Saturday, 25 June 2011

Simon Johnson, formerly of the IMF, has a brain wave.

As Bill Mitchell has pointed out numerous times, the IMF is made up of incompetents.

Simon Johnson in this article has a great idea for reducing the deficit and/or debt (DD): it’s to wait till the recovery really gets underway, and then pair down the DD in earnest. The crucial paragraph in his article is the penultimate one, which I’ve re-produced just below in purple.

The best way to bring the debt-to-G.D.P. ratio under control is to limit future spending increases and augment revenue while the economy continues to recover. In particular, health care spending needs to be credibly constrained but doing this properly would mean limiting health care costs as a percentage of G.D.P. — proposals that just push costs from government onto companies and individuals are not appealing.

There are several flaws in this argument.

First, deficits INVARIABLY decline in a recovery, and may even turn into surpluses. To that extent, Johnson is simply advocating the inevitable.

Indeed, taking an ideal scenario (a rather extreme one by today’s chaotic standards) governments would pitch their deficits at a level which resulted in almost no recessions or booms. That is, given for example a sharp decline in household spending because households are worried about the loss in value of their houses, government would ideally step in and keep demand more or less constant by running a deficit.

In this ideal scenario, DDs would decline in a recovery to an even great extent than they already do. But would there any point in cutting the DD by any MORE than was happening anyway? The answer is “NO”: because the result would be a totally unnecessary slow-down in the recovery.

Public spending cuts do NOT reduce public spending!

Next, the second sentence of Johnson’s above paragraph trots out the tired old nonsense that a way of reducing DDs is to cut government spending (he cites health care).

The flaw in this idea is that such cuts raise unemployment, which in turn increases spending on the automatic stabilisers, like unemployment benefit. In fact there is even evidence that public spending cuts actually RAISE public spending!

The above bit of nonsense is popular with those who have not grasped the difference between macroeconomics and microeconomics. A microeconomic entity (like a household or business) CAN reduce its deficit by cutting expenditure or raising income. A government which is a macroeconomic entity CANNOT.

But what a government CAN do – at least to cut the DD - is simply to reverse the process that brought the DD into being. And what brings a structural DD into being is failing to collect enough tax to cover spending. Reversing that consists of raising taxes and paying off the debt.

And of course the knee jerk reaction to the “increased taxes” idea is that living standards will suffer: there will be “austerity”. Now this is a strange claim, for the following reasons.

When a country INCURS a structural DD, no one ever claims the effect is wildly STIMULATORY (although my guess is that actually is somewhat stimulatory). That is, a structural deficit occurs simply because politicians fail to collect enough tax to cover spending (with a view to making themselves popular and winning votes).

So when the process is REVERSED, there is equally little reason to suppose the effect is deflationary or that it involves austerity.

However, it may well be (as mentioned above) that the effect of incurring and paying back a structural DD is indeed somewhat stimulatory and deflationary, respectively. But that’s not a problem. Anyone who has studied economics for a year or more knows how to give an economy a boost, or conversely, damp down economic activity. Adjusting interest rates is one possible tool (not one that I personally like, but that’s another story).

Thus Johnson’s claim that health care spending must be reined in so as to cut the DD is nonsense. And if you want empirical evidence to support this, look at Sweden: it devotes much more of its GDP to public spending that the US, yet it has a much smaller DD.

Incidentally, I am NOT, repeat NOT advocating a bigger public sector for the US or any other country. The size of a country’s public sector is a POLITICAL decision: one that has NOTHING to do with a country’s DD.

Afterthought, 18th July 2011. Simon Johnson's understanding of economics is also questioned here.


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