Sunday, 14 February 2010

Nonsense from Alistair Darling and 20 economists.

Alistair Darling, Britain’s finance minister, suffers from the popular delusion that if the deficit is cut, e.g. by cutting public spending, this will hinder the recovery (1). And twenty economists who signed a letter to the Sunday Times (14th Feb 2010) advocating a plan to reduce the deficit are not much better (2).

The idea that cutting public spending or raising taxes will be deflationary is understandable because deflation certainly is the effect OTHER THINGS BEING EQUAL. But we aren’t in an “other things being equal” situation: the proposal is to raise tax and/or cut spending PLUS cut borrowing. So what is the overall effect of this?

The U.K. government currently pays for roughly 10% of expenditure by borrowing. The latter involves inducing people and institutions to part with £Xbn in exchange for government I.O.U.s. This prevents people and institutions spending such money and enables government to spend it.

Now suppose as an alternative, government collects £Xbn via tax. This prevents owners of the £Xbn spending such money and enables government to spend it. Ring any bells? Put another way, borrowing and tax are not vastly different from each other. Most important: the effect of each on aggregate demand is much the same. Thus a drastic and immediate cut in borrowing, balanced by a significant tax increase (and/or cut in government spending) would NOT have a huge deflationary effect and would NOT significantly hinder the recovery.

Is there a difference between tax and borrowing?

The main difference between tax and borrowing is that the population SEES tax increases as being much more of a disaster than borrowing increases. There are two reasons for this delusion.

First, an increase in income tax or sales tax is obvious to everyone. For example if an extra £20 a month worth of income tax is deducted from your pay packet, you’ll notice it. In contrast, if borrowing becomes a bit more difficult for those wanting to build an extension or buy a car (because government has swept up much of the money available to borrow), that is not immediately obvious. Moreover, those who fail to get a loan for a new kitchen probably won’t attribute this failure to government.

Second, government borrowing involves giving those who lend pretty pieces of paper: government I.O.U.s Lenders SEE these pieces of paper as wealth. And for INDIVIDUAL lenders they certainly are wealth in that such lenders can cash the I.O.U.s at any time (either on maturity or by selling the I.O.U. to any willing buyer).

But in the aggregate these I.O.U.s are worthless. That is, if everyone tried to cash them at once, the value of the I.O.U.s would collapse to nothing. This simply reflects the fact that these I.O.U.s are simply pieces of paper or book keeping entries.

A small amount of government borrowing may make sense (though I doubt it). As to LARGE amounts of government borrowing, this involves moving in to South Sea Bubble territory.

Is Keynsian borrow and spend pointless?

Astute readers will notice that I have assumed above that crowding out completely nullifies Keynsian borrow and spend. I certainly think that assuming constant interest rates “borrow and spend” is pointless for reasons given here.

Of course if borrow and spend DOES have a reflationary effect, then the above proposal (i.e. cut borrowing and raise taxes/cut spending) will be DEFLATIONARY. But that’s not a problem: just effect whatever amount of unfunded budget deficit is needed to counter the deflationary effect.

The latter of course involves replacing a certain amount of government debt with base money. But what’s the problem with this? As the advocates of modern monetary theory have pointed out a million times, private savings are the counterpart of public sector deficits; and the total stock of private savings should be whatever induces the private sector to spend at a rate that brings full employment.

Or would it be a good idea to remain in a permanent “paradox of thrift” scenario where household net financial assets are inadequate?

A further problem with sticking to borrow and spend at a time when we are trying to reduce borrowing is that the reflationary effect of borrow and spend (at constant interest rates) could be minimal. If the effect IS minimal, then we are in the truly farcical situation of desperately trying to reduce borrowing at the same time as INCREASING borrowing in a vain attempt to keep aggregate demand up.

As to any concerns anyone might have about the inflationary effect of increasing the monetary base, well the ENTIRE U.K. deficit in 2009 was financed by new money – i.e. additional monetary base. Some people cannot see the wood for the trees.

And anyone with worries about the possible inflationary effect of this increased monetary base doesn’t understand how banks work. In particular, commercial banks are capital constrained, not reserve constrained (reserves are the main constituent of the monetary base). Nor, to coin a phrase, are they “reserve encouraged”. That is, a big increase in their reserves will not of itself encourage them to lend: witness the astronomic increase in U.S. bank reserves in 2009 combined with a thoroughly stingy attitude towards anyone wanting to borrow.


1. A.Darling said, “The case for maintaining public spending until recovery is established is overwhelming. Most countries are taking the same approach, because to cut now would be extremely risky and dangerous. But once the economy is back on track, we are setting a much tighter public spending environment.”

2. 20 economists argue in a letter to The Sunday Times for a clear plan to cut the deficit more quickly than the Labour Party envisages. They say amongst other things, “The exact timing of measures should sensitive to developments in the economy, particularly the fragility of the recovery.” If this is saying anything at all, the implication is presumably supposed to be that too fast a cut in the deficit will be deflationary.

They continue with more non-committal weasel words “The bulk of this fiscal consolidation should be borne by reductions in government spending, but that process should be mindful of its impact on society’s more vulnerable groups.” Well that’s easy to say, isn’t it? These economists don’t actually have to face elderly voters on the door step at election time who can’t pay their heating bills !

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