The key to deficit reduction is distinguishing between the structural and the stimulus deficits.

Summary.

The debt and deficit (DD) are made up of two elements. First, there is the structural DD. This derives simply from failure to collect enough tax to cover government spending. Second, there is DD which derives from stimulus.

Disposing of the structural DD is easily done by reversing the process which brought it into being. The process that brought it into being consisted of collecting insufficient tax to cover public spending, and having government borrow instead. So reversing the process consists of raising taxes and paying back creditors. In a closed economy no “pain” or “austerity” is involved here because the “pay-back” consists of nothing more than shuffling assets and liabilities between different groups of citizens. Those assets and liabilities net to nothing.

As regards the stimulus DD, the DEFICIT cannot be removed as long as stimulus is required. But there is no need for the DEBT to increase in consequence. As Keynes, Milton Friedman and numerous other economists have pointed out ad nausiam, deficits do not need to accumulate as debt: they can perfectly well accumulate as additional monetary base.

Conclusion: reducing the national debt is not difficult. To take the extreme case, reducing it to zero in a few years is perfectly feasible.


The flaws in popular DD discussions.

A mistake made by a large majority of those commenting on the DD in the U.S. and U.K. is the claim that the DD is best reduced by raising taxes or cutting public spending. In fact the Bowles-Simpson report is little more than a list of possible spending cuts and tax increases, as is a paper by Nobel Laureate Joseph Stiglitz.

Well the big problem here is that tax increases and public spending cuts raise unemployment!!!!

The advocates of increased taxes / public spending cuts are of course aware of the employment implications, but they get round the problem by assuming or hoping that the economy will recover at some stage.

That, frankly, is a bit feeble. We’ve moved on hopefully from the 1920s when it was thought that governments could do nothing about unemployment. That is, it is now generally accepted that they can do something. So what we need to hear from the likes of Bowles-Simpson and Stiglitz is how they propose maintaining employment while reducing DD and assuming the economy DOES NOT recover on its own. And we particularly need to hear this message in view of Keynes’s claim that economies can take an excessively long time to recover from recessions without government assistance.


“Pain” and “austerity”.

Another popular piece of nonsense is that cutting the DD involves “pain”, “austerity” and the like. Bowels-Simpson claim on page 4 of their report that “the Solution Is Painful”. And the Brookings Institution claims “The solutions to this problem will be painful and divisive.” And Stiglitz claims that significant amounts of austerity are involved (1st para).

As pointed out in the summary above, in a closed economy, no austerity is involved. In contrast, where other countries hold a significant proportion of government debt, some austerity might be involved. But more on that below.


The distinction between debt and deficit.

The distinction between debt and deficit is blurred here. This is because the deficit reduction policy advocated here is very flexible. That is, the policy could be used simply to reduce the deficit a little, while the debt continues rising. Or at the other extreme, the policy could be applied in large doses, which would result in actual debt reduction.


How to reduce the structural DD: just reverse the process that brought it into being!

A structural DD consists, to repeat, of government spending more than it collects in tax, so it borrows to compensate. Reversing this process simply consists of government raising taxes and repaying creditors (quantitative easing, in effect).

It is important to note here that so far as structural DDs go, there is, by definition, no effect on aggregate demand. In other words the deflationary effect of the above extra tax must equal the stimulatory or inflationary effect of the QE. And it is likely that the amount “QEd” will be much more than the amount involved in the above tax increase. Reason is that borrowing is not all that deflationary.

That is, when government borrows, it takes cash off the lenders, but the lenders get bonds in return (Treasuries in the U.S.). So the lenders are scarcely any worse off. Bonds are not quite as liquid as cash, so demand declines A BIT. But I’d bet my bottom dollar that the deflationary effect of government borrowing, dollar for dollar is much less than the stimulatory or inflationary effect of the average dollar of government spending.

At any rate, assuming government manages to get the inflationary effect of the QE equal to the deflationary effect of the extra tax, the net effect is neutral. That is, GDP shouldn’t change. Aggregate demand does not change. Total numbers employed do not change.

WITHIN the above aggregate “non-changes”, there is an important shift of income from low income groups towards the better off (i.e. bond holders). This effect lasts as long as the QE lasts. But that undesirable effect can always be countered by shifting the burden of tax from poor to rich. Given that Warren Buffet’s secretary allegedly hands over a larger portion of her income to the tax authorities than does Warren Buffet, there is, to put it mildly, scope for taxing the rich a little bit more.


Pain and austerity.

As pointed out above, some pain is involved in that a country is an open economy and for the following reasons. QE involves giving bond holders cash in exchange for their bonds. A proportion of those former bond holders will in consequence find they have more cash than they want. Thus they will seek alternative investments, a proportion of which will be outside the country. Possibly this applies particularly to foreign governments which hold the bonds of other countries (e.g. China’s large stock of U.S. government bonds). Anyway, the net effect of QE is to depress the value of the currency of the debtor country. And that means a small standard of living hit for the country concerned.

Indeed, the result of American QE in the last two years or so has been a substantial flow of dollars into countries which have not really welcomed this inflow.

But as regards a fall in the value of a country’s currency, the pound sterling lost about 25% of its value in 2008, and the response of the British population has been one big yawn. Certainly the standard of living hit has been nothing like the hit taken by residents of Ireland, Portugal and Greece recently (largely and ironically as a result of their INABILITY to devalue their currency).


The stimulus deficit.

As mentioned above, the stimulus deficit cannot be reduced so long as stimulus is needed. But the main concern that “DDphobes” have about deficits is the rising debt they cause. Well there is a simple solution to this non-problem which has been pointed out over and over again by economists for getting on to a century now. This is simply to have the deficit accumulate as extra monetary base instead of extra debt. E.g. see 1. Milton Friedman (p.250), 2. Keynes (2nd half of 5th para), 3. Claude Hillinger (p.3, para starting “An aspect of…”) and 4. Warren Mosler (2nd last para).


PROBLEM SOLVED?

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False logic from Krugman.

Krugman pointed correctly yesterday to the persistent and unnecessary level of unemployment in the US. He correctly identifies the root cause: indebted households. (On which topic, see this from Seven Keen.) Krugman then goes off the rails by advocating thee highly inappropriate cures, as follows.

1. W.P.A. type programs. 2. Help for underwater households. 3. Raise inflation to 4% so as to reduce the real burden of debt.

The flaws in the above three items are thus.

Re W.P.A. schemes, it is nonsense to boost employment in a narrow range of economic activities (W.P.A. type road and bridge building) just because unemployment is high. If unemployment is unnecessarily high, then ALL types of employment need boosting, don’t they?

As for the idea that W.P.A. type schemes can boost employment without boosting inflation as much as regular employment, that argument is badly flawed. See heading “The Flaws in WPA” here.

2. Re help for underwater households, why do those who have acted responsibly have to subsidise the irresponsible? This is just falling for moral hazard: that is, if it becomes traditional to bail out irresponsible households (or banks, come to that), that just encourages irresponsible behaviour in future.

3. Re raising inflation so as to reduce the burden of debt, that is next to useless for those on variable rate mortgages. That is, interest rates would just rise to take account of inflation.

As to so called “fixed rate” mortgages, increased inflation certainly wouldn’t work in the UK because, despite those adverts you see for so called “fixed rate mortgages”, there is really no such thing. That is, the maximum term of these so called fixed rates is around five years. Presumably the situation in the US is not much different.

Moreover, artificially boosting inflation (in as far as this cure works) is, again, to reward irresponsible behaviour.

So what is the best cure? Well it’s obvious: if there is a lack of demand, then enable the ultimate source of all demand (i.e. households) to “demand” more goods and services. That is, channel new money to Main Street rather than Wall Street.

But people never like obvious cures. As Abba Lerner said, “Fundamentally, the new theory, like all important discoveries, is extremely simple. Indeed, it is this simplicity that makes the public think it is too slick.” And economists don’t like simple cures for economic problems: that puts economists out of work.

Rodger Mitchell did a post on peoples’ refusal to consider simple cures for problems.

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In a recession, interest rates should be raised, not lowered.

We entered a recession a couple of years ago sparked off by excessive and irresponsible borrowing. And it’s not just the current recession that involved irresponsible borrowing: lax lending standards are common in the booms that preceed recessions.

So what was the reaction of governments round the world to the current recession, sparked off by lax lending? They cut interest rates with a view to encouraging more borrowing! Now there has to be something wrong there.

Of course reduced interest rates have a stimulatory effect. But that is not a good reason to cut interest rates where stimulus is required.

The Tinbergen principle is of supreme relevance here. The Tinbergen principle states that for each policy objective, one policy implement and one only is required (or words to that effect). And the implement chosen should obviously be the one most suited to the job at hand.

Now the fact that implement X is the one best suited to influencing policy objective X does not mean that implement X does not influence other policy objectives. For example, the main effect of interest rate changes is to influence the amount of borrowing and lending that takes place. By way of a side effect, this doubtless also influences aggregate demand: that is, for example, an interest rate reduction is stimulatory.

But that is not a reason to use interest rates to influence stimulus (unless interest rate adjustments are the BEST implement for influencing demand).

For the purposes of raising demand, the best and most obvious policy is to put more spending power into the hands of the ultimate source of all demand, that is households, or “Main Street”. So the correct response to the recession would have been to feed spending power into the pockets and Main Street residents and RAISE interest rates.

But of course the sub-human scum who make up the elite cannot bear to see more spending power in the hands of ordinary residents of Main Street. They’d rather stuff the pockets of the bankers with whom they socialise and inter-marry. And as to politicians, they are always mindful of the fact that (at least in the U.S.) its bankers who fund politicians’ election expenses.

Dean Baker is co-director of the Center for Economic and Policy Research in Washington. As he succinctly put it, “In elite Washington circles, ignorance is a credential”.

Afterthought on same day (25th May). The idea that interest rates should be RAISED in a recession is on second thoughts going too far, particularly as I advocated in earlier posts that interest rate should be determined by market forces. But certainly, there is not much of an argument for REDUCING rates in a recession.

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National debt.

The debt can actually be disposed of by printing money and buying it back. To do so, proceed as follows.

1. A fair amount of debt has already been bought back with printed money under the guise of QE. The result has not been rampant inflation. Indeed the price rises that HAVE occurred recently have more to do with increased demand for raw materials from developing countries than QE.

2. Any inflationary effect that DOES derive from a buy-back can always be nullified by raising taxes or cutting public spending. The two latter would NOT, repeat NOT damage living standards. The objective of such taxation is simply to prevent excess demand.

3. A potential problem with buying back is that former debt holders would take some of their money abroad (as indeed they have with QE). This would depress the value of the relevant country’s currency on forex markets. Well the first answer to that is that the pound sterling lost about 25% of its value in 2008, and the reaction of UK population has been one big yawn.

Secondly, ANY country which acts in isolation is asking for trouble. E.g. if one country raises interest rates when everyone else is lowering rates, the relevant country will have problems. In contrast if a significant proportion of countries with allegedly excessive national debts all buy back together, their creditors have fewer escape routes, thus the forex implications are less dramatic.

4. The next non-problem is that having replaced debt with monetary base, and come the recovery, the private sector could easily have an excess of such money which could easily be inflationary. Solution: raise taxes and/or cut public spending. Again, this would NOT damage living standards. Again, the objective here is simply to keep demand under control: i.e. keep it at the maximum level consistent with acceptable inflation (“NAIRU”, if you like).

5. Re the speed of buy-back, buying back a country’s entire national debt in just one year would doubtless involve too much dislocation. But doing it over five or ten years would be no problem.

6. So that’s it: national debt disposed of (or drastically reduced). However, it is legitimate to ask whether there are actually any good reasons for reducing or disposing of it. The fact that half the world is in a panic about debt is not a good reason. There are actually several reasons, as follows.

i) As Keynes said, stimulus can be funded either by borrowed money or printed money (see 5th para here). Now if stimulus is the objective, what is the point of borrowing? Borrowing is DEFLATIONARY. That is, it is ANTI-STIMULATORY. Mad or what?

ii) Second, where government borrows, the lenders – that is the wealthy – profit from the exercise. Now why should they, when there is an alternative, i.e. money printing, which does not benefit any particular group? Thomas Edison said that any new money should be the property of the people. He was right.

iii) Third, the mere existence of national debt tempts politicians to expand the debt, and put the country further and further in debt to other countries. There is nothing wrong with debt as such, but politician’s motive for running up debt is primarily to buy votes: a very poor reason.

iv) Both Milton Freidman and Warren Mosler have advocated a “zero debt” regime. See p.250 here, and 2nd last para here respectively.

v) The idea that governments need, or should borrow to fund infrastructure improvements is rubbish. See p.9, heading: “Borrowing to purchase assets” here. Plus see here.

Economics Prof thinks public spending makes us worse off.

This is the fourth instalment of my “Economics Profs off the rails” series!

Dr Richard M. Ebeling is Professor of Economics at Northwood University. He presented his testimony to the House of Representatives Subcommittee on Domestic Monetary Policy and Technology, on 11th May 2011.

In the third paragraph he claims that, “Every dollar borrowed by the United States government, and the real resources that dollar represents in the market place, is a dollar of real resources not available for use in private sector investment, capital formation, consumer spending, and therefore increases and improvements in the quality and standard of living of the American people.”

Just one problem here, professor. The “American people” (like people in every democracy) actually VOTE to have government confiscate a portion of their income and devote the money to law enforcement, schools, etc. That is, the people think they are better off – not worse off – with government taking a slice of GDP.

If the “learned” professor cannot get that one right, I don’t see any point in reading beyond his third paragraph.

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Economics Prof says excessive money supply never causes inflation.

John T. Harvey is the Prof. of Economics at the Texan Christian University, and he claims in this Forbes article that money printing cannot cause inflation. I’m sure Robert Mugabwe would pay Harvey handsomely for his advice.

Anyway, the core of Harvey’s argument is on his page 3: paragraph starting “But perhaps the real nail in the coffin “money growth==>inflation” view is…” Here, he claims that excess money cannot be forced onto the private sector because monetary base gets into private sector hands via the purchase of government debt by the central bank from the private sector. And, so claims Harvey, no one can force a sale on anyone. Thus there is no way the private sector can be forced to hold more money than it wants.

The first problem with this argument is that there is not much difference between government debt and monetary base. The former is essentially just a form of interest paying deposit account. And there is a very simple way in which the government / central bank machine can force excess government debt onto the private sector: government just runs a deficit!

That is, the Treasury borrows $X from the private sector and gives the private sector $X of bonds. The Treasury then spends the $X of cash: i.e. the $X of cash flows back to the private sector. So the net result is that the private sector is now up to the tune of $X (in the form of government debt, or “bonds” or “deposit account” – call it what you will).

Assuming that prior to the above $X worth of deficit, the private sector had the assortment of assets it wanted, then after this bout of deficit, the private sector will have what it regards as an excess supply of “cash plus bonds”. It will try to run this stock of assets down by selling bonds and then spending the cash it gets for said bonds. Hey presto: demand rises, and assuming the economy was at NAIRU prior to the $X bout of deficit, then inflation will rise as well (assuming demand rises faster than the economy’s maximum potential non-inflationary level of output).

In the above process, “force” is certainly involved. It occurs right at the start, that is where government borrows $X. Government can pay whatever rate of interest is needed to attract the $X because government can confiscate any amount of money it needs to pay that interest from taxpayers: not that governments (PIG countries apart) actually need to pay exorbitant rates of interest. That is, a rate which is marginally above the going rate will do. Plus, if and when the central bank buys those bonds back, rates subside again.

Harvey then claims on his page 4 that central banks have to accommodate the private sector’s demand for money, the suggestion being the cause/effect runs from the private sector to central banks. Well it’s true that this cause/effect relationship exists. But it is false logic to claim that because there is a cause effect relationship running from A to B that therefor there is no cause effect relationship running the other way! I just spelled out “the other way” above!

Afterthough (22nd May, 2011). Another piece of false logic in John Harvey’s article is his claim at the end of the article that because the inflationary episode of the 1970s was cost push or “wage / price spiral”, that casts doubt on the “money printing causes inflation” idea. I fully agree that that inflationary episode was cost push or “wage / price spiral”, as do many others. But the fact that X can influence Y does not preclude Z (or other factors) influencing Y!

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Economics Prof falls for Lump of Labour fallacy!

Prof. Robert Skidelsky, for whom I normally have a lot of respect, has gone right off the rails in this article. (Incidentally, my previous post (16th May) was about economics Profs who have gone off the rails. And some goes for the next post in a day or two. So welcome to my “economics profs off the rails” series!)

Skidelsky starts:

As the world recovers from the Great Recession, it has become increasingly difficult to discern the true trend of events. On the one hand, we measure recovery by our success in regaining pre-recession levels of growth, output, and employment. On the other hand, there is a disquieting sense that today’s “new normal” may be slower growth and higher levels of unemployment.

So the challenge now is to formulate policies to provide work for all who want it in economies that, as currently organized, may not be able to do so.

Hang on. Since when have we been able to “provide work for all who want it”? Never! No country or economy has ever been able to do that, so the fact that we currently, or in the future wont be able to, is no big deal.

On the other hand if Skidelsky is suggesting that we won’t be able to “provide work” for AS MUCH OF THE WORKFORCE as we used to, what’s his basis for this suggestion? No more, far as I can see, than the “disquieting sense” mentioned in his first paragraph. That is not a logical argument.

He continues:

The problem has two aspects. As countries become more prosperous, one would expect their growth rates to slow. In earlier times, growth was fueled by capital scarcity: capital investment attracted a high rate of return, and this created a virtuous circle of saving and investment.

Cobblers! Why does the fact of becoming more prosperous mean that growth rates decline? GDP per head in what is now the UK was more or less constant between the time of the Roman Empire and about 1,500AD. Then by around 1900 it had shot up. But it didn’t stop rising after 1900 did it?

As for the idea that “growth” is “fuelled by capital scarcity”, that’s a strange one. Skidelsky claims there is a “capital scarcity”, but in the next sentence claims there is a “virtuous circle of saving and investment”. Now that’s what I call a self-contradiction. Is he saying that “in earlier times” there was an adequate supply of capital or not? Darned if I know.

And as for the idea that “capital scarcity” can “fuel growth”, I’m baffled. If we couldn’t afford computers, roads, houses, factories, etc etc, that would “fuel growth” and make us better off?? Sorry: I don’t get it.

He continues:

Today, capital in the developed world is abundant; the saving ratio declines as people consume more; and production shifts increasingly to services, where productivity gains are limited. So economic growth – the rise in real incomes – slows. This was already happening before the Great Recession, so generating full-time jobs that pay decent wages was becoming ever more difficult. Hence the growth of casual, discontinuous, part-time jobs.

More nonsense on stilts. Why on earth does the fact of economic growth slowing down mean that “generating full-time jobs that pay decent wages becomes more difficult” and that the prevalence of “casual, discontinuous, part-time jobs” rises?

Suppose that economic growth ceases altogether, say because improvements to technology grind to a halt, why does that make it more difficult to pay “decent wages”? Given constant GDP per head, wages will just remain constant, other things being equal, won’t they? And why does “generating full time jobs” become more difficult? Again, given constant GDP per head, why on earth does that mean that half the workforce switches from full time to part time work. That is, why does aggregate demand decline? I can think of no reason whatsoever. Skidelsky continues:

The other aspect of the problem is the long-term increase in technology-driven unemployment, largely owing to automation.

Hang on. He is simply assuming the validity of the Luddite argument, i.e. that technology causes unemployment. No reasons given, apart from the “disquieting sense” mentioned above.

He continues:

The market’s solution is to re-deploy displaced labor to services. But many branches of the service sector are a sink of dead-end, no-hope jobs.

Oh yes? Take doctors and nurses: they’re a real bunch of “dead-end, no hopers” aren’t they? And then there are lawyers and computer programmers: also a bunch of thick headed, knuckle dragging, uproductive, time wasters, I don’t think. He continues:

Immigration exacerbates both aspects of the problem. A large part of migration, especially within the European Union, is casual – here today, gone tomorrow, with none of the costs associated with full-time hiring. This makes it attractive to employers, but it is low-productivity work, and it increases the difficulty of finding steady employment for the majority of a country’s workforce.

Immigration exacerbates unemployment…is Skidelsky a BNP member? Immigration can certainly cause temporary disruption to labour markets, e.g. the big influx of East European construction workers to the UK between around eight and three years ago. That certainly pushed significant numbers of UK construction workers out of their jobs. But there is no LONG TERM effect: those pushed out of work retrain or retire, etc etc. America has absorbed A MILLION IMMIGRANTS PER YEAR FOR TWO HUNDRED YEARS!!! How come unemployment in the US over the last few decades has been no different to other developed countries? Skidelsky continues:

So, are we doomed to a jobless recovery? Is the future one in which jobs are so scarce that many workers will have to accept a pittance to find any employment and become increasingly dependent on social transfers as market-clearing wages fall below the subsistence level? Or should Western societies anticipate another round of technological wizardry, like the Internet revolution, which will produce a new wave of job creation and prosperity?

What? Unless GDP per head dramatically falls there is no reason to suppose the average wage will fall or that “workers will have to accept a pittance”.

As for the idea that “technological wizardry . . . will produce a new wave of job creation and prosperity”, I thought the learned professor was trying to push the idea that technology CREATES unemployment. Now he’s saying it does the opposite: i.e. reduces unemployment.

I’ve had enough. But your’re welcome to go through the rest of Skidelsky’s article. It’s as “entertaining”, if I can put it that way, as the first half of the article.