The stories that are headlined on Page 1 of the New York Times in its on-line edition late January 21, 2011 are almost beyond belief and are like spoofs – if only. I must admit the shock factor is diminishing in this neo-liberal era where the most absurd ideas are brush-stroked up to appear normal. Some time ago I would have just laughed and concluded that some extremist or another was getting a moment of airplay – a day in the sun and would then disappear to a dark room where they would continue writing endless handwritten letters to all and sundry outlining their crackpot ideas and schemes for the renewal of humanity – which always seemed to involve some communist purge (the reds are everywhere you know) and handing over authority to citizen militia’s. But these nutty ideas are gathering pace. It seems the deficit terrorists are getting bored with their predictions of inflation (that doesn’t arrive) or rising interest rates (which do not arrive) – so they have to invent even more bizarre angles. They get so far out there that sometimes even I cannot believe they could be serious.
Here’s a snippet of Page 1 of the New York Times on its on-line edition late January 21, 2011. The two main headlines tell you how mad the world has become and how out of control the politicians in the US are.
As an aside I am a very experienced recipient of the letters that I mentioned above. They usually come with spindly handwriting and/or old type written addresses. They are invariably long and accompanied by newspaper cut-outs underlined or highlighted and other more esoteric material. They ramble on for ages about the way to fix the economy and demand my acceptance of the propositions being outlined. I get these types of letters often. Some provide the office with considerable humour.
But these days, this standard of reasoning is mainstream and as such poses a serious threat to economic and social progress.
One of those headline stories in the New York Times – Path Is Sought for States to Escape Debt Burdens – read like a comedy given how absurd the proposition being developed is. But in this neo-liberal era anything seems to be possible.
The NYT article claims that:
Policy makers are working behind the scenes to come up with a way to let states declare bankruptcy and get out from under crushing debts, including the pensions they have promised to retired public workers.
It goes onto articulate the case that some states have to declare bankruptcy which would allow them to “alter its contractual promises to retirees, which are often protected by state constitutions, and it could provide an alternative to a no-strings bailout. Along with retirees, however, investors in a state’s bonds could suffer, possibly ending up at the back of the line as unsecured creditors”.
So why would US politicians ever support a deliberate and unnecessary erosion of the entitlements of workers and investors (retirement funds etc)? That would, in my view be the equivalent of a criminal act quite apart from a relinquishment of their responsibilities as public officials to advance honesty and good.
… have taken an interest in the issue, with nudging from bankruptcy lawyers and a former House speaker, Newt Gingrich, who could be a Republican presidential candidate.
I just laughed when I read this. Like all the privatisations where the brokers and the lawyers creamed huge surpluses from the sale price, the bankruptcy lawyers are also compromised by conflict of interest in this case. Of-course, they would want such a legal development. What a pack of parasites. As to Newt – Newk comes to mind (him!).
The article says that:
… discussions about something as far-reaching as bankruptcy could give governors and others more leverage in bargaining with unionized public workers.
Which tells you that the neo-liberals are continuing their onslaught to tip all the marbles in the favour of the elites. The crisis interrupted this onslaught. The entrenched mass unemployment is of-course beneficial to them but they now want to “finish the job”. The fiscal austerity in Britain is similarly motivated – to drive the workers into total submission and undermine their entitlements.
The solution to the fiscal problems that US states are currently experiencing can be solved with a stroke of a computer keyboard. A simple per capita grant from the federal government could have all those schools re-opening, the street lights on and the cleaners tidying streets up. There is no financial constraint on the federal government which would prevent it from doing that.
It is clear that the US government quickly found cash and capital for the car firms (GM and Chrysler) and they could obviously do the same for the states.
Anyway, the fact that people are actually talking about this amazes me.
And then I read my notes from last week which I took while reading the latest Citibank report (January 7, 2011) from their economist Willem Buiter. The 84-page Global Economics View – The Debt of Nations – tries to convince us that:
There are no absolutely safe sovereigns …
That was the opening line. Immediately I knew the overall tenet of the report would be spurious even if some of the detail (especially in relation to the EMU nations) might have some traction.
This document is just a repeat in fact of a report he put out last year which I analysed in detail in this blog – Fiscal sustainability and ratio fever. Same arguments and a year on, as deficits and public debt has risen, we are still not looking anything like the world he is depicting with reference to the truly sovereign non-Euro nations. I suppose Buiter thinks that if you say it enough it might just one occur.
But in that regard, saying that Japan and the US are about to hyperinflate or their exchange rates are about to collapse or they are about to deliberately default on their sovereign debt is just “pie in the sky” assertion. You can say that until the “cows come home” and it will never happen.
Buiter introduces terms such as “unsustainable fiscal trajectories” and “fiscal unsustainability” without even defining what he means. He uses a table of deficit and debt ratios for many nations to show the ratios are “high” and provides some recent historical narrative to support the data but doesn’t pin any particular meaning to his basic terms.
I share his conclusion that “(t)here are likely to be several sovereign debt restructurings in the euro area … in the next few years. Liquidity support should not stop this; only permanent bail-outs would”.
I do not share his conclusion that there are viable options for the Eurozone which include “much larger liquidity support facility”; a “restructuring of the unsecured debt of EU zombie banks and recapitalisation of the systemically important ones” and “restructuring of the debt of insolvent EA sovereigns”.
The only thing propping up the Eurozone at present is the large-scale ECB intervention in the secondary public bond markets. Take that away and the nations line up to default. In the meantime life for the disadvantaged and those that are becoming disadvantaged (as a result of the fiscal austerity) life is getting worse.
How does a government turn the middle class into an underclass? Answer: impose unnecessary fiscal austerity.
While Buiter’s proposals for the EMU might stop the banks crashing and may stop widespread default by member states (especially the weaker ones) it will do nothing to address the fundamental design flaws in the system which start from the Euro bosses refusing to create a unified fiscal authority to cope with asymmetric demand shocks.
Further, Buiter’s proposals are also in the context of on-going fiscal austerity and the results of those policy stances do not define in my opinion what Buiter chooses to call a “viable and dynamic” Eurozone. Far from it.
Buiter suggests that:
Although we have experienced, since the West-German sovereign default in 1948, a 62-year interval without sovereign default in the AEs, the risk of sovereign default is manifest today in Western Europe, especially in the periphery of the EA.
The short-hand is AE = advanced economy and EA = Euro Area. So you can see that Buiter is lumping together economies that span quite different monetary systems which in fact cannot be so conflated.
When you see someone use this conflation you realise that they are either ignorant of the differences and their implications for the conduct for fiscal and monetary policy or they know well and choose to mis-inform the reader for the their own ideological purposes.
The fact is that the fiat currency system that the US or the UK operates leaves them financially at no risk ever of default. The other fact is that the nations in the “EA” are at no risk of sovereign debt default because once they entered the European Monetary Unit (the Eurozone) they surrendered their currency sovereignty anyway.
All Eurozone governments are in the same straitjacket and face insolvency as a consequence. Most nearly all of the “governments of advanced industrial countries” are not in this situation. And … it is not a matter of degrees. The sovereign governments are not financially constrained in any way although they have erected institutional machinery (debt-issuing agencies with prescribed rules) which make it appear as they have constraints.
However, these voluntary “constraints” are only of a political nature and could be disassembled at any time (with some political narrative to go with it).
Clearly, the “markets” understand this. One might ask when will Japan be tested by the markets and suddenly stopped given it has been running consistent budget deficits and has experienced rising public debt ratios for nearly 2 decades?
The fact is that the basic premise underlying Buiter’s report is flawed at the most elemental level. There is no solvency risk in the US or Japan (or any sovereign nation in terms of debt it has issued in its own currency.
Modern Monetary Theory (MMT) examines the way in which fiat monetary systems work (subject to voluntary constraints imposed on the system by governments) and can work (free of those voluntary constraints). There was a fundamental shift that occurred in history when Bretton Woods collapsed in 1971 this dramatically altered the opportunities available to sovereign governments.
First, under a fiat monetary system, “state money” has no intrinsic value. It is non-convertible which means that you can take a $AUD coin to the government and in return you will get a $AUD coin back. There is no responsibility to do more than this. So for this otherwise “worthless” currency to be acceptable in exchange (buying and selling things) some motivation has to be introduced. That motivation emerges because the sovereign government has the capacity to require its use to relinquish private tax obligations to the state. Under the gold standard and its derivatives money was always welcome as a means of exchange because it was convertible to gold which had a known and fixed value by agreement. This is a fundamental change.
Second, given the relationship between the commodity backing (gold) and the ability to spend is abandoned and that the Government is the monopoly issuer of the fiat currency in use (defined by the tax obligation) then the spending by this government is revenue independent. It can spend however much it likes subject to there being real goods and services available for sale. This is a dramatic change.
Irrespective of whether the government has been spending more than revenue (taxation and bond sales) or less, on any particular day the government has the same capacity to spend as it did yesterday. There is no such concept of the government being “out of money” or not being able to afford to fund a program. How much the national government spends is entirely of its own choosing. There are no financial restrictions on this capacity.
This is not to say there are no restrictions on government spending. There clearly are – the quantity of real goods and services available for sale including all the unemployed labour.
Further, it is important to understand that while the national government issuing a fiat currency is not financially constrained its spending decisions (and taxation and borrowing decisions) impact on interest rates, economic growth, private investment, and price level movements.
We should never fall prey to the argument that the government has to get revenue from taxation or borrowing to “finance” its spending under a fiat currency system. It had to do this under a gold standard (or derivative system) but not under a fiat currency system. Most commentators fail to understand this difference and still apply the economics they learned at university which is fundamentally based on the gold standard/fixed exchange rate system.
Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for more discussion on this point.
None of the EMU nations (Buiter’s EA nations) enjoy these characteristics. No advanced economy outside of the Eurozone has any risk of sovereign debt default. It is a lie to assert otherwise.
Further, I like the way the deficit terrorists wheel out the 1948 West German default as an example that might be applicable today. I would never use that example given how extreme the circumstances were that time. In fact, the government did not default on any debt in 1948. It changed its currency (degrading the old currency) for reasons other than those relating to inability to service public debt.
For interest I consulted my archives of notes I have taken over the years to see exactly what I have researched about that default. Here are some facts. If you can come up with something remotely like those facts in the current setting among sovereign nations please let me know.
After World War II, the German economy was in a parlous state and they introduced major currency reforms in 1948 to address the issues they were facing.
The German economy was wrecked by the war. By 1948, manufacturing production had fallen to around 55 per cent of its pre-war level (1936) and real per capita consumption was around 66 per cent of the 1936 level. Between 1935 and 1945, real GDP had fallen by 40 per cent.
Public debt stood at around 400 per cent of GDP and the attempt to implement wage and price controls to cope with the inflationary effects of the supply-side shortages were undermined by a vibrant blackmarket. The capacity of the currency to serve as a viable unit of value was lost. Any export income was forceably converted to local currency which undermined profit-seeking behaviour.
The government sought advice from US-based economists (some of who fled Germany in the face of the Nazi oppression) under the Colm-Dodge-Goldsmith-Plan which went about establishing a new currency – the Deutsche mark and winding back the growth of M1 (currency and demand deposits held by banks) which had grown 5 times over the decade since 1935.
The situation was that while liquidity had expanded dramatically, the supply-side of the economy had shrunk and from 1939 rationing under a system of wage and price controls was implemented.
They planned to cut M1 by 90 per cent to restore pre-War ratios and sought to accomplish this by setting an exchange rate for the DM against the Reichsmark (old currency) that would allow a major contraction of liabilities in the banking system. An exchange rate of about 1 in 10 was used to accomplish this task meaning that all liabilities in DM were around 1/10 of the Reichsmark levels. All assets were similarly restructured.
Special rules were implemented for liabilities and credit held by the non-government sector in relation to the government (and National Socialist Party). All were extinguished – but this was an act of psychological cleansing and had nothing at all to do with solvency issues. Federal government bonds were substituted for any credit extended to the state by the non-government sector.
I could go into a lot of detail about how the currency conversion was implemented and some of the accompanying measures designed to minimise the impacts of the redistributions (between creditors and debtors) of such a restructuring.
For example, the US provided Germany with a huge reconstruction fund to rebuild the supply-side of its economy.
The point is that this is not remotely like the situation we have in any nation today. It was not a solvency-based default. The German government could have continued to honour all debts in the Reichsmark. The problem it faced was that the economy had been destroyed by the War and there was a huge imbalance between liquidity and the supply-side capacity of the economy.
Further, it was operating a fixed exchange rate system with respect to the US dollar (under Bretton Woods) which reduced the capacity of fiscal and monetary policy to target domestic reconstruction. It also enjoyed a major fiscal injection (reconstruction aid) from the US.
So I would never hold the German currency reforms of 1948 out as an example to justify the inevitability of sovereign default.
The other stunning aspect of Buiter’s claims is that he decides to extend the concept of sovereign debt default to events that follow from the normal operations of the market. He says:
We expect these concerns to extend before long beyond the EA to encompass Japan and the US — especially if we extend the concept of sovereign default to include not only violations of the legal terms of the sovereign debt contract, but also the infliction of severe capital losses on owners of domestic-currency denominated sovereign debt by deliberately engineered unanticipated inflation and currency depreciation.
So there is a sleight of hand going on here. Debt default is no longer just a violation of “the legal terms of the sovereign debt contract” which is the normal way we would consider it. So the government borrows too much (usually denominated in foreign currencies) and then finds that trade is faltering and the nation’s capacity to generate foreign exchange earnings that are necessary to repay the debt falls below that which makes repayment possible. Then they seek a restructuring of the debt. This was the Argentinean experience in 2001.
I would accept that as a reasonable construction of a debt default although once a nation either fixes its exchange rate and/or borrows in a foreign currency it surrenders its sovereignty under a fiat monetary system.
But Buiter want to suggest that the Japanese and US governments are deliberately plotting to engineer what must be severe inflation (to inflict “severe capital losses”). What evidence is there for that? Both nations have been deflating. Japan has had falling or zero inflation for 2 decades and has the highest public debt ratio in the advanced world. When are they going to burst into an inflationary attack on its bond holders?
Buiter also thinks these governments are plotting to engineer a major currency depreciation. How will they actually do that? What is the evidence that they are likely to do that. Answer: none! Japan has been buying foreign currency denominated debt to keep the yen from appreciating lately but that is not the same thing as a deliberate plot to wipe out the net worth of its debt-holders.
And if the exchange rate falls in either nation due to the normal operations of the foreign exchange markets can we call that a sovereign debt default? Answer: it would be rendering the term meaningless if we tried.
So how does Buiter intend to differentiate between normal market movements which reflect the underlying fundamentals of the external sector and deliberate interventions designed to erode the value of foreign resident bond holdings? He doesn’t offer any insight in that regard.
To finish this week I want to remind you of a speech that Ben Bernanke made in 2002 – Deflation: Making Sure “It” Doesn’t Happen Here. He said that:
… the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
So of-course Buiter and his cronies and the mad Austrian School all consider this a statement that government spending engineered via the “printing press” is inflationary.
Bernanke was acknowledging that there is no financial constraint on US government spending. But his next association reflected his own prejudices and blindness. By increasing the number of US dollars in circulation via government spending the US government does not inevitably cause inflation.
It may but then in most situations (that we have experienced in the last 30 years) it will not. The prices of goods and services will only rise in line with increased nominal demand if the firms have no capacity left to expand real output. At present many nations (including the US and Japan) have significant unused resources (especially labour) which can be brought into production to satisfy the unmet wants in the market as a result of the high unemployment rates (relative for Japan).
At some point, continued spending will be inflationary. But at present rising deficits pose no threat to inflation.
I was pushed for time today – hence the lateness of my post. Sorry!
All this mainstream dogma about fiscal sustainability is erroneous and completely misunderstands that a sovereign government is never financially constrained.
For an alternative narrative from a MMT perspective on what fiscal sustainability really means for a sovereign government which issues its own currency please read the following suite of blogs – Fiscal sustainability 101 – Part 1 – Fiscal sustainability 101 – Part 2 – Fiscal sustainability 101 – Part 3.
The Saturday Quiz will be returning tomorrow sometime. So brush up and be prepared.
That is enough for today!