.
Even less enlightened households, particularly the Japanese, will know that Japan has experienced rising budget deficits (as a per cent of GDP), has the largest stock of public debt when compared to GDP, and has maintained low interest rates for two decades. When the government tried cutting the deficit in 1997 – using Alesina’s logic – the Japanese economy tanked. A renewed expansion of net public spending provided the growth spurt that they enjoyed in early 2000s.
Second, in the examples used by Alesina to make his case household and corporate debt levels were nothing like they are today. The imperative to save by households is now well embedded in their psyche and that better explains why the demand for credit remains weak and why economies are slowing as the fiscal stimulus packages are being withdrawn.
Third, none of these examples were coincident – that is, what a single country might be able to achieve with a supportive external demand environment cannot be applied to all countries cutting at the same time.
You need world demand to stay strong to exploit your increased competitiveness. As I argued in this blog – Fiscal austerity – the newest fallacy of composition – it is flawed reasoning to think that if all nations deflate that there will be enough demand available to take advantage of the increased competitiveness.
Fourth, if all nations are deflating, the competitive gains of any single nation are likely to be small anyway.
Fifth, the neo-classical labour supply model that Alesina is using is without application. The macroeconomy is well “off” any possible labour supply frontier at present as a result of the very significant aggregate demand constraint being imposed on the labour market. The unemployment we are seeing is involuntary unemployment and “agents” are not on the “margin of their indifference between labour and leisure”.
So all the alleged substitution and income effects that Alesina is hinting out would not work even if they ever worked. And … they do not. The neoclassical labour supply model has very little empirical support. People do not exhibit large reactions in their labour supply in relation to tax changes.
Sixth, implicit in Alesina’s claim is that US bond yields are higher than they would otherwise be because there is fear of future insolvency. The following chart makes a joke of that sort of claim.
You can access the data from the US Federal Reserve database. I am using their measure “Market yield on U.S. Treasury securities at 10-year constant maturity, quoted on investment basis” as a guide. The choice is not particularly important for this purpose.
Further, you can go here to see the results of the US bond auctions and you will see that there is no shortage of buyers for the debt. So if there was a widespread fear that the US government is about to default and so bond premiums are being squeezed up to reflect the rising risk you would also see it in the volume take up. No evidence at all.
The same sort of evidence applies to most major nations at present (it is just easy to get US data to show you this is the case).
Overall, there is no credibility gap being revealed by the bond trading data despite very significant rises in debt ratios and on-going budget deficits.
I know what the terrorists are now saying – it is only a matter of time! Sure and doom-merchants have been predicting the end of the world forever and the 2000k bugs were predicting it then and the terrorists were predicting the sky would fall in by the end of 2009 and … We can just let the “it is only a matter of time” brigade worry themselves sick and leave us in peace.
Seventh, none of the nations that Alesina examined had very low interest rates. In many of the cases he examined the monetary authority eased policy as fiscal policy was tightening which not only reduced borrowing costs but also eased the exchange rate.
The only nation in recent history that has followed Alesina’s preferred policy path is Japan in 1997. It has zero interest rates, low private demand growth and the Japanese government listened to the deficit terrorists then and a fiscal austerity was imposed. What happened? It is clear what happened as a result. As noted above, the Japanese economy double-dipped and more hardship was caused.
Business week quote Alesina in this regard as follows:
I don’t see how anyone can argue that we should push even more on the fiscal accelerator.
Which is not answering the question. The question focused on the irrelevance of his research findings to the present situation – zero interest rates. Further, Alesina ignored the fact that in the only case that resembles the situation we are in now – Japan – the pursuit of austerity made matters worse. That result was predicted by those who have an understanding of how macroeconomies respond to negative demand shocks.
You might also like to read this paper by Federal Reserve Bank of New York researcher Gauti B. Eggertsson – What Fiscal Policy is Effective at Zero Interest Rates?. He shows that the Labor Tax Multiplier is 0.096 when there is a positive interest rate and -0.81 when there is a zero interest rate. Conversely, the government Spending Multiplier is 0.32 and 2.27, respectively.
The multipliers summarize by how much output decreases/increases if the government cuts tax rates by 1 percent or increases government spending by 1 percent (as a fraction of GDP). At positive interest rates, a labor tax cut is expansionary, as the literature has emphasized in the past. But at zero interest rates, it flips signs and tax cuts become contractionary. Meanwhile, the multiplier of government spending not only stays positive at zero interest rates, but becomes almost eight times larger.
This empirical result conforms with Modern Monetary Theory (MMT) whereby government spending goes straight into aggregate demand whereas tax cuts are, in part, lost to higher private saving.
Using the same sort of models that Mankiw and Alesina use, Eggertsonn’s results convincingly refute the claims by the likes of Alesina and Mankiw that tax cuts are more expansionary than government spending increases. He says that:
The principal goal of policy at zero interest rates should not be to increase aggregate supply by manipulating aggregate supply incentives. Instead, the goal of policy should be to increase aggregate demand – the overall level of spending in the economy.
His point is that at zero interest rates, real output is “demand-determined”, which means that macroeconomic policy should not be aimed at “increasing the supply of goods when the problem is that there are not enough buyers”. The tax cut/incentives camp all think, erroneously, that by increasing the supply of goods in a recession you will increase demand – via some mystery Say’s Law type mechanism.
Eggertsson’s position is basically that monetary policy loses effectiveness when interest rates are low or zero. MMT might argue that monetary policy is generally ineffective except when personal debt levels are very high.
Stiglitz doesn’t agree with Alesina
I mentioned in yesterday’s blog that Joseph Stiglitz was interviewed last night on the ABC national current affairs show 7.30 Report. You can see the full transcript to see what he said or watch an extended version of the segment.
Stiglitz was asked about his recent book “Freefall” which is predicting that the US economy will slow again and is in danger of entering a double-dip recession.
He was asked what the state of the US economy is in right now. He replied: “In a single word, weak, ah, and probably going to get weaker”.
It’s almost sure that growth in the United States is going to slow markedly. Whether it slows from where it was to one half per cent or one per cent or to minus one half per cent isn’t yet clear. I think what’s been happening in Europe has been increasing the likelihood that we go into a double dip, for two reasons: one, it means that global financial markets are in a little bit more unsettled state. But secondly, the US had hoped to export its way out of the recession through a weak dollar. We had a weak dollar policy. We didn’t call it that, but that’s what was going on. But, exchange rates are like negative beauty contests in the current context: who is the ugliest? And, we were winning, the US was winning hands down until this year and Europe’s financial troubles have put it in – have meant that it is doing much better in this negative beauty contest, so the dollar is stronger, and that’s gonna make it more difficult for the US to export and that’s going to mean that our economy is going to be all the weaker.
The whole world is relying on an export-led growth strategy. This is one of the two major claims being made by the austerity proponents. That is the government deflates the economy and gets costs down then the international competitiveness of the nation will be enhanced and so growth will come via net exports. There are two things wrong with this strategy which bears on what Stiglitz is saying here.
First, as noted above in my discussion of Alesina, you need world demand to stay strong to exploit your increased competitiveness. It is a fallacy of composition to think that if all nations deflate that there will be enough demand available to take advantage of the increased competitiveness.
Second, if all nations are deflating, the competitive gains of any single nation are likely to be small anyway.
Alesina’s so-called successful austerity examples are all violated by a mass austerity event as well.
The 7.30 Report asked Stiglitz what was currently needed. He replied telling the viewers of advice he gave President Obama last year:
You oughta be preparing the politics and the economics for a second round of a stimulus … we do need a second round of the stimulus. Unfortunately, the politics are working against us and the likelihood of getting that second round is very dismal.
The US politicians and polities everywhere are being swayed by the dishonest use of selective data by the likes of Alesina who courts celebrity and obviously doesn’t have to bear the costs of the unemployment and lost living standards that are being created in his name by the same politicians.
While the deficit terrorists will be buoyed by Business Week’s claim that “Alesina has provided the theoretical ammunition fiscal conservatives want” and that they are stupid enough to use the “research” (that term used lightly), any reasonable person would be ill-advised to consider the work has any bearing on anything applicable to our contemporary situation.
But then, how many of the really vocal deficit terrorists are in danger of losing their jobs and pensions? Not many.
A good test of their resolve would be to put some contingencies on the likes of Alesina and the rest of them. So Alesina might lose tenure and his position if the unemployment rate in any of the nations he is advising didn’t fall by x percent in the first months after the austerity packages. Or if GDP per capita fell instead of rose then he would get a pay cut calibrating accordingly and then lose his job.
Would he then be so cavalier with his desire for celebrity by pushing such flaky research out into the general arena where it is being misused by all and sundry who wish to press their own misguided dirty agenda.
That is enough for today!