Sometimes one agrees with a conclusion but realises the logic that was used to derive the conclusion was false. Which means that the person will get things wrong when applying the logic to other situations. This is almost always the case when we encounter the reasoning offered by so-called deficit doves. These are economists who do not out-rightly reject the use of deficits but typically believe them to be cyclical phenomenon only and should thus be offset at other points in the economic cycle by surpluses – the so-called balanced budget over the cycle rule. While many progressives think that is a sensible strategy – the reality is that it is an unsustainable fiscal rule to try to follow. The same economists talk about the dangers of pro-cyclical fiscal positions but fail to appreciate that such positions are desirable in certain cases and there is a fundamental asymmetry that applies to evaluation the desirability of a “cyclical” position. Fiscal austerity (pursuing surpluses when the economy is contracting) is never appropriate whereas expanding the deficit when the economy is growing might be. It all depends. This blog aims to clear up some of these misconceptions.
One such article (August 7, 2012) was written by Harvard economist – Jeffrey Frankel – The Procyclicalists: Fiscal austerity vs. stimulus.
This article demonstrates some of the classic mistakes that economists make when considering the relationship between the government and the non-government sector.
Dr Frankel wrote:
The world is seized by a debate between fiscal austerity and fiscal stimulus. Opponents of austerity worry about contractionary effects on the economy. Opponents of stimulus worry about indebtedness and moral hazard …
Is austerity good or bad? It is as foolish to debate this proposition as it would be to debate whether it is better for a driver to turn left or right. It depends where the car is on the road. Sometimes left is appropriate, sometimes right. When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit.
Which is not only a poor (inapplicable) analogy but also a rule that should never be specified in such terms.
First, the analogy. There is no inherent accounting rule of traffic that says that if x per cent turn left, -x per cent will turn right. So attempting to apply that to a sectoral balance – such as the government budget outcome – which depends and influences the spending and saving decisions of the private domestic and the external sectors is clearly inappropriate.
In the case of sectoral balances, the national accounting methodology and the national income adjustments that underpin it, ensures that if the sum of these three balances (government, private domestic and external) add to zero.
Second, which leads to the further observation. The statement of the fiscal rule that booms require surpluses and recessions require budget deficits is deeply unsound and does not equate to appropriate or responsible fiscal policy.
Why is that?
Modern Monetary Theory (MMT) is built, in part, from the insights provided within what is known as functional finance (as per Abba Lerner). Please read my blog – Functional finance and modern monetary theory – for more discussion.
Functional finance is very clear – responsible fiscal policy requires two conditions be fulfilled:
1. The discretionary budget position (deficit or surplus) must fill the gap between the savings minus investment minus the gap between exports minus imports.
In notation this is given as
(G – T) = (S – I) – (X – M)
Which in English says for income to be stable, the budget deficit (G – T) will equal the excess of saving (S) over investment (I), which drains domestic demand, minus the excess of exports (X) over imports (M), which adds to domestic demand.
If the right-hand side of the equation: (S – I) – (X – M) – is in surplus overall – that is, the non-government sector is saving overall then the only way the level of national income can remain stable is if the budget deficit offsets that surplus.
A surplus on the right-hand side can arise from (S – I) > (X – M) (that is, the private domestic sector net saving being more than the net export surplus) or it could be associated with a net exports deficit (draining demand and adding foreign savings) being greater than the private domestic sector deficit (investment greater than saving) which adds to demand.
It could also occur if both balances on the right-hand side are in deficit.
However, that simple observation doesn’t mean that the discretionary fiscal policy associated with this position is desirable. Note, that we have to think of this in terms of dynamic flows (which combine to render the balances).
I used the term – “level of national income can remain stable” – at the point where these balances sum to zero. That condition will be satisfied by national income adjustments. So if, for example, we had all balances equal to zero and private consumers became pessimistic and consumption fell (so saving rose) then the right-hand side would go into surplus, immediately.
But it wouldn’t stay that way because the resulting downturn in economic activity and fall in national income would impact on the other two balances. Imports would fall pushing the external balance into surplus and taxation revenue would fall as welfare oriented public spending rises. That would push the budget balance into deficit. The national income adjustments would stop when the balances were summing to zero – but now we would have a budget deficit.
The important point though is that the “level” of national income where these adjustments ceased – that is, the macro-equilibrium or steady-state – may not be very desirable and there could be mass unemployment.
Which leads to the second insight from functional finance.
2. Most importantly, the prior discussion focused on the level of income remaining stable but as we have seen that may bear no relation to what we would consider to be full employment. In other words, the fiscal rule doesn’t necessarily define a full employment condition.
We can define a full employment level of national income as being achieved when all resources are fully utilised according to the preferences of workers and owners of land and capital etc.
Given that S, T and M are all positively related to the level of national income, there is a unique level of each of these flows that is defined at full employment, given the current population, technology etc.
Changes in behaviour (for example, an increased desire to save per dollar earned) will change that “unique” level but for given behavioural preferences and parameters we can define levels of each.
So lets call S(Yf), M(Yf) the corresponding flows that are defined at full employment national income (Yf). We also consider investment to be sensitive to national income (this is outlined in the so-called accelerator theory) such that higher levels of output require more capital equipment for a given technology. So I(Yf) might be defined as the full employment flow of investment. We consider export spending to be determined by the level of World income.
Accordingly, to sustain full employment the condition for stable national income is written more specifically:
Full-employment budget deficit condition: (G – T) = S(Yf) + M(Yf) – I(Yf) – X
The sum of the terms S(Yf) and M(Yf) represent drains on aggregate demand when the economy is at full employment and the sum of the terms I(Yf) and X represents spending injections at full employment.
If the drains outweigh the injections then for national income to remain stable, there has to be a budget deficit (G – T) sufficient to offset that gap in aggregate demand.
If the budget deficit is not sufficient, then national income will fall and full employment will be lost. If the government tries to expand the budget deficit beyond the full employment limit (G – T)(Yf) then nominal spending will outstrip the capacity of the economy to respond by increasing real output and while income will rise it will be all due to price effects (that is, inflation would occur).
In this sense, MMT specifies a strict discipline on fiscal policy. It is not a free-for-all. If the goal is full employment and price stability then the Full-employment budget deficit condition has to be met.
Please read my blog – The full employment budget deficit condition – for more discussion on this point.
You should thus be able to critique the fiscal rule espoused by Dr Frankel – that “(w)hen an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit”.
He was right in one respect, notwithstanding the poor analogy he used about turning right and left. What the appropriate fiscal position of the government should be – does depend “where the car is on the road” – which in more correct terms means – does all depend on the state of non-government spending relative to the full employment level of aggregate demand and the desired mix of public versus private command of real resources.
Note that last qualification. Economists cannot dictate what the appropriate mix of public and private spending in an economy is. They try to tell is that small government is better but that just reflects their ideology. There is nothing in economic theory that can determine that an economy where 90 per cent of the national income is due to government net spending is worse (or better) than an economy where this ratio is, say 10 per cent.
These are essentially political choices. Every time you hear an economist say small government is better you can conclude that they are making an ideological statement which has no more merit than the religious incantation from a priest. They might pretend they are backed by the authority of economics but that is a smokescreen to expres their religious preferences.
Dr Frankel then makes another fundamental error, which is common of this deficit dove style of reasoning.
Deficit doves think deficits are fine as long as you wind them back over the cycle (and offset them with surpluses to average out to zero) and keep the debt ratio in line with the ratio of the real interest rate to output growth.
Deficit doves are within the same species as the “deficit hawks” in that they believe that the long-term deficits pose serious risks. They differentiate themselves from the “hawks” by their willingness to accept that short-term deficits might be necessary during a recession. A standard aspiration for a deficit dove is thus to propose the government runs a “balanced budget” over the business cycle which is clearly dim-witted as a stand-alone goal and un-progressive in philosophy.
Please read my blog – When you’ve got friends like this … Part 6 – for more discussion on this point.
A deep understanding of national accounting, that I briefly outlined above, tells us that if a government was successful in achieving this fiscal goal (balance over the cycle), then the private domestic sector balance (the difference between its spending and income) would be equal, on average over the business cycle, to the external balance (the difference between income flows in and out of of the nation).
The import of this is that if a nation was running a continuous external deficit, then the private domestic sector will also, on average, be in deficit. Which means it would be continuously accumulating debt – an unsustainable dynamic.
Dr Frankel says that timing issues relating to fiscal policy (there are lags in making decisions etc) give us:
… no reason to follow a pro-cyclical fiscal policy. A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes in response to downturns. Budgetary profligacy during expansion; austerity in recessions. Procyclical fiscal policy is destabilising, because it worsens the dangers of overheating, inflation, and asset bubbles during the booms and exacerbates the losses in output and employment during the recessions. In other words, a procyclical fiscal policy magnifies the severity of the business cycle.
Yet many politicians in the US, the UK, and the Eurozone seem to live by procyclicality. They argue against fiscal discipline when the economy is strong, only to become deficit hawks when the economy is weak. Exactly backwards.
This is a common source of confusion. Regular readers will know I rail against pro-cyclical fiscal policy under certain conditions but make the distinction between a steady-state flow of net public spending and discretionary changes in net spending designed to alter the budget balance.
This distinction is crucial to understanding why the term “pro-cyclical” can be mis-interpreted.
Following on the earlier discussion about the full employment budget deficit condition, it becomes obvious that if the non-government sector is in surplus at full employment then the budget balance has to be in deficit to sustain full employment. That might be interpreted as a pro-cyclical budget position given that the economy would be booming (growing at full capacity utilisation) and the budget would be in deficit.
But of-course it would be an appropriate fiscal stance. Budget deficits that support growth up to full employment are appropriate.
Think about an economy that is returning from a recession and growing strongly. Budget deficits could still be expanding in this situation, which would make them obviously pro-cyclical, but we would still conclude the fiscal strategy was sound because the growth in net public spending was driving growth and the economy towards full employment.
Even when non-government spending growth is positive, budget deficits are appropriate if they are supporting the move towards full employment.
However, once the economy reached full employment, it would be inappropriate for the government to push nominal aggregate demand more by expanding discretionary spending, as it would risk inflation.
Further, there is an asymmetry to this discussion. Pro-cyclical fiscal strategies when the economy is contracting are never appropriate. That is, trying to reduce a budget deficit, when the non-government sector is trying to increase its net position (saving overall) is pro-cyclical – but always a flawed and damaging strategy.
There is also the nuance that the two components of the final budget outcome – the discretionary fiscal policy choices (spending and tax structure) and the automatic stabilisers (the cyclical part) – can move in opposite directions. The automatic stabilisers are always counter-cyclical by definition.
While Dr Frankel supports the use of fiscal deficits and is critical of the widespread use of fiscal austerity, that conclusion is derived from a theoretical framework which is inapplicable to the
So he gets the right answer – in this case – for the wrong reasons. That means that in other cases, the fiscal position he advocates will not be appropriate. That is a common problem when we consider the class of so-called progressives who are deficit doves.
They wrongly assume that there are financial constraints on currency-issuing governments and that these constraints mean that budget deficits will normally drive up interest rates and damage private spending. Neither the assumption or the predictions are valid.
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.