As the economic crisis has dragged on and deepened, it has changed complexion. It clearly started out as a balance sheet crisis which means it originated from the excessive borrowing of the private sector driven by personal greed and an overzealous and often criminal financial sector. Hence the term GFC. It quickly moved into a real crisis (meaning it affected real GDP growth, employment and incomes) because governments around the world reacted too cautiously in terms of their fiscal intervention. However, it was clear that the fiscal responses that were introduced saved the world from another Depression. China’s fiscal intervention helped many nations including Australia. Now the crisis is all down to incompetent government policies – not before the crisis but now. Governments are now following strategies that defy the most basic principles of sound fiscal management – it is irresponsible to cut net public spending at at time when unemployment is rising. Or in other words, you don’t send more workers into the mine when the canaries start dying.
From a functional finance perspective, budget deficits are crucial if there is a deficiency in private aggregate demand – which means that private spending is not sufficient to creates orders for goods and services that will entice firms to employ all the available labour force.
Please read my blog – Functional finance and modern monetary theory – for more discussion on this point.
In this case, net government spending can make the difference between a decline into recession and full employment (or somewhere in between).
The other important point is that fiscal policy, while directly influencing aggregate demand also prevents adverse supply effects from occurring. This means that once a recession occurs, business firms react by slowing the rate of investment and this means that the potential growth path is lower than previously. The longer the recession the worse this problem becomes.
This means that once the economy starts to recover the scope for non-inflationary real growth is reduced relative to what it might have been because the growth in productive capacity has been damaged.
This is referred to as hysteresis – where you are is a function of where you have been. That is, the economy is path dependent and once we understand that and its consequences then it indicates that a major role of government is to quickly fill aggregate demand gaps that emerge as private spending declines due to pessimism or other negatives.
There has been a long mainstream literature attacking the use of fiscal policy as a counter-stabilising mechanism. In the context of this blog I will summarise a few of the issues – which are interrelated.
First, it is argued that governments fall prey of what is termed a “deficit bias” which relates to the political difficulties that governments face when they would like to increase taxes or reduce spending to reduce the degree of expansion. This is especially the case during periods of strong growth.
It is claimed that the electorate is ignorant of the fact that the government, like a household, faces an intertemporal budget constraint (has to pay the deficits back) and so fail to realise they will be hit by higher taxes in the future. So in blithe ignorance they pressure governments to continue net spending. Several mainstream writers argue in this way.
If you think about that for a moment it runs counter to several other mainstream propositions which are used to dispute the effectiveness of fiscal policy. There is almost a schizoid element in the various attacks.
Key propositions that dominate mainstream macroeconomics include rational expectations which tell us that individuals “know” the true economic model that drives outcomes (and thus – how could they not understand something as basic as an intertemporal budget constraint?).
Further, austerity is currently being justified on the grounds that the private sector behaves in a Ricardian manner which the mainstream claims means that the private sector is not spending at present because they know that the budget deficits now will mean higher tax rates in the future and they are busily saving to ensure they can pay those higher tax rates. So if they learn that the deficits will be lower they will save less and spend more – problem solved.
The way to understand the “conflict” is to realise that all the arguments are ruses to justify the mainstream dislike for government behaviour and help them promote their myth that markets will self-regulate and deliver optimal outcomes including maximising private wealth.
Rational expectations and Ricardian Equivalences are among the many mainstream propositions that have logical inconsistencies and also fail to withstand empirical scrutiny.
It is clearly the case that governments make decisions on political rather than economic grounds – which is really what this blog is about. But the political biases are now all towards austerity rather than deficits and have been for decades.
An aspect of the deficit bias argument is that if a government has been running a large deficit (whatever “large” means) then it constrains them from acting in the future should a recession occur. This concept is more often referred to by the IMF and the OECD and such as “fiscal space”. I am sure you will have read articles where this terminology is used.
The claim is fallacious. A sovereign government can always react to an increasing private spending gap irrespective of its previous fiscal position. Running surpluses does not give a government any extra resources or extra “space” to run deficits in the future. A sovereign government can spend whatever it wants whenever it wants – which means it can always purchase goods and services for sale in the currency it issues.
That means it always has the capacity to offer a job to unemployed workers. There is never a reason for workers to remain chronically unemployed.
Further, the term – deficit bias – is loaded as is the claim that fiscal policy should never be pro-cyclical (which I will come to in a moment). We can never evaluate the appropriateness of the size of the deficit in isolation.
When the Stability and Growth Pact came up with the 3 per cent of GDP rule upon what basis was that assessed to be sound? The answer is that it was ad hoc. A 3 per cent of GDP deficit might be perfect in some situations, while a 3 per cent surplus might be perfect. Similarly a 10 per cent deficit might be the right balance.
Seeing a budget outcome rise from 2 per cent of GDP to say 10 per cent of GDP is not a cause to say the deficit is inappropriate. Most of the current debate is conducted along these false and superficial lines.
The deficit is really a mirror of what is going on elsewhere in the economy. It has two components: (a) the discretionary choices of government about tax rates and spending; and (b) the cyclical component (the automatic stabilisers) which mean that tax revenue falls (rises) and welfare spending rise (fall) when economic activity falls (rises).
A rising budget deficit often will just reflect the cyclical component as private economic activity declines. It would be totally inappropriate to conclude that such an outcome demonstrated that the budget was too large.
Moreover, governments should aim to have the discretionary component (the structural deficit) is sufficient to ensure the cyclical component is zero. What does that mean? It means they should aim to keep the economy at full employment at all times.
Which translates into the only fiscal rule that makes sense – the net spending position of the government has to be consistent with nominal aggregate spending growth that keeps pace with the supply potential of the economy.
When there is entrenched unemployment then there is insufficient aggregate demand and so we know the government net spending position (its deficit) is too small. Whenever desired private savings is positive overall (meaning the non-government sector is spending less than its income) then a budget deficit has to be positive.
It is possible that the deficit will exceed this fiscal rule in which case we would conclude that it is too expansionary and liable to create inflation.
The point is that governments can run continuous deficits which support non-government savings and full employment as they did for most of the post Second World War period.
There was no “deficit bias” in this. It was the exemplar of responsible fiscal practice.
That is not to say though that when there is a need (rarely) to curb the discretionary component of the deficit that political considerations may make it difficult for the government to cut back sufficiently.
The problem of fiscal adjustment that the mainstream claim makes fiscal policy dangerous generalises into the discussion of lags. He we confront the claim that fiscal policy should not be pro-cyclical because it exacerbates the direction of private spending.
The literature points out that there are lags in the design and execution of fiscal policy which lead to fiscal policy imparting the intended stimulus (for a declining economy) or the contraction (to a booming economy) too late – that is, missing the turning points in private spending.
For example, by the time the government has designed its fiscal stimulus in response to a decline in private economic activity, the implementation comes at a time when the private sector spending has recovered and so the stimulus drives the economy too quickly.
The same sort of argument applies when the government tries to arrest a boom – it just ends up making the recession deeper.
The literature identifies two types of lag: (a) inside lag – the time that government takes to determine that a change in fiscal policy is required and enact the decision; and (b) outside lags – the time it takes for spending decisions to impact on aggregate demand.
Automatic stabilisers, for example, have zero inside lags and very short outside lags. So policy design that acts like a reinforced automatic stabiliser are desirable. That is one of the reasons I advocate a Job Guarantee.
It is a policy that has very short lags – the government’s spending change is triggered every time a person goes to the “JG depot” seeking work. The pay is immediate (after a week) and the impact on aggregate demand is immediate.
However, governments can reduce the inside lags by forward planning. One of the problems of the recent fiscal interventions (for example, in Australia) was that there were clearly problems at the administration level (within government) which were compounded by some implementation problems for some of the infrastructure programs.
The December 2008 cash in hand bonus that the Australian government provided in response to the faltering world economy was fine – and was spent in the next two weeks (leading up to Christmas) demonstrating a near zero lag (inside or outside).
The point is that large-scale stimulus interventions of the type taken by the Australian Government – which in international terms was early and large relative to GDP – are very complicated and you can expect some administrative inefficiencies. Imagine if the private sector had to ramp up investment spending within a quarter or so – what do you think would be the outcome of those projects.
More importantly, the neo-liberal era has been marked by a major reduction in Departmental capacity to design and implement fiscal policy – given the obsession with monetary policy and the major outsourcing of “fiscal-type” government services to the private sector.
Many of the major Federal government policy departments are now just contract managers for outsourced service delivery. So with the voluntary reduction in “fiscal space”within the federal government over the last 20 years or more it is no surprise that the overall capacity of the government machine to implement efficiently and speedily complicated nation-wide infrastructure programs has been diminished.
Governments should maintain a “project-ready” capacity within the relevant departments to ensure they can respond quickly and appropriately.
The point is that the mainstream economists have long criticised governments for what they claim is the “pro-cyclical” tendency of fiscal policy.
Pro-cyclical means going in the same direction as the business cycle. So in a recession, a pro-cyclical policy is one which contracts the economy further – that is reinforces the recession.
The empirical research is unclear. Most studies agree that advanced nations generally pursue a-cyclical or counter-cyclical fiscal policy while developing countries tend to pursue pro-cyclical policy positions.
But the methods are typically flawed and ambiguous. For example, the mainstream literature (reflecting its inherent biases) claims there is a causal relationship such that government spending. Clearly, the data is full of such correlations but it is unreasonable to assume that direction of causality.
Some studies have demonstrated fairly convincingly that in developed nations the reverse causality is more likely – that is fiscal policy stimulus pushed the growth process along (as it should). In other words, the correlation observed between say the budget deficit and private consumption is going from fiscal support to output and income growth.
Which raises the general point. Pro-cyclical fiscal policy is only inappropriate if it pushes the boom beyond the inflationary threshold or worsens unemployment in a downturn. A rising budget deficit at a time when say, private consumption is rising is not, in itself, a reflection of bad policy decisions.
But it is clear that a contractionary fiscal policy at a time when non-government demand is contracting or insufficient to support full employment (in sum with the actual fiscal position) is always a sign of irresponsible fiscal management.
Two developments over the last several days reinforced this point.
First, the UK Guardian article (November 25, 2011) – Eurozone looks to International Monetary Fund as contagion spreads – reported that the Euro bosses “were tonight looking again to the International Monetary Fund (IMF) to help countries in distress as bond yields in Italy and Spain hit new highs and the credit-ratings agency Standard & Poor’s (S&P) downgraded Belgium”.
As an aside, at least the S&P decision hurried the Belgians into (finally) putting a government in place – after how long (18 months or so!) Maybe the lack of government has been good because they have not had the mandate to follow the path of other European governments and hack into their economy in pursuit of fiscal rectitude.
A few weeks ago, the Eurozone bosses were crawling through China and Brazil, nations with per capita incomes vastly lower than the advanced European nations, with their begging bowl out – can your poor nations help us rich nations out with some pennies because we are too stupid to use the capacity we have to help ourselves!
The poorer nations showed good judgement to reject the mendicants.
Now, the Eurozone leaders think the IMF will bail them out.
The crisis has escalated very quickly recently with grave consequences for the unemployed and poor in Europe – a growing proportion of citizens. The classic European paralysis is not threatening the stability of their system – which though poorly conceived and implemented – still has the capacity to engender growth should they choose to use it.
The ECB could step in today and solve the so-called sovereign debt crisis. It could announce that it was going to support the purchase of member state debt so that they can increase their deficits and kick-start growth.
That does reward governments that have been recalcitrant – such as the German government which deliberately forced German workers to suppress their real wages growth and stifle domestic demand which meant that German growth relied on the spending of the southern states.
But the ECB intervention is the only viable “fiscal” action the Eurozone can now take. It would give them time to work out the mess. Structural adjustment – such as dismantling the Euro union and restoring currency sovereignty to the member states – is always easier in a growth environment than a recession.
I think in the medium-term they have to dismantle the currency union. But in the short-term they should pursue expanded deficits and attack unemployment. Only the ECB can support that strategy.
The financial aspects of the crisis would disappear the moment the ECB announced their intention to do that. Then the Eurozone could focus on the “real” crisis and start getting people back to work, earning incomes, paying taxes and over time reducing the budget deficits accordingly.
It is very clear that fiscal austerity demonstrates the worst fiscal practice one can imagine. Deliberately creating unemployment is the ultimate denial of government responsibility.
And, this ultimate denial is being forced on governments by the Euro cabal because they have an ideological obsession against the ECB using its obvious capacity to underpin growth.
The mainstream economists are acting in a totally hypocritical way in this regard. Even within their own paradigm – pro-cyclical fiscal policy such as is being engaged in in Europe at present is the exemplar of poor practice. But in this case it suits their ideological aims and so they have dressed it up as TINA.
There is clearly an alternative – increase deficits, increase domestic demand in each nation, increase national income, and then … see the deficits falling in relation to the scale of the economy.
The other aspect of this hypocrisy is that the Eurozone bosses are fiercely eschewing ECB intervention because they claim it would be inflation. This is despite the fact that they know full well that the intervention is going on already and stopping the system from total collapse. However, the intervention so far is not large enough and in return for enforced austerity.
So it is stopping insolvency but killing growth and making the solvency risk even larger.
But think about their alternative – Chinese “funding” or now IMF support. The reason is that the EFSF that they created will not be able to – in the words of the Guardian article:
… fill the funding gap if countries as significant as Italy and Spain completely lose the confidence of markets and hover near bankruptcy.
Repeat: fill the spending gap
There are also “doubts over whether private investors would bring enough new money for the EFSF”.
Think about those statements in relation to the alleged ECB inflation threat. Why would an injection of IMF funds “to fill the spending gap” be acceptable (and presumably, in the judgement of the Euro cabal – non-inflationary) but an injection of ECB funds to fill the same spending gap be dangerously inflationary?
There is no consistent answer to that question. The fact is that both would have the same impact on aggregate demand and have the same inflationary risks. Those risks are zero at present given the huge output gap that the Eurozone has created for itself as a result of misguided fiscal austerity.
It is laughable (and tragic).
The second development was the news over the weekend that the Euro crisis has wiped $A7 billion off the capital gains tax estimates that the Australian Federal government expected to receive. The lost revenue has arisen as a result of the Australian sharemarket being down about 15 per cent since the May 2011 Budget delivered its forward estimates.
The tax revenue received from superannuation funds and individuals have fallen substantially as a result.
Now, think about what that means. Private incomes are falling and that will translate into slower growth overall. We have been seeing that in the labour market data with virtually flat employment growth and rising unemployment over the last 6 months.
What should a responsible government do under those circumstances? Introduce a counter-cyclical fiscal change which in this context means increase the budget deficit. Otherwise, the government would be deliberately worsening the rise in unemployment.
Pro-cyclical fiscal policy in this environment is to repeat – the exemplar of fiscal mismanagement.
Yesterday (November 27, 2011), the Sydney Morning Herald article – Swan foreshadows tough budget decisions – quoted the Australian Treasurer Wayne Swan as saying:
Government revenues are down by $130 billion over the five years to 2012-13 from the pre-GFC forecast … All up, we expect that lower asset prices will reduce forecast capital gains tax by $7 billion over the forward estimates compared to what was expected in May … The substantial hit to revenues cause by global economic turbulence means we’ll have to make some difficult decisions to find savings in the upcoming MYEFO … Europe’s turmoil showed it was absolutely critical to maintain fiscal rigour as international financial markets punished countries lacking discipline.
The MYEFO – Mid-Year Economics and Fiscal Outlook which is due to be delivered later this week.
The Treasurer was also quoted as saying:
Every self-funded retiree and investor can see the effect on our sharemarket … The heightened global volatility is making households more cautious in their spending and businesses more hesitant in their hiring decisions.
The Finance Minister Penny Wong js a lawyer by education and reports no qualifications in economics. It shows in the robotic (neo-liberal) statements she makes. She reinforced the Treasurer’s line yesterday ( as reported by ABC News):
I think it’s reasonably self-evident, if you’ve got for example the share market I think is some 15 per cent down since the may budget, as a matter of logic that will flow through for example to capital gains tax … So you should anticipate some difficult decisions in the mid-year budget update in the coming week.
The Sydney Morning Herald article (November 27, 2010) – European woes rip $7b from coffers, forcing Swan to wield the axe – also quoted the Finance Minister as saying:
Our economy is being affected, our budget is being affected. There are no easy saves left to take … The European circumstances have worsened … Our economy is being affected, our budget is being affected. There are no easy saves left to take.
And this is a political party that emerged as the political arm of the trade union movement and used to support socialism as a keystone platform position.
The SMH also said that “Senator Wong said working Australians would be spared the full force of the spending cuts”. This is in relation to the Government proposing to reduce tax breaks on certain corporate activities and high income earners.
The Labor Party is trying to claim they are insulating the workers from the cuts but fail to realises that it is the workers who disproportionately bear the brunt of a slowing economy via lost incomes and rising unemployment.
The budget cuts will impact on aggregate demand – irrespective of their initial equity aims (“tax the rich”) and that will feed through to slower growth and lost jobs. I have no problem with equity-motivated changes to fiscal policy to make the higher income earners pay higher taxes if it is deemed “fair” that that cohort should have less purchasing power.
But the problem is that the deficit is too small overall irrespective of the equity dimensions. So it might be sensible to “tax the rich” but at the same time the government has to increase net spending to ensure the deficit rises.
It is true that high income earners spend a smaller proportion of every dollar they earn relative to low income earners. But they still spend – in absolute terms – a much greater amount and so policies targeted at reducing that spending capacity will be deleterious to overall growth and will hurt the poor disproportionately.
The conservative opposition is no better. Their finance spokesman Andrew Robb was reported as saying “Australia’s structural deficit on a percentage of gross domestic product was worse than Italy’s” and that “Labor has no plan to pay off our massive debt and fix our huge structural deficit”.
So both sides of politics are advocating what economists – mainstream or otherwise – should rightly reject – pro-cyclica fiscal policy.
Why is the Government doing this? The answer is that they have locked themselves into a political bind. This is a case where the Austerity Bias that governments are now locked into politically is acting to undermine sound fiscal practice.
Please read my recent blog – Economy faltering – Australia’s wind-up Treasurer “We will cut harder” – for more discussion on this point.
In the May 2011 Budget the Treasurer said:
… our commitment to tightening our belt has not diminished one bit. We’ll be back in the black by 2012-13, on time, as promised. The alternative — meandering back to surplus — would compound the pressures in our economy and push up the cost of living for pensioners and working people
The budget estimates were based on assumptions that at the time were too optimistic and in the passing of time have been revealed to be so. The constant narrative that our “once-in-a-hundred-years” mining boom was going to bring bounty to all of us has fallen well short of realisation. Employment growth has been virtually zero for some months and other indicators of growth are faltering.
The reality is that the external sector remains a contractionary force because more of the income we earn from our booming exports are going into imports. So the rest of the world is actually enjoying our mining boom in terms of growth impetus. We end up with lots of imported gadgets etc but a drain on growth. I realise this is hard to for people to understand.
Further, the Australian household sector is carrying record levels of debt as a result of the credit binge prior to the crisis. It is now trying to increase its saving ratio back to the norms that pervaded before the financial sector unleashed the array of tantalising credit products.
Add into the equation the fact that the Australian property market is overvalued by a considerable margin as a result of the boom and prices are now dropping. There will be an increasing number of Australians with negative equity over the next several years.
The Government’s obsession with achieving a budget surplus next financial year under these circumstances amounts to vandalism. The Government’s growth strategy hinges on the private sector going further into debt as the public sector withdraws spending support. Even at the time of the budget in May it was clear that private spending was weak and the intention was to save.
A report in the Sydney Morning Herald today (November 28, 2011) – Americans bemoan our closed purses – relates that:
AUSTRALIA’S downbeat consumer is starting to infiltrate the boardroom discussions of some of the largest companies in the United States, with global food leader Campbell Soup the latest to bemoan the reluctance of Aussie shoppers to spend money, saying they were increasingly reflecting a “recessionary mindset”.
Another US company CEO said “There is no doubt that in terms of retail environment, the Australian market is the worst market”.
The reality is that the Government despite their “tough talk” were never going to succeed in achieving their May 2011 fiscal ambitions for next year. The reason – growth will not be strong enough. Why? Because the external sector is not adding to growth despite the boom and the private sector is now resuming more normal patterns of spending and saving. I say more normal to mean the behaviour that was evident for decades before the neo-liberal free market credit binge occurred.
In these “normal times” the Australian government ran budget deficits to support growth. The recent period of budget surpluses (1996-2007) was abnormal. On the rare occasions that the Australian government has run surpluses, a major slump has followed. That pattern is common in most nations – especially if they run external deficits.
The European shenanigans are only making the prospects worse.
The other point is that the Government’s growth strategy replicated the circumstances that led the world into this crisis – a reliance on the private sector borrowing increasing amounts (spending more than it earns) – to drive spending and hence output growth.
At a time when the private domestic sector should now be deleveraging significantly (and for several years into the future) the Government is deliberately putting into place a strategy that relies on exactly the opposite occurring.
The role of the fiscal policy is not deliberately create unemployment when it is clear that the economy is nowhere near full employment (in Australia, 12.5 per cent labour underutilisation continues)! The role of fiscal policy is to add to aggregate demand and ensure that economic activity is generating enough employment (hours and jobs) to match the desires of the workers once private spending and saving decisions are made.
There was one good response to the Treasurer’s obsessive claims to cut spending further. The Melbourne Age economics correspondent – the ever affable Peter Martin wrote the lead Opinion article this morning (November 28, 2011 – Treasurer must tread fine line on budget cuts.
I say good despite the misleading references where the author “scaled down” the Federal Budget to a “household budget”. It never helps the public to be reminded of these erroneous comparisons between a public and private budget. The government budget is not a “bigger” household budget. Households use the currency, the government issues it.
Peter, please do not reinforce these myths!
He goes on to say:
IT’S dangerous to cut the budget now and Wayne Swan knows it … But he’ll do it anyway this week because he feels he has to in order to continue to credibly forecast a budget surplus in 2012-13.
And that this it will “hurt an economy for a government to rein in its spending when things are uncertain”. I would have said – it will hurt the economy when it is clear that the non-government spending gap is positive and growing”.
It is not just about uncertainty – which is endemic at all times but even more skittish at present. It is a factual matter – the economy is growing but not fast enough. Employment growth is flat and labour underutilisation persists at over 12.5 per cent according to the official data. The deficit is too small in relation to private spending decisions and available productive capacity.
Peter Martin reminds us that:
The Reserve Bank warned this month a deep recession in Europe would represent “a downside risk for the Australian economy”. Households are already shutting their wallets and businesses are holding off hiring in anticipation of such a risk. Cutting household and corporate welfare will unsettle them further.
He concludes that “Swan is doing it because the jibes about never delivering a surplus in four budgets have got to him”. That is, politics is now driving economic policy to the detriment of the economy.
It is ironic that the claims made by the mainstream economics literature about “deficit bias” and the political constraints that were meant to lock governments into so-called “excessive deficits” are really better targeted against the “surplus bias”. Not that my professional colleagues would ever admit that.
The political pressures for austerity are now driving in appropriate fiscal policy – which is deliberately causing higher unemployment and poverty. This is the triumph of the ideological obsession against government activity. There is no empirical basis for it and the theories that are used to give the political aspirations authority are deeply flawed.
But the Government fears it will be accused of being poor fiscal managers by the conservatives so they bow to the ideology and cut at a time when expansion is needed.
Peter Martin concludes:
But it was right not to deliver a surplus during one of the greatest global recessions on record. It is almost certainly right not to deliver one now. We better hope he cuts carefully.
The first two sentences are correct. The third is not. I would write – We better make as much noise as possible deploring cutting at a time the economy is slowing.
As an aside, if you think about the Treasurer’s logic, it means that their original surplus target for next year must have been too low. That is, using their own reasoning, they were targeting a small surplus in 2012-13 based on estimates of a strong growth coming from the mining sector.
If a surplus is still appropriate now but they are acknowledging the economy is now slower than they expected then it must have been that the surplus that they deemed appropriate given their previous growth estimates should have been higher.
Their reasoning is of-course flawed from the inception but that gets lost in their robotic response to everything – we will deliver a surplus no matter what!
The automatic stabilisers (for example, the $A7 billion losses in tax revenue) are the canaries. You don’t send more workers into the mine when the canaries die.
I have to catch a flight now (sorry for flying!) and so …
That is enough for today!