I gave a talk about Modern Monetary Theory (MMT) today at a workshop on Stock-Flow consistent macroeconomics organised at the University of Newcastle by the economics group here. While I hold the research chair in Economics at this university I am not formally part of the economics group – my affiliation is with my research centre (CofFEE) which stands outside the Department/Faculty structure. So it was good to interact with the economics group. It is coincidental because the things I was talking about were being played out in the US and elsewhere (for example, Greece). The US conservatives are now pushing hard for a balanced budget amendment to the US Constitution. If they understood economics they would never consider doing that. If they succeed they will undermine US prosperity forever. It is a case of ignorance undermining prosperity which really describes a lot of what is going on at present in the public debates.
The news is that the US Republicans are once again demonstrating their lack of responsibility as political leaders. They walked out of budget discussions surrounding the negotiations about extending the debt ceiling and the House Majority Leader Eric Cantor (R-VA) today issued a statement “regarding House consideration of a balanced budget amendment”.
I will come back to that in the context of today’s talk.
But first, today (given time differences) is also notable because the University of Chicago closed the highly controversial Milton Friedman Institute after only three years in operation in what is an embarrassing retreat for them. The press release waxes lyrical about the new venture (a merger with an existing but smaller Becker Center but the closure is humiliating for the conservatives associates with the MFI.
Why was this merger necessary? University of Chicago is silent on that front. It seems that Gary Becker (the neo-classical human capital theorist who doesn’t understand that labour (the flow of services) is not the commodity bought in the labour exchange) has supplanted Mr Freakonomics (Steve Levitt the former Director of the Becker Center) and Lars Hansen the former MFI Director has been pushed down the hierarchy (now Research Director of the new centre).
The MFI has been the subject of staff petitions opposing its existence given the role that mainstream economics of the type championed by Milton Friedman himself played in the financial crisis and the poverty of the paradigm in addressing the crisis once it occurred. You will laugh at this statement (issued June 1, 2010) from Hansen defending the MFI against the petitioners.
Here is a Chronicle of Higher Education report that backgrounds the controversy. The news from those that opposed the MFI is that the University of Chicago has had trouble raising funds to support the institute partly because of the “declining value of the Friedman name and reputation” (severely compromised one might say by the global financial crisis) and also has been severely embarrassed by the campaign pointing out the flaws in the decision to create such a centre in the first place.
Anyway, good riddance.
But talking about embarrassing developments, come in Mr Cantor!
The Balanced Budget amendment would change the US Constitution such that the US Congress would have to balance the budget each year. The goal to keep the US public debt “in check”.
In his press release (linked above) Eric Cantor described the move as a “common sense measure” which will “get our fiscal house in order”.
The reality – RIP America.
The BB bill was approved last week (on June 15, 2011) by the House Judiciary Committee – which is sometimes referred to as “the lawyer for the House of Representatives because of its jurisdiction over matters relating to the administration of justice in federal courts, administrative bodies, and law enforcement agencies”. The Committee considers legislation that “carries a possibility for criminal or civil penalties”.
The Committee voted 20-12 for the balanced budget amendment proposal. Here is a Transcript of their deliberations. It would have a comical air to it if it wasn’t so tragic.
You read statements like this:
In fact, as written, this bill would cut total funding for non-defense discretionary programs by approximately 70 percent in 2021, by more than $3 trillion over 10 years
… in balancing the budget, we will have to find savings in a variety of government programs, and that discussion should include Medicaid. Social Security, Medicaid and other government social programs will be helped, not hurt, by a balanced budget amendment. If the Federal Government is crippled with debt, it won’t be able to fund Medicaid or other government programs.
… I think it is unfortunate that the Medicare issue is being used to distort this debate … But the truth is Medicare, Social Security, this country itself is at risk unless we change our budgetary and our fiscal habits … Mr. Goodlatte has put the balanced budget amendment here before this committee to remedy that situation
The problem is you can’t repeal the laws of arithmetic. The fact of the matter is Medicare is going broke
And in the Statement of Judiciary Committee Chairman we read:
America cannot continue to run huge federal budget deficits. Financing federal overspending through continued borrowing threatens to drown Americans in high taxes and heavy debt.
Members of Congress on both sides of the aisle recognize this problem.
According to President Reagan, “Only a constitutional amendment will do the job. We’ve tried the carrot, and it failed. With the stick of a Balanced Budget Amendment, we can stop government squandering, overtaxing ways, and save our economy.
The workshop talk I gave today examined fiscal austerity from within a stock-flow consistent framework with MMT underpinnings. You can start with this simplified transactions matrix which is a particular view of the National Accounts. I explain that framework in considerable detail in this blog – Stock-flow consistent macro models.
Here, Gross Domestic Product, Y, is equal to Private expenditure, PX, plus government expenditure, G, plus exports, X, minus imports, M. The ROW account reveals that imports minus exports, transfers paid and interest received by the external sector, TF, equals the current account deficit.
Every item in the Production (GDP) account is matched by a corresponding negative entry in some other column. Taxes net of transfers are received by the government who pay interest on outstanding debt (B).
Net property income, taxes and transfers, TF and TP, are paid by the external and private sectors, respectively.
The final row totals reveal that the Budget deficit (or public sector net borrowing) equals the private net acquisition of financial assets, NAFA (private savings less investment) minus the external surplus (or plus the deficit).
The last row expresses the familiar sectoral balances accounting relations which is another “view” of the National Accounts. The sectoral balances provides a first-line reality check against some of the propositions that are abroad in the policy debate.
Sectoral of financial balances relate to total receipts less total outlays of the three sectors – government, external and private domestic.
You have seen this accounting identity for the three sectoral balances before:
(G – T) = (S – I) – (X – M)
National income adjustments in response to aggregate demand shifts ensure this relationship between the three sector financial balances always holds.
From the perspective of a stock-flow consistent approach to macroeconomic modelling outlined above, the fundamental accounting identity states that government savings (surplus) or tax revenue net of government spending and payment of interest on bonds is equal to the non-government sector’s dis-saving.
If (G – T) > 0 (that is, a budget deficit) then the sum to the right-hand of the equals sign (the non-government balance) must be in surplus and vice versa.
The term (S – I) equals total private domestic saving and (X – M) or net exports represent the net savings of non-residents. That has to hold as a matter of accounting.
As I noted in the talk, an understanding of this framework produces four incontrovertible facts.
- If budget deficit (as a percent of GDP) is less than the external deficit (as a percent of GDP) then private domestic sector will be in deficit.
- If budget deficit (as a percent of GDP) equals the external deficit (as a percent of GDP) then private domestic sector is in balance.
- If budget deficit (as a percent of GDP) is greater than the external deficit (as a percent of GDP) then private domestic sector is in surplus.
- If the external sector is in deficit, then a budget surplus or a balanced budget is always associated with a private domestic sector deficit.
These are accounting realities and but require a deep understanding of the operations of the monetary system and the way the macroeconomy works to interpret their movements and predict their future path.
So rather than mis-use the sectoral balances a solid theoretical grounding is required to augment the accounting consistency.
MMT is an integration of that theory with the national accounting and that makes it unique in the field of macroeconomics.
For a nation running an external deficit, the following graph (and data table) show the options which would exist depending on public and private spending decisions.
The last three cases (States 5 to 7) are budget deficits of increasing size (relative to GDP). It is only when the budget deficit is greater than the external deficit that the private domestic sector can save.
The earlier States show differing private domestic deficits. From a stock-flow perspective, we know that the flow (the private deficit) manifests in stock form as an increasing indebtedness. A growth strategy that relies on the private sector increasingly funding its consumption spending via credit is unsustainable.
Eventually the precariousness of the private balance sheets becomes the problem and households (and firms) then seek to reduce debt levels and that impacts negatively on aggregate demand (spending) which, in turn, stifles economic growth.
Today I talked about how the public debate that has led to fiscal austerity being centre-stage began by recognising that too much private debt led to the crisis.
The proponents of fiscal austerity then have convinced us that the real problem is that the private debt crisis has morphed into a public debt crisis.
Fiscal austerians argue that we need to reduce debt per se. That is only possible if if the external surplus is large enough. Otherwise, if you attempt to achieve that stage via fiscal cutbacks the policy strategy will undermine employment and growth. The upshot is that the budget deficit is likely to rise because of the slowing economy will undermine tax revenue.
The problem is that once you comprehend the sectoral balances you will soon realise that this is logically impossible as a global solution. Not all countries can run external surpluses.
The striking aspect of the public debate is that an awareness of this logical inconsistency is low to zero (apart from MMT types).
There is an alternative interpretation of-course: the fiscal austerity proponents know damn well what is going on but are just intent on finishing off the neo-liberal program of privatisation, welfare cutting and deregulation that the financial crisis rudely interrupted.
The irony that Stage One of the neo-liberal program led to the crisis in the first place escapes the conservatives. The Balanced Budget crew in the US are oblivious to the inconsistencies of their approach in the same way.
Even the so-called “progressive” who advocated what they think is a reasonable “balance the budget over the business cycle” rule fall into logical inconsistencies when they also argue that the driving force of the crisis was the exploding private debt.
If the government balances the budget over the cycle as they desire then the income adjustments that occur will always force the private sector into deficit over the business cycle equal to the external deficit. All nations cannot enjoy external surpluses and most have deficits.
External deficits are good as long as domestic policy is focused on maintaining high employment levels and providing support to demand to allow income growth to deliver the appropriate level of saving.
A stock-flow understanding tells us that in the “balance the budget over the business cycle” case, the progressives would be forcing the private sector into increasing indebtedness overall, exactly the problem they connected to the crisis in the first place.
Again, the sectoral balances provide a quick reality check to evaluate these sorts of propositions.
I then examined three case studies: Greece, the UK and the US to check what the implications of the fiscal austerity would be over time once we integrated a theoretical understanding of how national income is determined (MMT) and economic projections provided by the IMF and other bodies. I also modelled the Tea Party budget plans (budget deficit 2.2 percent of GDP by 2015).
The overwhelming conclusion that you reach once you simulate various projections and marry actual data that has been generated since the forecasts is that the fiscal austerity programs will drive the private sector into further debt (to support growth) or kill growth altogether. The latter is more likely given that the demand for credit at present is very low and the private domestic sector “players” are seemingly loathe to borrow again until they stabilise their already precarious debt levels (legacies of the last credit binge).
The British situation is very interesting and I covered it in this blog – I don’t wanna know one thing about evil (a great song by the way).
In that blog I documented some research I did in April 2011 digging deeply into the less publicised supplementary documents supporting the 2011 British budget. My talk today focused on the sheer cant of the British government in first claiming that:
Over the pre-crisis decade, developments in the UK economy were driven by unsustainable levels of private sector debt and rising public sector debt. Indeed, it has been estimated that the UK became the most indebted country in the world … Within the financial sector, the accumulation of debt was even greater. By 2007, the UK financial system had become the most highly leveraged of any major economy … This model of growth proved to be unsustainable.
And then projecting a growth strategy on a very optimistic net exports outlook and private consumption growth as the public sector contracted. I noted that the net exports data released since the Budget have already fallen well below the growth forecasts.
The Budget also estimated that the fiscal austerity program would lead to negative real household disposable income in 2011 and very low growth in the following years of the forecast horizon (to 2015). The fact is that the net exports growth assumed will not drive growth sufficiently and so the forward projections require a very strong recovery in household consumption.
Digging deeper into more obscure documents that have not been discussed in the public arena in any coherent fashion you find that the Office of Budget Responsibility (a division of the British Treasury) predicts the following:
Our March forecast shows household debt rising from £1.6 trillion in 2011 to £2.1 trillion in 2015, or from 160 per cent of disposable income to 175 per cent. Essentially, this reflects our expectation that household consumption and investment will rise more quickly than household disposable income over this period. We forecast that income growth will be constrained by a relatively weak wage response to higher-than-expected inflation. But we expect households to seek to protect their standard of living, relative to their earlier expectations, so that growth in household spending is not as weak as growth in household income. This requires households to borrow throughout the forecast period.
So the record levels of private sector debt caused the crisis yet the British government’s fiscal strategy is predicated on even greater levels of private debt.
When it comes to the US a similar story can be told. The following graph shows the actual sectoral balances for the US from 2000 to 2010 augmented by the April 2011 IMF World Economic Outlook projections to 2016 and the dotted lines represent the Tea Party ideals.
If you examine the US sectoral balances since 1952 (see this blog – In policy you have to wish for the possible) you will see there is a tendency for the current account balance to decline as a percent of GDP. That is a good thing for the US because it means they are able to get more real goods and services for a given real resource sacrifice to exports.
But it requires domestic spending to ensure that the drain on aggregate demand coming from the negative external contribution is offset. The IMF projections which more or less reflect the fiscal austerity debates have the budget deficit slowly falling (via growth mostly) but that also means (given the external trajectory) that the private domestic balance is heading to the zero line.
If you model (roughly) the Tea Party proposals which (if you can make any sense of them) seem to target a budget deficit of 2.2 per cent of GDP by 2015 and the external sector follows the IMF trajectory, which is probably optimistic (I predict a widening external deficit), then the private balance would be in deficit by 2015 if the budget aims were realised.
I thought the problem was too much private debt!
This sort of thinking can expose the contradictions in the public positions. At present, the private sector in the US is now firmly in saving mode as the combination of entrenched joblessness, threat of job loss and the overhang of huge private debt levels demand caution. This spending withdrawal by the private sector has reduced the external deficit (as import growth declines) and forced the budget into increasing deficit.
If the US government had have resisted that dynamic and tried to maintain a lower deficit by countering the automatic stabiliser component (falling cyclical tax revenue and increased welfare outlays) with discretionary spending restraint then the US unemployment rate would have been much higher than it already is.
The current agenda which is being followed by both main parties will only bring the deficit down as a percentage of GDP while the private domestic sector is intent on reducing its debt exposure at the expense of a significant decline in economic growth.
The current policy agenda being pursued by both sides of politics will reduce economic growth and pit the automatic stabilisers (pushing a rising deficit) against the discretionary cuts. What most commentators do not recognise or admit if they do is that the private spending (and saving) decisions are very powerful and the government cannot really run counter to them.
The appropriate role of government is not to try to force a lower deficit when there is such entrenched unemployment and no demand-pull inflation. The correct policy response in this environment is to accommodate the private spending plans to ensure that there is sufficient aggregate demand to propel growth. That suggests in the current situation that the budget deficit has to rise.
The private sector has to reduce debt which in the current climate (external deficits) and institutional arrangements (government issues debt to match its deficit) means that public debt has to keep rising. That is a sound outcome and will ensure that economic growth picks up and has a chance to eat into the huge pool of unemployment.
But to put all those realisations together you have to use a stock-flow consistent macroeconomic framework like MMT. The piecemeal (partial) analysis that goes for public debate does not come up with logically consistent outcomes because it ignores the interrelationships between the sectors.
Finally, the problem with the US Republican’s Balanced Budget amendment is that is will undermine economic activity. Even if the external sector was in balance each year, the sectoral balances then tell us that the private sector would be forced to have zero saving overall under an annual balanced budget rule.
If the private domestic sector tried to save overall, then such a rule would only be consistent with growth if the external sector created surpluses greater than the surpluses targetted by the private domestic sector. That coincidence hasn’t resembled any consistent period of recorded US history. It is highly unlikely to be consistent with the state of the non-government economy in the coming year.
A deeper understanding of the way the economy works requires us to understand what drives the income adjustments that are “accounted for” in the sectoral balances. An important starting point – often overlooked when fiscal rules are discussed – is the endogeneity of budget outcomes.
Fiscal austerity becomes self-defeating because private sector spending decisions overwhelm discretionary government policy changes. In Ireland, Greece, the UK and elsewhere budget deficits are rising and austerity grinds on.
The Balanced Budget amendment would destroy prosperity in the US. It would not allow the government to responsibly respond to negative fluctuations in private spending and the result would be the degradation of government services and entrenched unemployment.
It would be madness to introduce that into the US Constitution.
It is clear that the policy debate is being driven by advisers and material that presents a seriously deficient view of how the macroeconomy works.
A simple understanding of the sectoral balances provides a quick reality check to evaluate the statements coming from politicians.
The Saturday Quiz will be back sometime tomorrow – somewhat harder than last week!
That is enough for today!