My time is short today so an early post. I am catching up on my reading and had time to study the evidence given by Simon Johnson to the Joint Economic Committee of the US Senate on June 21, 2011. There are many such committees within any national government and at present they are being bombarded with analysis from so-called experts who assume a non-problem, call it THE problem, then propose various solutions to the problem (that is, non-problem) which all in various ways would make the real problem even worse. That is the state of the public debate.
Simon Johnson is a former senior economist at the IMF and now lists among his affiliations – the Peter Peterson for International Economics.
The specific JEC hearing he testified at was entitled – Spend Less, Owe Less, Grow the Economy – which sounds biased enough but then you see that he was joined by John B. Taylor who is leading the charge for the “fiscal contraction expansion” lobby and Kevin A. Hassett (American Enterprise Institute), who is regularly in the conservative press claiming that deficits are excessive, and C. Stone (Center for Budget and Policy Priorities in Washington) another US-based “think-tank” that prescribes meaningless fiscal rules to ensure the government doesn’t run out of money. So bias is not the word.
Interestingly, Johnson quotes the IMF World Economic Outlook, October 2010:
A budget cut equal to 1 percent of GDP typically reduces domestic demand by about 1 percent and raises the unemployment rate by 0.3 percentage point.
and admits that “immediate spending cuts would, by themselves, likely slow the economy. In another blog I will look into this formula a little more because I think it is an interesting vehicle for putting things into some perspective.
He notes that the sort of conditions that the Ricardian Equivalence crew (the “fiscal contraction expansion” lobby) think might operate in the face of a cut in fiscal stimulus do not apply in the US.
1. “US is currently one the lowest perceived risk countries in the world” in terms of sovereign default risk. Apart from the political shenanigans going on in Washington at the moment the US has zero risk of default – it issues its own currency. I note that there has been some innovative people lately examining the options available to the US President at present in relation to the debt ceiling.
For example, the redoubtable Joe Firestone wrote that – Will He Say He Has No Choice or Will He Use Seigniorage? – which refers to the power of the US Treasury under US law to mint coins of any denomination. So two $US 2 trillion coins minted and deposited at the US federal reserve would keep things going withtout the Republicans being able to blackmail the Administration into very silly corners.
So there is no solvency risk in the US notwithstanding the elaborate legislative ways the conservatives have tried to limit public spending.
2. “It is also highly unlikely that short-term spending cuts would directly boost confidence among households or firms in the current US situation” especially given unemployment is so high and the output gap so large. “Fiscal contractions rarely inspire confidence in such a situation”.
3. There is a limit to the capacity of the US Federal Reserve to fill the gap if spending was cut as “short-term interest rates are as low as they can be and the Federal Reserve has already engaged in a substantial amount of “quantitative easing” to bring down interest rates on longer-term debt”.
4. The US is not a small open economy that is likely to benefit beneficial terms of trade effects to enhance their net exports “in part because other industrialized countries are also undertaking fiscal policy contraction”.
The available evidence, including international experience, suggests it is very unlikely that the United States could experience an “expansionary fiscal contraction” as a result of short- term cuts in discretionary federal government spending.
At least that is where he should have concluded his evidence. But he didn’t and the rest of the testimony serves to undo the above logic in the face of the conservative howls for “cut, cap and balance”.
He first claims that high debt to GDP ratios makes a country “much more vulnerable to external shocks – particularly if it is relying on foreign investors to buy a substantial part of its debt”. He wasn’t precise in this section but clearly is referring to public debt to GDP. In that sense, a fully sovereign nation that does not issue foreign currency denominated debt (such as the US) is not vulnerable at all to external shocks (such as a fall in demand for its bonds from foreign investors).
That change in preference might manifest by a reduction in the current account deficit which could be severe and impose costs on consumers and firms who are enjoying imported goods. But while a foreign-imposed adjustment in the current account might be painful it doesn’t impact at all on national government solvency or budget options.
A sovereign government can always pay its debt in its own currency – it does not rely on foreigners to buy debt in order to spend because spending is independent of revenue for such a government – perceived constraints imposed by institutional arrangements notwithstanding.
Further within the capacity of the consolidated government sector (treasury and central bank) the private bond markets can be rendered irrelevant and interest rates (yields) at various segments of the yield curve controlled (for example, the central bank paying returns on reserves and strategically buying financial assets at different maturities along the curve).
Johnson gets further embedded in erroneous logic when he says:
It is important not to oversimply fiscal concerns into precise cut-offs for “dangerous” debt levels. Recent European experience provides ample illustration that countries can run into trouble refinancing their debts at a wide range of debt-to-GDP values.
EMU nations are not sovereign in their own currency and thus participate in a different monetary system which exposes them to solvency risk. Nations like the US, Japan, Australia, the United Kingdom, and most nearly all other nations use fiat currency that they as sovereign governments issue.
It is the worst sort of macroeconomic analysis that conflates the EMU with a sovereign monetary system.
Johnson’s examples of Greece, Portugal and Ireland are thus irrelevant to the options facing the US government. It is a sad statement that a senior economist with such a high profile such as Johnson offers such poor logic and isn’t picked up on it in questioning. The members of Congress (and their advisors) after all are making the laws and it is scary how ill-informed they are about fiscal options.
He also perpetuates the “Japan has high domestic saving” myth which sets it apart from the US:
Within the set of industrialized countries, Japan stands out as an extreme. Government debt- relative to GDP is expected to reach 229.1 percent in 2011 (on a gross basis) and rise to 250.5 percent in 2016 … But nearly 95 percent of Japanese government debt is held by residents – and, at least for the time being, Japanese household and business savings remain high. Countries with greater reliance on foreign savers, such as the US (where nonresidents held over 30 percent of general government debt in 2010) and the UK (nonresidents held 26.7 percent of general government debt in 2010) need to be much more careful.
Once again even if Japan was in the same position as the US or the UK it could instruct the central bank (under law) to credit treasury (Ministry of Finance) bank accounts whenever it wanted to.
The relevance of the high domestic saving in Japan is for the size of the deficit. If the private domestic sector net saves in yen then the deficit has to make up the gap between that net saving and net exports (assuming net exports is the lower) or real GDP will fall as a result of a decline in aggregate demand. The fact is that Japan’s external surplus has not been large enough to add sufficient aggregate demand to the local economy to maintain potential growth rates and low unemployment. That is the reason they have had large budget deficits and rising public debt ratios.
But don’t think for a minute that the bond markets could undermine the Japanese economy independent of the wishes of the Japanese politicians.
I then agreed with his point on the distributional consequences of a public spending cuts and/or tax increases. He noted that:
The financial sector managers and traders who do well during a financial boom are highly paid … [and poor incentive schemes mean] … they take on too much debt. When the downside risks materialize, the costs of the crisis are borne by those who lose jobs and suffer other collateral damage. If sharp spending cuts follow that reduce public services (e.g., government-funded education), this effectively transfers the costs of dangerous compensation schemes for the financial elite onto the middle class and relatively poor people.
That is a major issue now and government around the world have steered clear of addressing it. In many ways, the financial sector (so-called Wall Street – wherever it might be located) has recovered by the socialisation of the losses. The legacy of that socialism has been to neglect fiscal initiatives that could have redressed the real crisis – the high unemployment and failed productive businesses – and now, inflame the deficit terrorists so that they demand large public net spending cuts which will worsen the real crisis.
And all because governments have acted as if they have financial constraints in their own currency.
Johnson is correct in saying that “(t)here is nothing pro-market or pro-private sector about an inefficient redistribution scheme that allows a few people to become richer due to implicit government subsidies for “too big to fail” global financial institutions”. The inefficiency in government policy at present is the huge pools of idle labour and productive capacity that represents billions of dollars (or whatever currency) in foregone – never to be regained – national income – not to mention the damage to the unemployed individuals, their families and their communities.
Johnson then went on to discuss what he called three fiscal adjustment scenarios – which are based on the false presumption that there is an actual fiscal problem that has to be addressed.
All these discussions – including the recent UK OBR report – start by asserting there is a problem and then proceed to outline solutions to the “problem”. Of-course, if there was such a thing as a national government that issues its own currency being nearly out of money (or likely to be at some future date as the population ages) then the solution would have to include reducing the factors that are leading it to be “out of money”.
Problem: not enough money.
Solution: cut spending and/or increase revenue.
But if there is no such thing as a national government that issues its own currency being nearly out of money or likely to be at some future date then these solutions are nonsensical.
Then if you understand that the “solutions” to the non-problem have consequences that are likely to worsen these “distributional consequences” and defeat the aims of the “cutters” anyway – courtesy of the automatic stabilisers – you will want to start at first principles.
Why do they think there is a problem and why are they wrong in thinking that. That is what I try to do with this blog.
The only debate they should be having in Washington at present (and London and elsewhere) is how much the national government spending (or tax cuts) have to be to get all those willing to work back into work and all those who want to save to get enough income to allow them to do so.
Rising deficits are necessary to create work and private saving when aggregate demand is deficient as it is now.
Johnson introduced this section with the classic:
There is a growing consensus that the US faces some sort of fiscal crisis that will force an adjustment – implying some combination of lower spending and higher revenue.
I love it when the “growing consensus” is cited. News Limited journalists, those bought with Peter G. Peterson’s money, scheming politicians, and the mainstream economists who have an appalling track record in predicting major macroeconomic events and providing viable solutions to them. These are among the “growing consensus”. It is a consensus that has no basis in first principles.
Someone shouted “fiscal crisis” and the lemmings charged in. Many of those who are aiding and abetting the lemming charge are those who a few years ago were pocketing billions from the real GDP and gambling it on financial markets. Then with hands stretched well out towards Washingon (and elsewhere) they accepted billions in bailouts. Remember those distributional consequences noted above.
Johnson claims there are “three kinds of fiscal adjustment around the world today”:
… those forced by the market, typically involving sharp spending cuts (e.g., Greece); those undertaken by governments trying to get ahead of the market, often placing greater weight on moderate tax increases (e.g., the UK); and those involving the need the control future spending on health care (almost all countries are in this boat to some degree). Where does the US fit in this comparison?
Greece is irrelevant for the US case. Its fiscal adjustment is because the ECB will not provide enough “fiscal support” on ideological grounds and its own “socialist” government would rather privatising public wealth and trash peoples’ entitlements than exit the Eurozone.
The UK government has set up a false problem – “getting ahead of the market” – and is now inflicting massive real damage on the most disadvantaged of its citizens. It is not a reliable model of fiscal adjustment.
The need to control future spending on health care would only arise if there was a genuine concern that there will not be enough real resources available in the future to provide adequate health care to all individuals. If that was the concern then choices have to be made about how to use what real resources will be available. Those choices are not about the “financial” capacity of the US (or other sovereign) governments but are political decisions.
The problem is that in constructing the future health care debate as a financial problem (“excessive deficits”) the proposed solutions are likely to create a “real” problem when there may not have been one in the first place. By cutting back spending now because of the erroneous notion that the government will “run out of money” in the future, essential investments in infrastructure, education etc are undermined which could make health care cheaper (in real resource terms) in the future. The best way a person can provide for their own retirement is to be gainfully employed in well-paid jobs for the duration of their productive life. I use productive here to mean working for a wage.
By creating unemployment (via the spending cuts) and reduced investment – people become more reliant on the state for basic needs.
Johnson clearly falls into the deficit terrorist camp by invoking these non-problems and failing to articulate the real problems correctly.
He focuses on the correct fiscal adjustment path for the US and says:
US general government spending will rise from 36.6 percent of GDP in 2007 to 41.4 percent in 2016. It’s this future increase in spending that needs to be constrained in the United States. Most of this is not about discretionary spending, at least not about its domestic components – spending on overseas wars continues to be a significant issue. And not much is about pensions either; the IMF’s projections of net present value of pension spending change over 40 years, 2010-50, are 23.5 percent of GDP, one of the lowest in the industrialized world. But the US is definitely at the bad extreme of the charts when it comes to future health care spending. The net present value (NPV) of the change in health care spending, 2010-50, is 164.5 percent of GDP, the highest in the industrialized world (p.129). Among comparable countries, Sweden seems to have this under control at 11.7 percent. Greece and the UK have looming problems – NPV of 106.9 percent and 113.3 percent respectively – but most industrial countries have this number contained in the range of 30-80 percent of GDP (still, not good news for anyone).
So the debate should be in terms of whether it is politically sensible to be allocating the (implied) level of real resources on health care. It should never be a debate about whether the US government (or any sovereign government) can “afford” to outlay the nominal spending to command those real resources. Of-course it can.
At present the opportunity cost of them doing so is very low given the huge pool of idle productive labour and productive capital. It might come a time when the US economy approaches full employment that hard decisions have to be taken about what use some resources will be allocated to. At that point, government might have to reduce spending in area A to ensure spending on health care is non-inflationary.
The risk of government spending (and indeed, all spending) is inflation – that is, pushing nominal spending at a rate that outstrips the real capacity of the economy to muster real resources and produce more goods and services.
Economists have nothing sensible to say about what choices should be made when the economy is at the inflation barrier and spending cuts – private, public or both – have to be made. These decisions are always political.
The problem with the current debate and inputs from people like Johnson (who otherwise appears to hold reasonable views about the costs of unemployment and has a sensitivity to the distributional issues involved in bailing out Wall Street while allowing unempoyment to rise and then persist) – is that they construct the issue as relating to the financial capacity of the national government.
In that sense, the solutions all become spurious.
I note that Johnson did say in ending that:
There are three ways to deal with the real US fiscal crisis: ignore it, which would be a bad mistake; transfer rising health care costs off the government budget and onto individuals and firms, which would seriously impede private sector growth; or really find ways to limit future increases in health care costs.
Note the slippage in language – “real US fiscal crisis”. He means real in terms of what he thinks the crisis actually is – health care rather than pension entitlements. But when I say real I am meaning real production, employment etc. This is the normal terminology in economics.
At present the “real” US fiscal crisis is that there is 9 per cent official unemployment, firms going broke that otherwise should not, cities are crumbling and people are defaulting on debts which make good debt toxic.
That crisis indicates one thing: aggregate spending is not sufficient.
If as Johnson believes (and I concur) there is no “fiscal contraction expansion” potential in the US then cutting spending is a recipe for disaster.
In terms of the longer term political challenges – the government should always being looking to ensure that real resource constraints will be averted (say in health care should any arise) and that the real resources at each point in time are equitably shared.
I also don’t want readers to think that I consider it useful for the government to be commanding expensive real resources in the health care sector and claiming that they are advancing public health. Clearly, the US has a health care issue which is separate from the obvious capacity the US government always has to buy anything that is for sale in its own currency.
The overservicing of health care at the high income levels and the denial of adequate health care at the low income levels is a major issue that the US should address. Further, getting people fit and engaged in participatory sport is something governments should assist with. But these are not the sort of debates that are going on at present.
How the press misleads
I was listening to the radio yesterday – the ABC Radio National program – Rear Vision – which examines the history of events in the news.
Yesterday they were looking “at the origins of Greece’s excessive national debt”. The link is to the transcript of the program. The level of analysis was generally appalling.
Take this section where one Professor Kevin Featherstone was being interviewed. He is the director of the Hellenic Observatory, part of the European Institute at the London School of Economics.
Here is the question and answer:
Interviewer: Can you give us some sense of how much money Greece actually owes? What’s the debt of the Greek government?
Kevin Featherstone: In relative terms at the moment it’s judged to be approximately 150 per cent of its gross domestic product. That means that the debt level is one and a half times all of the economic wealth and economic transactions taking place within Greece as a system. Now clearly 150 per cent is astronomical and the fear is that this debt level will actually increase and may rise as much as 200 per cent. In other words, it’s Greece owing twice as much as Greece is actually worth in economic terms.
Quiz question: What is the difference between GDP and wealth?
Answer: one is a flow the other is a stock.
His statement makes one of the most fundamental errors in economics. Even if the public debt rose to 200 per cent of GDP that tells you nothing about what “Greece is actually worth in economic terms”. All it tells you is that the outstanding government obligations are twice the national income the economy produces in a given period. It tells us nothing about the wealth of the nation.
That particular interchange was representative of the biased and wrongful analysis that our national broadcaster allowed to go to air. The ABC has become just another mouthpiece for the conservative deficit terrorists.
At least News Limited is under the pump at the moment and Rupert is unlikely to received as favoured an ear from politicians for a while to come.
I have to catch a plane now so I have run out of time. Soon I will model the “cut, cap and balance” mania that is occupying the US polity at the moment – quite incredibly should I add.
That is enough for today!