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One good reason for the government to remain in office

In today’s Sydney Morning Herald, the Opposition Shadow Treasurer revealed two things. First, he doesn’t know a thing about economics and would be dangerous in that position should he ever get the chance. Second, he is prepared to say anything to undermine the government whether he understands it or not. What it tells me is that this is a pretty good reason for the current government to stay in power! Spare that thought.

The article – Cloud of debt hangs heavy argued that “our future is gloomy” unless the government cuts spending quickly. Apparently:

ONE of the biggest mistakes a government can make is to stubbornly continue with a policy that is no longer necessary or beneficial for the nation. This is the position that the Rudd Government finds itself in with its overblown response to the global financial crisis – a multibillion-dollar economic stimulus that is being financed with borrowed money.

Hockey then went on to outline factors that were working in Australia’s favour in terms of our GDP result last week which has stood out in a time when most countries are shrinking.

He lists the banking system “strong and well-regulated” but forgot to mention the federal guarantee that is giving it continued access to credit lines and driving its competition (the smaller banks and mortgage brokers) out of business. In turn, the increasing oligopolistic nature of our banking sector is forcing interest rates higher.

When Hockey and his ilk start associating the rising interest rates (at mortgage durations at present) with the budget deficits, we will all know to send him to do a course in microeconomics rather than macroeconomics. I think he is a lost cause when it comes to the latter. The gap between central bank overnight rates and the mortgage rates which has opened in the last 6 months is due to unregulated market power which is now held more than ever by our big four banks as a result of the government guarantee.

I noted this morning, courtesy of a Guardian report, that the current G20 meeting has bowed to UK and US pressure to:

… to stop “unenforceable” new rules to cap bankers’ bonuses yesterday as G20 nations struggled to agree on how to keep the global economy on course for recovery.

Anyway, Hockey also said that “China’s solid growth continued to support demand for Australian resources” although he failed to mention in the June quarter National Accounts released last week, while Australia grew in output terms by 0.6 per cent on an annualised basis, Real gross domestic income contracted by 1.2 per cent over the same period, largely because of falling export prices coming from renegotiated commodities contracts.

According to ABS our terms of trade fell 7.4 per cent in the June quarter following a 7.7 per cent decrease in the March quarter. The terms of trade is the prices we get for our exports relative to the prices we pay for our imports.

What also wasn’t noted very loudly last week, is that Real net national disposable income contracted by a staggering -3.2 per cent between June 2008 and June 2009. So we are producing more (just) but earning much less.

He also said that “the large and rapid reduction in interest rates boosted household and business spending power” although the impact on consumption has not been established in any study and is likely to be small and investment has fallen over the downturn period. See my analysis of this in the blog – GDP is growing but further stimulus is required.

So not a breathtaking grasp on the statistics or underlying trends. But then it gets worse.

The wannabe-Treasurer said this:

Most importantly, the Coalition’s sound financial management during its 11 years in government left the country with a world-leading balance sheet: no net debt and money in the bank. We entered the global financial crisis as the envy of the developed world. In less than 18 months, the Rudd Government has managed to turn Australia’s strong fiscal position upside-down.

For the many international readers of the blog – the Coalition is the conservative axis between the (mis-named) Liberal Party and the rural-interest party The National Party (as the junior partner). They have never really come to terms with the fact that the Liberals have become the arch-type neo-liberal party while the National Party remains a xenophobic old-style socialist party whenever it comes to giving state handouts to farmers.

As an aside: there was a joke a while back which said that the reason the Country Party changed their name to the National Party is because the former Labor Prime Minister used to stutter the first part of their name in ridicule … anyone know the origin of that (very funny) joke.

Anyway, apparently the federal government had money in the bank after 10 out of 11 years of running budget surpluses. He might be meaning the assets in the Future Fund (Australia’s sovereign fund) but then they were not accumulated from surpluses. All the Future Funds represents is government spending on speculative assets rather than hospitals, schools, research, direct job creation, universities and a host of other useful things. If you want to read a more detailed analysis of this then you might like – .

You might like to have a look at the diagram in this blog – Deficit spending 101 – Part 3 where I describe what happens to net financial assets when the government runs a surplus.

In part, I said this about the diagram:

The diagram above shows how the cumulative stock is held in what we term the Non-government Tin Shed which stores fiat currency stocks, bank reserves and government bonds. I invented this Tin Shed analogy to disabuse the public of the notion that somewhere down in Canberra was a storage area where the national government was putting all those surpluses away for later use – which was the main claim of the previous federal regime. There is actually no storage because when a surplus is run, the purchasing power is destroyed forever. However, the non-government sector certainly does have a Tin Shed within the banking system and elsewhere.

Any payment flows from the Government sector to the Non-government sector that do not finance the taxation liabilities remain in the Non-government sector as cash, reserves or bonds. So we can understand any storage of financial assets in the Tin Shed as being the reflection of the cumulative budget deficits.

Taxes are at the bottom of the exogenous vertical chain and go to rubbish, which emphasises that they do not finance anything. While taxes reduce balances in private sector bank accounts, the Government doesn’t actually get anything – the reductions are accounted for but go nowhere. Thus the concept of a fiat-issuing Government saving in its own currency is of no relevance. Governments may use its net spending to purchase stored assets (spending the surpluses for instance on gold or as in Australia on private sector financial assets stored as the Future Fund) but that is not the same as saying when governments run surpluses (taxes in excess of spending) the funds are stored and can be spent in the future. This concept is erroneous. Finally, payments for bond sales are also accounted for as a drain on liquidity but then also scrapped.

So there was no “money in the bank”. But moreover, the idea that the capacity of the sovereign government to net spend in its own currency is path-dependent is nonsensical although it is commonly raised in public discussions. The government inherits stocks of obligations etc from yesterday but these are irrelevant in determining its capacity to spend this period.

No matter what the government did yesterday it can always spend today as long as there are real goods and services to purchase. I always note that with the massive unemployment that has been maintained by governments over the last 35 years around the OECD economies, you would be hard put to argue there were not real goods and services available for government to buy.

The idea that a previous surplus helps governments respond to crisis now is plain wrong. And he aspires to be the next Treasurer.

While the surpluses did not give the government any extra capacity to conduct its stimulus program they certainly damaged the economy and have made it harder to achieve desirable outcomes. For example, one manifestation of the surpluses was persistent shortage of work (jobs per se and hours of work).

The other major manifestation was the massive rise in indebtedness of the public sector which has exposed world financial markets to near meltdown scenarios. So while the government didn’t have any money in the bank (because this is a non applicable concept to a sovereign government) what the surpluses ensures was that the private sector (particularly households) didn’t have any money in the bank either (and at the level of the user of the currency that is a problem) – and the rising insolvencies is the expression of that problem.

Hockey then gets deeper into flawed household-government analogy, which is always at the bottom of all neo-liberal statements about macroeconomics. And because of that you always know what they say is incorrect.

He says:

In what can only be described as a massive over-reaction to events offshore, the Government whipped out the national credit card, announced to the markets that it was increasing its credit limit and committed taxpayers to more than $52 billion in “stimulus” spending and at least another $50 billion increase in spending over four years.

Well the concept of a credit card certainly applies to a household and it has become one of the better financial innovations in the last 30 years. But it has no application to a sovereign government which is not revenue-constrained.

He does make one point I agree with although he is not intending to make that point. He said:

In recent weeks the Reserve Bank has been sending clear signals to the Government that it would soon increase interest rates … The Treasurer has said on many occasions that monetary and fiscal policy must work in tandem. Yet now we face the imminent prospect of the two major levers of economic policy heading off in opposite directions.

Which leads him to conclude that by not cutting net spending now, the Government is forcing the RBA into a corner and mortgage rates will rise as a consequence. He then outlines doom and gloom that will follow. Household will be squeezed and “rate rises on overdrafts may force some small business owners to let staff go.”

Well think about that for a moment. First, with unemployment tipped to rise for the next 12 months at least and that is without the slightest double-dip scenario occurring, and households continuing to increase their saving ratio, why would it be correct to assume that the RBA is correct on this?

Second, so Hockey thinks the RBA will force us towards a double-dip – with reduced spending and increased lay-offs.

Third, if Hockey believes that and believes the RBA has it right, and then advocates fiscal policy cutting back “in tandem” with the tightening monetary policy, then that implies he also thinks net spending should be lower with similar consequences.

It is clear that if the Government withdrew the stimulus now and reversed it, the RBA would still hike interest rates because it is operating under a flawed model and the entire board should be sacked for not making decisions according to their legislative charter – to create full employment.

A double dip would then be certain and business confidence. which has been improving within the fiscal security blanket, would plummet. With declining world export prices for our primary commodities, the economy would be in very poor shape indeed.

Hockey says that if we don’t do that then:

The alternative is clearly higher interest rates and higher taxes to pay off the massive debt … The blame for any interest rate rise will therefore lie squarely with the Rudd Government. Its inability to make tough decisions will pose the greatest threat to Australia’s recovery.

The rising interest rates will arise because of the cartel-like banking sector operating within the fiscal guarantee security blanket and the inappropriate conduct of the RBA. If the RBA management’s pay was docked for every percentage point that labour underutilisation went above 2 per cent (currently around 14 per cent) then they would be less willing to put rates up while the economy was struggling to generate any growth in employment at all much less enough to soak up the wasted labour.

The “greatest threat to Australia’s recovery” is that the Australian government will not take “tough decisions” – I agree. But the decisions I am thinking off are – a third stimulus aimed squarely at direct job creation – a million or so jobs!

It was a bad weekend for newspaper commentary on the economy. Yesterday, I woke up to headlines that I guess were trying the scare the bjesus out of me – Chinese equity to fund our deficits. Anyway, a totally wrong-headed way of thinking about the external economy.

But worth noting is the comment from the ANU economics professor W. McKibbon, who is also on the RBA Board and so helps decide monetary policy. He said:

As long as it is financing investment which is getting a return, then there are enough resources being generated to service any additional debt … But if it’s coming in to finance government spending or consumption because people are not saving enough, then you might have a problem.

Where do you start with that? The Chinese are allowing us to receive more ships of real goods and services from them than we are sending back to them because they want to save in AUD-denominated assets. Our trade deficit (with them) is financing their desire to accumulate our dollar assets. We get more real goods and services than we give up and they deny their citizens in the reverse way.

Remember, exports are costs and imports are benefits.

If they decide to stop accumulating financial assets denominated in AUD then they won’t be prepared to ship real goods and services to us on such adverse terms for their citizens. Then we will have less junk available. So what?

Further, he reveals a total lack of understanding of how a fiat monetary system operates in thinking it is possible that the Chinese currency would be funding Australian government spending. The Chinese money cannot possible “fund” government spending in Australia because the latter only spends in AUDs and has a monopoly on issuance in that currency.

Totally unrelated digression

You may have read this Review if you read the Sydney Newspapers.

It is about my favourite TV program although I have never watched it on TV. I refer to The Wire. It is just started on ABC-2 (Monday nights) but I am up to Season 4 at present via the world of DVD. The DVD version also allows you to put sub-titles on which are essential given the totally (at first) incomprehensible language the “ball mer” characters use (street talk).

I might write something more about the show in a stand-alone blog. But for Australian TV watchers this quote from the review really summed it

The Wire may look like a cop show, but it feels like an Augustinian meditation on the nature of evil, like a 21st century homicide investigation into truth. It may make Underbelly look like The Wiggles (our murder rate is a hundredth that of Baltimore … ) but it deals with our stuff all right.

For overseas readers, Underbelly was a TV series recently about cops and the underworld. It was meant to be provocative. But relative to The Wire it was a snack!

Anyway, I’ve even starting talking like the Wire characters. Better than economics that is for sure.

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    This Post Has 5 Comments
    1. This will be the oppositions strategy. They will push the “deficit will push up interest rates” for all it’s worth. It’s all they have. But there is something more I think.

      I’m sure they are aware of the parlous state of heavily mortgaged households who have lost income as so many full time jobs have become part time and are holding onto their homes only because interest rates are low. When the RBA decides to raise rates above the “emergency setting” and back toward the normal range – inflation or no – foreclosures will spike. Many of these people could well be swayed to blame the governments stimulus for the rate rise that cost them their home. If you keep on repeating the same lie endlessly, some of the people will start to believe it, especially if something bad happens. In this way, the oppostion – whose position is desperate – may possibly just garner enough votes to prevent themselves from being blown all the way back to minor party status.

      Isn’t it remarkable how short our memories are? Only a couple of years ago, official interest rates were nudging 7.5% and heading North. And the amount of government debt at the time? None. The government had no net debt if I recall right. So interest rates were high and going higher, all while the government debt which supposedly pushes them up simply wasn’t there. Each year from 2001, government debt fell, yet each year over the same period interest rates rose. And then there were those years in the 90’s when government debt rose year after year but rates fell over the same period.

      I have only veiwed data going back 20 years but what I have seen suggests that there is no causal link between government debt and interest rate movements.

    2. “As an aside: there was a joke a while back which said that the reason the Country Party changed their name to the National Party is because the former Labor Prime Minister used to stutter the first part of their name in ridicule … anyone know the origin of that (very funny) joke.”

      Believe Hawke replied to the Leader of the Country Party who, when he said I’m a Country Member, Hawke said, I do.

    3. Bill,

      I am interested in your thoughts on the following reasoning: I don’t entirely buy it myself, but would like to hear a cogent counterargument. In concerns the impact of the total stock of Government debt.

      * The higher the stock of Government debt, the higher the amount of Government spending on interest servicing (of course the level of interest rates will also be a factor).
      * Government spending (in a modern fiat money economy, etc) is not constrained, so this interest servicing does not pose a solvency risk.
      * Government spending in the form of interest servicing ultimately makes it into the real economy, so will contribute to aggregate demand.
      * While there is no hard constraint on Government spending, if the economy runs out of excess capacity, further increases in Government spending can become inflationary.
      * The production capacity of the economy creates a (“soft”?) constraint on the level of Government spending.
      * (Aside) presumably, by the time this soft constraint is hit, there will be full employment…
      * The higher the level of interest servicing, the less “room” (loaded term) there will be for other forms of Government spending.
      * Therefore high levels of Government debt have the potential to reduce the ability of the Government to direct their spending at their own discretion.


    4. Dear Sean

      All the propositions you list are logical. The production capacity of the economy is the real constraint on government spending. I have always been careful to say that while there is no financial constraint on national government spending (unlike a household or a state government) there is very clearly a real constraint. The government cannot buy what is not available for sale!

      The aside about whether the capital capacity coincides with the full employment level of output is interesting. This was a major debate in the 1980s when Malinvaud (the French disequlibrium theorist who was the rage at the time) wrote his book about capital shortage unemployment. But you can always create enough jobs if you are lateral in thinking via public employment. Of-course, the debate at the time was conducted during the period public employment was being vilified and neo-liberalism was taking hold.

      If there is no further capacity for the economy to absorb nominal spending growth then a rising nominal public debt interest component as a matter of accounting reduces the scope for other nominal public spending. Clearly. Options? Well it depends on whether you are happy with the private/public mix in total spending. If not, then you can increase taxes (reduce private share) or reduce public spending (reduce public share). Or the other option, which all the Austrians and monetarists etc are claiming is the path all governments will take is to inflate the debt away. I don’t think governments deliberately do this as a fiscal strategy.

      Further, strong public spending on health, education and infrastructure adds to productive capacity throughout the economy and thereby pushes the inflation barrier ahead of itself. It is usually assumed that government spending is wasteful and unproductive. Just listen to the current offerings in Australia from the conservatives. But we can all think of many areas of our lives where strong education and public goods help reduce our costs and make things work more smoothly.

      However, before you get to that point the sectoral balances are going to do a lot of work. For example, imports will be rising and financing foreign savings in our currency which takes the “pressure” of domestic capacity use. How far that can go is empirical. I guess the point at which you get to full capacity with no further import capacity is a long-way down the track and the levels of public debt that we are seeing will not generate enough interest rate servicing to really impinge on other discretionary public initiatives.

      But ultimately, a government that is pushing the inflation constraint has some choices it has to make. What I do not agree with – and which is the intent of those who raise this issue (usually) – is that you should abandon the quest for strong public goods and full employment because the inflation constraint will ultimately be reached. This would be as stupid as saying we should stop private investors building capacity because the spending phase may be inflationary if it is too strong.

      Does that help?

      best wishes

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