The Financial Times still doesn’t fully understand deficits, austerity etc.

 

It’s good to see the FT admitting they were wrong to advocate austerity in the aftermath of the 2007/8 bank crisis (like many newspaper economics commentators, as pointed out by Simon Wren-Lewis). That’s in a recent FT article entitled “A Fiscal Policy for all Seasons”.

Unfortunately, the FT still hasn’t totally got to grips with this subject. In particular they say their new more relaxed attitude to deficits  “….is not a reason to abandon the goal of fiscal sustainability. Governments can, usually, simply roll over their debt stock at reasonable interest rates. There is, however, an ever-present risk that the market will move against governments and the cost of borrowing will rise to such an extent that the choice will be between a painful default or vicious austerity.”

The reality is that if bond holders do demand a higher rate of interest, that is no reason for austerity, as I’ve been trying to explain for about ten years, e.g. here. Reasons (for the umpteenth time) are as follows.

First, if those holding government bonds do demand a higher rate of interest, there is very little initial effect on the amount of interest a government has to pay because the rate of interest payable on a large majority of those bonds is fixed at the date they are first issued. That is particularly true of UK government debt where the average time between the date of issue and date of maturity is about ten years.

But as regards bonds which mature in the very near future, a rise in the interest rate demanded by potential bond holders is on the face of it a problem for government: government seems to be faced with the choice of rolling over the debt and paying the higher rate or raising taxes so as to obtain the money to simply pay off debt holders and tell those seeking new bonds which yield a higher rate to go away. And certainly doing the latter would involve the “austerity” to which the FT refers.

In fact there is a third option, which the FT and the majority of economics commentators are completely unaware, and that is to create new money, pay off the old bond holders and then see what happens. Possibly the resulting increase in the money supply would not be inflationary: the vast amounts of money created so as to implement QE do not seem to have been inflationary.

But if excess inflation did rear its ugly head, there is a very simple solution, which involves no austerity, and that is to raise taxes and “unprint” or destroy the money collected. The effect of that would not, repeat not, repeat not, repeat not be austerity, i.e. deficient demand. Reason is that the sole purpose of the latter “tax and unprint” exercise would be to cut demand to the maximum level consistent with hitting the inflation target.

So assuming aggregate demand was for the sake of simplicity at that maximum level before the unprint started and at the same level after the unprint, then (hey presto and roll of drums) there’d be no effect on real household incomes!!!

At least that would certainly be the case where all government debt is domestically owned. In fact, while a majority is domestically owned, a significant proportion is foreign owned, and if those foreign or internationally mobile investors took their new found pile of cash out of the country, the relevant country’s currency would fall on foreign exchange markets, which would mean a cut in real household incomes.

However, if bond holders start demanding a higher rate of interest on the bonds issued by government X, chances are they’ll demand a higher rate on the bonds of other governments!! So taking their money out of country X probably won’t do them any good.

The only circumstance where it would pay internationally mobile investors to quit country X would be where X started to behave in a seriously irresponsible way relative to other countries.

So the conclusion is that as long as a government doesn’t do anything which is clearly more stupid than what other governments are doing, a rise in the rate of interest demanded by those holding its debt need not cause austerity.