A continuum of infinitely lived agents normalized to one – GIGO Part 3

The IMF released a working paper recently (January 2012) – Macroeconomic and Welfare Costs of U.S. Fiscal Imbalances – which purports to estimate the losses that the US economy will incur if the US government delays a major fiscal consolidation. The paper attracted a Bloomberg news headline (February 3, 2012) – How Reducing the Deficit Can Make Us Richer: The Ticker – which, in its own way provides an example of a dishonest piece of reporting. What has the IMF paper have to say about real world issues like real GDP growth, unemployment, underemployment etc? Answer: virtually nothing. It is an example of GIGO (Garbage In, Garbage Out) and confirms that my profession has learned very little (if anything) from its total failure to see the crisis coming or offer valid solutions. It also confirms that while the IMF leadership might be going around lately trying to sound reasonable (warning against austerity) the engine room of the IMF hasn’t changed direction at all. It is still pumping out indefensible rubbish, which then garner headlines and influence the policy debate to the detriment of the unemployed everywhere. The IMF consider humans to be a “continuum of infinitely lived agents normalized to one”. Which means this paper becomes Part 3 of my GIGO series.

The Bloomberg article asked:

How bad can it get if the U.S. government fails to get its debts under control? If you believe a new paper published by the International Monetary Fund, Americans could be worse off to the tune of about $2.6 trillion.

There was a giant graphic displaying the following “2.6 Loss, in trillions of dollars, associated with a failure to fix the U.S. government’s long-term finances”.

The use of this graphic was dishonest and failed to provide balance in the reporting.

The caption might have read – “Incredible IMF estimate – only in another universe not known to humans”. Which would have been more accurate given the IMF paper’s content.

I will consider the paper’s content soon but the Bloomberg article repeats the main conclusion:

In the world with no fiscal reforms, interest rates end up being 4.6 percentage points higher, and the U.S. suffers a permanent economic loss equal to 17.1 percent of annual output. In today’s terms, that amounts to about $2.6 trillion. And that’s assuming there won’t be a nightmare scenario in which concerns about government debt levels trigger an investor strike and financial meltdown.

So full of neo-liberal nonsense – its all in there – crowding out, bond market boycotts of US government debt and insolvency.

When has the bond market refused to purchase US government debt? Answer: never.

Then as if to present to balance, the Bloomberg article say that:

These results should be taken with a healthy dose of skepticism, as they depend on a kind of economic modeling that, while commonly used, is increasingly under debate. For one, the model assumes that people are extremely rational and will always act in a way that maximizes their utility.

Which I will come back to.

But then discounting those warnings the Bloomberg article concludes that:

Still, the overall message is clear: When it comes to getting the government’s long-term finances in order, sooner is a lot less expensive than later.

Which is not a conclusion that you can gain from the IMF paper. It is what the IMF paper wants us to believe. But that is another matter. The exercise they use to convince of that “overall message” is totally disconnected from anything that might justify such a conclusion.

The IMF black box model generates that conclusion because it was built by IMF researchers who believe that outcome is valid. The validity of that conclusion with respect to the real world is highly doubtful if not far-fetched.

In this blog – Mainstream macroeconomic fads – just a waste of time – I considered so-called New Keynesian models of the macroeconomy which dominate the mainstream of my profession.

The New Keynesian approach has provided the basis for a new consensus emerging among orthodox macroeconomists. It attempts to merge the so-called Keynesian elements of money, imperfect competition and rigid prices with the real business cycle theory elements of rational expectations, market clearing and optimisation across time, all within a stochastic dynamic model.

New Keynesian theory is actually very easy despite the deliberate complexity of the mathematical techniques that are typically employed by practitioners.

It is worth recalling the lovely observation by American (Marxist) economist Paul Sweezy who wrote in 1972 in the Monthly Review Press an article entitled Towards a Critique of Economics.

Paul Sweezy argued that orthodoxy (mainstream) economics:

… remained within the same fundamental limits … of the C19th century free market economist … they had … therefore tended … to yield diminishing returns. It has concerned itself with smaller and decreasingly significant questions … To compensate for this trivialisation of content, it has paid increasing attention to elaborating and refining its techniques. The consequence is that today we often find a truly stupefying gap between the questions posed and the techniques employed to answer them.

In these blogs – GIGO and OECD – GIGO Part 2

In the GIGO blog, I defined GIGO (Garbage In Garbage Out) as that process or mechanism that we are beguiled by what amounts to nothing.

The ;atest IMF paper is in this class of models – GIGO (exemplified).

The paper simulates “four alternative fiscal scenarios” for the US:

The benchmark scenario maintains current fiscal policies for about twenty years. More precisely, in this scenario we feed the model with the spending (noninterest mandatory and discretionary) and revenue projections from CBO’s Alternative Fiscal scenario (CBO 2011)—allowing all other variables to adjust endogenously—until about 2030, when we assume that the government increases all taxes to stabilize the debt at its prevailing level. Three alternative scenarios assume, instead, the immediate adoption of fiscal reform aimed at gradually reducing the federal debt to its pre-crisis level.

The paper uses a Dynamic Stochastic General Equilibrium model (DSGE) to generate its conclusions. DSGE – or Dynamic stochastic general equilibrium models are one of the latest fads of the mainstream – who are intent on remaining irrelevant.

Even mainstreamers like Willem Buiter described DSGE modelling as The unfortunate uselessness of most ‘state of the art’ academic monetary economics.

This conclusion was made with some style in evidence that famous (pre-DSGE) economist Robert Solow gave to the US Congress Committee on Science, Space and Technology – in its sub-committee hearings on Investigations and Oversight Hearing – Science of Economics on Jul 20, 2010. The evidence is available HERE.

Here is an excerpt relevant to the topic:

Under pressure from skeptics and from the need to deal with actual data, DSGE modellers have worked hard to allow for various market frictions and imperfections like rigid prices and wages, asymmetries of information, time lags, and so on. This is all to the good. But the basic story always treats the whole economy as if it were like a person, trying consciously and rationally to do the best it can on behalf of the representative agent, given its circumstances. This can not be an adequate description of a national economy, which is pretty conspicuously not pursuing a consistent goal. A thoughtful person, faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on.

An obvious example is that the DSGE story has no real room for unemployment of the kind we see most of the time, and especially now: unemployment that is pure waste. There are competent workers, willing to work at the prevailing wage or even a bit less, but the potential job is stymied by a market failure. The economy is unable to organize a win-win situation that is apparently there for the taking. This sort of outcome is incompatible with the notion that the economy is in rational pursuit of an intelligible goal. The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.

Solow also said that the DSGE fraternity “has nothing useful to say about anti-recession policy because it has built into its essentially implausible assumptions the “conclusion” that there is nothing for macroeconomic policy to do”.

None of the DSGE models (or papers) anticipated the financial crisis despite the portents of it being obvious for at least a decade or more.

In my 2008 book (with Joan Muysken) – Full Employment abandoned – we considered the standard DSGE approach in detail. I summarised a bit of that discussion in this blog – Mainstream macroeconomic fads – just a waste of time.

The alleged advantage of the New Keynesian approach (which incorporates DSGE modelling) is the integration of real business cycle theory elements (intertemporal optimisation, rational expectations, and market clearing) into a stochastic dynamic macroeconomic model. The problem is that the abstract theory does not relate to the empirical world. To then get some traction (as Solow noted) with data, the “theoretical rigour” is supplanted by a series of ad hoc additions which effectively undermine the claim to theoretical rigour.

You cannot have it both ways – first, try to garner credibility by appealing to the theoretical rigour of the model – but then, second, largely compromise that rigour to introduce structures (and variables) that can relate to the real world data.

This is the fundamental weakness of the New Keynesian approach. The mathematical solution of the dynamic stochastic models as required by the rational expectations approach forces a highly simplified specification in terms of the underlying behavioural assumptions deployed. As Solow says this simplicity cannot remotely relate to the real world.

Further, the empirical credibility of the abstract DSGE models is highly questionable. There is a substantial literature pointing out that the models do not stack up against the data.

Clearly, the claimed theoretical robustness of the DSGE models has to give way to empirical fixes, which leave the econometric equations indistinguishable from other competing theoretical approaches where inertia is considered important. And then the initial authority of the rigour is gone anyway.

This general ad hoc approach to empirical anomaly cripples the DSGE models and strains their credibility. When confronted with increasing empirical failures, proponents of DSGE models have implemented these ad hoc amendments to the specifications to make them more realistic. I could provide countless examples which include studies of habit formation in consumption behaviour; contrived variations to investment behaviour such as time-to-build , capital adjustment costs or credit rationing.

But the worst examples are those that attempt to explain unemployment. Various authors introduce labour market dynamics and pay specific attention to the wage setting process. One should not be seduced by DSGE models that include real world concessions such as labour market frictions and wage rigidities in their analysis. Their focus is predominantly on the determinants of inflation with unemployment hardly being discussed.

Of-course, the point that the DSGE authors appear unable to grasp is that these ad hoc additions, which aim to fill the gaping empirical cracks in their models, also compromise the underlying rigour provided by the assumptions of intertemporal optimisation and rational expectations.

In this blog – The IMF – incompetent, biased and culpable – I examined the IMFs Independent Evaluation Office (IEO) – 2011 report – IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07 – which presents a scathing attack on the Washington-based institution.

The External Evaluation Report commented on the ideological biases at the IMF – which they call “Groupthink” (“the tendency among homogeneous, cohesive groups to consider issues only within a certain paradigm and not challenge its basic premises”). They said:

The prevailing view among IMF staff—a cohesive group of macroeconomists—was that market discipline and self-regulation would be sufficient to stave off serious problems in financial institutions. They also believed that crises were unlikely to happen in advanced economies, where “sophisticated” financial markets could thrive safely with minimal regulation of a large and growing portion of the financial system.

This Groupthink is defined, in part, by the flawed models that the mainstream macroeconomists use to conduct their analysis. The External Evaluation Report says that “IMF economists tended to hold in highest regard” models proven to be inadequate (dynamic stochastic general equilibrium models).

DSGE models are useless for analysing anything of importance in a modern monetary economy. Their construction has absorbed countless person-hours – a major productivity loss for the respective institutions and nations as a whole. My profession is obsessed with these useless artefacts.

So what about the current IMF Working Paper?

Here are some highlights.

First, in any one year, a person (“agent”) can choose to be a labourer or an entrepreneur:

In the model, ex-ante identical agents face idiosyncratic entrepreneurial ability and labor productivity shocks, and choose their occupation. Agents can become either entrepreneurs and hire other workers, or they can become workers and decide what fraction of their time to work for other entrepreneurs.

All agents are “identical” and choose between being a capitalist or working for one. They can swap this role on a yearly basis.

Second, “the government raises”:

… distortionary taxes on labor, consumption, and income, and issues one period non-contingent bonds to finance lump sum transfers to all agents, other noninterest spending, and service its debt.

So it is assumed from the outset that taxes reduce labour supply at the macroeconomic level (“distortionary”). But the empirical evidence fails to categorically support that finding.

Further, governments are revenue-constrained and subject to a budget constraint.

Third, given “the core issue threatening debt sustainability in the U.S. is the explosive path of spending on entitlement programs, the heterogeneous agents assumption is crucial” – and that assumption is:

Agents in our model face individual uncertainty but have perfect foresight about future paths of fiscal instruments and prices. Allowing for uncertainty about the timing and composition of the adjustment would be interesting, but would severely increase the computational cost.

1. the “explosive path of spending on entitlement programs” is assumed rather than demonstrated from the basic operations of the fiat monetary system. In fact, there is no financial explosion ahead but perhaps there will be some political difficulties as different generations discuss via the political system how to share the real resources available.

The IMF is not sophisticated enough to understand that the entitlements issue is a political debate about real resource proration across time and generations. It has nothing to do with the capacity of the US government to purchase anything that is for sale in US dollars at any time in any place. It always has that capacity.

It will be able to fund a first-class entitlements program in the future as long as there are real resources available. The latter condition is where the debate should be. If it was, then the US government would be urgently ensuring all workers are in employment and developing productive skills etc as the dependency ratio rises.

2. All “agents” have perfect knowledge of what the future holds with regard fiscal policy and inflation. They are not sure from period to period if they will be entrepreneurs or workers but they know exactly what the government is going to do and the future course of inflation.

This is clearly false but is imposed because then the Ricardian results can emerge. The discredited Ricardian Equivalence argument is used by mainstream macroeconomists to justify cutting fiscal deficits. It suggests that households and firms are deliberately refraining from spending as much as they might at present because they expect that the deficits will have to be paid back via higher future tax rates and so are saving to make sure they can pay those future taxes.

This is why they have to have “perfect foresight” of the “future paths of fiscal instruments and prices”.

Needless to say the overwhelming evidence negates the validity of the concept. Private spending at present is subdued because people are scared of unemployment, they are trying to pay down debt after the credit-binge, and firms are experiencing poor sales and so have no incentive to create new productive capacity because they can meet their expected sales with existing capacity.

When this concept emerged in the modern literature in the 1970s (courtesy Harvard economist Robert Barro) there was there was a torrent of empirical work, particularly after the US Congress gave out large tax cuts in August 1981, which was the first real world experiment possible.

I explained in these blogs – Deficits should be cut in a recession. Not! and Pushing the fantasy barrow – the highly restrictive assumptions that have to hold (in theory) for the notion to even have internal theoretical consistency.

The 1981 US tax cuts were legislated to be given over 1982-84 to stimulate aggregate demand. Barro’s adherents all predicted there would be no change in consumption and saving should have risen to “pay for the future tax burden” which was implied by the rise in public debt at the time.

The evidence is clear – the personal saving rate fell between 1982-84 (from 7.5 per cent in 1981 to an average of 5.7 per cent in 1982-84).

3. This ad hoc assumption that is imposed on the model is because it would not solve to give the results intended otherwise (this is couched as “severely increase the computational cost”).

Section 2 of the paper describes “The Model” and there we learn that:

The economy is closed and inhabited by a continuum of infinitely lived agents normalized to one. Time is discrete and each period represents a year. Individuals are endowed with one unit of time, and each period decide whether to become workers or entrepreneurs … Upon deciding to become workers, agents optimally choose how many hours to offer … Agents are ex-ante identical. Each period they face idiosyncratic shocks to labor productivity .. and to entrepreneurial ability … which affect their returns to working and operating a firm.

So each “year” everyone receives a “shock” which determines their capacity in that year to maximise income as a worker or an entrepreneur. They then choose the relevant optimal activity for that year.

This “occupational choice allows for endogenous entry and exit of entrepreneurs from the productive sector and of workers from the labor force”. So no frictions between moving freely between running a company and hiring workers one year and being a worker next year.

The banks that lend to the firms are “perfectly competitive” and are thus bound by a “zero profit condition”. All bank lending (whether to entrepreneurs or government) is “risk free”.

All macroeconomic variables (“aggregates”) are “found by integrating over all agents” which amounts to a denial of the devastating results proven during the Cambridge Capital Debates by non-neoclassical economists.

The upshot of the Cambridge controversies what that such aggregation was flawed and rendered the production and distributional aspects of neo-classical theory invalid. But the IMF economists just ignore that knowledge.

Section G. Market Clearance describes all the “equilibrium states” that are imposed on the solution. Among the conditions imposed is “The equilibrium in the labor market requires that: Ld = Ls = L”.

In other words, everyone who wants a job (Ls or labour supply) can find an entrepreneur to employ them (Ld or labour demand). There is no demand-deficient unemployment. It is simply assumed away.

At this stage you might be wondering is this what professional economists really do and the answer is yes – its sad isn’t it.

There was a two-part series by Sydney Morning Herald economics correspondent Ross Gittins in the last week. On February 4, 2012 – The very model of a future based on guesswork – he examined so-called computable general equilibrium models (CGEM) that are popular among the mainstream of my profession.

Ross Gittins noted that:

Thus an economic model is, unavoidably, a simplified version of the economy, or an aspect of the economy. It includes those aspects of reality the model builder regards as most important in explaining what happens and leaves out all those aspects that don’t seem to make a big difference.

So the results you get from a model are only as good as the modeller’s choice of what to include and what to leave out. In practice, the model’s predictions will often prove astray because some factor the modeller assumed wouldn’t be important turned out to be.

If you reflect on the model description above you will realise that these models are highly unrealistic in structure. I will talk more about that in a moment.

This quote by Post Keynesian economist Paul Davidson [in the book by Bell and Kristol The Crisis in Economic Theory, Basic Books, 1981, p.157] describes how mainstream economics uses methods and approaches that renders it unable to embrace real world problems. It is very applicable to DSGE models such as those employed by the IMF:

There are certain purely imaginary intellectual problems for which general equilibrium models are well designed to provide precise answers (if anything really could). But this is much the same as saying that if one insists on analyzing a problem which has no real world equivalent or solution, it may be appropriate to use a model which has no real-world application. By the same token, if a model is designed specifically to deal with real-world situations it may not be able to handle purely imaginary problems.

Post Keynesian models are designed specifically to deal with real-world problems. Hence they may not be very useful in resolving imaginary problems that are often raised by general equilibrium theorists. Post Keynesians cannot specify in advance the optimal allocation of resources over time into the uncertain, unpredictable future; nor are they able to determine how many angels can dance on the head of a pin. On the other hand, models designed to provide answers to questions of the angel-pinhead variety, or imaginary problems involving specifying in advance the optional-allocation path over time, will be unsuitable for resolving practical, real-world economic problems.

Note that I am not against simplified (abstract) modelling. Clearly, it is essential if you want to gain some traction on a real-world problem that is complex.

But the structure of the simplified model has to have some logical coherence in terms of the main characteristics of the monetary system. DSGE models are in the “counting angels” class of experiments and have no causal features (or parameters) that are likely to be found in the real world.

For example, the way the IMF paper is able to conclude that no fiscal consolidation in the US is highly damaging for real output and income in the future is pre-determined by the theoretical assumptions they employ. The calibration they impose just gives them a number.

First, they impose the assumption that the federal government raises taxes to pay back its outstanding debt which damages the incentives to “incentives to work, save and produce” the interest rate has to be higher to “increase private savings”.

This is a loanable funds model where interest rates mediate real saving and investment to “clear the market” – that is, Say’s Law. This theory was designed by classical economists to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

The financial system is represented by the loanable funds market where savers provide funds and borrowers use these funds to invest. The interest rate is the return to saving and the cost of borrowing.

This doctrine was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving. So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

Government deficits are then assumed to put a strain on available funds and drive the interest rate up.

The fall in investment because of the government borrowing is called crowding out.

Obviously, a currency-issuing government is not revenue-constrained so their borrowing is for other reasons – we have discussed this at length. This trilogy of blogs will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 | Deficit spending 101 – Part 2 | Deficit spending 101 – Part 3.

But governments do borrow – for various (mostly ideological reasons) and so isn’t it reasonable to assume that this borrowing reduces the “loanable funds” available for investors and pushes up the interest rates?

The answer to both questions is no! Modern Monetary Theory (MMT) does not claim that central bank interest rate hikes are not possible. There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.

MMT proposes that the demand impact of interest rate rises are unclear and may not even be negative depending on rather complex distributional factors. Remember that rising interest rates represent both a cost and a benefit depending on which side of the equation you are on. Interest rate changes also influence aggregate demand – if at all – in an indirect fashion whereas government spending injects spending immediately into the economy.

Savings are not finite in the real world. Saving is predominantly a positive function of income. A budget deficit that expands national income generates more saving. Further, bank loans create deposits. So there is a disconnect between available saving and investment. This is captured by the observation that “investment brings forth its own saving” (which reflects the fact that spending generates income which increases consumption and saving).

Please read my blog – Saturday quiz – January 28, 2012 – answers and discussion – Question 3 – for more discussion on this point.

The IMF paper quotes for authority a number of papers that allegedly find that higher budget deficits drive interest rates up. But these papers have no empirical grounding – they are of a similar nature – the causality is assumed not proven.

Conclusion

I could have gone straight to the conclusion without having read the paper to determine its plausibility – that is, how far off the mark it is with respect to the real world.

The authors actually think their conclusion that of the losses of fiscal deficits “can be interpreted as a lower bound” – that is, conservative.

They offer two reasons for this conclusion one of which is that “we abstract from default” which “as the debt crisis in Europe has revealed, interest rates can soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy”.

So they fail to understand that the EMU is an entirely different monetary system at the individual member state level to that run by the US government. There is no default risk in the US. History tells us that “abstracting from default” is a very reliable assumption.

They further claim that “the results in this paper are not exempt from the perils inherent to any model-dependent analysis”.

Clearly that is true.

But what might the problematic assumptions be from their perspective? Answer:

For example, given the current reliance of the U.S. on foreign financing, the closed economy assumption used in this paper may be questionable.

There is no US government reliance on “foreign financing”.

However, it is clear that the private domestic sector has been using “foreign savings” to enhance their consumption (and productive investment).

But the major reason why the “closed economy assumption” may be “questionable” relates to the way in which supply chains have moved off-shore and the impact of the external balance on aggregate demand and growth.

The external balance is in deficit (draining demand) which has to be compensated for by government deficits and/or private domestic sector deficits to ensure that growth is maintained. By ignoring these issues, the IMF paper presents a nonsensical transmission model of government spending and its impact on the domestic economy.

Conclusion: GIGO (of the worst kind).

Do not take advice from someone just because they say they know what they are talking about

The financial planning industry which has grown like topsy over the last few decades has been under fire during the current crisis as a result of some of the schemes it foisted onto unsuspecting individuals and families in the period leading up to the crisis.

There is a desperate need for more regulation to stop shonks from opening up shop-fronts and taking huge commissions from major banks for pushing their risky products onto clients. Moreover, it is clear that the standard of education about matters macroeconomic in that segment of the financial markets is appallingly low.

The regular Australian Financial Review supplement in the Fairfax newspapers (the major competitor to News Limited) over the weekend carried this article from its “editor” (February 5, 2012) – Forget GFC, avoid a PFC.

The writer describes herself as a “highly respected financial editor, commentator and author, as well as a qualified financial adviser and stockbroker”. My assessment – the writer should be asked to undertake some basic macroeconomic training before offering any more “advice” to the readership of this paper.

The article claimed to be offering a “few precautions” (three lessons) to “ensure your finances don’t suffer the same catastrophe as Europe’s”.

She claimed that “it’s within your power to prevent a personal financial crisis” and that “Lesson 1: Live within your means” is essential.

Apparently:

On a national level that means either keeping a handle on a budget deficit or, even better, retaining a surplus.

First, there is no applicable analogy that can be drawn between household finances and government budgets. Most governments issue the currency that we use and accordingly are never revenue constrained in their spending decisions no matter how hard they try to convince us otherwise.

A household uses the currency and as such has to finance all of its spending (either from income, drawing down savings, and/or selling assets).

To increase future consumption at each income level, the user of the currency has to forego current consumption and increase saving. An issuer of the currency never has to “save” – in fact, it makes no sense to talk about a currency-issuing government as “saving” when it runs a budget surplus.

A currency-issuing government can always buy whatever is for sale in that currency, irrespective of whether they have been running budget deficits or surpluses in the past.

Of-course, not the same thing as saying that a currency-issuing government has no constraints. All the constraints are real rather than financial. The government is ill-advised to push nominal spending faster than the growth in productive (real) capacity. Otherwise, inflation is the risk.

Second, why it is “even better” to run budget surpluses for a national government?

For Australia, where the private domestic sector has record levels of debt (relative to disposable income) and heightened sensitivity to interest rate rises and the external sector is continuously in deficit (thus draining aggregate demand – spending), what sense does it make to run a budget surplus?

Answer: zero.

With the external sector draining demand the aggregate demand growth can only come from the private domestic sector spending more than they earn and/or the government sector running a deficit.

The private sector debt levels have to come down overall which means it must start to spending less than earnings overall. That means the government deficit has to fill the spending gap left by the other macroeconomic sectors.

Our Financial Review editor then told her readers:

For a bit of perspective, the Euro area ran a 4.3 per cent deficit in 2011 but it was minus 5.7 per cent in France and minus 8 per cent in Spain. Across the pond in the US, though, the figure was an even less responsible minus 9.5 per cent.

Not the value judgement – a higher deficit is “less responsible”. The reality is that the size of the deficit tells us nothing per se about the appropriateness of the fiscal stance being adopted by the government.

The budget deficit outcome is not a “clean” figure – because it contains the results of discretionary fiscal decisions (spending and tax rates) and the cyclical effects of the automatic stabilisers (spending and tax revenue vary with private economic activity and hence, private spending).

So a deficit could rise even though the government is cutting discretionary net spending because the net spending cuts undermine economic growth which creates losses in tax revenue and increases in welfare payments. That is exactly what is happening throughout the advanced world at present as fiscal austerity programs cut into growth.

The US government should have expanded its deficit by greater than 9.5 per cent of GDP given the persistently high unemployment rates it has endured over the last several years.

While the economy is starting to grow now, under the support of the deficit spending, it would have grown more quickly and the unemployment rate would have been much lower earlier had it ran greater deficits.

It was very irresponsible not to run higher deficits given that the costs of unemployment dwarf all other known costs that can arise (microeconomic inefficiencies).

Our Financial Review editor then offered her lesson to the readership:

The lesson you can apply from all this is to spend less than you earn. That simple. Money in must exceed – or at least equal – money out. If it doesn’t, and you have previously borrowed, you may lose the ability to meet your debt repayments.

Which is what has happened in Europe.

None of which applies to a sovereign government that issues its own currency. It certainly applies to a household that uses the currency.

It also applies to governments in the EMU as a result of their surrendering currency sovereignty to the ECB.

But that lesson could have been drawn for the private households that read this column without all the lies about the state of government deficits.

Lessons 2 and 3 got worse.

That is enough for today!

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15 Responses to A continuum of infinitely lived agents normalized to one – GIGO Part 3

  1. jms.grmwd says:

    Thanks Bill, you really hit it out of the park today. If it didn’t have the potential to cause so much damage, I’d say that IMF paper was pure comedy gold. At least, I don’t often read excerpts from academic papers and burst out laughing. But mustn’t tarry, I’ve decided to be an entrepreneur again this year.

  2. GLH says:

    I have to say that thanks to you and this website I believe I have a much better understanding of what is going on with the world economies. Without your efforts I would still be listening to some of the economist on the business news and that would be sad. I can actually picture what is happening in terms of sectors and also currency users and issures. Now, I just tune out the people who are ignorant of MMT. Thanks again.

  3. Erik says:

    I think this post is especially interesting if you read it through the lens of Lakatos, on research programmes. Think of the neoclassical, the ‘New Keynesian’ and the Post Keynesian approaches as competing programmes and read the section in the link, then tell me which of these approaches should be described as ‘progressive’ or ‘degenerating’!

  4. Neil Wilson says:

    I’d love to comment but I have to carry on being one of those ‘infinitely lived agent normalized to one’

    And since I have to be rational the next decision I make will take longer than the entire age of the universe to calculate.

    So I may be some time.

  5. dnm says:

    I think I like the IMF’s vision of a world where the “U.S. government fails to get its debts under control”. Sure, we lose $2.6 trillion dollars in output, but we get full employment, so it’s swings and roundabouts. BTW, is that $2.6 trillion per annum, or in total? After all, forever is a very long time to prorate even a trillion dollars.

  6. Sergei says:

    “continuum of infinitely lived agents normalized to one” deserves a PhD. And I am almost sure it got one. Maybe even two.

  7. Benedict@Large says:

    It’s great to have stuff like this to read during my leisure preference. It sure would be nice however if you could tell my bank to make my mortgage payments a little less sticky.

  8. MamMoTh says:

    Is the loanable funds model totally inapplicable? I think only about 25% of credit in the US is bank credit, so the rest must come from the loanable funds market where loans don’t create deposits.

  9. Talvez... says:

    All “agents” have perfect knowledge of what the future holds with regard fiscal policy and inflation. They are not sure from period to period if they will be entrepreneurs or workers but they know exactly what the government is going to do and the future course of inflation.
    I laughed so hard I forgot whether I’m an entrepreneur or a worker in the current period.

  10. Will Richardson says:

    The market is omniscient and eternal but indecisive?

    Interesting piece on local currency being adopted in Bristol with a Credit Union behind it and the currency being allowed to pay local rates (and council tax?)

    http://www.bbc.co.uk/news/uk-england-bristol-16852326

  11. gastro george says:

    Absolutely Talvez. Can they not see the irony that they assume perfect knowledge of the future by the public, but can’t predict the next quarter’s growth figures themselves?

  12. bill says:

    Dear Sergei (at 2012/02/07 at 1:29)

    You conjectured:

    “continuum of infinitely lived agents normalized to one” deserves a PhD. And I am almost sure it got one. Maybe even two.

    Many more than that.

    best wishes
    bill

  13. bill says:

    Dear MamMoTh (at 2012/02/07 at 2:05)

    Your observation is correct but doesn’t salvage the loanable funds doctrine which assumes that saving is a function of the interest rate which mediates current and future consumption choices and ignores (implicitly) the large impact national income has on the saving flows in the economy.

    best wishes
    bill

  14. Andy says:

    Bill
    I’m often wondered how much time you have to spend having to learn what Dynamic Stochastic general equilibrium, and other trendy models, are all about before you can confidently proclaim them as bollocks. It must be very annoying.

  15. Max says:

    MamMoTh, banks can’t force people to hold deposits if they don’t want them. And they don’t need to make loans to create deposits.

    Whether a loan (bank or non-bank) ultimately ends up as a deposit or a bond depends on the preference of investors and government regulation.

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