I mentioned in yesterday’s blog that there is a growing number of deficit-terrorists out there who are trying to appear reasonable to separate themselves from the more loony Austrian-school fringe. They are appearing reasonable by saying that “now we should have deficits” but soon (unspecified) “we will need surpluses” to “pay back the excesses”. That sort of spurious reasoning. Even some self-styled progressives who want us to think they are both reasonable people and knowledgeable commentators are starting to emerge within this broad camp. But in general their arguments reflect, at best, an ignorance of how the monetary system operates. This unholy gathering will prove to be very damaging to the need for a broader understanding of how these operations and how government fiscal interventions impact.
This crazy crew have been helped along in the last few days by the IMF release of its The State of Public Finances Cross-Country Fiscal Monitor: November 2009 prepared by the fancy sounding “Staff of the Fiscal Affairs Department”. Sounds like a make work program to me and after reading the Report I would urge them to get real jobs – productive ones – perhaps helping the community sector or offering to assist in environmental rehabilitation schemes.
I read two articles following my reading of the IMF report … and well … you know … they all reinforce each other’s misconceptions.
Take this article – Worries about Budget Deficits and Inflation: Let’s Avoid Repeating Our Mistakes which is representative of the genre “let’s not cut back just yet but soon we will have to pay it all back”.
The article appears in the self-styled Maximum Utility blog from Mark Thoma. He has a reasonably high media profile in the US and is a macroeconomist from the University of Oregon and he tells us that “his research focuses on how monetary policy affects the economy”.
That is a good thing to focus one’s research activities on. But it is a wasted life if you don’t actually achieve that aim because you are locked into textbook fantasy worlds.
While professing to provide Maximum utility my reflection is that all a reader will get out of this blog is a minimum and mostly wrongful understanding of the way the monetary system operates, and, hence, the way monetary policy affects the economy.
Thoma’s first proposition that when considering the US fiscal position it is crucial to separate out the TARP-type packages administered by the central bank and the more spending-oriented fiscal packages introduced by the Congress (via the Treasury) is sound.
On the former, Thoma says that the Fed policies have meant that “a very large quantity of excess reserves has accumulated within the banking system” and idle reserves “are not much of a problem”. I don’t know whether the use of the word much was anything more than “folksy American jargon” but the reality is the reserves present no problems.
Thoma then notes that the fears that the reserves are an inflation-outbreak waiting to happen are unfounded as “long as we are still below full employment, then inflation – which is driven by an excess demand for goods and services – is not much of a worry.” I agree.
He entertains the idea that when spending recovers, demand for loans will increase and the massive stockpile of reserves in the banking system will be “looking for something to finance cause excess demand and hence inflation?” and rejects it as an inevitability largely because the central bank is paying interest on reserves at present.
So the interest on overnight reserves can be adjusted “to keep the reserves in the banking system and avoid the inflationary consequences”. We have discussed before the equivalence of issuing debt to drain bank reserves and paying interest on reserves and leaving them sitting in the banking system.
My discomfort at this stage reflects the fact that there should have been mention of the fact that once demand begins to recover there will be increasing numbers of credit-worthy customers lining up at the banks’ doors for loans. So?
The capacity of the banks to meet those loans will not be increased at all because they have a stock-pile of reserves (currently earning interest).
Banks just make loans which create deposits and then chase down the reserves they might need later to satisfy the central bank requirements for prudence. They will not make more or less loans as a result of their reserve positions.
Further, if the credit creation and resulting spending is so robust that it pushes nominal aggregate demand beyond the real capacity of the economy to respond to it (in output) then inflation will result. This is a completely separate matter from the state of commercial bank reserves which the central bank will always ensure are adequate for their purposes.
So the question of bank reserves is a furphy. However, Thoma does suggest they might matter because the reserves will be cheaper forms of credit for banks. But the central bank can (as he understands) control that anyway by adjusting the rate it pays on them or draining them by issuing more debt.
Then we turn to the fiscal aspects of the stimulus and here the wheels fall off. Thoma says that with the tax cuts and government spending that was designed to “simply prevent conditions from being much worse than they already are” (because the package was far too small):
The worry here is that government borrowing will drive up interest rates, that the increase in interest rates will lower private investment (this is called “crowding out”) and that, in turn, will cause economic growth to be lower that it would be otherwise.
Right now, this is not a very realistic worry. When the economy is near full employment, and when there are not bundles of cheap cash available from the excess savings in countries like China, an increase in government borrowing adds to the competition for the available funds. The increased competition for available savings drives up interest rates and crowds out private investment. But when there is an excess of available funds, as there is now (this is the excess reserves described above), and cheap loans available from foreigners (e.g. from China) – more than the demand for funds at the current interest rate (which is essentially zero) – the government can borrow without putting any upward pressure at all on the interest rate …
This is a reiteration of the mainstream macroeconomics textbook causality that is categorically rejected by modern monetary theory (MMT).
It is not even necessarily true that higher interest rates lower private investment in a growing economy. Investment decisions compare cost and benefit and when income is growing (as a result of the stimulus and then private spending recovery) even if interest rates are rising so to will be the expected benefits. The textbooks conduct “other things equal” analysis in a static time frame – so they just superimpose a cost increase without considering the income growth.
But that issue is smaller in seriousness to what follows. The implication is that there is a finite savings pool that is the subject of competition from borrowers – public and private. First, saving grows with income and so we say that “investment brings forth its own saving”, which is a way of saying that the income adjustments that occur when aggregate demand change provide a reconciliation between the planned saving and investment.
Second, where do the funds come from that the government borrows? Answer: $-for-$ from the net spending. The government just borrows its own net financial assets back. If you want to profess to understand how the monetary system operates then you have to start with a basic understanding of how net financial assets denominated in the currency of issue enter the banking system in the first place.
Third, the statement “excess of available funds (this is the excess reserves …)” is just nonsensical for reasons discussed above. Statements like this really give the game away … and tell you that the writer is operating in the money multiplier world of the gold-standard textbook. For more on that you might like to read this blog – Money multiplier and other myths.
The reserve situation will not influence the ability or the willingness of the banks to lend. That has been one of the fallacies that this downturn has so categorically exposed. The UK example is manifest. The BoE keeps increasing reserves in the hope that the banks will start lending but the banks will not lend because there is no credit-worthy borrowers (in their estimation) lining up for the loans. If there was they would lend – huge stockpiles of reserves or not.
Fourth, the central bank sets the interest rate at whatever level it desires.
After claiming that the health care issue in the US will represent a future financial constraint on US fiscal policy (it will not – although it might give the Administration a huge political headache (excuse the pun)), Thoma then gets more confusing. He says:
I don’t want to be misunderstood. It’s important that, once the economy recovers, we do what is necessary to pay for the stimulus package … Doing stabilization policy correctly requires deficit spending in bad times, and then paying for that spending when times are better. We have been very good at running up deficits during the bad times, but not so good at paying the bills when things improve, and that needs to change.
But beginning to pay down the deficit too soon can endanger a recovering economy, and it’s important to be sure that the economy is on solid footing before starting to pay the bills for the stimulus package. The day will come when it’s time to do just that, but we are not there yet. (In fact, given the poor state of the job market, I’d favor even more stimulus presently, particularly programs that directly target jobs).
So this is a deficit-dove with good intentions talking. The last sentence in brackets is impeccable – with 17.2 per cent of willing US labour resources currently broadly underutilised – there should be further stimulus and it should be in the form of direct public job creation – like a Job Guarantee
But what comes before that is unsound and gives the game away.
First, a household has to “pay for” any past spending above income. The only way a revenue-constrained household can spend above its income is if it borrows, runs down assets (including saving) or sells things for revenue. Each of these “financing” sources involves a form of “pay back”.
But there is no applicability in using this logic for a sovereign government which issues the currency. Governments do not pay down deficits. Deficits are flows – daily occurrences – yesterday’s deficit is gone and won’t be coming back.
So what he is talking about is the debt, which is the stock accumulation of the flows, given the voluntary and stupid constraints the US government places on itself when it net spends.
So why doesn’t he just say that straight rather than use language like “time to pay the bills” (which evokes household comparisons)? Rhetorical question!
You have seen the next graph before. It shows US Government budget position as a percentage of GDP (deficits are below the zero line) from 1940 to 2009 (data from US Bureau of Economic Analysis). So a large rise in the ratio during the Second World War then consistent deficits ever since except for a few misguided times when the government tried to run surpluses only to find they ran against leakages from the expenditure system that forced them back into deficit (via income adjustments and the automatic stabilisers).
The next graph shows the evolution of US federal debt from 1940 to 2008 split into components (data from US Office of Management and Budget). So the blue line is total (gross) federal debt, the green line is the total federal debt held by the public (noting they count the holds of the Federal reserve, the central bank, as public – purple line), the red line is that held by Federal government accounts, and the indigo line is the non-fed public holdings (public here means private or non-government).
The break-up is interesting in itself and the OMB provides further details. If I was a debt phobe I might spend a lot more time wondering about it but as I am not the essential point I will make here is that with the almost continual deficits that the US government was running over the time span shown, the Debt/GDP hardly exploded and so arguments that imply that the government will have to run surpluses to “pay for the party” are fallacious.
So while national government’s clearly pay the debt they issue at an appropriate time as per the “contract” this in no way reduces their capacity to keep running deficits. No-one is saying that the central bank interest payments on overnight reserves will limit its ability to provide reserves in the future. It would be a nonsense to say that.
Well why would you suggest that the simple crediting of a bank account at some point in the future – with a corresponding ledger entry – bond repayment XXXXX – would financially hamper the capacity of the federal government to spend at that time? It clearly will not. So what does the notion of having to “pay for the deficits” mean? Answer: nothing. For more on that you might like to read this blog – I guess they didn’t want to win the wars.
Conclusion: pity the students at the University of Oregon who have to learn this stuff.
After that I sought relaxation by reading the latest Martin Wolf contribution in the November 23 edition of the Financial Times – Give us fiscal austerity, but not quite yet.
I knew it would make me laugh and they say laughing is good for you and relaxes you. I wasn’t wrong.
Here is a teaser. Wolf said:
So what is the problem? It is that people may lose confidence that the governments will ultimately bring deficits under control. There are at least two reasons for such doubt. First, wars have a natural ending, while deficits in peacetime do not. Second, cutting deficits at the end of wars is easy, while cutting peacetime deficits is hard: every pound or dollar comes with a lobby group attached.
You get the drift. Deficits cut themselves in peace-time when the economy grows again. A significant portion of the deficits that have arisen around the world in response to the crisis has been by the automatic stabilisers. This involves no political pain – it will just happen because more people are working and enjoying life again.
What remains of the budget deficits as the economies approach full employment (if they are allowed to by their governments) may actually match the leakages arising from the external and domestic private sector. Nothing needs to be cut out of net public spending if that is the case.
If there is excess nominal demand growth at that point then the government has options. Increase taxes and/or cut spending. But their economies will be bouyant and incomes will be high and at that point the political decisions are much less likely to cause individual damage or widespread political fallout.
Wolf fails to mention the automatic stabilisers anywhere in his article even though they were so significant in accounting for the increasing deficits. Why not?
Well for the same reason Thoma uses misleading household-type language “paying back the bills”. It forces the reader into a particular state of mind.
If the average reader knew that say 80 per cent of the deficits will be wiped away once the economy gets back onto trend growth because unemployment falls and people have higher incomes and more enjoyable lives then there would be no story for the conservatives to write.
Wolf concluded this article in this way:
So what should be done? I agree fully with the remark by Dominique Strauss-Kahn, managing director of the IMF, in London this week that “it is still too early for a general exit” from accommodative policies. That applies also to the UK and US. What is needed, instead, are credible fiscal institutions and a road map for tightening that will be implemented, automatically, as and when (but only as and when) the private sector’s spending recovers. Among the things that should be done right now is to put prospective entitlement spending – on public sector pensions, for example – on a sustainable path. It is, in short, about putting in place a credible long-term tightening that responds to recovery automatically.
Yet we also cannot escape from an “inconvenient truth”. Neither the UK nor the US is quite as wealthy as it once believed. There are losses to be shared, much of which will fall on public spending, taxation, or both. Once it becomes evident that neither of these countries can rise to the challenge, fiscal crises are inevitable. It would only be a question of when.
Well there is a credible “road map” that “will be implemented, automatically” which will wipe many percentage points of the deficit to GDP ratios that are presently being witnessed. They are the automatic stabilisers discussed above.
Anyone who knows anything about macroeconomics knows about them and knows how they work.
Anything more than that doesn’t make sense unless Wolf is claiming that he could perfectly forecast the desired non-government saving intentions in the coming years.
My bet is that households in general will not return to their credit-bingeing past and will continue to consolidate their balance sheet by saving. I cannot foresee a return to aggregate private dis-saving.
So for all countries with current account deficits, that means there will be deficits required to keep growth going and to allow the private sector to continue this process of consolidation.
Wolf seems to be in denial of that prospect and the accounting realities that arise as a consequence. Or if he knows about them he prefers not to tell the reader.
Why? Because he just wants to get to his punch line as misleadingly and/or wrongfully as he can – that way he can assert that a fiscal crisis is inevitable.
Conclusion: hack journalism.
But if you really want a laugh read this little extract, which is one paragraph of many along the same theme, from what appears to be a rival to wikipedia – wait for it – conservapedia
In the 1990s leftists in Australia demanded strict gun control based on isolated violence that was sensationalized in the media. Predictably, the rate of assaults in Australia increased with the stricter gun control, and the politics of the country moved to the Left in greater reliance on government protection.
The isolated violence was the slaughter of 35 people in 1996 (another 19 were were seriously injured) in Tasmania. Australians have never been able to bear guns. Further, the legislation was introduced by the previous conservative government which went as far right in the political spectrum as any government had ever gone over here.
That’s enough for today.