Sometimes we get lost in detail and forget the simple macroeconomic relationships that sit below the complexity. I also like to get lost in detail too – to work out tricky little aspects of the financial system, etc but it is always a sobering experience to go right back to the beginning. I have been forcing myself to think “basic” lately as I progress the macroeconomics textbook that my mate Randy Wray and I are writing at present. It seems that our national governments have lost their perspective to think at this basic level – to really understand what drives prosperity in their nations. The evidence for this statement lies in the various fiscal austerity plans that are being rehearsed around the world at present. The most blatant and severe example of this in the non-EMU world has just been announced in Britain. This is a case of a government driven by ideology deliberately inflicting massive damage on its citizens while lying to the population about the necessity for such a policy. Its fits my definition of a state-motivated terrorist attack. If only the people of Britain understood the most basic economic relationship – aggregate demand drives output and national income. Cut spending and prosperity falls. Only by lying to the people, has the British government been able to take this policy path.
When I think about the British Government’s Comprehensive Spending Review I am reminded of Noam Chomsky’s Monthly Review interview in November 2001 entitled – The United States is a Leading Terrorist State where he said:
If you read the definition of low-intensity conflict in army manuals and compare it with official definitions of “terrorism” in army manuals, or the U.S. Code, you find they’re almost the same. Terrorism is the use of coercive means aimed at civilian populations in an effort to achieve political, religious, or other aims.
That is what the British government is engaged in at present.
The British government is claiming it is providing space for a private sector led-recovery based on a revival of consumption and investment spending aided and abetted by a surge in net exports. The basic hope is that private citizens and firms are Ricardian in nature. So apparently, consumers and investors are lying quietly with idle funds – saving them to pay for the higher taxes that would have been forced on them to pay for the rising budget deficits.
This pool of funds will allegedly burst into a spending frenzy once these citizens realise that the budget deficit will be lower as a result of the harsh fiscal cutbacks the Government has announced in the Comprehensive Spending Review and that they do not have to save to cover any higher tax burdens. That is the Ricardian world that the British government thinks it is operating in.
This is the mythical world that inhabits mainstream economics departments in universities around the world and the drivel that lecturers in macroeconomics feed their young students who would say boo and just sit there docile ingesting all the fairy tales. Please read my blog – Pushing the fantasy barrow – to see why the people are not Ricardian.
The predictions from these “Ricardian models” are regularly proven to be false in the world where real outcomes are determined. But my profession is blithe to that. Never let the facts get in the way of the theory. It is an appalling anti-intellectual approach.
Mainstream macroeconomics has virtually no content that is applicable to the real world. Yet a national government of an advanced nation of some 61.4 million people is prepared to introduce policies which will severely damage the life prospects of millions of these citizens based on these theories that are so thoroughly discredited. We have lost all sense of judgement in the last few years.
The reality is that the private sector is not spending at present because they are trying to restructure their precarious balance sheets after the credit binge that pushed growth along previously and because they are fearful that they might not have a job next week and/or that there will be no buyers queuing up to purchase the goods and services that might be produced.
Unemployment is a powerful deflationary force. The fiscal cutbacks will worsen unemployment and cause further conservatism among private spenders. Firms will revise their expectations of future sales downwards and lay off workers and consumers will further try to lift their savings ratio to provide some risk management in the case of a job loss. The probability of job loss will rise in the UK.
Further, I have heard people say that the large number of job cuts in the public sector will just clear out “unproductive labour”. Well, even if the workers being sacked were doing “nothing” each day – just sitting at their desks surfing the Internet or whatever – the loss to aggregate demand as their incomes vanish will be huge.
When was the last time, a checkout operator in a supermarket asked you whether you had a productive job or not as you handed over the cash to buy your weekly groceries? Answer: you have never been asked that! But the lost spending would cause the supermarket to contract, and as these impacts reverberated up the supply chain, further spending losses would occur and so it goes.
The British government has lost sight of the most basic understanding of macroeconomics and has instead listened to the shamans of my profession. The liars, the frauds who comprise the mainstream macroeconomists of the world.
There is a view that the Government knows full well what they are doing and are using it to advance ideological agendas. There is truth in that for sure. Either way, ignorance or malevolence – the implementation of the Comprehensive Spending Review is an act of state terrorism.
A few weeks ago I read a paper from the a researcher at the Federal Reserve Bank of San Francisco entitled – Fiscal Spending Jobs Multipliers: Evidence from the 2009 American Recovery and Reinvestment Act – which estimates the employment impact of the fiscal stimulus in the US.
It is a fairly carefully constructed empirical study and concludes that:
The estimated jobs multiplier for total nonfarm employment is large and statistically significant for ARRA spending through March 2010, but falls considerably and is statistically insignificant beyond March. The implied number of jobs created or saved by the spending is about 2.0 million as of March, but drops to 0.8 million as of June. Across sectors, the estimated impact of ARRA spending on construction employment is especially large, implying a 23% increase in employment (as of June 2010) relative to what it would have been without the ARRA. Lastly, I find that spending on infrastructure and other general purposes has a large positive impact, while aid to state government to support Medicaid may actually reduce state and local government employment.
So again the evidence is clear – the fiscal expansion was a positive contributor to employment in the US.
What is also important to note is that the funds provided by the US government are still significantly unspent. You can track the spending trail at Recovery.gov by state using their GIS tool. The accompanying data shows that for the period February 17, 2009 to June 30, 2010 a total of $US218,206,202,543 was awarded but only $US85,703,541,778 was received by spending agencies. Even so, the total jobs dividend associated with the actual spending was 750,045.
They could have offered a minimum wage job to anyone and still not spend all the allocation.
The point is that the UK government is going against the obvious and using the lives and fortunes of their citizens as gambling chips in a casino where the punter will always lose. It is almost unbelievable how misguided the cuts are.
Back to basics
The following will be obvious for many of you but for the non-economists it might be a useful organising framework for understanding what is going on at the moment.
Sometimes we get lost in detail and forget the simple macroeconomic relationships that sit below the nuances. I also like to get lost in detail too – to work out tricky little aspects of the financial system, etc but it is always a sobering experience to go right back to the beginning. I have been forcing myself to think “basic” lately as I progress the macroeconomics textbook that my mate Randy Wray and I are writing at present.
So what drives output? What determines national income? What largely determines employment growth? What causes mass unemployment? These are much more important questions than having esoteric discussions about the pricing of some 3rd degree derivative that some engineer has contrived to fleece the clients of some hedge fund she/he is working for and redirect real output into the hands of the rich.
I am not saying that detailed discussions about financial markets, banking and whatever are not important but we tend to lose sight of what drives the big aggregates. The British government has clearly lost sight of what delivers wealth and prosperity in the UK.
Let us start at a most basic level. In this blog – Deficit spending 101 – Part 1 I discuss the two-person economy. It doesn’t get much simpler than that. You might nominate yourself to be the government and your partner to be the non-government private sector to make it personal.
The government issues the currency in this two-person economy and the non-government offers labour (productive resources) in return for payments. Some product is created. We open a spreadsheet that records all transactions.
The government announces a tax of 100 dollars. The non-government person asks: “Where will I get the 100 dollars from to pay this tax?” The government says: “I will spend $100 on private sector activity which will provide the currency necessary to pay the taxes”. The relevant spreadsheet entries are made recording these transactions.
The column – budget balance in period 1 records a zero. The government runs a balanced budget (for example, spends 100 dollars and taxes 100 dollars). The private sector receives 100 and pays it back in taxes so has a zero balance at the end of the period. The private accumulation of fiat currency (savings) is thus zero in that period and the private budget is also balanced – they spend all they get and do not save.
Sit down with your partner at the table and type some numbers into the spreadsheet to see the entries appear and disappear electronically as the economy evolves – as the government injects spending and drains it via taxation. Watch what happens to the private saving column and compare it with the entry in the government budget each period.
Note clearly that the printer attached to the computer is silent – there is no “money” being printed.
What happens if the government spends 120 and taxes remain at 100? Answer: then private saving is 20 dollars and this can be accumulated as financial assets – initially in the form of numbers in the spreadsheet under private currency holdings. The government might call these holdings “private bank deposits” if it liked.
Where did the 20 dollars in savings come from? The additional net spending by the government to elicit further activity in the non-government sector provided the funds. The budget deficit for period 2 is 20 and this corresponds to the private saving in that period. A simple, ineluctable and pervasive result.
The government person might then say to the non-government person that they are prepared to encourage further saving and will issue an interest-bearing bond. So a column in the spreadsheet is created to record any “bond sales” which just amount to reducing a number in the “private bank deposits” column and putting that number into the bond sales column.
The government is not obliged to issue this bond. The net spending will still appear as before in the spreadsheet. The deficit does not need to be “financed” by borrowing. There is no operational imperative for the government to issue this debt as things stand. It is clear that the government is “borrowing” back what it has already spent.
Should the non-government person not wish to buy the bond (and earn the interest) they would just leave their savings in the “private bank deposit” column and presumably be happy about that. Nothing significant would arise from this decision. Yes, we could conduct elaborate analyses of bond prices, yields, secondary markets, etc but the essential insight is provided in this example. Nothing significant would happen to the level of activity in this economy if the bond was not issued.
The government deficit of 20 is exactly the private savings of 20 which may be stored in bonds or deposits. We could add any number of financial assets without contradicting the basic finding – over time, the accumulated private savings would equal the cumulative budget deficits.
Now what would happen if the government person decided to run a surplus (say spend 80 and tax 100)? Answer: in the next period the private sector person would owe the government a net tax payment of 20 dollars.
Where would they get that shortfall from? They would need to sell something back to the government to get the needed funds or run down their bank deposits. The result is the government generally buys back some bonds it had previously sold.
Either way accumulated private saving is reduced dollar-for-dollar when there is a government surplus. The government surplus has two negative effects for the private sector:
- The stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and
- Private disposable income also falls in line with the net taxation impost. Some may retort that government bond purchases provide the private wealth-holder with cash. That is true but the liquidation of wealth is driven by the shortage of cash in the private sector arising from tax demands exceeding income. The cash from the bond sales pays the government’s net tax bill. The result is exactly the same when expanding this example by allowing for private income generation and a banking sector.
From the example above, and further recognising that currency plus reserves (the monetary base) plus outstanding government securities constitutes net financial assets of the non-government sector, the fact that the non-government sector is dependent on the government to provide funds for both its desired net savings and payment of taxes to the government becomes a matter of accounting.
You will not find this basic understanding of the relationship between the government and non-government sector outlined in any of the mainstream macroeconomics books. Students do not learn the basic nature of the relationship – that from a national accounting perspective – a government surplus (deficit) has to be equal ($-for-$) with the non-government deficit (surplus).
If the non-government sector is to save overall then the government has to run deficits. There is no escaping that result. It is not my opinion or my prediction. It is the most basic macroeconomic fact that there is. If you don’t like it – get over it!
The British Government clearly doesn’t understand this basic fact. If it does, then its actions in cutting net public spending amounts to a malevolent deed and satisfies the conventional definition of a terrorist act.
So what drives output? What determines national income?
So what drives output? What determines national income? What largely determines employment growth? What causes mass unemployment?
Again we can be very simple in seeking answers to these questions.
In our two person economy the level of activity was determined by the government spending and the private sector was just paying taxes and saving. For the level of activity (employment of the private sector person) to remain constant and the private sector person to maintain a steady saving flow, the government had to maintain its deficit spending.
If we now think of a real world economy where the non-government sector is further decomposed in an external sector (where exports and imports are recorded) and a private domestic sector.
Starting out simply what if there was just a firm and a household and we abstract from government and the foreign sector.
The household provides productive resources to the firm which pays it an income. The firm in turns uses the productive resources to make goods and services which it sells to the household. The household can buy these goods and services with the income it receives from the sale of labour (or other productive inputs).
This sort of model is the basic macroeconomics circular flow model which is deficient overall because it abstracts from the basic government/non-government relationship but does offer some insights once you understand how net financial assets in the currency of issue enter the non-government sector (as explained in our simple two person economy above).
The following diagram is the most basic you can get in this context. It shows a steady-state where the business firms expect to sell $100 worth of goods and services each period and hire labour accordingly paying out $100 in national income. The households in turn spend all this income on consumption (the thick green line is the first component of aggregate demand in this economy) and do not save.
Each period, the expectations of the firms will be ratified by the spending decisions of the consumers and output and national income will remain unchanged.
What would happen if the households decided to save? The following diagram captures that initial decision to withdraw consumption. Clearly, the circular flow is broken – and the firms would find they had $20 worth of output unsold. The national accountant would record this as unintended inventory accumulation which means that actual saving (S) would equal actual investment (I) but actual investment which is the sum of desired investment and unintended investment would be dominated by the unplanned inventory accumulation.
The normal inventory-cycle then would drive reductions in output and employment. Output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.
The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.
Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms lay-off workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.
At that point, the economy is heading for a recession. So in this example, unless there was an offsetting source of expenditure to fill the expenditure loss (gap) that is manifest as saving the economy would contract and income, consumption, saving all would fall until the actual level of saving equalled the desired investment level which in this case (so far) is zero.
We call saving a leakage from aggregate demand because it is taken out of the expenditure flow. Other things equal, a rise in a leakage will reduce output and national income.
So the only way this economy can remain at its previous level of activity is if there is new source of expenditure to match the withdrawal of consumption. The following diagram shows that this could be accomplished by an injection of desired investment of $20. We call this “exogenous” investment (that is, derived from outside the circular flow) an injection.
Income adjustments will always ensure that the sum total of the injections will always equal the sum total of the leakages. That is the basic expenditure-output relationship that the British government is ignoring or choosing to ignore.
So the following diagram shows the injection of desired investment. There would be no unintended investment (unwanted accumulations of inventory) and actual saving ($20) would equal desired investment ($20) and the firms would be selling all they desired (and expected to sell). National income would remain at $100 comprising consumption (C) = $80 plus investment (I) = $20.
We would write total aggregate demand as:
Y = C + I
Now what if the government decided to raise taxes (say 20 cents in the dollar) which means at the current national income level it would seek revenue of $20 (for simplicity, all in the form of household taxes). The following diagram shows, first, the taxes (T) of $20 draining the household’s capacity to spend (reducing disposable income) and then the corresponding government spending (G) of $20 restoring the aggregate demand. Now we have the total supply of goods and services being divided between households and government.
The taxation is a leakage (drain) from aggregate demand while the government spending is an injection to the spending stream. Unless the government injected the $20, then the economy would begin to contract in the same way that the saving leakage would have forced a contraction in the earlier simple model.
You might also get confused here and ask – well the government sector is running a balanced budget yet the households are saving – so how does that square with the previous claim that government surplus (deficit) has to equal the non-government deficit (surplus)? The answer lies in realising that the non-government sector is the sum of the firms and the households and while the households are saving the firms are dis-saving an equal amount via investment. So overall, the balanced budget is not providing the scope for any net saving in the non-government sector.
So our aggregate demand model (the thick green lines) is now more complicated:
Y = C + I + G.
The uses of national income are as follows:
Y = C + S + T
So we can bring those two concepts of national income (sources and uses) together to get the sectoral balances in this two sector (government and private domestic) economy:
C + I + G = C + S + T
(S – I) = (G – T)
which tells you the private domestic balance (S – I) is indeed equal to the budget deficit (G – T) and income adjustments will ensure that is always the case.
The other point to note is that the leakages (red line flows) are always equal to the injections (green line flows) via income adjustments.
S + T = I + G
What would happen if we introduced a foreign sector? The same logic would apply. The following diagram shows a stylised example. Households (assumed to be the only purchasers of imports for simplicity) now by $10 on imports (M) which represents a leakage or drain from aggregate demand. If there was not a corresponding injection of aggregate demand then the economy would contract. In this case I have allowed the injection to be in the form of exports (X) to match the imports. The firms can thus sell all they plan either to households (C), the government (G) or to foreigners (X).
Aggregate demand (the thick green lines) is now:
Y = C + I + G + X – M
The uses of national income are as follows:
Y = C + S + T + M
So we can bring those two concepts of national income (sources and uses) together to get the sectoral balances in this two sector (government and private domestic) economy:
C + I + G + X = C + S + T + M
(G – T) = (S – I) – (X – M)
which is the familiar three-sector economy sectoral balances model. The way I have written this is to verify that the budget deficit (G – T) is always equal to the non-government surplus and vice versa, where the former is the sum of the private domestic balance (S – I) and the external balance (X – M).
In this stylised example, all the balances are zero whereas in the real world that is not found. I will come back to that next.
But also note, that the sum of the leakages (red line flows) are still always equal to the sum of the injections (green line flows) via income adjustments.
S + T + M = I + G + X
To apply this understanding we need to introduce some real world parameters. Most nations run external deficits (X – M < 0) which means that there is a net drain on aggregate demand coming from the external sector. If there is not a corresponding adjustment in the other balances (to fill the spending gap) then aggregate demand would fall and national income would decline. The income adjustments would ensure that at least one other balance (government budget or private domestic balance) went into an equal deficit. The following graph with an accompanying data table lets you see the evolution of the balances expressed in terms of percent of GDP. I have held the external deficit constant at 2 per cent of GDP (which is artificial because as economic activity changes imports also rise and fall) to show what the changes to the other balances mean for each other. To aid interpretation remember that (I-S) > 0 means that the private domestic sector is spending more than they are earning; that (G-T) < 0 means that the government is running a surplus because T > G; and (X – M) < 0 means the external position is in deficit because imports are greater than exports.
In Period 1, there is an external deficit (2 per cent of GDP), and if the government was able to run a budget surplus of 1 per cent of GDP this would mean the private sector would be in deficit (I > S) to the tune of 3 per cent of GDP.
If the private sector resisted the need to “finance” that deficit by increasing indebtedness, then national income would contract and the government would be unable to run the surplus (as the automatic stabilisers would force taxation revenue to decline).
In Period 2, as the government budget enters balance (presumably the government increased spending or cut taxes or the automatic stabilisers were working), the private domestic deficit narrows and now equals the external deficit.
This provides another important rule with the deficit terrorists typically overlook. If there is an external deficit and the government pursues a balance budget strategy (and succeeds) then the private domestic sector has to be running a deficit equal to the external deficit. That means, the private sector is increasingly building debt. That conclusion is inevitable when you balance a budget with an external deficit.
A balanced budget rule could never be a viable fiscal rule for an economy running an external deficit because it would force the private domestic sector into increased indebtedness if national income was to remain unchanged. Ultimately, the private sector would resist the increased precariousness of its balance sheet and attempt to save overall. At that point the income adjustments that would result would force the budget into deficit at much higher levels of unemployment.
In Periods 3 and 4, the budget deficit rises from balance to 1 to 2 per cent of GDP and the private domestic balance moves towards surplus. At the end of Period 4, the private sector is spending as much as they earning.
Periods 5 and 6 show the benefits of budget deficits when there is an external deficit. The private sector now is able to generate surpluses overall (that is, save as a sector) as a result of the public deficit.
In yesterday’s blog – Why budget deficits drive private profit – you also learned that under these conditions, the government deficit would be stimulating private sector profits.
So what is the economics of this result?
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 external deficit also means that foreigners are increasing financial claims denominated in the local currency. Given that exports represent a real cost and imports a real benefit, the motivation for a nation running a net exports surplus (the exporting nation in this case) must be to accumulate financial claims (assets) denominated in the currency of the nation running the external deficit.
A fiscal surplus also means the government is spending less than it is “earning” and that puts a drag on aggregate demand and constrains the ability of the economy to grow.
In these circumstances, for income to be stable, the private domestic sector has to spend more than they earn.
You can see this by going back to the aggregate demand relations above. For those who like simple algebra we can manipulate the aggregate demand model to see this more clearly.
Y = GDP = C + I + G + (X – M)
which says that the total national income (Y or GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).
So if the G is spending less than it is taking out in the form of taxes and the external sector is adding less income (X) than it is absorbing spending (M), then the other spending components must be greater than total income.
Only when the government budget deficit supports aggregate demand at income levels which permit the private sector to save out of that income will the latter achieve its desired outcome. At this point, income and employment growth are maximised and private debt levels will be stable.
So you see what is likely to happen in Britain
All of this is basic macroeconomic reasoning. Output and income growth is driven by aggregate demand. You can get as complicated as you like but that basic result remains. There are no other sources of national income.
So if the government aims to achieve a surplus (or reduce its deficit) and net exports remains negative then the only source of growth is a rising private domestic deficit (or reduction in its overall saving).
The other source of growth could be a sudden reversal of the external situation and thus a positive net contribution from the external sector.
Neither “new” source of aggregate demand is likely to emerge in Britain.
Households and firms are unlikely to start expanding their spending given that unemployment remains high and is likely to rise as the planned job cuts begin. The deflationary impact of the fiscal austerity will spread throughout the expenditure system and further discourage injections from private investment and or a decline in household saving.
All the likely private sector reactions are in the opposite direction – more desired household saving and less investment.
Further, net exports are unlikely to go into a large enough surplus given that world markets are now faltering. Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.
Once you realise that mass unemployment is caused by a failure of aggregate demand then you will appreciate that the British government is orchestrating what is likely to be a significant rise in unemployment as a result of the planned direct public sector job losses and the multiplied job losses in the private sector that will follow the spending collapse.
The exact opposite policy remedy is required in the UK.
Budget deficits build productive infrastructure which exerts a positive influence on economic growth. Budget deficits typically help stimulate private investment because they keep aggregate demand from plummeting. So net public spending “crowds in” private spending because expectations of future demand are improved.
Budget deficits also “finance” the private sector’s desire to save because they stimulate national income growth.
If you withdraw spending from an economy and there is no likelihood that it will be replaced from one of the other known sources of spending then aggregate demand will decline. The economy will adjust to that spending cut by contracting output and employment. The initial losses will reverberate throughout the supply chain and spread beyond that into the wider economy as lost incomes lead to further losses of spending.
There is not magic solution but to restore aggregate demand.
In the UK as in most nations at present, the major component of growth is net public spending. Cutting that at this point is madness.
The Saturday Quiz will be back sometime tomorrow with some easy questions and one more difficult (premium) question to head of the boasters out there who think they are on top of all of this! (-:
That is enough for today!