Sunday, 1 November 2009

The deficit terrorists are getting uppity.

“Deficit terrorist” is a phrase used by Warren Mosler to describe someone who disapproves of deficits. DTs have been getting uppity in the last week or so.

Disapproval of a deficit is justified if it can be shown that the deficit concerned is likely to do harm – inflation being the usual “harm”. And certainly some deficits have been a disaster. The UK’s “Barber boom” around 1972 is a famous example: it lead to rampant inflation.

But to prove that a deficit is likely to be inflationary, one must give evidence that the deficit will result in excessive demand. And excessive demand means employers being incapable of meeting demand because of skilled labour shortages, etc. However, the DTs who have been vociferous recently have not only failed to demonstrate this. They don’t even seem to be aware that they need to shown this.

The DTs I have in mind are Stefan Karlsson (Oct 28th post) who endorses a Bloomberg article by Matthew Lynn. The main reasons given by the latter for withdrawing stimulus in the UK are thus.

1. The UK’s National Debt has expanded at an unsustainable rate and needs to be curbed.

Answer: The UK’s alleged National Debt increase is largely a myth – it’s a mirage because the apparent expansion in the National Debt in 2009 is approximately equal to the amount quantitatively eased.

I’ll expand on that. Governments borrow to spend. This involves, 1, cash moving from private sector to government, 2, gilts moving the other way, 3, government spending on usual items government spends money on. Quantitative easing involves reversing 1 & 2. Thus the only net effect is 3.

In short, the increase in the National Debt is largely money owed by the government to the Bank of England. As I pointed out under “200bn off the National Debt at a stroke!” below, this is a bit of a nonsense: it’s a bit like saying your left hand pocket owes your right hand pocket some money.

This is not to deny the possibility that the money printed (at at least some of it) will have to be reined in. It probably will. Nor is this to deny that there is a structural element to the deficit. WHEN the economy recovers, and not before, this structural element will need to be dealt with.

Also, the UK’s debt has not increased in the most serious sense of the phrase, that is indebtedness to foreigners: far from it. Foreigners seem to have reduced their holding of UK National Debt in 2009.

2. Lynn claims the deficit hasn’t worked. Well that’s very hard to prove or disprove. He seems to be making this claim because the UK economy has’nt bounced back to health just yet. Well I would argue that the deficit HAS worked in that had it not been for the deficit, things would be far worse.

3. Lynn deplores the fall in the pound and claims the government should support the pound on the grounds that “A modern, advanced nation can’t devalue its way out of trouble. The idea that the U.K. is going to suddenly build lots of factories that compete with Eastern Europe and China on price is ridiculous. Britain can export plenty of things, but they are high-end, design and technology.....”

The truth is that the UK like every developed economy produces a whole range of goods and services from the very low tech to the ultra high tech. Tourism is one of the UK’s main foreign currency earners (as it is for many developed economies). Now running a hotel is not advanced technology.

4. Lynn claims the UK should cut taxes on businesses. It is a popular myth that low taxes for businesses benefit business (particularly in a country that issues its own currency). Obviously the initial effect of increasing taxes on business drives some businesses under or drives them out of the country. But that leads to unemployment. Which induces governments to do what? Increase demand, of course. And given a free market, this will drive up the rewards for entrepreneurship relative to the rewards for “employeeship”. Put it another way, assuming the post tax rewards for employership relative to employeeship were optimum before a tax increase on businesses, then this ratio should return to optimum after the tax increase if market forces are working.

Stephan Karlsson (30th Oct post) opposes the stimulus because “it is unsustainable and could create negative after effects.” In support this argument, he cites “cash for clunkers”.
Well there is a world of difference between a government deficit, which is macro economic, and cash for clunkers which is concerned with just one industry, and which is thus largely micro economic.

And it is certainly true, as he points out, that the increase in car sales while the clunker scheme is in effect, will be approximately matched by a fall in car sales when the scheme is withdrawn.
But the answer to this is that a well designed clunker scheme will boost car sales during the worst of a recession and will only hit car sales when the economy recovers: that is, when a fall in car sales is not so much of a problem.

Karlsson also claims that clunker schemes result in the destruction of cars which are economically viable. True. But it replaces them with better fuel consumption cars, which is a plus for the environment.

Having said that, I agree that clunker schemes are pretty stupid. Where the problem is macro economic, subsidising a specific industry is a nonsense.

As to a government deficit (macro economic), what are the “negative after effects”? Ideally there won’t be any.

UK households seem to have decided that the debt binge of the last decade was a bad idea and are now saving as never before. If this means a permanent reduction in household debt/increased desire to save then some or all of the additional money that government has printed can just be left in households’ bank accounts.

Alternatively, if the deficit results in too much economic expansion in six months or a year’s time, then deflationary measures will be needed.

Knowing whether to impose deflationary measures, and if so, when and by how much is a HORRENDOUSLY difficult question. But if the authorities get this right, there won’t be any “negative after effects”. And if government get it wrong, and we do have “negative after effects” what does this prove: that we should do nothing about recessions, and endure a decade of catastrophic unemployment like the 1930s?

And finally, please note that Stefan Karlsson’s blog is normally brilliant. This is the first time I’ve disagreed with him.

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