The title reflects fact not opinion. However, most commentators still fail to grasp that reality. In the current economic climate it means one thing – imposing fiscal austerity in the hope that governments can reduce debt levels will fail and bring with it devastating consequences for the non-government sector. It is the latter sector that has reduce its debt exposure and under current institutional arrangements that means the government sector has to increase deficits (and debt) not other way round. The simple fact is that when private spending is subdued the government sector has to run commensurate deficits to support the process of private de-leveraging by sustaining growth. Those advocating fiscal austerity or those who claim that the amount of outstanding private debt is simply too large for the Government to replace with public debt fail to understand the basic tyranny of the sectoral balance arithmetic. Put simply, not everybody can de-lever at the same time.
On May 14, 2009, at the time of the 2009-10 Federal budget release, the Australian Broadcasting Commission ran this Opinion piece – Economists tackle the deficit and debt debate – which reported on an interview he had conducted with three economists – myself, Steve Keen (University of Western Sydney) and Stephen Kirchner (Centre of Independent Studies – a right-wing organisation based in Sydney).
I wrote about that discussion in this blog – The deficit and debt debate – and concluded that two out of the three economists interviewed did not understand how the modern monetary economy works.
If you are interested in the full exchange I recommend you go back to that blog. But for today there is only one aspect I am focusing on – the de-leveraging issue. The motivation is that two years after that exchange not a lot has been learned and in maintaining inconsistent positions, economists have been providing policy advice that, when adopted, has deepened rather than eased the crisis.
My position remains as it was – Not everybody can de-lever at the same time. Until that message is understood and reflected in public policy, the crisis will endure.
To put today’s blog in context, in the 2009 ABC Opinion piece, under the heading Stimulus stymied by debt the Reporter quoted Steve Keen as saying:
We have had far too much debt, more than the system can actually cope with, we therefore can’t get out of this the way we used to get out of it by re-encouraging private lending once more.
I agree that the volume of high risk private sector debt was a major part of this current crisis. But encouraging credit worthy businesses to borrow is still sound. Banks have no current constraints extending credit to these customers. The residual of so-called toxic debt is a separate issue and would be significantly attenuated if the debt holders were not unemployed.
The Reporter then quoted Keen’s view as saying “the amount of outstanding private debt is simply too large for the Government to replace with public debt.”
Those who understand Modern Monetary Theory (MMT) will realise that this comment misses the point.
The stimulus efforts in 2009 and 2010 had nothing to do with replacing private debt with public debt. Private debt was incurred to “finance” spending by revenue-constrained private sector agents (households and firms). The private debt build-up was matched $-for-$ with asset accumulation because all non-government transactions net to zero in an accounting sense.
Conversely, public debt doesn’t finance anything even if the institutional arrangements which see the national governments issue debt $-for-$ to match their net spending (deficits) seem to suggest they do. Currency-issuing governments are not intrinsically revenue-constrained and can spend when they like without prior recourse to revenue.
The implication of the Keen quote was that a national government could not overcome the real downturn in the private sector by expanding its budget deficit. Events since then have proven that viewpoint to be wrong.
The actual crisis being endured around the world is a real crisis where spending is below potential capacity output. That is exactly what a budget deficit aims to resolve. If the financial crisis (and the “toxic debt”) has impacted on spending so much that the spending gap is huge then that just means the deficit has to be that much larger.
When the non-government sector spends less than it earns and that gap widens we know that the government deficit has to rise for national income to grow.
The Reporter than coaxed Steve Keen into giving his solution to the debt problem which is “for the Government to get rid of the debt by causing higher inflation or by simply cancelling it and nationalising the banking system.” Keen is quoted as saying:
Ultimately, we’re going to see governments changing across either to abolishing debt, or to literally printing money rather than running out debt to finance their spending … We know this crisis was caused by too much debt, how on earth do we think that getting into more debt is going to solve the problem.
At that point you realise that basic concepts about the monetary system are not grasped.
Currency-issuing governments were not “running out debt to finance their spending” – the spending provided the private sector with the funds to buy the debt instruments not the other way around.
Further, governments do not spend by “literally printing money”. I covered this issue in my blog – Quantitative easing 101.
At the time, Steve Keen was running the line that governments would have to inflate away the nominal debt to reduce the real burden to maintain fiscal sustainability, a thoroughly orthodox line.
This viewpoint implies that if deficits are not matched by debt issuance then inflation results. So if the government wants to reduce its debt burden and run deficits it should “print money” (rather than issue debt), drive up inflation, and erode the real value of the private debt until it is worthless – thereby solving the problem.
You would read that narrative in a mainstream macroeconomics textbook written by luminaries such as Greg Mankiw or Olivier Blanchard or Robert Barro.
First, we need to understand the banking operations that occur when governments spend and issue debt within a fiat monetary system. That understanding allows us to appreciate what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?
In this situation, like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.
The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.
This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.
When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks (and most in the current crisis) offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.
What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.
The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).
There is no difference to the impact of the deficits on net worth in the non-government sector. This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.
Firms will respond to the spending stimulus by increasing output and employment. Once the economy reaches full employment then nominal demand will exceed the real capacity of the economy to absorb it and then inflation becomes a threat. No sensible government would push the deficit into this zone though. So at the point the deficit becomes inflationary you have already overcome the recession and created full employment!
So the monetary operations (debt-issuance or not) do not increase or decrease this risk. Budget deficits are good only when they close non-government spending gaps and underwrite employment. Outside of that there are problems.
The imperative to de-lever
The foregoing view – that there is too much debt and both the government and the non-government sector have to de-lever to restore growth – still resonates in the current period and is driving the fiscal austerity ambitions of most political leaders.
Somehow we are to believe that we have a sovereign debt crisis occuring simultaneously with a private debt crisis.
We read this morning in a Bloomberg news story (May , 2012) – Japan Rating Cut Rings Alarm for Lawmakers Gridlocked on Taxes – that the ratings agencies are still trying to assert their relevance by downgrading Japanese sovereign debt.
We have been there before – and the Japanese government at the time (early 2000s) ignored the supposed loss of credibility and continued to use deficits to stimulate it ailing economy. Debt continued to be issued at near zero yields and bond tender bid-cover ratios didn’t blink (remaining high).
The OECD, another organisation trying to assert its relevance when it has been shown by this crisis to be completely irrelevant – warned the Japanese government that it was ((Source):
… pushing Japan’s public finances further into uncharted territory.
They said as much – more than twice – in the last 20 years. Again – their predictions, regularly rehearsed in their publications and media statements – never came to anything.
All of their utterings resemble – in Pooh Bah’s words (from Act II of the opera Mikado) – “Merely corroborative detail, intended to give artistic verisimilitude to an otherwise bald and unconvincing narrative”.
Doesn’t the fact that Japan has recorded good growth (with a reviving private sector) in recent quarters while Europe and the UK are heading backwards with dismal confidence levels being recorded in the private sector and the entire monetary system in the case of the Eurozone on the brink of collapse – tell these characters anything?
At least sometimes you read an article that really understands the situation. Such was the case when a central banker friend of mine (thanks TM) send me some documents today.
One of those documents was written by Paul McCulley, former Managing Director at PIMCO and is now involved with the Global Interdependence Center. You might say as a former portfolio manager (a very large one at that) Paul McCulley might have some operational experience.
He had earlier written this PIMCO paper, reprinted in this Levy Institute paper in 2010 – Global Central Bank Focus: Facts on the Ground – which explored “the tyranny of arithmetic for the flow of funds” (which we call the sectoral balances framework) where as a result of “double-entry bookkeeping” used in the National Accounts:
… the only way that one of the four sectors can run a deficit or surplus is for one or more of the other three sectors to run the opposite
Where the four sectors are the private households and firms and the foreign sector (taken together to be the non-government sector) and the government sector.
Paul McCulley in that brief note contends (correctly) that as a result of this tyranny:
… any notion that fiscal austerity in the developed world will not be a cyclical drag on global aggregate demand growth, much less boost it, must rest on the presumption that (1) the household and business sectors in the developed world will reduce their surpluses and/or (2) that the emerging world will reduce its surpluses with the developed world.
He concludes that the Ricardian-equivalence arguments used to support the argument that private domestic spending will replace the spending losses arising from fiscal austerity ignore “why the private sector in the developed world is running a financial surplus”:
… deflated asset prices, which have undermined the debt that had been applied to inflated asset prices. The private sector in the developed world wants to get its financial house in order! This is a profound structural change, running in parallel to a permanent downsizing of the shadow banking system and derisking of the conventional banking system. Simply put, both the demand and supply curves for private sector credit creation have shifted inward.
Please read my blog – Pushing the fantasy barrow – for more detailed discussion on why the Ricardian Equivalence notion is both theoretically and empirically flawed.
But the important point is that the crisis was, in part, caused by excessive private sector debt extending out into the margins of risk, which has proven to be unsustainable.
Households and firms are returning to more prudent balance sheet practices and the only way they can do that is to “de-lever” – that is, bring down the debt levels – a process which takes considerable time.
As Paul McCulley notes:
… the only way that can happen without increasing the risk of a deflationary depression is either for the developed country governments to continue to run large financial deficits and/or for the emerging countries to reduce their financial surpluses. Again, the tyranny of arithmetic.
The evidence over the last several years is that a major rebalancing of current accounts across the world is unlikely to occur in the near future. While that might be a policy discussion that is worth having, the fact is that the damages of recession arise daily and then have long-lived effects. Long-term unemployment not only reduces the prospects of the victim but then bestows that disadvantage onto their children. Overlapping generations of disadvantage emerge from a deep and enduring recession.
The world is now in its fifth year of economic crisis and some teenagers will become adults having never worked because of the fiscal austerity.
In combatting the fiscal austerity logic, Paul McCulley reminds us that:
Current fiscal deficits in fiat currency countries are not the cause of the Great Recession but the consequence of the Great Recession, which was the consequence of the blowing up of asset price bubbles and Ponzi debt arrangements in the private sector. If current fiscal deficits had not been allowed to unfold, the Great Recession would now be the Great Depression 2.0.
And importantly, the “fiscal deficits are facilitating the private sector’s desire to save more, delevering their balance sheets. Remember, the government
sector’s liability is the private sector’s asset!”.
When there is a “cyclical deficiency of aggregate demand” because private spending growth has been reduced “fiscal austerity would only add to that deflationary cocktail”.
He also fully understands the difference between say the US or Japan – fiat currency-issuing nations and the Eurozone:
… the vigilantes have fled Greece, but Greece does not have a fiat currency; Greece is a risk asset, and all risk assets depend upon growth for valuation support. And fiscal austerity is not the path to growth if everybody wants to do it at the same time.
So “cyclically speaking, current fiscal deficits in fiat currency countries are a blessing, not a curse”.
He provided a more in-depth treatment of these issues in this recent paper – Does Central Bank Independence Frustrate the Optimal Fiscal-Monetary Policy Mix in a Liquidity Trap? – (March 26, 2012). It is worth reading carefully.
The tryanny of the arithmetic is, of-course, an accounting tyranny and requires behavioural understandings to allow it to be translated into policy analysis.
The starting point is that the crisis was caused by the excessive growth in private debt holdings which led to unsustainable balance sheets and so the first and essential requirement of a recovery is that this damaging process be reversed – as quickly as possible.
As Paul McCulley says that private sector “has to” deleverage as it “is a part of the economy’s healing process and a necessary first step toward a self-sustaining economic recovery”.
That observation then conditions how we understand what governments should be doing right now. Trade patterns react to cyclical events (imports fall for example) but fundamental change is of a more structural nature and takes time. Productivity shifts have to occur, relative inflation rates have to be reduced and the like.
Exchange rate movements assist in this process but like private sector de-leveraging – these shifts in balances take time.
So the many nations with current account deficits the only way forward is to expand fiscal deficits.
Paul McCulley says that private “deleveraging”:
… is a beast of a burden that capitalism cannot bear alone. At the macro level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.
This recognises that the treasury and central bank operations are intrinsically linked (on a daily basis) and it is fraught to start thinking of the central bank as “independent”.
Please read my blogs – The consolidated government – treasury and central bank and Central bank independence – another faux agenda – for more discussion on this point.
Paul McCulley says that fiscal austerity at a time when the private sector will not spend sufficiently “makes as much sense as putting an anorexic on a diet”.
The rest of the paper discusses how this affects the role of the central bank. He says that when when private spending is subdued “someone simply has to borrow and invest to fill missing demand” and this is a “a game changer” for central banks.
The situation moves from one where the central bank will be “policing the government to keep it from borrowing too much” (as the economy approaches full employment) – “to one of helping it to borrow and invest by targeting to keep long-term interest rates low by monetizing debt, with the aim of killing the fat tail risks of deflation and depression”.
Paul McCulley says that:
In the present circumstances, however, the problems are austere governments, while central banks know all too well that someone must borrow and spend to avoid a depression. The problem for central banks currently is not to protect their independence, but to help governments let go of their fears of false orthodoxies that hold them back from borrowing and investing.
The paper continues to discuss how the central bank has to play this role. There is a lot of interesting historical material presented.
I don’t entirely agree with some of his interpretations but those disputes are minor relative to the main message – some sector has to run deficits right now and an understanding of the circumstances of each sector leads to the conclusion that governments have to be the saviours.
Those advocating fiscal austerity or those who claim that the amount of outstanding private debt is simply too large for the Government to replace with public debt” fail to understand the basic tyranny of the arithmetic.
The next time you hear someone tell you that the private and government sectors have to reduce their debt to resolve this crisis ask them to outline, in detail, the tyranny of the arithmetic. My bet is that very few will know where to start.
Even debt-obsessed economists get this wrong.
The inescapable rule is that if one sector is running a surplus then at least one other sector has to be running a deficit. In times of private de-leveraging, it is fairly obvious which sector has to be supporting that process with commensurate deficits.
That is enough for today!