Wednesday, 26 October 2016
If you understand this, you’re smarter than Harvard economics professors.
Two Harvard economics professors have spent the years since the 2008 crisis claiming that stimulus brings a serious problem, namely rising government debt. That’s Kenneth Rogoff and Carmen Reinhart (though there are other equally clueless economists at Harvard).
To access their works, just Google their names and “government debt”.
The first flaw in the idea that more stimulus (i.e. more deficit) means more debt is that (as Keynes said), deficits can be funded via borrowed money, OR PRINTED MONEY. Thus there’s no need for extra debt at all! Of course the AMOUNT printed can’t be so much as to cause excess inflation, but if it’s just right, it will cure the recession while not causing excess inflation. Indeed, the effect of QE is to fund the deficit via printed money, which makes you wonder whether Rogoff and Reinhart (R&R) have heard of QE, or if they have, whether they know what it consists of.
Another ploy of R&R’s is to use emotionally loaded phrases to back their arguments (since they are evidently short of “logic loaded phrases”). For example they refer the “debt overhang” instead of the more accurate phrases “national debt” or “government debt”. Well clearly something which is “overhanging” and about to drop on your head is a threat. I’m worried stiff (ho ho).
Another emotionally charged phrase they use is “financial repression”. Financial repression is their name for the collection of measures which may need to be used to reduce excessive government debt, like raised taxes or excess inflation which cuts the real value of the debt and robs creditors. Well clearly any form of “repression” must be horrible, disastrous, nasty, harmful, cruel, bad – add synonyms to taste. I’m in emotional turmoil as a result of “financial repression” (ho ho again).
Incidentally, when searching for R&R articles, the latter two emotionally charged phrases can help.
However, credit where credit is due, their “financial repression” point does contain a small element of truth, not that that basically gets their argument anywhere. So let’s examine so called financial repression.
The basic flaw in financial repression.
The basic flaw is thus. Government debt (and the considerable quantities of base money now sloshing around as a result of QE) are ASSETS as viewed by the private sector. More particularly they are liquid assets: i.e. they are easily swapped for consumer goodies and other items. And if the private sector has what it thinks is an excessive stock of those assets, it will try to spend away those liquid assets, as a result of which demand and inflation will become excessive. So in that circumstance, government has to impose some sort of deflationary measure, like raising taxes and confiscating some of that money / liquid asset.
However, the sole purpose of that extra tax is to keep demand down to a level where the economy can meet that demand. I.e. the purpose is NOT TO cut GDP: the purpose (and hopefully the actual effect) is simply to prevent excess inflation. Now excess inflation actually REDUCES living standards, thus ironically, the effect of the above extra tax (if excess inflation has already started) is to RAISE living standards, not to cut them. At the very least the effect of the extra tax is to prevent a fall in GDP. But you won’t find anything about that “prevent a fall” point in R&R’s works.
It’s beginning to look like we can take the phrase “financial repression” with a big pinch of salt.
R&R’s mistake there is to confuse microeconomics with macroeconomics. Paying off debts, as we all know is a painful process. Or at least it is in the case of microeconomic entities like a household: that is, the household has to earn money and far from spending that money on consumer goodies, it has to repay money to relevant creditors. In contrast, macroeconomics does not work the same way as microeconomics: one gets bizarre results like the above mentioned phenomenon of raised taxes actually INCREASING living standards.
Incidentally, the above “prevent a fall in GDP” point applies in a closed economy, but not open economies (as more astute readers may have noticed). Open economies are considered below.
Having set out the basic flaw in financial repression, the real world involves a few complexities not mentioned above. So let’s consider them. But as you’ll see, those complexities do not basically dent the latter conclusion, namely that “financial repression” is largely a mirage.
First, having said above that demand becomes excessive because the private sector has an excessive stock of money / liquid assets, another possible effect of that excess stock is that holders of those assets demand a higher rate of interest for holding the assets which could be in part down to creditors losing confidence in a government’s ability or willingness to repay the debt. Creditors may demand a higher rate of interest for that reason.
Well that’s not a problem for a country which issues its own currency: it can very easily cut interest rates. And that’s done by having the central bank print money and buy back the debt (and/or abstain from rolling over debt as it matures).
Of course printing money and buying up government debt (QE effectively) is likely to be stimulatory and/or inflationary (though precious little inflation stemmed from QE over the last few years). But if the latter “print and buy” policy DOES PROVE INFLATIONARY, that can be remedied very easily by raising taxes. And as explained above, the purpose of those taxes is simply to supress inflation: thus those extra taxes as such do not cut living standards.
However, there is an effect on living standards where FOREIGNERS withdraw money from the relevant county as a result of the fall in interest rates: the country’s currency falls in value on foreign exchange markets, and that depresses living standards. On the other hand there will have been an equal and opposite effect when those foreigners first purchased debt. So in a sense, that’s a wash.
The next complexity: politics.
It was claimed above that raising taxes is easy. It should however be said that raising taxes can be POLITICALLY difficult. I.e. raising taxes is no problem from the strictly technical and economic point of view, but the politics can be tricky.
The solution there is to let the elevated interest rates run for a few more years than is strictly desirable and raise taxes more slowly. That is not ideal: it is not a “GDP maximising” strategy, but it’s the least bad real world solution to the problem.
Why let government debt rise at all?
Having admitted that an elevated stock of government debt and/or base money can cause significant problems, it might be tempting to claim a solution is not to let that stock rise at all, which is more or less what R&R propose. Well the answer to that is that if we do NOTHING about recessions then excess unemployment and inadequate GDP will just linger for God knows how long: two decades instead of five years?
Conclusion: the optimum or GDP maximising policy is to always to aim to let the private sector have a stock of state liabilities (government debt and base money) which induces the private sector to spend at a rate that results in the economy running at capacity. Or as Keynes put it, “Look after unemployment and the budget will look after itself”.