I have always been antagonistic to the mainstream economic theory. I came into economics from mathematics and the mainstream neoclassical lectures were so mindless (using very simple mathematical models poorly) that I had plenty of time to read other literature which took me far and wide into all sorts of interesting areas (anthropology, sociology, philosophy, history, politics, radical political economy etc). I also realised that the development of very high level skills in empirical research (econometrics and statistics) was essential for a young radical economist. Most radicals fail in this regard and hide their inability to engage in technical debates with the mainstream by claiming that formalism is flawed. It might be but to successfully take on the mainstream you have to be able to cut through all their technical nonsense that they use as authority to support their ridiculous policy conclusions. That is why I studied econometrics and use it in my own work. It was strange being a graduate student. The left called be a technocrat (a put-down in their circles) while the right called me a pop-sociologist (a put down in their circles). I just knew I was on the right track when I had all the defenders of unsupportable positions off-side. But an appreciation of the empirical side of debates is very important if a credible challenge to the dominant paradigm is to be made. That has motivated me in my career.
The Australian Treasury released a paper last week – Reconsidering the Link between Fiscal Policy and Interest Rates in Australia – which “examines the empirical relationship between government debt and the real interest margin between Australian and US 10 year government bond yields”.
In English, that means they were seeking to examine whether increasing budget deficits pushed up interest rates which is one of the conservative claims to butress their case against the use of fiscal policy as a counter-stabilisation tool (that is, to correct aggregate demand failures).
An often-cited paper outlining the ways in which budget deficits allegedly push up interest rates is – Government Debt – by Elmendorf and Mankiw (1998 – subsequently published in a book in 1999). This paper was somewhat influential in perpetuating the mainstream myths about government debt and interest rates. Clearly Mankiw still believes in the logic given it occupies a central part of his macroeconomics textbook.
Elmendorf at the time was on the US Federal Reserve Board. It is a pity for the American people that he is now the director of the US Congressional Budget Office.
If you read the paper (and frankly it will waste your precious time to do so), you will note that the paper’s motivation was the rise in public debt between 1980 and 1997. The same sort of rhetoric was being used then as now – spiralling (out of control) public debt. Did the sky fall in then? Answer: No! The rise in the debt presented no problems – interest rates didn’t balloon and inflation didn’t become accelerate out of control.
Elmendorf and Mankiw state that the “conventional” view, which is “held by most economists and almost all policymakers”, considers that:
… the issuance of government debt stimulates aggregate demand and economic growth in the short run but crowds out capital and reduces national income in the long run.
Their depiction of the alternative to the convention view is – Ricardian equivalence – which alleges that:
… the choice between debt and tax finance of government expenditure is irrelevant … [because] … a budget deficit today … [requires] … higher taxes in the future. Thus, the issuing of government debt to finance a tax cut … [or any net spending increase] … represents not a reduction in the tax burden but merely a postponement of it. If consumers are sufficiently forward looking, they will look ahead to the future taxes implied by government debt. Understanding that their total tax burden is unchanged, they will not respond to the tax cut by increasing consumption. Instead, they will save the entire tax cut to meet the upcoming tax liability; as a result, the decrease in public saving (the budget deficit) will coincide with an increase in private saving of precisely the same size. National saving will stay the same, as will all other macroeconomic variables.
I have dealt with this view extensively in a number of blogs – Pushing the fantasy barrow – Even the most simple facts contradict the neo-liberal arguments – Deficits should be cut in a recession and We are sorry – for more detailed discussion on the folly of Ricardian equivalence
Ignoring the fact that the description of a government raising taxes to pay back a deficit is nonsensical when applied to a fiat currency issuing government, the Ricardian Equivalence models rest of several key and extreme assumptions about behaviour and knowledge. Should any of these assumptions fail to hold (at any point in time), then the predictions of the models are meaningless.
The other point is that the models have failed badly to predict or explain key policy changes in the past. That is no surprise given the assumptions they make about human behaviour.
There are no Ricardian economies. It was always an intellectual ploy without any credibility to bolster the anti-government case that was being fought then (late 1970s, early 1980s) just as hard as it is being fought now. Stacks of doctoral theses were written about it – justifying it, etc. None should have passed because they had no knowledge value at all. PhDs are meant to be awarded for advances in knowledge.
Everytime you read an article or chapter or whatever that invokes Ricardian Equivalence to justify its thesis – stop reading immediately and finds something better to do.
In terms of the “conventional” analysis, Elmendorf and Mankiw state that in the short-run an increase in the budget deficit (say via a tax cut with spending constant):
… raises households’ current disposable income and, perhaps, their lifetime wealth as well. Conventional analysis presumes that the increases in income and wealth boost household spending on consumption goods and, thus, the aggregate demand for goods and services … This Keynesian analysis provides a common justification for the policy of cutting taxes or increasing government spending (and thereby running budget deficits) when the economy is faced with a possible recession.
So far so good. This account is not at odds with Modern Monetary Theory (MMT) except that the decision to run budget deficits does not turn on the state of the business cycle. It depends on the state of non-government spending and saving decisions. The aim of the budget deficit is to ensure aggregate demand gaps do not occur which would undermine output and employment growth.
The prior choice that the government has to make is the mix of public and private activity at full capacity. How much public output is required to advance the socio-economic mandate that the political process has bestowed on the government? That is the question that has to be considered initially.
The answer sets the full-employment size of government. Then the government has to manage fluctuations in that size when private spending fluctuates. If private spending increases above this implied “size” then the government would tax the private purchasing power away. If the non-government spending fell below the necessary level (or rate of growth) then the budget deficit has to rise temporarily to fill the gap and maintain growth.
This is the way in which counter-stabilisation policy is conducted. But it may be appropriate (and typically will be) within this process for the government to continuously run budget deficits to ensure the non-government is continuously net saving in the currency of issue. So deficits are not just about bailing out recessions.
But then the wheels fall off in the Elmendorf and Mankiw paper. They say:
Conventional analysis also posits, however, that the economy is classical in the long run. The sticky wages, sticky prices, or temporary misperceptions that make aggregate demand matter in the short run are less important in the long run. As a result, fiscal policy affects national income only by changing the supply of the factors of production. The mechanism through which this occurs is our next topic.
This is the crucial point. The analysis belongs to the class of models that consider that business cycle fluctuations occur because the supplies of input vary as their owners (including workers) make optimising adjustments to the quantities they are prepared to supply. These fluctuations occur around the “natural rate of output” or “natural rate of unemployment” (the two concepts are linked via technology).
Only technology and population matter in the long-run and government spending cannot alter short-run variations in output. Ultimately, the economy sits on its long-run growth path which is invariant to government policy.
Elmendorf and Mankiw us the standard national accounting identities to make their case. So they say that national income (Y) is from the perspective of the households either consumed (C), saved (S) or taxed (T):
Y = C + S + T .
National income (output) is equal to aggregate demand (expenditure):
Y = C + I + G + NX
where I is domestic investment, G is government purchases of goods and services, and NX is net exports of goods and services.
Combining these accounting identities and re-arranging them, provides us with the familiar sectoral balances:
S + (T-G) = I + NX .
Which says that private saving (S) plus the government surplus (T-G) equals investment plus net exports.
Elmendorf and Mankiw call (T-G) public saving but that is an erroneous description of the monetary implications of a sovereign government running a budget surplus.
When individuals (households) save they postpone current consumption because they want to have higher future consumption. Saving is a time machine for non-government entities to allow them to transfer consumption across time. The obvious motivation is that they face a budget constraint – as users of the currency – and have to forgoe consumption now if they want to save.
For the monopoly issuer of the currency – the sovereign government – there is no such financial constraint on spending. It does not have to forgoe spending now to spend in the future. It can always spend what it desires at any point in time irrespective of what it did last period or any previous periods.
Further, when the government runs a budget surplus the purchasing power it extracts from the non-government sector doesn’t go anywhere – it is not stored in any account to use for later purposes. Just as a budget deficit (excess of spending over tax revenue) creates net financial assets (in the currency of issue) a budget surplus destroys net financial assets.
There is no store of purchasing power when the government runs a surplus nor does it make any sense for a government to think in those terms. It can always spend what it likes.
So it is nonsensical to characterise a budget surplus as being “saving”. It is more correctly described as the destruction of non-government purchasing power the non-government net financial assets.
But the sectoral flow equation is sound as written.
Elmendorf and Mankiw then correctly point out that:
… a nation’s current account balance must equal the negative of its capital account balance.
So net exports equals net foreign investment, or NFI, “which is investment by domestic residents in other countries less domestic investment undertaken by foreign residents”:
NX = NFI
This just means that the “international flows of goods and services must be matched by international flows of funds”. This equality is however subject to interpretation and the mainstream paradigm constructs it as meaning that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings.
From an MMT perspective, a CAD can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the CAD.
This desire leads the foreign country (whichever it is) to deprive their own citizens of the use of their own resources (goods and services) and net ship them to the country that has the CAD, which, in turn, enjoys a net benefit (imports greater than exports). A CAD means that real benefits (imports) exceed real costs (exports) for the nation in question.
So the 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 our 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 while the situation lasts the importing nation is getting real benefits and should enjoy them.
Please read my blog – Modern monetary theory in an open economy – for more discussion on this point.
The standard procedure is then to substitute the NX = NFI into the previous sectoral balance expression S + (T-G) = I + NX to get:
S + (T-G) = I + NFI
which they say:
… shows national saving as the sum of private and public saving, and the right side shows the uses of these saved funds for investment at home and abroad. This identity can be viewed as describing the two sides in the market for loanable funds.
Note the comments above about the erroneous contruction of public saving.
MMT constructs this version of the sectoral balances as saying for national income to be unchanged the leakages from the spending system [left-hand side => S + (T-G)] have to be equal to the injections [right-hand side => I + NFI]. If the actual leakages in any period exceed the injections then income will fall to bring the relationship back into equality. I could go on about this at length but haven’t the time today.
But more importantly, once Elmendorf and Mankiw introduce the loanable funds model to explain why budget deficits drive up interest rates you know they are entering the land of myths.
They motivate their discussion of the previous identity in this way:
Now suppose that the government holds spending constant and reduces tax revenue, thereby creating a budget deficit and decreasing public saving. This identity may continue to be satisfied in several complementary ways: Private saving may rise, domestic investment may decline, and net foreign investment may decline.
They claim that “private saving rises by less than public saving falls” which means that “total investment–at home and abroad–must decline as well”.
The fall in investment reduces the capital stock (reducing income and output) and increasing the interest rate. Why? Answer: according to the marginal productivity theory (MPT) the lower capital stock means the smaller stock of capital is now more productive and so the rate of return rises which forces all interest rates up as well as pushing real wages down.
Further, because they claim there is a “decline in net foreign investment” this requires a “decline in net exports” and a rising budget current account deficit – and so they think they substantiate the “twin deficits” argument. Please read my blog – Twin deficits – another mainstream myth – for more discussion on this point.
None of this is remotely what happens.
In terms of the above model [S + (T-G) = I + NFI], MMT suggests that as (T-G) falls (net public spending rises), national income rises which also stimulates saving (S). Further, it may increase imports which may reduce NX but in that situation the exchange rate pressure will increase international competitiveness and stimulate exports (X) and attract foreign investors (NFI).
The rising activity will also stimulate investment (I) as firms sense improved opportunities to realise profits by expanding capacity (this is known as the accelerator effect in the literature). With the central bank in charge of interest rates, the budget deficit “crowds-in” private spending.
So where do the mainstream economists go wrong? At the heart of this conception is the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.
In Mankiw’s macroeconomics textbook, which is representative, we are taken back in time, to the theories that were prevalent before being destroyed by the intellectual advances provided in Keynes’ General Theory.
Mankiw assumes that it is reasonable to represent the financial system as the “market for loanable funds” where “all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.”
This is back in the pre-Keynesian world of the loanable funds doctrine (first developed by Wicksell).
This doctrine was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.
So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.
The following diagram shows the market for loanable funds. The current real interest rate that balances supply (saving) and demand (investment) is 5 per cent (the equilibrium rate). The supply of funds comes from those people who have some extra income they want to save and lend out. The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.
Note that the entire analysis is in real terms with the real interest rate equal to the nominal rate minus the inflation rate. This is because inflation “erodes the value of money” which has different consequences for savers and investors.
Mankiw claims that this “market works much like other markets in the economy” and thus argues that (p. 551):
The adjustment of the interest rate to the equilibrium occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage … would encourage lenders to raise the interest rate they charge.
The converse then follows if the interest rate is above the equilibrium.
Mankiw also says that the “supply of loanable funds comes from national saving including both private saving and public saving.” Think about that for a moment. Clearly private saving is stockpiled in financial assets somewhere in the system – maybe it remains in bank deposits maybe not. But it can be drawn down at some future point for consumption purposes.
Mankiw thinks that budget surpluses are akin to this. As noted above – budget surpluses are not even remotely like private saving. You should clearly understand by now that budget surpluses destroy liquidity in the non-government sector (by destroying net financial assets held by that sector). They squeeze the capacity of the non-government sector to spend and save. If there are no other behavioural changes in the economy to accompany the pursuit of budget surpluses, then as we will explain soon, income adjustments (as aggregate demand falls) wipe out non-government saving.
So this conception of a loanable funds market bears no relation to “any other market in the economy” despite the myths that Mankiw uses to brainwash the students who use the book and sit in the lectures.
Also reflect on the way the banking system operates. The idea that banks sit there waiting for savers and then once they have their savings as deposits they then lend to investors is not even remotely like the way the banking system works.
This framework is then used to analyse fiscal policy impacts and the alleged negative consquences of budget deficits – the so-called financial crowding out – is derived.
In relation to the diagram above, Mankiw asks: “which curve shifts when the budget deficit rises?”
Consider the next diagram, which is used to answer this question. The mainstream paradigm argue that the supply curve shifts to S2.
Why does that happen? The twisted logic is as follows: national saving is the source of loanable funds and is composed (allegedly) of the sum of private and public saving. A rising budget deficit reduces public saving and available national saving. The budget deficit doesn’t influence the demand for funds (allegedly) so that line remains unchanged.
The claimed impacts are: (a) “A budget deficit decreases the supply of loanable funds”; (b) “… which raises the interest rate”; (c) “… and reduces the equilibrium quantity of loanable funds”.
Mankiw says that:
The fall in investment because of the government borrowing is called crowding out …That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment. Thus, the most basic lesson about budget deficits … When the government reduces national saving by running a budget deficit, the interest rate rises, and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.
The analysis relies on layers of myths which have permeated the public space to become almost “self-evident truths”. Obviously, national governments are not revenue-constrained so their borrowing is for other reasons – we have discussed this at length. This trilogy of blogs will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 | Deficit spending 101 – Part 2 | Deficit spending 101 – Part 3.
But governments do borrow – for stupid ideological reasons and to facilitate central bank operations – so doesn’t this increase the claim on saving and reduce the “loanable funds” available for investors? Does the competition for saving push up the interest rates?
Answer: No and no!
But we need to be careful. MMT does not claim that central bank interest rate hikes are not possible. It is possible that a poorly managed central bank will interpret a rising budget deficit as being inflationary and push up interest rates. There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.
MMT proposes that the demand impact of interest rate rises are unclear and may not even be negative depending on rather complex distributional factors. Remember that rising interest rates represent both a cost and a benefit depending on which side of the equation you are on. Interest rate changes also influence aggregate demand – if at all – in an indirect fashion whereas government spending injects spending immediately into the economy.
But having said that, the Classical claims about crowding out are not based on any of these mechanisms. In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. The result competition for the “finite” saving pool drives interest rates up and damages private spending. This is what is taught under the heading “financial crowding out”.
A related theory which is taught under the banner of IS-LM theory (in macroeconomic textbooks) assumes that the central bank can exogenously set the money supply. Then the rising income from the deficit spending pushes up money demand and this squeezes interest rates up to clear the money market. This is the Bastard Keynesian approach to financial crowding out. Please read my blog – Those bad Keynesians are to blame – for more discussion on this point.
Neither theory is remotely correct and is not related to the fact that central banks push up interest rates up because they believe they should be fighting inflation and interest rate rises stifle aggregate demand.
So the Elmendorf and Mankiw claim is summarised like this (from the Australian Treasury paper):
… a budget deficit reduces national saving, which implies a shortage of funds to finance investment. This would place upward pressure on interest rates as firms compete to finance their investments from the existing pool of domestic saving.
But from a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Its what astute financial market players call “a wash”. The funds used to buy the government bonds come from the government!
There is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.
But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or “finances” private saving not the other way around.
The Australian Treasury paper also notes that “a budget deficit may not reduce the domestic capital stock as the adjustment can occur through higher capital inflows — which may not necessarily change interest rates”. Pretty basic really even without the extra MMT insights in the preceding paragraphs.
In discussing the conventional view, Elmendorf and Mankiw offer the parable of the debt fairy to compute the “crowding out of capital” effects? They ask us to:
Imagine that one night a debt fairy (a cousin of the celebrated tooth fairy) were to travel around the economy and replaced every government bond with a piece of capital of equivalent value. How different would the economy be the next morning when everyone woke up?
How cute! A debt fairy who can just alter the maximising decisions of the private sector overnight and force portfolio choices upon that same sector that presumably do not correspond with the profit-seeking circumstances that prevailed when the investors eschewed the decision to accumulate physical capital and invested in bonds instead.
The debt fairy in fact has no application to the modern monetary system. The
Had they invested in physical capital the public deficit would have been lower anyway and the debt-issued lower.
But even they have to admit that this construction is erroneous (you can read why if you are interested).
The Australian Treasury paper acknowledges that the state of mainstream theory is such that:
the theoretical ambiguities about the connection between debt and interest rates … [provide no robust conclusions].
That is, the mainstream theoretical literature is so dependent on extreme assumptions and total falsehoods about the way the real world monetary system operates that the major conclusions are without theoretical authority
Most of the results in the mainstream literature require extreme assumptions to derive the main conclusions. Even within the logic of their own flawed models if you relax one of these key assumptions the whole analytical edifice collapses and the conclusions are no longer supported by the theory.
Virtually none of the assumptions that underpin the key mainstream models relating to the conduct of government and the monetary system hold in the real world. This means that the mainstream macroeconomic conclusions cannot be typically based on the theoretical models. At that point they become ideological.
In terms of the New Keynesian models which drive the Elmendorf and Mankiw reasoning and now represent the “conventional” view of monetary systems, the claimed theoretical robustness of their models always give way to empirical fixes in response to anomalies.
This general ad hoc approach to empirical anomaly cripples the mainstream macroeconomic models and strains their credibility. When confronted with increasing empirical failures, the mainstream economists introduce these ad hoc amendments to the specifications to make them more realistic. I could provide countless examples which include studies of habit formation in consumption behaviour; contrived variations to investment behaviour such as time-to-build , capital adjustment costs or credit rationing.
Further, the New Keynesian authors (like Mankiw et al) appear unable to grasp is that these ad hoc additions, which aim to fill the gaping empirical cracks in their models, also compromise the underlying rigour provided by the assumptions of intertemporal optimisation and rational expectations. At least, they never admit to this and leave the unsuspecting (usually uncritical) reader thinking that the conclusions are valid.
Please read my blog – Mainstream macroeconomic fads – just a waste of time – for more discussion on this point.
Next time you hear a politician or some conservative start raving about crowding out ask them a few questions:
1. Why are you assuming the pool of domestic saving and/or foreign saving is finite?
2. Don’t banks lend to credit-worthy customers?
3. Where did the funds the government borrows come from?
4. Why have interest rates been around zero and long-term yields not much higher in Japan for two decades despite rising budget deficits?
See their eyes roll and enjoy the moment?
Australian Treasury Paper results
Anyway, the Australian Treasury Paper cites a number of empirical studies that “find” that rising deficits drive up interest rates. I know all of the papers cited well and each one is deeply flawed in both conception or empirical application. None of them hold water.
I won’t describe the econometric method the Paper employs but it is standard and the results are not biased one way or another by the choice of estimation technique. We could quibble about some technical matters but it would be “chess playing” rather than a constituting a substantive attack on the results.
The Australian Treasury Paper concludes that:
… in the long run, the real interest margin rises by around three basis points in response to a one percentage point of GDP increase in the stock of Australian general government net debt … In the short run, however, Australian fiscal variables do not have a statistically significant impact on the interest margin. Importantly, the results indicate that a number of US economic variables, namely inflation and the current account, exert the most powerful influence on the real interest margin.
So domestic budget deficits do not drive up interest rates. The long-run effect (a stylised econometric state!) is virtually zero. The short-run effect is zero!
Zero means nothing – no relationship – go away!
I posted the following graph in an earlier blog – Twin deficits – another mainstream myth – but it is worth repeating. It is based on Reserve Bank of Australia data and shows the relationship between the federal budget deficit and the overnight interest rate from 1977 to now. The different colours indicate the period before (blue) and after (green) the exchange rate was floated.
You will appreciate clearly – there is no relationship. This graph could be reproduced for the advanced world and you wouldn’t find a robust relationship. So that avenue for the TDH is missing.
The Australian Treasury Paper used advanced econometric analysis to find the same thing. Good on them but they could have just looked at this graph and reflected on the way the monetary system operates to reach the same conclusion. I am happy though that they have jobs and are free from the ravages of unemployment!
In his Melbourne Age article last week (September 18, 2010) – Treasury backflip on deficit link – economic correspondent Tim Colebatch describes the Australian Treasury Paper as providing:
… a stunning backflip from Treasury’s earlier views … [which] … challenges a large body of work by other economists that find a strong link between fiscal policy and interest rates.
Lets hope that within Australian macroeconomic policy circles, at least, this insight becomes the norm.
Also all you macroeconomics teachers and lecturers out there – toss out your Mankiw textbooks and start teaching your students something that is closer to the truth. Otherwise, you should resign.
That is enough for today!