skip to Main Content

Who is in charge?

Today I was looking over some macro data from Ireland which is leading the charge among the peripheral EMU nations (the so-called PIIGS) to impoverish its citizens because: (a) the amorphous bond markets have told them too; and (b) they had previously surrendered their policy sovereignty. Their actions are all contingent on the vague belief that the private sector will fill the space left by the austerity campaign. The neo-liberals are full of these sorts of claims. More likely what will happen is a drawn out near-depression and rising social unrest and dislocation. But as long as the Irish do it to themselves then the Brussels-Frankfurt bullies will leave them to demolish their economy. It raises the question who is in charge – the investors or the government? The answer is that the government is always in charge but what they need to do to assert that authority varies depending on the currency arrangements they have in place.

The UK Guardian carried a story yesterday (February 7, 2010) – Thousands to lose jobs as universities prepare to cope with cuts – which details how “(u)niversities across the country are preparing to axe thousands of teaching jobs, close campuses and ditch courses to cope with government funding cuts.”

As I noted last week in this blog – Another intergenerational report – another waste of time – for all practical purposes there is no real investment that can be made today that will remain useful 50 years from now apart from education. Unfortunately, tackling the problems of the distant future in terms of current “monetary” considerations which have led to the conclusion that fiscal austerity is needed today to prepare us for the future will actually undermine our future. The irony is that the pursuit of budget austerity leads governments to target public education almost universally as one of the first expenditures that are reduced.

So the UK government is just confirming they have no foresight. They are willing to sacrifice the chance to invest in future productivity growth because they are living in daily fear that the corrupt credit rating agencies will downgrade their sovereign debt standing and that the bond markets which ultimately call the shots will punish them.

The public at large share this myth intuitively and so political pressure means they are cutting. The cuts are needless once the false intuition is exposed.

The Guardian today (February 8, 2010) discussed the prospect that – Ireland’s suffering offers a glimpse of Britain’s future under the Tories.

The story then documents that vehemence of the Irish government’s fiscal austerity actions. The writer says that;

Unlike Britain, the United States, France, Germany, China and the rest of the G20, Ireland has not rediscovered Keynes. It has spurned counter-cyclical budgetary policy and instead has been raising taxes and cutting spending in a series of budgets and mini-budgets that have sucked demand out of the ­economy. Lenihan has cut child benefit by 10%, public-sector pay by up to 15%, and raised prescription charges by 50%. One eighth of the working population has no job, yet unemployment benefit is being cut by 4.1%. For the young ­unemployed, the measures are even more draconian: the dole has been slashed by 50%.

The popular line being pushed out of Brussels and Frankfurt is that Ireland is showing the other PIIGS what can be done and “will be rewarded for its prudence. Bond yields will come down because investors will grow less anxious about a default. The ratings agencies will think again about downgrading ­Ireland’s credit rating.”

Of-course, given the extremely depressed nature of the Irish economy, it is highly unlikely that private spending will fill the gap left by the fiscal contraction. The impoverishment of the Irish population will be drawn out and generations will suffer.

The Guardian said that:

Greece, Spain and Portugal – all under pressure to follow the Irish lead – also have to balance the struggle for “credibility” in the markets against the short-term hit to demand.

So the narrative is again that the markets rule! If you don’t have credibility then the markets will close down the government. So it is better for the government to close itself down by pursuing harsh austerity plans.

The case of Ireland (and the PIIGS) in general is, of-course, not comparable to that of the UK. The PIIGS are hamstrung as a consequence of their membership of the EMU which essentially means they ceded monetary policy authority to the ECB, pegged their real terms of trade via the common currency and abandoned any capacity to run an independent fiscal policy.

The interesting aspect of their decision to enter the EMU is that it set up the preconditions for their crisis. And now the same membership is making the crisis worse.

The Irish construction boom was driven by low Eurozone interest rates (in part) which the Irish government had no control over. Had they been a sovereign nation they may have tightened monetary policy (although that may not have been as effective as a fiscal contraction). But the EMU membership required they abandon an independent monetary policy without any corresponding fiscal redistribution mechanism being made available within the system.

There is now civil unrest growing in Ireland, Greece, Portugal and Spain as the “bond markets” allegedly force these governments into harsh, anti-social fiscal contractions.

The Guardian also carried a story yesterday (February 7, 2010) about Greece – The wider financial impact of southern Europe’s Pigs. It said:

Financial markets like to bet against countries and punish those who have policies or deficits that look unmanageable. Back in 1992 the pound came under brutal attack from speculators led by George Soros who were prepared to gamble that the Tory government of the day would not be able to maintain its peg to the Deutschmark in a bid to finally rid the country of inflation.

By the time Black Wednesday was over in September 1992, Soros had reputedly pocketed £1bn and the reputation of the government of John Major for economic competence was in tatters.

In a similar way, the governments of Greece and Portugal, and also Spain and Italy, are under attack from the bond markets. That may not sound like a national emergency for the countries concerned but the financial impact is real.

The writer said that the investors are selling “Greek government bonds with a vengeance” and this is a problem because “governments that run big deficits need to finance them by selling new bonds to financial markets. If people don’t want to buy them, they have to offer a higher coupon, or interest rate, to investors”.

So by “selling off existing Greek bonds, dealers pushed up the yields on those bonds because yields move inversely to price” which further drive up the budget deficits of the nations involved.

As noted above – the EMU nations have voluntarily signed up for this nightmare – to enter a system that allowed the bond markets to hold any country hostage.

But sovereign nations are not in that position which raises the question – why do they act as though they are operating at the behest of the amorphous bond markets?

There was some unintentional symbiosis today. After several commentators have been discussing how to best get the message of modern monetary theory (MMT) out to the public to gather support for it, given how unintuitive it seems to most people (I disagree that it is, but I am continually told otherwise), I have been reading up on the psychology literature on what in communications technology is called the last mile problem.

And then today, Scott Fullwiler sent me a link to a video about this issue in the context of reducing child mortality in India arising from diarrhoea – watch it HERE if you are interested.

The facts are that child mortality has fallen dramatically over the last 50 years or so after doctors found the application of oral re hydrations therapy (a very simple fluid supplement) worked. They fell from 24 per cent in 1960 to 6 per cent in 2009. But it still remains that around 400,000 babies still die from this totally preventable condition even though the technology is available and known.

The point is that a problem is not solved once you have solved the technology. I have noted before that we have long been able to solve most of the problems that still cause misery in less developed countries. But there is reluctance to provide these solutions for various reasons. In the case of the Indian mothers the problem solving requires working at the psychological level – the so-called “last mile”.

We react intuitively all the time and this blinds us to what is going on. An the example given in the video was the following. A bat and ball costs $1.10. The bat costs $1 more than the ball. How much does the ball cost? Most people in controlled experiments acting on intuition say 10 cents whereas the correct answer is of-course 5 cents.

I have been reading this literature for sometime now because I think it resonates with the challenge that MMT has in disabusing the wider public of falsehoods in macroeconomics that arise from the application of intuition. This intuition is continually reinforced by analogies between the household and government budgets, for example.

In my view, the last mile application relates to this hurdle. The first “90 per cent” of the paradigm development is done. I refer to the correct specification of stock-flow consistent macroeconomic relations and well-specified behavioural relations that drive these flows into the stocks. That has been a major theoretical effort and I consider it very robust.

I have been giving public presentations and have written millions of words about this stuff over many years and no mainstream theoretical attack has been able to be sustained. In most cases, the attackers give up and resort to mouthing the intuitive emotions that they hold about these issues.

So concepts such as hyperinflation; sovereign debt default; tax slavery; and all the rest of these emotional knobs are turned when the attacker has run short of logic. These emotional defences are what constitute the last mile and so a cerebral approach is needed. The technology of MMT is almost complete – there is further work going on at present on applying it to development economics – a book is coming!

Where might we start exposing faulty intuition which allows policy makers to devastate their populations via fiscal austerity packages at the height of a near-depression?

A basic confusion starts when we consider the so-called inter-temporal government budget constraint (GBC), which mainstream macroeconomists use as their organising framework. The public, of-course, are spared the fine detail of the GBC by the economists, but all the “takeaways” reinforce the intuition that the GBC is a down-to-earth concept that we can all relate to because it is what we do ourselves on a daily basis – spend according to a budget constraint.

The GBC is in fact an accounting statement relating government spending and taxation to stocks of debt and high powered money. However, the accounting character is downplayed and instead it is presented by mainstream economists as an a priori financial constraint that has to be obeyed. So immediately they shift, without explanation, from an ex post sum that has to be true because it is an accounting identity, to an alleged behavioural constraint on government action.

The GBC is always true ex post but never represents an a priori financial constraint for a sovereign government running a flexible-exchange rate non-convertible currency. That is, the parity between its currency and other currencies floats and the the government does not guarantee to convert the unit of account (the currency) into anything else of value (like gold or silver).

The following accounting relation, is the often erroneously called GBC and can be used to show the impact of budget surpluses/deficits on spending and private wealth:

where G is government spending net of interest payments on debt, i is the nominal bond rate, B is the stock of outstanding bonds, M is base money balances, and T is tax revenue. In an accounting sense, when there is a budget surplus then ΔM <0 (destruction of base money) and/or ΔB < 0(destruction of private wealth). So in English, this equation just says that government spending on goods and services (G) plus the interest payments on the outstanding stock of public debt (iB) minus revenue (T) comprises the budget balance which is a flow of currency. It has to manifest in the non-government sector as the sum of the change in the stock of high powered money (bank reserves) (ΔM) or the issuing of new debt (ΔB), which are stocks. The mainstream macroeconomics models then eschew the ΔM option, which they call "monetisation" (in other words, the central bank ratifying the treasury spending - which might involve for accounting purposes, the purchase of treasury bonds by the central bank). Why do they eschew this? They draw on the Quantity Theory of Money to argue that ΔM => ΔP – or money supply growth directly translates to price level growth and the longer the left-hand side of the equation (above) is positive (that is, a deficit) the longer the price level will continue to escalate.

In other words, it is a religious belief that ΔM causes inflation. The Quantity Theory of Money begins with an accounting identity MV = PY, where M is the stock of money, V is the velocity or the times the stock turns over per measurement period, P is the price level and Y is the real output level.

Clearly from a transactional viewpoint this has to hold. All the transactions (left-hand side) have to equal the value of production (right-hand side). That doesn’t get us very far.

The mainstream macroeconomists then assert the following – V is constant despite the empirical evidence which shows it is highly variable if not erratic – and Y is always assumed to be at full employment and as such is fixed. With these assertions it follows that changes in M => directly lead to changes in P because with V assumed fixed the left-hand side is driven by M and if Y is assumed to always be at full employment then the only thing that can give on the right-hand side of the accounting identity is P. Please read my blog – Questions and answers 1 – for more discussion on this point.

Of-course, with unemployment and idle capacity now common, Y (real output) can hardly be seen as fixed at full employment no matter how much the mainstream want to deny that mass unemployment exists. Even if V was constant then all you could say then was that changes in M lead to changes in PY – that is nominal GDP, which is a trivial statement.

The GDP growth is always mixed between changes in the price level and changes in real output. For any nominal increase in demand, it is the division between the two (prices and output) that is the issue at stake.

Keynesians (the real ones); Post Keynesians and MMT’ists consider that with costs relatively constant over the normal output range and firms setting prices by marking up unit costs – then the division will favour real output until the economy reaches very high levels of resource utilisation. The extreme position is that the economy has a reverse-L shaped supply curve (where price is on the vertical axis and real output on the horizontal). The right-angle is at the full employment level of real output.

In this case, there is a dichotomous response to nominal demand increases – all quantity (real output) up to full employment then all price (inflation) afterwards as no further output can be produced with the current capacity. The empirical reality support a reverse-L shape with some arcing in the right angle – so bottlenecks occur close to full capacity and there is some mix of price and output response after that point until no further output can be gleaned from the system.

Anyway, the intuition that has been successfully inculcated into the brains of most people with the help of imagery from the Wiemer Germany and more recently Zimbabwe is that ΔM will lead to hyperinflation as the evil government printing presses run overtime in seedy basements somewhere in our national capitals. It is clearly not a sensible conclusion to make. Excessive ΔM will be inflationary if it leads to nominal demand growth outstripping real output capacity.

So at full employment this becomes a major risk (if you care about inflation). But below full employment a demand-pull inflation is a remote possibility. But the imagery and the intuition is now ingrained.

The mainstream then focus on the ΔB part of the GBC. This is the change in the stock of outstanding bonds. So to avoid inflation and to maintain fiscal discipline, governments have to issue debt $-for-$ when they net spend [(G + iB) > T]. This is allegedly a major constraint because it ensures the “bond markets” can discipline errant governments by “closing them down” (that is, not funding their deficits).

It also provides a disincentive to governments to pursue deficits because once again the imagery and intuition about the alleged inevitability of sovereign default is ingrained in the public. That is what the hysteria at present is working on – this falsehood. The smart economists know full well that a sovereign (currency-issuing) government has no insolvency (that is, default) risk.

In the short-run, the mainstream clearly think that a public deficit that is associated with ΔM is more inflationary than one that is associated with ΔB.

But the mainstream have such an ideological obsession against government command of resources for to pursue a socio-economic program (because such programs are “wasteful”, “inefficient”, “roads to no-where”; “undermine incentives”; “enslave free people”, etc) that they realise they can pull the emotional strings and invoke this faulty intuition in the public.

If you then take the two intuitive arguments together the ΔM = inflation and the ΔB = higher taxes and likely default – then you have a powerful case against government deficits – despite both propositions being essentially erroneous depictions of how a modern monetary system works and the opportunities that a fiat currency presents to the government.

But if you think about it clearly and address the inflation, higher tax, sovereign default issues one by one then you will quickly realise that the ΔM option is easily superior to the ΔB option. That is, based on my understanding of MMT, I would have no public debt issuance. Our friend Scott Fullwiler called this a matter of “political economy” in his paper Interest Rates and Fiscal Sustainability. I urge people to read this excellent coverage of the literature.

I have covered the refutations of the arguments about inflation, higher taxes, sovereign default in many of my previous blogs. These blogs – Will we really pay higher taxes? and Will we really pay higher interest rates? – are good places to start.

Two things that then arise from this:

  • Can the bond markets dictate the cost of public borrowing?
  • Can the bond markets close down a sovereign government?

The answer to both questions is absolutely not! The intuition that is rehearsed daily in the media commentary and is being encacted by policy makers is flawed. The last mile requires us to work harder to clarify the flaws and to indicate how a better path can be laid.

Consider the first question: do governments have to pay what the bond markets demand? The correct answer is only if the governments conceded to the false authority of the markets. Otherwise, the government is fully in charge of the bond issuance process and the markets become compliant recipients of corporate welfare in the form of a guaranteed (risk-free) annuity (with interest) in exchange for non-interest bearing bank reserves.

The mainstream claim there is a finite pool of saving (which is directly taken from the discredited Classical loanable funds doctrine – see my blog – Studying macroeconomics – an exercise in deception for a critique of this docrine). They also believe that investors demand a risk premium in case insure again sovereign default.

They consider the government might absolutely default or the more likely “run the printing presses” to repay the debt and inflate it away. All strongly false intuitive elements in the public’s perception of these matters.

So it is presented as obvious that public debt competes for funds which could be deployed elsewhere and so this drives up interest rates. At present the emphasis on rising yields is mostly slanted to the default argument.

First, the empirical evidence is that there is very little relationship between fiscal policy positions and interest rates. So the basis predictions from the mainstream model are not supported by the data. The mainstream then introduce all sorts of dodges which I won’t bore you with to explain this anomaly (mainly concentrating on the role of expectations etc).

Second, the mainstream fail to comprehend that the central bank sets the interest rate at whatever level it wants. Bond market traders have no say in that decision. The central bank then stands ready to ensure that the reserve balances are maintained at a level where the interest rate target is maintained. Budget deficits, for example, add extra reserves which may be deemed by the commercial banks to be above the minimum levels they require to facilitate the cheque clearing house (payments system).

In that case, the central bank has to “drain” those excess reserves or lose control of the interest rate (because the commercial banks will try to lend the excess reserves among themselves in the interbank market which drives down the overnight interest rate).

The central bank can also control all rates along the yield curve (different maturities of investment assets) if it wants to. Please see my blog – Things that bothered me today for a discussion of how the central bank can announce explicit ceilings for yields on longer-maturity Treasury debt and enforcing those ceilings by committing to make unlimited purchases of securities (at those maturities) at prices consistent with the targeted yields.

Third, the government only ever borrows what it has already spent so there is no demand on “scarce” saving.

Fourth, government net spending increases output (as long as it is non-inflationary) which increases saving overall. There is no finite pool of saving in a growing or contracting economy.

Ultimately our intuition about the GBC (above) has to start from the knowledge which is undeniable – that a sovereign (currency-issuing) government is not revenue constrained.

In other words, the GBC has to be an ex post (after the fact) accounting statement of the changes in stocks that accompany the flow of net spending (positive or negative) rather than an a priori (before the fact) financial constraint.

Once you start from that understanding the erroneous intuitions are easier to break down.

The sovereign government can clearly pretend the GBC is an a priori financial constraint – the so-called gold-standard logic – but that is a political choice and is not ground in economic reality.

Once that is understood then that political choice has to be considered against all other political choices including enforcing major fiscal austerity programs on the population.

In the case of the PIIGs, it is a political choice to stay in the EMU. They could restore their sovereignty if they chose to. So that is another political choice that has to be assessed against their choices to impose harsh impoverishment on their citizens.

Once we get to that stage of understanding then it is quite clear that it is the sovereign government that is in charge rather than the bond markets.

The government (via the central bank) can simply enforce a yield structure onto bond markets. Like it or lump it. If the bond markets don’t like it then the central bank can buy the debt.

Better still, the government can simply avoid issuing debt altogether and deprive the “bond markets” of the corporate welfare.

The inflationary risk will be unchanged as I explain in this blog – Building bank reserves is not inflationary. The inflation risk comes from the impact of the net spending on aggregate demand. There is nothing intrinsically inflationary about the ΔM option.

It also clearly takes the bond markets out of the equation and would serve to disabuse us of notions such as the sovereign government has “run out of money”; or will “go bankrupt”; or “will not be able to afford future health care”; and all the related claims that flow from the flawed intuition that initially is advanced and exploited by mainstream macroeconomics.

Of-course, this approach would change the conduct of monetary policy – either a zero rate policy such as Japan has run for years or paying a positive return on excess reserves (as many governments have done in the crisis) would be required. This point relates to the impossibility of using ΔM (that is, monetising net public spending) if the central bank has a positive interest rate target and doesn’t pay a return on overnight excess reserves.


The last mile is the hard journey for all thought-changing struggles. Getting the message across to those who have ingrained intuition which is resistant but fallacious is the hard part.

I see my role as developing the conceptual ideas and structures and pointing out where faulty logic is being pursued. But I am also increasingly thinking about the last mile … to really drive these ideas into the intuitive understanding of those that lose out when governments needlessly pursue these austerity programs or enter into arrangements (such as the EMU) which prevent them from advancing the welfare of their citizens as a matter of structure.

That is enough for today!

Spread the word ...
    This Post Has 203 Comments
    1. “It raises the question who is in charge – the investors or the government? The answer is that the government is always in charge … So the UK government is just confirming they have no foresight. They are willing to sacrifice the chance to invest in future productivity growth because they are living in daily fear that the corrupt credit rating agencies will downgrade their sovereign debt standing and that the bond markets which ultimately call the shots will punish them.”

      If governments are always in charge, and the bond markets ultimately call the shots, then???

      Austerity is an economic means to a political end. Yes, it makes no sense not to invest in education, provided that one believes that future productivity is a goal. It is not. The goal is to reduce the standard of living across the board, except for the neo-feudal elite.

    2. Seems like your last mile problem really is just that — getting the right people into the White House, Fed, and the Treasury (in the case of the US) that understand MMT and are willing to act on it. They’re probably just down the street right now :-)

    3. Ran across your writings and while some I can concur, I am not sure your points are relevant to all.

      With regards to your comment along the lines that there is no investment more valuable 50 years from now than education. Education today is a highly consumptive activity. Education for the masses used to be productive in that it was training on skills required, needed and/or wanted. Only the very wealthy could literally afford to spend years studying art history, interpretive dance, hand ball, logic and 16th century feline addictive behaviors (ok I made that one up). But, my point is that not only is much of education today completely useless and obsolete 50 years from now, it is completely useless today. Many graduates bartending and waiting tables can confirm this if you care to ask them.

    Leave a Reply

    Your email address will not be published. Required fields are marked *

    This site uses Akismet to reduce spam. Learn how your comment data is processed.

    Back To Top