I am writing this on late Friday afternoon European time. Today has been very busy and so I don’t have a lot of time to write this blog. I had a birthday in my immediate family to deal with and so some special celebrations were in order. Then I had meetings with two government officials – one from the Flemish government and the other from the Dutch government – they travelled down to Maastricht for consultations. The topic was the Job Guarantee and how they could implement such a buffer stock employment scheme into their own policy thinking. I will write up some thoughts about this meeting next week. Then I had to wade through a new International Labour Organization (ILO) report – World of Work Report 2010 – which has estimated that high unemployment will persist for much longer than they had previously forecast. The talk is that the “product market” (real output) recession is now becoming an entrenched labour market recession. Meanwhile, I also read the latest IMF World Economic Outlook report and noticed they were advocating changes to macroeconomic policy positions across the advanced world that would by their own reckoning increase unemployment and prolong recovery. They are still appealing to the nonsensical idea that fiscal austerity is good for a nation. Their view now is nuanced but still a disgraceful mis-use of econometric modelling. So only a relatively short tour through this work today.
The IMF World Economic Outlook has a chapter entitled – Will It Hurt? Macroeconomic Effects of Fiscal Consolidation – which claims that:
Budget deficits and government debt soared during the Great Recession. In 2009, the budget deficit averaged about 9 percent of GDP in advanced economies, up from only 1 percent of GDP in 2007.1 By the end of 2010, government debt is expected to reach about 100 percent of GDP—its highest level in 50 years. Looking ahead, population aging could create even more serious problems for public finances. In response to these worrisome developments, virtually all advanced economies will face the challenge of fiscal consolidation.
The only things that are worrisome are not mentioned by the IMF in thus summary of the Great Repression. The skyrocketing unemployment, underemployment and hiddden unemployment accompanying the massive real income losses that the Great Recession brought to most nations are the worrisome features that should be focused on and which drive the fiscal parameters – rising deficits and debt.
The fiscal parameters are just like wind or heat measuring equipment in the sense they measure changes in real activity via the cyclical changes in tax receipts and welfare payments. They have not particular meaning in themselves when they are driven largely by the movements in these automatic stabilisers.
Further, if population ageing is a problem at all then it is a real resource problem – it is never going to be a financial problem for a national government. Please read my blogs – Democracy, accountability and more intergenerational nonsense and Another intergenerational report – another waste of time – for more discussion on this point.
The entire logic underpinning the population ageing is flawed. Financial commentators often suggest that budget surpluses in some way are equivalent to accumulation funds that a private citizen might enjoy. This has overtones of the regular US debate in relation to their Social Security Trust Fund.
This idea that accumulated surpluses allegedly “stored away” will help government deal with increased public expenditure demands that may accompany the ageing population lies at the heart of the intergenerational debate misconception. While it is moot that an ageing population will place disproportionate pressures on government expenditure in the future, it is clear that the concept of pressure is inapplicable because it assumes a financial constraint.
A sovereign government in a fiat monetary system is not financially constrained.
There will never be a squeeze on “taxpayers’ funds” because the taxpayers do not fund “anything”. The concept of the taxpayer funding government spending is misleading. Taxes are paid by debiting accounts of the member commercial banks accounts whereas spending occurs by crediting the same. The notion that “debited funds” have some further use is not applicable.
Further, the so-called government budget constraint is not a “bridge” that spans the generations in some restrictive manner. Each generation is free to select the tax burden it endures. Taxing and spending transfers real resources from the private to the public domain. Each generation is free to select how much they want to transfer via political decisions mediated through political processes.
When MMT argues that there is no financial constraint on federal government spending they are not, as if often erroneously claimed, saying that government should therefore not be concerned with the size of its deficit. We are not advocating unlimited deficits. Rather, the size of the deficit (surplus) will be market determined by the desired net saving of the non-government sector.
This may not coincide with full employment and so it is the responsibility of the government to ensure that its taxation/spending are at the right level to ensure that this equality occurs at full employment. Accordingly, if the goals of the economy are full employment with price level stability then the task is to make sure that government spending is exactly at the level that is neither inflationary or deflationary.
This insight puts the idea of sustainability of government finances into a different light. The emphasis on forward planning that has been at the heart of the ageing population debate is sound. We do need to meet the real challenges that will be posed by these demographic shifts.
However, all of these remedies which focus on “fiscal consolidation” miss the point overall. It is not a financial crisis that beckons but a real one. Are we really saying that there will not be enough real resources available to provide aged-care at an increasing level? That is never the statement made. The worry is always that public outlays will rise because more real resources will be required “in the public sector” than previously.
But as long as these real resources are available there will be no problem. In this context, the type of policy strategy that is being driven by these myths will probably undermine the future productivity and provision of real goods and services in the future.
It is clear that the goal should be to maintain efficient and effective medical care systems. Clearly the real health care system matters by which I mean the resources that are employed to deliver the health care services and the research that is done by universities and elsewhere to improve our future health prospects. So real facilities and real know how define the essence of an effective health care system.
Further, productivity growth comes from research and development and in Australia the private sector has an abysmal track record in this area. Typically they are parasites on the public research system which is concentrated in the universities and public research centres.
For all practical purposes there is no real investment that can be made today that will remain useful 50 years from now apart from education. Unfortunately, tackling the problems of the distant future in terms of current “monetary” considerations which have led to the conclusion that fiscal austerity is needed today to prepare us for the future will actually undermine our future.
The irony is that the pursuit of budget austerity leads governments to target public education almost universally as one of the first expenditures that are reduced.
Most importantly, maximising employment and output in each period is a necessary condition for long-term growth. The emphasis in mainstream integenerational debate that we have to lift labour force participation by older workers is sound but contrary to current government policies which reduces job opportunities for older male workers by refusing to deal with the rising unemployment.
Anything that has a positive impact on the dependency ratio is desirable and the best thing for that is ensuring that there is a job available for all those who desire to work.
Further encouraging increased casualisation and allowing underemployment to rise is not a sensible strategy for the future. The incentive to invest in one’s human capital is reduced if people expect to have part-time work opportunities increasingly made available to them.
But all these issues are really about political choices rather than government finances. The ability of government to provide necessary goods and services to the non-government sector, in particular, those goods that the private sector may under-provide is independent of government finance.
Any attempt to link the two via fiscal policy “discipline:, will not increase per capita GDP growth in the longer term. The reality is that fiscal drag that accompanies such “discipline” reduces growth in aggregate demand and private disposable incomes, which can be measured by the foregone output that results.
Clearly surpluses helps control inflation because they act as a deflationary force relying on sustained excess capacity and unemployment to keep prices under control. This type of fiscal “discipline” is also claimed to increase national savings but this equals reduced non-government savings, which arguably is the relevant measure to focus upon.
But the IMF chapter is seeking to investigate the following issue:
An important and timely question is, therefore, whether fiscal retrenchment will hurt economic performance.
In this context, they advance the so-called masterpiece of the deficit terrorists – the “expansionary fiscal contractions” hypothesis which claims that austerity improves real output growth in the short-term because it increases “household and business confidence” who are refusing to spend because they are scared of the deficits (allegedly higher tax burdens and higher interest rates).
The IMF conclude that:
Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point. Domestic demand—consumption and investment—falls by about 1 percent …
Reductions in interest rates usually support output during episodes of fiscal consolidation. Central banks offset some of the contractionary pressures by cutting policy interest rates, and longer-term rates also typically decline, cushioning the impact on consumption and investment. For each 1 percent of GDP of fiscal consolidation, interest rates usually fall by about 20 basis points after two years. The model simulations also imply that, if interest rates are near zero, the effects of fiscal consolidation are more costly in terms of lost output.
A decline in the real value of the domestic currency typically plays an important cushioning role by spurring net exports … [but] … this finding implies that fiscal contraction is likely to be more painful when many countries adjust at the same time …
So they agree that in the short-run that fiscal austerity damages economic activity and worsens unemployment. The offsets they model via monetary policy clearly are not available in the current situation in most countries – even if they were credible offsets (which I dispute).
They also claim that public spending cuts are less contractionary that tax adjustments but this is because “central banks usually provide substantially more stimulus following a spending-based contraction than following a tax-based contraction”. So even if that result is sound (and I do not think it is), it is largely irrelevant in the current situation because central banks have nowhere to move on interest rates.
The literature the IMF cite is very selective and supportive of the idea that fiscal austerity is good. For example, they cite a few examples of Alberto Alesina’s work.
In this blog – The deficit terrorists have found a new hero. Not! – I provide a thorough critique of Alesina’s work in this regard.
In all his work he assumes that 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. 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.
Further, 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. It is well-known that the Japanese economy double-dipped and more hardship was caused.
So there is plenty of empirical evidence and a stack of theoretical argument that would dispute the major conclusion of the austerity proponents that are trying to foist the “expansionary fiscal contractions” hypothesis onto policy makers and the public. Recent evidence is compelling – Ireland, Britain etc. Japan in 1997, the major economies in 1937 … the reality is that fiscal austerity damages aggregate demand and reduces real output and employment growth.
The IMF’s main claim that they use to justify their claim that governments should invoke fiscal austerity to cut their budget deficits is that the output losses are worth it in the longer-term because:
… lower debt is likely to reduce real interest rates and the burden of interest payments, allowing for future cuts to distortionary taxes …
This result is derived from the IMF econometric model which is structured in such a way to get that conclusion. That is, the structure of the model assumes that nominal interest rates rise with increased deficits. Of-course, their model would fail badly to forecast Japanese economic outcomes since the 1990s. It would further be subject to significant forecasting errors at present where interest rates are low (short- and long-term) and bond yields are falling despite significant increases in public debt being issued.
The more realistic result is that by damaging demand in the short- to medium-term, fiscal austerity curtails investment which further erodes the long-term growth potential of the economy and stretches the recession out even longer. When growth resumes the trend capacity is lower than when the economy entered the downturn. This is called the hysteresis effect – that is, that growth is path-dependent and where the economy has been affects where it goes. Please read my blog – The Great Moderation myth – for more discussion on this point.
There is a credible body of research work that shows that these longer-term effects are substantial. The other longer-term problem is that workers who have been unemployed for a long time suffer a series of pathologies that undermine their position in the labour market. Please read my blog – The daily losses from unemployment – for more discussion on this point.
Which brings me to the ILO Report – World of Work Report 2010 – which has estimated that high unemployment will persist for much longer than they had previously forecast.
The ILO say that despite some growth recovery:
… new clouds have emerged on the employment horizon and the prospects have worsened significantly. In advanced economies, employment is expected to return to pre-crisis levels by 2015, instead of 2013 as expected in last year’s World of Work Report … In the case of emerging and developing countries, it is estimated that employment will reach pre crisis levels already this year – as predicted in last year’s Report. However, over 8 million jobs are still needed to meet the growing workforce in those countries (Table 1). In many other countries in which employment growth was positive at the end of 2009, more recent trends suggest a weakening of the job recovery or even a “double dip”.
The following Table is the Table 1 in the ILO report. It shows that the recovery has not been sufficient to make significant inroads into the labour market damage that has resulted from the aggregate demand collapse. Please read my blog – What causes mass unemployment? – for more discussion on why this situation occurs.
The costs of the extended slowdown are severe and dwarf all other economic costs.
The ILO say that:
The longer the labour market recession, the greater the difficulties for jobseekers to obtain new employment. In the 35 countries for which data exist, nearly 40 per cent of jobseekers have been without work for more than one year and therefore run significant risks of demoralisation, loss of self-esteem and mental health problems. Importantly, young people are disproportionately hit by unemployment and, when they find a job, it often tends to be precarious and does not match their skills. Because the labour market has been depressed for so long, many unemployed people are getting discouraged and leave the labour market altogether. Already, close to 4 million jobseekers had stopped looking for work by the end of 2009 in the countries for which information is available.
And the ILO is clear on why the outlook has deteriorated. They sheet the blame home directly to government:
The first reason behind the deteriorated outlook is that fiscal stimulus measures, which were critical in kick-starting a recovery, are being withdrawn.
This is an emerging theme in all countries that are engaging in fiscal withdrawal. The evidence is mounting that opposes the view that austerity is good. It is clearly bad and for obvious reasons. Employment growth depends on growth in spending. If a major contributor to spending growth (the public sector) is withdrawing but the other sector (private) is not picking up the slack then demand will fall and along with it real output and employment growth. It is not rocket science ladies and gentleman.
The ILO implicate a second factor:
A second, more fundamental factor is that the root causes of the crisis have not been properly tackled. The coexistence of debt-led growth in certain developed countries with export-led growth in large emerging economies has proved to be the Achilles’ heel of the world economy. Before the start of the financial crisis, real labour incomes grew less than justified by productivity gains, thereby leading to growing income inequalities. In certain advanced economies such as the US and several EU countries, this situation pushed households to borrow in order to fund their housing and consumption plans –which was possible because of a dysfunctional financial system. In other advanced economies like Germany and emerging countries such as China, growing inequalities translated into relatively modest domestic demand growth. But this was outweighed by higher exports to high-spending, debt-led economies. The private-debt bubble exploded with the onset of the global financial crisis and for a while was replaced with public debt as an engine of growth.
I traverse these themes in my blog – The origins of the economic crisis. For long-term stability there has to be a fundamental shift in the distribution of national income towards the workers – which will require real wages growing in line with labour productivity. To achieve that we will have to dismantle the neo-liberal machinery that has shifted national income shares dramatically to profits.
Further, fiscal deficits have to support non-government saving overall to allow economic growth to occur without relying on ever increasing private sector indebtedness.
But the ILO then advances its own neo-liberal approach:
However, there is a limit as to how much public debt can increase in order to stimulate the economy. For a sustainable exit from the crisis, it is therefore crucial to address both the income imbalances and the dysfunctional financial system.
The rise in public debt does not stimulate the economy. It is the increase in net public spending that provides the stimulus. The rise in public debt is a voluntary exercise – driven by mis-placed notions of fiscal discipline – which merely alters the asset portfolios of the non-government sector.
It has not been shown in any credible study that we are close to the limit that fiscal stimulus can provide. There is a limit – the availability of real resources. By the ILOs own reckoning the employment gaps (idle resources) are huge in most countries.
So the ILO has this schizophrenia – which has bedevilled its effectiveness for years – which allows it to mostly be the handmaiden of the IMF and the OECD. I would prefer the ILO to take a more courageous pro-worker stance given its origins and funding base.
The policy prescription the ILO proposes involves three planks. First, they want:
…. active labour market policies, work-sharing arrangements and targeted measures to support vulnerable groups, notably youth, are especially relevant in this respect.
Which is just the OECD employability model that attacks the supply side. These approaches do not produce very many jobs at all and tend to focus on the victim of the aggregate demand failure (the unemployed) rather than the cause (a lack of spending).
… ensuring a closer link between increases in labour incomes and productivity in surplus countries, unemployment would decline in these surplus countries but also in those facing acute deficit problems
This would be based on “income-led strategies” which “not only support aggregate demand, but also result in enlarged domestic markets and new business opportunities that can be seized by sustainable enterprises”.
I agree with this but extend it to say that public sector job creation also does this.
… financial reform … [because the] … volume of credit to the real economy has declined in advanced economies” and that “savings … [need to be ] … channelled to productive investment … [to make] … jobs … more stable.
I agree that far-reaching financial reform is needed. Please read the following blogs – Operational design arising from modern monetary theory and Asset bubbles and the conduct of banks for further discussion.
But there is no shortage of credit – just a shortage of willing and credit-worthy borrowers. Further growth in spending creates its own saving not the other way around.
Finally, the ILO notes that the current debate about fiscal austerity has not addressed the issue of social cohesion. They say that:
… continued social cohesion cannot be taken for granted if the strategy became less inclusive. Already, there is growing evidence of a deteriorated social climate, especially in countries where job losses have been the highest … higher unemployment and growing income inequalities are key determinants of the deterioration in social climate indicators …
So they are not only estimating that the labour markets will not recover as quickly as the IMF etc are claiming but also that this sustained “labour market recession” will undermine social cohesion and the social fracturing will manifest in many destructive ways.
We are observing increased labour unrest – strikes, marches etc in many European nations now. In these situations, workplace actions (sabotage, go-slow etc) also usually rise as an expression of worker dissatisfaction.
In 2001 in Argentina, as the crisis deepened there were fatal street riots which ultimately led to the government changing policy tack altogether and rejecting its neo-liberal approach that had nearly destroyed it.
It is time that such policy reversals started occurring everywhere to ensure that the “labour market recession” ends quickly. It will get very ugly if it doesn’t.
The IMF position is just what you expect from them. It is without credibility.
I have run out of time.
The Saturday Quiz will be back sometime tomorrow. If I get the time I plan a premium question 5 to trip up the smarties who are claiming it is getting too easy for them. We will see about that!
That is enough for today!