Friday, 17 June 2011

Fast fiscal consolidation would not hinder the recovery or involve austerity.

Note dated 26th Oct 2011. The article below is 2,700 words. I put a slightly longer and hopefully better version (3,300 words) online on about 25th Oct 2011.


I’m tired of being told “we must consolidate the debt, but too fast a pace of consolidation would hinder the recovery”.

This message comes from numerous “authorities” who should know better, including the IMF, a long list of Britain’s academic elite, and William Dudley of the New York Fed. (For some directions to the relevant paragraphs in their pronouncements, see references at the end.)

The phrase “fiscal consolidation” is defined in the Financial Times online Lexicon as a reduction in the deficit but not the debt. In contrast, the OECD defines it as reducing both.

This disparity is not important for the arguments below because these arguments apply regardless of whether a country wants to reduce just its deficit, or both deficit and debt (DD).

As implied above, the argument here is that the pace of consolidation is largely independent of stimulus or attempts to adjust aggregate demand. To explain this, it is necessary to divide the DD into two parts: the structural DD and the part of the DD that results from stimulus. These two are significantly different, and I’ll start with the structural DD.

The structural deficit and debt.

The structural DD arises simply from a failure by politicians to collect enough tax to cover public spending. That is, they borrow instead of taxing.

Since there is no intention to give the economy any stimulus (or anti-stimulus) here, the deflationary effect of the borrowing ought to equal the stimulatory or “inflationary” effect of the spending (had that spending not been covered by tax or borrowing). At least, the two will be the same if those implementing the deficit know what they are doing.

Thus disposing of a structural DD is child’s play: just reverse the process that brought it into being. I.e. the debt needs be paid back. That is, taxes need to be raised and creditors paid off. Those tax increases would NOT mean “austerity”. Reason is that, as mentioned above, incurring a structural DD does not involve stimulus, thus reversing the process would not involve “anti-stimulus” or austerity. Put another way, there would be no reduction in GDP, total numbers employed, etc. At least that is certainly the case with a closed economy. Open economies are slightly different, and I’ll deal with them below.

As to where some stimulus DOES inadvertently result from incurring a structural DD (and I think this DOES happen to some extent), this is not a problem. It means that an exact mirror image of incurring the DD would involve an anti-stimulatory or demand reducing effect. But countering the latter demand reducing effect is not difficult: anyone who has studied economics for more than a year knows how to raise demand. For example, some of the money for the debt buy back could come from the printing press (as is the case with QE).

Having said that GDP, numbers employed etc remain unaltered, it is of course it is not ESSENTIAL to aim for this “everything stays the same” outcome. It would be possible to mix some stimulus with the DD reduction process. But to keep things simple, I’ll stick with the “everything remains constant” assumption.

And for any readers who are puzzled as to how taxes can be raised while all the above factors remain constant (especially take home pay), the explanation is that the effect of the debt buy-back would be to raise pre-tax incomes, while tax would nullify that increase.

So that’s the structural DD gone. Vanished. A few apparent problems associated with this cure for the DD will be dealt with below, but the stimulus DD will be considered first.

The stimulus DD.

Making a reduction in the stimulus deficit an objective is COMPLETELY BALMY.

The purpose of a deficit is to raise aggregate demand where there is a shortfall in AD (for example when indebted households rein in spending because they find the value of their houses falling dramatically compared to their debt – ring any bells?)

So long as the latter shortfall in demand persists there is NO POINT in trying to reduce the stimulus deficit.

But if such a deficit lasts a relatively long time, that might appear to involve an unacceptable expansion in the debt.

The answer to the latter non-problem is that as Milton Friedman, Keynes and others pointed out long ago, a deficit does NOT HAVE TO BE FUNDED BY DEBT. That is, a deficit can be funded EITHER by increased debt, OR it can be funded by expanding the monetary base.

There isn’t actually a huge difference between the two: that is, monetary base and government debt both appear on the liability side of a central bank’s balance sheet. Moreover, a chunk of government debt is simply a promise by government to pay the holder of such debt some money on a particular date. As to where that date is in the NEAR future, (i.e. where the debt is near maturity) there is virtually no difference between the two.

Given this rather small difference it is reasonable to ask whether it is worth turning debt in to monetary base. Well, one good reason is that the world is full of panic stricken folk who think an expanding debt means the end of the world. So keeping these folk happy is no bad idea.

Second, as I explain here, the traditional arguments for having governments run into debt do not stand inspection.

The stimulus debt.

As pointed out above, given inadequate demand, government should feed financial assets to the private sector (bonds or money). In other words, given inadequate demand, the stimulus DEFICIT should not be reduced.

However, if over recent months or years a stimulus deficit has accumulated in the form of bonds or “national debt”, there is nothing wrong with reducing or “consolidating” that debt in the sense of converting the bonds to cash. In other words the buy-back proposed here can perfectly well extend to the stimulus debt.

There is a minor problem involved in doing this, namely that simply “doing a QE” on such debt (i.e. printing money and buying it back) might be too stimulatory, and thus too inflationary. But the solution to this little problem was referred to above, namely that the funds for buying back debt can come from the printing press or alternatively from extra tax. The former is stimulatory and the latter has the opposite effect, that is it is “anti-stimulatory” or “demand reducing”.
So mix the two in the right proportions, and you get a neutral effect. That is, no effect on GDP, numbers employed, and so on.

Apparent problem No.1: distributional matters.

I’ll now consider a few apparent problems with the above DD reduction ploy.

The first apparent problem is that the ploy might benefit the asset rich (holders of government debt) at the expense of the average tax payer. Well the answer to that is that in principle, matters and policies relating to wealth and income distribution should not be mixed up with matters relating to DDs.

For example, when governments expand a deficit, the prime aim is NOT to re-distribute income or wealth (although given the less than perfect competence of governments, some inadvertent re-distribution probably does take place normally). Likewise, when the process is reversed, assuming it is reversed in a competent manner, there ought not to be any significant distributional effects. I.e. if changes to the income tax and social security system are needed to counter-balance any distributional effects of reversing a DD, then so be it. That is not a big technical or economic problem. (As to the politics, that’s a different matter!)

So let’s move on to the next problem.

Apparent problem No 2: a large monetary base expansion would be inflationary.

Laugh out loud!

The monetary base in the US just has expanded by an astronomic and unprecedented amount: it’s TREBBLED IN THE LAST TWO YEARS!!!! And where’s the hyperinflation?

To be more serious, there are some very good reasons for this lack of serious inflation. First, additions to the money supply are not inflationary till they are spent, and spent in sufficient volume and speed to cause excess demand and thus inflation. (David Hume, the Scottish philosopher pointed this out 250 years ago. It would be nice if we’d learned something about economics in the last 250 years, would’nt it?)

But wait a minute: an increase in demand IS THE SOLUTION TO THE PROBLEM! In other words it is not possible to get serious inflation without first “solving the problem” (i.e. the recession). Of course the tricky bit is to avoid overshooting the solution, to coin a phrase. But certainly in principle, it is not possible to get excess inflation without having first “solved the problem”

Second, as to the idea that this additional money might cause inflation a few years down the line, that is a feeble point, and for two reasons.

First, increases in demand and thus inflation can perfectly well occur EVEN WITH NO INCREASE IN THE MONEY SUPPLY AT ALL. For example a big increase in consumer confidence, i.e. a willingness by consumers to go into debt and a willingness by banks to lend to them would cause a rise in demand. Indeed, this was the source of a sizeable portion of many countries’ aggregate demand prior to the recession.

Perhaps the “anti money supply increase” brigade can tell us what they propose doing with the money supply given that inflation can arise ABSENT any money supply increase. Do they advocate abolishing money altogether?

Of course, expanding the monetary base raises the RISK of inflation in a few years time to a finite extent. But that should not be difficult to deal with: there are a host of anti-inflationary measures that every government has at its disposal. One of these measures is simply to reverse the above “money printing”. I.e. raise taxes, rein in money and “unprint” it, or extinguish it.

Any additional tax imposed for the latter reason would not, repeat not, mean austerity or “hindering the recovery” in any way. The sole purpose of such taxation is to remove money from the private sector, which, were it left in the private sector would cause excess inflation. And inflation REDUCES living standards rather than increases them. I.e. tax, paradoxically, can improve living standards.

Second, as to the idea that banks will lend money just because they have loads of it sitting in idle accounts, LOL yet again. Right now, as I write, banks ACTUALLY ARE sitting on larger than ever reserves, while not lending it out with any great enthusiasm. And apart from the latter evidence, there are some simple theoretical reasons that explain why banks do not automatically lend out “idle” money, as follows.

Any bank with its head screwed on, lends where it sees a PROFITABLE LENDING OPPORTUNITY, not when it happens to have money in idle accounts. Likewise car hire firms do not hire out cars at any old bargain basement price just because they have cars lying idle.

Indeed, as long as banks see profitable lending opportunities, banks will lend EVEN IF THEY HAVE INADEQUATE RESERVES!!!!! In short, the amount that banks have in idle accounts or reserves, is one big irrelevance. For more on this, see here, or Google “banks are capital constrained not reserve constrained”. Or see here.

And if by any chance it turns out that banks do lend simply because they have money in the kitty, that just proves they are incompetent. And that is a good reason for tighter bank regulation, not an argument against letting households have the amount of money they feel comfortable with, which in turn should bring full employment. Given the numerous crooks and incompetents running banks, personally I’d favour much tighter bank regulation that Basle III.

Third, one daft aspect of the idea that “money supply increases cause inflation” is that those who promote this view never tell us what the OPTIMUM amount of money per person should be. This is exactly the same as saying that ANY increase in speed for a car on a particular stretch of road will be dangerous, without saying what the OPTIMUM speed is (i.e. where the best trade-off is as between reduced journey time and danger).

In contrast, a very clear idea has been set out above (hopefully) as to what the optimum amount of money should be: whatever brings the maximum level of demand that is consistent with acceptable inflation.

Apparent problem No.3. Permanent low interest rates.

Buying back debt as advocated here is similar to QE. And the large scale and long lasting “QE” operation advocated here possibly implies low interest rates for an extended period, but this is not a problem. Far from being a problem, there are actually good arguments for the current zero or near zero interest rates to become a permanent feature. First, see two of Warren Mosler’s works: here and item No.3 under the heading “Proposals for the Federal Reserve” here.

Second, as far as stimulus is concerned, it makes no sense for a government which wants to do some Keynsian “borrow and spend” to pay any interest for the money borrowed. That is, what is the point of paying for the privilege of borrowing something (money) which you can produce yourself at no cost?

Third, one of the few valid reasons for government debt (or monetary base) is that this provides the private sector with the net financial assets it wants. Put another way, without such assets, one gets “paradox of thrift” unemployment. But in demanding such assets, private sector entities do not do society as a whole any favours. Thus there is no reason to reward such private sector entities.

Put another way, the attitude of government to private sector entities which threaten to go into saving mode and cause unemployment unless they have the savings they want should be “OK, here are the savings you want, but there is no reason taxpayers should be burdened with paying you interest, so you’re not going to be rewarded for demanding these savings”.

Should we abolish interest rate adjustments?

The above argument, of course, implies abandoning attempts to adjust aggregate demand by adjusting interest rates. That is, the implication is that it is the quantity of money that should be adjusted not its price (though of course adjustments to the quantity will inevitably impinge on the price).

This idea may be novel, but there are actually a host of weaknesses in the idea that interest rate adjustments are a good idea, which I set out here.

Apparent problem No.4: balance of payments effects.

Let’s start with the stimulus part of the deficit. QE has lead, particularly in the US, to funds quitting the country in search of better returns elsewhere. And this in turn will have depressed the dollar relative to other currencies.

Given that what is proposed in this article is QE writ large, is there a problem here?

The answer is that ANY form of stimulus depresses the value of a country’s currency. That is, the alleged “problem” here is not unique to the policy advocated here.

That is, given excess unemployment, a country will normally be better off reducing that unemployment, even if there is a slight drawback in the form of its currency losing value.

As to the structural part, QE certainly leaves debt holders with spare cash, and a proportion of those will lodge their cash abroad, which means a finite devaluation of the currency of the country concerned. And that means a standard of living hit, i.e. austerity.

On the other hand the pound Sterling was devalued by 25% or so in 2008 and any standard of living hit has been negligible compared to the standard of living reduction being experienced by European periphery countries.

Moreover, the greater the number of countries with allegedly excessive debt that implement the above policy at the same time, the less the incentive for former debt holders to shift money from one country to another, thus the less will be the changes in living standards of one country relative to another.



Dudley: see para starting “As discussed earlier….”
IMF: see para starting “The policy advice to advanced economies….”

Note: The above last section “Apparent problem No 4…” was re-written on 25th Sept 2011.

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