In the UK Guardian article (September 26, 2015) – John McDonnell: Labour will match Osborne and live within our means – analysis of the position being taken by the new Shadow Chancellor in Britain, John McDonnell was provided. I have to say it seems to have caused some serious conniptions among those disposed to Modern Monetary Theory (MMT) if I am to judge by the E-mails I have received in the last 36 hours and the tweeting activity that followed the publication. But if we consider what he said carefully, it may not be as bad as the Guardian headlines suggest. However, his statement discloses a deep insecurity in the Corbyn camp that leaves them adopting fiscal rules that are the hallmark of the neo-liberals. It retains focus on the fiscal balance, however, decomposed into current and capital, whereas the focus should be on creating full employment and prosperity. The adoption of the Tory fiscal rule – the so-called – Charter of Budget Responsibility – still provides some flexibility for government to avoid harsh austerity. However, it can easily become a source of unnecessary rigidity, which prevents the government from fulfilling its responsibilities to advance welfare. Overall, the insecurity it betrays is the worrying part of this statement. This blog is in two parts – today is more conceptual (and longer). Tomorrow – will be more empirical (and much shorter). We will conclude that the British Labour Party is mad to sign up to the ‘Charter of Budget Responsibility’, which is a chimera – it is not a responsible framework at all.
If you struggle with some of the technical details about fiscal balances etc then I would urge you to read this blog – The full employment fiscal deficit condition – prior to wading through today’s blog.
It provides an easy to understand background to the discussion today.
In December Autumn Statement 2014, the British Chancellor George Osborne introduced a tougher – Charter of Budget Responsibility – with the clear aim of putting politicially binding constraints into place to limit the capacity of government to spend.
The earlier incarnation of the Charter, introduced in 2010 when the Tories were elected, forced the government to achieve a fiscal balance over a ‘rolling five-year period’.
The revised 2014 version states:
3.1 The Treasury’s objectives for fiscal policy are to:
- ensure sustainable public finances that support confidence in the economy, promote intergenerational fairness, and ensure the effectiveness of wider Government policy; and
- support and improve the effectiveness of monetary policy in stabilising economic fluctuations.
3.2 The Treasury’s mandate for fiscal policy is:
- a forward-looking target to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period.
3.3 The Treasury’s mandate for fiscal policy is supplemented by:
- an aim for public sector net debt as a percentage of GDP to be falling in 2016-17.
3.4 To ensure that expenditure on welfare remains sustainable, the Treasury’s mandate for fiscal policy is further supplemented by:
- the cap on welfare spending, at a level set out by the Treasury in the most recently published Budget report, over the rolling five-year forecast period, to ensure that expenditure on welfare is contained within a predetermined ceiling.”
The Updated Charter was approved by the British Parliament on January 13, 2015.
The British Office of National Statistics defines Public Sector current expenditure (PSCE) as:
Spending on items that are ‘consumed’ in the year of purchase, such as public sector salaries and transfers.
Public Sector Gross Investment (PSGI) is the sum of Gross spending on investment including depreciation and it normally refers to spending that purchases assets which deliver benefits that span beyond the year of purchase.
So you can see that the year cut-off is the demarcation between current and capital expenditure in National Accounts and Public Finance data dissemination.
Cyclically-adjusted current expenditure is the discretionary component of PSCE, that is, the spending that the government is choosing to make rather than the spending that is driven by changes in the economic cycle acting automatically on the fiscal parameters (tax rates, income support rules etc) to change government spending.
So if the economy is in recession and the automatic stabilisers are pushing the current deficit upwards, there is no need to cut current spending to meet the fiscal rule. The ‘cyclical effects’ will be netted out before the relevant fiscal balance is computed.
Please read my blog – Structural deficits and automatic stabilisers – for more discussion on this point.
A non-political/ideological reading of the Charter of Budget Responsibility, using its own logic, suggests that it says nothing definite about austerity and is a fairly loose framework within which fiscal policy can be implemented.
1. It only aspires to balance the “cyclically-adjusted current balance” and only “by the end of the rolling, five-year forecast period”.
As noted above, it nets out the cyclical consequences of a recession on the fiscal balance. So the government caught in a recession, could satisfy the rule without spending cuts or tax hikes, even if the fiscal deficit on the current balance was relatively large over the entire rolling window.
2. It can still inject significant discretionary stimulus into the economy by running relatively large capital budgets.
3. The Charter says nothing about the monetary arrangements (the operations) that would accompany (be driven by) the fiscal choices. So, a Labour Government could use Overt Monetary Financing (OMF) to facilitate a large capital spending program to ensure the nation has first-class infrastructure.
I considered Overt Monetary Financing (OMF) in some detail in these blogs:
In the UK Guardian article, Shadow Chancellor John McDonnell says that British Labour “will vote in favour of a new fiscal charter proposed by George Osborne.”
He also said that:
We accept we are going to have to live within our means and we always will do – full stop … We are not deficit deniers.
At this point we conclude that the British Labour Party is choosing to be caught up in the framing and language of the neo-liberals.
Using terms such as “live within our means” and suggesting there is credibility in their position because they “are not deficit deniers” is straight out of the neo-liberal handbook.
Let me state straightforwardly – I am a deficit denier – if that means someone who considers the fiscal balance to be a ridiculous financial variable to focus on as a policy target.
And what does ‘living within our means’ actually mean?
John McDonnell use of the expression is straight mainstream. The mainstream belief is based on the erroneous conflation of a household and government budget.
When a household/firm borrows now to increase current consumption (or build productive capacity) there is a clear understanding that future income will have to be sacrificed to repay the loan with interest.
This result follows because spending by the non-government body (household and/or firm) is financially constrained.
A household must finance its spending either by earning income, running down saving, borrowing and/or selling previously accumulated assets. There is no other way. Borrowing has to be repaid via access to the other sources of spending capacity but by implication such repayments reduce the future capacity to spend.
So, in the context of the spending unit being financially constrained, the concept of ‘living within our means’ has some meaning.
A household, for example, cannot buy unlimited quantities of items that are for sale in the local currency because it is financially constrained.
But a sovereign government is never revenue constrained because it is the monopoly issuer of the currency and so it can buy whatever is for sale in the currency it issues whenever it likes and in whatever quantities that are available – if it so chooses.
So the ‘means’ that constrain a sovereign government are not the same ‘means’ that constrain a non-government sector player (household, firm).
And when there is mass unemployment and underemployment then an economy has plenty of ‘means’ to bring back into productive use.
For a sovereign government, ‘means’ mean real resources.
For example, a sovereign government can always employ any idle labour that is willing to work for the currency the government issues.
Once there is full employment, then the ‘means’ become constrained and the government has to deprive the non-government sector of some usage (for example, via taxation) if it wants a larger share of resource usage itself.
There is no sense that a currency-issuing government is ‘living within its means’ as measured by any fiscal outcome. The only sense that can be made of such a concept is to examine the state of productive resource utilisation.
Unfortunately, that is not what John McDonnell was seeking to focus on. So we can understand the MMT angst.
Please read my blog – Who are the British that are living within their means? – for more discussion on this point.
John McDonnell was also quoted as saying:
We will support the charter. We will support the charter on the basis we are going to want to balance the book, we do want to live within our means and we will tackle the deficit … We will tackle the deficit but the dividing line between us and the Tories is how we tackle it. Our basic line is we are not allowing either middle or low earners or those on benefit to have to pay for the crisis. It is as simple as that.
One could be excused for saying ‘austerity lite’ is alive and well within the so-called ‘New Politics’ of the British Labour Party.
The article noted that “McDonnell indicates that his main message to the conference in his speech on Monday will be designed to reassure voters that Labour is committed to tackling the deficit”.
Which again buys into the ‘cult of the deficit’. Deficit denial is a much more sophisticated and intelligent position to take.
McDonnell is just rehearsing the ‘cult’ talk and will therefore struggle to get free of the neo-liberal framing that constrains governments and has caused mass unemployment and the financial crisis.
The problem with with the article is that it was not actually talking about the deficit.
McDonnell, himself, says that “his support for the charter is qualified because he believes that only the current account should be balanced to give the government space to borrow to fund infrastructure projects.”
Why qualified? As noted above, the Charter only requires the current fiscal balance to be zero by some rolling period. It says nothing about the capital budget.
So there is no qualification at all. The Guardian should be more precise when using terms because in this area of public debate the language really matters.
McDonnell is thus not signing up to a zero fiscal balance overall but rather a zero current balance.
However, Clause 3.3 of the Charter requires the government to ensure “public sector net debt as a percentage of GDP to be falling in 2016-17.”
As we will see, obeying this part of the Charter clearly imposes a restriction on the extent to which British Labour could “borrow to fund infrastructure projects”.
At present, Public Sector Net Investment is only 1.5 per cent of GDP having falling over the neo-liberal period from a high of nearly 7.6 per cent in the last 1960s.
Quite apart from the rigidities implied, which I will consider later, this constraint therefore may not provide sufficient scope for British Labour to maintain full employment and best-practice public infrastructure.
Of course, it if also embraced OMF and funded the capital deficit in that way (that is, directly using its currency issuing capacity rather than spending and then borrowing back past spending in the form of debt issuance as McDonnell is proposing), then the capital balance could be whatever the government chose without violating the Charter.
Current versus Capital ‘Budgets’
In this blog – The roots of MMT do not lie in Keynes – I discussed the way in which John Maynard Keynes approached fiscal policy and the fiscal balance.
The clearest statement was in two articles which appeared in the The Times (November 14 and 15, 1939) under the title “Paying for the War”, Keynes provided detailed analysis of the conduct of fiscal policy. These articles came out in his short 1940s book “How to Pay for the War”.
I won’t repeat the discussion only to say that Keynes understood that fiscal deficits were a means of resolving a “deficiency of effective demand”, which Keynes demonstrated was the principle cause of mass unemployment.
But he also divided the fiscal balance into what he called the ‘current budget’ (we now use the term recurrent to describe revenue and spending flows exhausted within a year) and the ‘capital budget’, which relates to public infrastructure expenditure or Gross public investment.
In correspondence to Sir Richard Hopkins (July 20, 1942) – which is recorded in his Collected Works, Volume 27, Keynes wrote:
… the ordinary Budget should be balanced at all times. It is the capital Budget which should fluctuate with the demand for employment.
This is the precursor to the modern concept of the ‘Golden Rule’. which limits fiscal deficits to the rate of net public investment in productive capital.
This is what John McDonnell is committing British Labour to obey. It is an unwise path to follow.
The ‘Golden Rule’ essentially means that over some defined economic cycle (from the peak of activity to the next peak) the government deficit should match its capital (infrastructure) spending.
All ‘recurrent’ spending (that is, spending which exhausts its benefits within the current year) should be ‘funded’ through current revenue (taxes and fines, etc.).
The ‘Golden Rule’ is considered equitable across generations because the current taxpayers ‘pay’ for the public benefits they receive now, while the future generations have to pay for the benefits that the infrastructure delivers to them in the years to come.
Thus, day to day spending that benefits the current taxpaying public should be covered by taxation revenue and capital infrastructure should be funded through debt.
The fiscal balance would thus always be zero net of public investment spending.
The ‘Golden Rule’ reflects the mainstream economics view that governments have to ‘fund’ their spending just like a household.
In Victorian times, the ‘Golden Rule’ was that in good times, the current ‘budget’ should deliver a surplus, which would then allow the government to repay the debt incurred in bad times, when it was running deficits.
This reasoning then left to the conclusion that balanced ‘budgets’ as a principle was dangerous and that ‘budgets’ should, rather, be balanced over an economic cycle.
Run deficits in bad times and surpluses in good times to avoid inflation and build up the funds to run down the debt accumulated during the deficit years.
Most of this analysis was conducted under closed economy assumptions. Keynes was focused on fluctuations in private investment and national income and certainly didn’t consider what an on-going external deficit would mean for the conduct of fiscal policy if the private domestic sector desired to net save.
The Golden Rule logic may be legitimately applied to governments that do not issue their own currency, such as state governments in a federal system. But it makes no sense to impose it for a currency-issuing national government.
It just imposes unworkable rigidities as we will see.
Japan, for example, embedded the Golden Rule into the 1947 Public Finance Law (Article 4) which constrained current expenditure to not exceed domestic revenues.
However, this proved to be unwieldy and in the interests of efficient fiscal policy operations, the Japanese government requested a waiver of the rule in 1975 and has only briefly reinstated it (1990-93).
What is the problem?
I provided a detailed discussion of the requirements for government fiscal policy in this blog – The full employment fiscal deficit condition.
The analysis bears on why the Charter is a bad idea.
This blog – Functional finance and modern monetary theory – also provides essential background.
In an open economy, if there was no government spending or taxation (so an overall fiscal balance of zero) the level of economic activity (output) will be determined by private domestic spending (consumption plus investment) and net external spending (exports minus imports). If one or more of those spending sources declines, then activity will decline.
A spending gap is defined as the spending required to create demand sufficient to elicit output levels which at current productivity levels will provide enough jobs (measured in working hours) for all the workers who desire to work.
A zero spending gap occurs when there is full employment.
An overarching responsibility of the national government is to ensure there is no spending gap so that all resources are being used productively (which also would require them to be used sustainably).
That should be the first aim of British Labour rather than claiming that the the “main message is … to reassure voters that Labour is committed to tackling the deficit”
It becomes obvious (and uncontestable) that if the private spending sources decline from a given position of full employment, the only way that the spending gap can be filled is via a fiscal intervention – direct government spending and/or a tax cut (to increase private disposable income and stimulate subsequent private spending).
That is a core insight of functional finance which underpins MMT.
This bears on what we think about the ‘Charter of Budget Responsibility’ and whether there is enough scope in the capital account to efficiently deal with spending fluctuations in the economy.
In the background reading recommended above, the concept of spending injections and leakages was outlined in detail.
We noted that the private investment (I), exports (X) and government spending (G) comprised – injections into aggregate spending stream and stimulate economic activity.
The leakages from the income-spending cycle are household saving (S), taxation (T) and imports (M). When national income is generated these leakages reduce the amount of spending that is recycled back into the income-output generating process.
The leakages drain aggregate demand, which is the total spending in a domestic economy per period (say a quarter or a year).
For example, when Private Investment increases (G and X constant) this stimulates aggregate demand (spending) and firms react by increasing output to meet the new orders. This requires them to increase employment and the increased income paid out is consumed by Households (who supply the labour and other resources). But it is also used to increase saving (S), pay more tax (T) even if tax rates are unaltered, and increase imports (M).
The economy stops expanding again once the change in Investment is equal to the sum of the changes in S, T and M. This dynamic response and subsequent resolution is what we term an movement to a new equilibrium position.
The new injection (in this case the investment boost) creates a new equilibrium at a higher income level via a multiplier process. Please read my blog – Spending multipliers – for more discussion on this point.
Essentially, the new income generated by the initial increase in investment stimulates household consumption (C) and the induced consumption then feeds back into the income-output generating system to produce more income and so on.
But note that at each subsequent stage, the extra spending that is induced is getting smaller and smaller because of the leakages.
A macroeconomy is in a steady-state (that is, at rest or in equilibrium) when the sum of the injections equals the sum of the leakages. The point is that whenever this relationship is disturbed (by a change in the level of injections, however sourced), national income adjusts and brings the income-sensitive spending drains into line with the new level of injections. At that point the system is at rest.
But this point of rest:
1. May not correspond to full employment. There can be mass unemployment and the system will be in equilibrium if spending is unchanged.
This means that in equilibrium there can still be a major spending gap.
2. The equilibrium implies nothing about the size of the fiscal balance.
If in a state of mass unemployment (therefore a positive spending gap), there is no dynamic which would lead to an increase in private (or non-government) spending then the only way the economy will increase its level of activity is if there is increased net government spending.
This means that the injection via increasing government spending (G) has to more than offset the increased drain (leakage) coming from taxation revenue (T). That is, the fiscal balance has to go into deficit or into a higher deficit to offset the non-government spending gap.
Our steady-state rule then has to be modified to ensure attaining it also simultaneously achieves the basic goal of full employment.
The steady-state rule in symbols is:
(I + X + G) = (S + M + T)
(injections) = (leakages)
If (I + X) less than (S + M) then the only way the current level of economic activity (real GDP) can be maintained on an on-going basis (at the current implied rate of unemployment) is if (G > T). That is a fiscal deficit is required on a continuous basis to sustain a given level of activity.
In this case, the fiscal deficit ‘finances’ the desire by the non-government sector to save overall by maintaining sufficient demand to produce a level of income which will generate that level of net saving.
MMT uses the concept of sectoral balances which is another way of looking at the leakages and injections.
Accordingly, the discretionary fiscal position (deficit or surplus) must fill the gap between the savings minus investment minus the gap between exports minus imports.
In symbols we write the now familiar (to my blog readers) sectoral balances as:
(G – T) = (S – I) – (X – M)
Which in English says for income to be stable, the fiscal deficit will equal the excess of saving over investment (which drains domestic demand) minus the excess of exports over imports (which adds to 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 fiscal 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.
So far so good!
But as noted above, the level of national income (GDP) that is achieved by the current sectoral balance may still be associated with mass unemployment because total spending and the income generated in response is too low – insufficient to generate output levels that will fully utilise the productive resources available.
We note 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. 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.
S(Yf), M(Yf) and T(Yf) are the corresponding leakage flows that would occur at full employment national income (Yf). They will be higher than the flows that would occur when there was mass unemployment.
We abstract here from any sensitivity to the state of the cycle from the injections, although a case can be made that private investment is more likely when confidence is high and economic activity is high.
Accordingly, to sustain full employment the condition for stable national income is written more specifically:
Full-employment fiscal deficit condition: (G – T) = S(Yf) + M(Yf) – I – X
Further, relevant to the breakdown between current and capital public spending, we need to recognise that the total public spending term G is the sum of public sector current spending and public sector investment spending.
In the data, you will see that the Public Sector current fiscal balance is defined as Public sector current expenditure plus depreciation on capital plus interest paid on outstanding debt minus the Public sector current receipts.
If we simplify, and call GC – total public current outlays (including interest paid and depreciation) and GI to be Public sector net investment (which is the difference between gross investment and depreciation) then we can write the full-employment fiscal deficit condition as:
(GC – T) + GI = S(Yf) + M(Yf) – I – X
The expression on the left-hand side of the equation is the reported fiscal balance – that is, total government spending ((GC + GI) minus government receipts (T). We use T to capture all receipts, which includes more than taxation receipts.
The first expression on the left-hand of the equation (GC – T) is the current fiscal balance (deficit if positive, surplus if negative) because it is the balance between all spending that is exhausted in the year and all revenue received in that period.
The expression GI is the capital account deficit that John McDonnell would match against debt issuance.
In other words, the flow of spending GI becomes the main source of counter-stabilisation to adjust for non-government spending gaps because the net current public deficit is zero in “normal times” – that is, when the automatic stabilisers are zero.
I say ‘main source’ because GC includes total current government spending, which therefore could be broken down into discretionary spending and the automatic stabilisers.
The ‘Charter of Budget Responsibility’ does not require (GC – T) – 0, but just the cyclically-adjusted part of that difference to be zero, which is another thing altogether.
So in a downturn, the government could still rely on tax revenue falling and income support payments rising as well as net investment rising as the way it could offset the non-government spending gap.
But at full employment, (GC – T) = 0 (the current fiscal balance would be zero – at least) and the net injection to ensure that level of national income would be sustained would be the public net investment GI.
A question that then arises is whether that specific level of public net investment can be productively deployed. Is there sufficient scope in a growing economy to maintain that growing level of public investment?
We also note that capital formation is a two-edged sword. It adds to total spending in the current period but adds productive capacity in subsequent periods, which has to be absorbed by increased growth in spending. Maintaining a balance in this ‘chase’ is not easy, if there are constraints on the current fiscal balance.
While current public receipts would rise in a growing economy, would that increase be sufficient to ensure current public spending could rise enough to ensure the growing public infrastructure was effectively used? (Teachers in schools!).
I will consider these questions in Part 2.
We will conclude that fiscal rules such as those in the ‘Charter of Budget Responsibility’ are designed to frustrate efficient public administration, bias a nation to under-full employment equilibrium states, and are totally unnecessary for a currency-issuing government.
The British Labour Party is mad to sign up to the Charter. It is just another neo-liberal obstruction.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.