Deficits, Surpluses and Government Spending: What does it all mean? How
should governments run themselves?
The key observation of “Modern Monetary Theory”, in its
descriptive essence, is that a sovereign currency-issuer (a country which
produces its own currency) with a floating exchange rate is not, in fact,
directly financially constrained (it is, of course, constrained in several
other ways, a subject which will later admit of lengthy discussion (and we must
include the caveat, for reasons we’ll explore later, that the currency is
desired by other countries)). Why this is so is – to put it in a nutshell – that
such a government has no issue of convertibility: it doesn’t have to maintain
gold reserves sufficient to back the circulating currency, as everyone did
before Nixon’s gold shock and the end of the Bretton-Woods era (the beginning
of the ‘fiat money’ era), and it doesn’t have to do the same with some other
country’s sovereign currency either (as happens with a ‘fixed exchange rate’, a
system which Australia kept until 1983). Such a government therefore can’t
default, except on foreign-currency-denominated liabilities (though the major
sovereign countries wouldn’t have any such liabilities). These facts mean that
whatever other purposes the issuing of bonds may serve for a sovereign
currency-issuing government (purposes which I will later discuss), it is simply
erroneous to claim that this operation is ‘funding’ spending.
Probably around half of the
world’s countries are sovereign currency-issuers. The Eurozone countries are not sovereign currency-issuers (a major cause
of the EU’s problems, as I will discuss); Ecuador, East Timor, El Salvador,
Marshall Islands, Micronesia, Palau, Turks and Caicos, British Virgin Islands
and Zimbabwe all use the US dollar as their official currency; and there a few
other miscellaneous examples of countries which are not financially sovereign [https://qz.com/260980/meet-the-countries-that-dont-use-their-own-currency/]. But the rest of the world’s countries use
unbacked, inconvertible fiat money. Unfortunately, all of the world’s financially
sovereign countries still impose more or less arbitrary operational constraints
on the extent to which they can spend, and set budget-balancing goals
completely divorced from relevant economic fundamentals. In setting these
budget-balancing goals, the politicians and technocrats of these countries universally
adopt the fallacious analogy of a sovereign government to a business (‘Just
like a small business owner, we need to keep our finances in order!’) and loudly
fret the prospect of credit rating downgrades (or, if they are from an
opposition party, hammer the sitting party for jeopardising the rating).
Although it is boring, I think it
is important to understand the nature and effect of the self-imposed
operational constraints because it allows one to understand two things crucial
to my thesis in this essay:
1.) How sovereign governments actually
run themselves today
2.) How they might run themselves
ideally.
Sadly, I have come to realise
that in order to explain the nature and effect of these self-imposed operational
constraints, I will have to do something much bigger first: explain, in broad
outline, how monetary policy works. In particular, I will have to explain how
central banks manage interest rates through “open market operations” with private
banks, and what would happen if this process was changed. The most crucial
thing I will touch on in the process is what the sale of debt actually does,
and whether it needs to happen at all. After completing all this will I get
onto discussing the substantial, macroeconomic constraints – the discussion
which will eventually lead me to a verdict on the debate between the deficit
owls and hawks.
Part I: How the Monetary System Currently Works
The key, general self-imposed
constraint on spending is central bank independence. As L. Randall Wray points
out here [http://neweconomicperspectives.org/2011/12/mmp-blog-28-government-spending-with.html],
two very common specific operational constraints for financially sovereign
countries across the world are: “A) the treasury keeps a deposit account at the
central bank, and must draw upon that in order to spend, and B) the central bank
is prohibited from buying bonds directly from the treasury and from lending to
the treasury (which would directly increase the treasury’s deposit at the
central bank)”. These are both products of central bank independence. The US apparently
has both of these self-imposed constraints; Australia, it turns out (from
perusing the RBA’s website), has constraint A and only allows the treasury to
overdraw on its account at the central bank in special circumstances (http://www.rba.gov.au/monetary-policy/about.html#the_implementation_of_monetary_policy).
About other countries, I can’t be bothered to find out the specifics (and
nobody makes it obvious (you can’t search “operational constraints on fiscal
policy imposed in [Country X]”)). But certainly it’s clear that central bank
independence has been the norm in the ‘West’ since the Reagan-Thatcher
devolution, so I’m sure the UK and Canada (and so on) have similar constraints.
Anyway, the long and short of these
operational constraints is that they impose an extra pain in the bum for the government
to spend money (deposit private bank accounts). By imposing multiple layers of
separation between the treasury and the central bank, you make it harder to
carry out fiscal policy.
The question is: what effect does
this separation have? As I established above, answering this involves taking a
detour through the exciting world of monetary policy. So that’s what we’ll do
now.
In order to even begin to understand
how central banks do the main thing they do – namely, set the interest rate – you
first need to recognise that private banks hold a chunk of their reserves in
(of course purely electronic) accounts at the central bank. In Australia, these
are called “exchange settlement accounts”, which helpfully conveys a sense of
their purpose: banks need to have accounts at the central bank to settle their
direct obligations to each other after the day is done (because of all the
non-cash transactions between their respective bank customers) and to borrow
from and lend to each other to equalise their reserves to the reserve-requirement
level.
Now, everybody knows that central
banks set interest rates, but probably only a small slice of the population knows
that this process isn’t just a kind of legal dictate which the banks obey when
making loans; instead, central banks operate daily with what is called an “overnight
interest rate target” for interbank lending. The achievement of this rate
target requires the central bank to add or drain private bank reserves (held in
their accounts at the central bank) in just the right quantity. Banks decide
the interest rates they will set for consumer and business loans based more or
less on the interbank lending rates (when the system’s working right at least).
(And, of course, barring a huge
build-up of private debt in the economy (as there has been in the countries
worst hit by the GFC since 2008, bringing about “secular stagnation” (read:
“credit stagnation” or “debt deflation”)), low interest rates typically spur
investment (it may, of course, be wildly misdirected investment, like
investment in toxic financial instruments, and this kind of investment is
encouraged when the real economy is so indebted) while higher interest rates
don’t as much.)
The overnight rate (note that
this is minus the “target” part) is, of course, the interest rate at which
major financial institutions actually borrow and lend one-day funds among
themselves (called the “cash rate” in Australia and probably New Zealand). All
central banks set an overall target for this rate: it happens monthly in the
UK, monthly in Australia, eight times a year in the US and eight times a year
in Canada. It’s when these rate-setting meetings occur that we get those
familiar news reports, usually ominous in tone and mood (“Today the [insert
specific name of central bank here] is set to lower the interest rate, in the
face of persistent stagnation”).
Now, in order to hit a non-zero
overnight rate, the central bank needs to add or drain reserves to ensure that
the banking system has just the amount of reserves desired. Why? Unfortunately,
it’s complicated.
The first thing you need to know
is what actually happens when the central bank buys from or sells to the
private banks. Fortunately, this can be articulated fairly simply (at least
when you overlook precise details which aren’t relevant to the accounting).
Basically, it works as follows:
When the central bank sells bonds
to a private bank, that bank’s reserve account (analogous to a “checking
account”) is debited and it is credited with treasury securities (in a kind of
higher-paying “savings account”): thus, reserves are depleted. When the central
bank buys bonds from a private bank, the reverse happens: reserves are added.
The second
thing you need to know is that the amount that the government has spent in a
given day over taxes is the determinant of the overall level of bank reserves. At
the end of any given day, if the government has spent as much as it has taken
out in taxes, the reserve surpluses and reserve deficits of banks will cancel
out; if the government has spent more than it has taken out in taxes, then the
bank reserves will overall be in surplus; and if the government has taxed more
than it has spent, then the bank reserves will overall be in deficit.
With this
knowledge transmitted, I can now explain how bank-reserve-alterations help the
central bank hit its target rate.
However much
money has been spent in a given day, the banks with reserves below the
required-rate (“deficit banks”) will be looking for the best deal on loans:
they will either look to the other banks for loans, or they may expect the
central bank to sell discount window loans/“repos” (a “repurchase agreement”
where the government buys one of its own securities on the condition that it
will sell it back at a higher price, typically within 1-7 days), to buy back
government securities outright, or to purchase gold, foreign currencies or even
private sector financial assets. The central bank will only want to do these
purchases, however, if the overnight (interbank) lending rate is higher than
their own target overnight rate (an overall reserve deficit does make this more
likely because it will generally push up the overnight rate (when lenders’
funds are tight, interest rates go up)). By making these purchases, the central
bank is getting the overnight rate on target, to the lower level they desire.
As for surplus
banks, the story is a bit more complicated again: in many countries – Australia
and Canada, for example – and in zones like the EU, the government actually
pays interest on surplus reserve accounts: the RBA sets this return at 25 basis
points less than the cash rate. By contrast, in the US and Japan before the
crisis, this was at 0 (MMTers tend to prefer this zero rate, as we will see). However
much money has been spent in a given day, surplus banks will only be willing to
reduce their reserves if they can get a better rate of interest by lending to
deficit banks than keeping their excess reserves in their respective central
bank accounts. If the banking sector is overall in surplus, and the central
bank wants to hit a nonzero overnight rate, the central bank will seek to sell
“reverse repos”, sell securities outright, and hand off all the other things it
has its hands on in order to drain these reserves. If it wants to hit a
relatively high interest rate relative to the amount of spending that has gone
on in the day, it will need to sell a lot of debt. Because targeting the
interest rate involves manipulating the reserve accumulations, the amount of
bank reserves is never discretionary when a non-zero interest rate is the
target. The interest rate itself is often not really discretionary: the QE
policies that were applied across most of the world after the GFC made zero
rates pretty much unstoppable by massively overstuffing bank reserves; the
treasury can’t make an infinite number of securities after all.
In this paper
[http://www.cfeps.org/pubs/wp-pdf/WP48-Wray.pdf], Mr. Wray adds some
interesting details to this story:
“While a
central bank employs a fairly large staff to estimate and predict reserve
supplies and demands, it is actually quite easy to determine whether the
banking system faces excess or deficient reserves: the overnight rate will move
away from target, triggering a nearly automatic offsetting reserve add or drain
by the central bank. Central banks also supervise banks and other financial
institutions, engage in lender of last resort activities (a bank in financial
difficulty may not be able to borrow reserves in the interbank lending market
even if excess reserves exist at the aggregate level), and occasionally adopt
credit controls, usually on a temporary basis.”
To finish this
section, I will present some irrefutable evidence that bond sales do not ‘fund’
deficits for sovereign currency-issuers: Japan’s “public debt” exceeded one
quadrillion yen (10.46 US$10.46 trillion) in 2013, more than twice its annual
gross domestic product, after more than 20 years straight of budget deficits
(look up the distinction between “public debts” and “deficits” if you don’t
already know it). And yet it has not been forced to pay higher bond yields and
thereby ‘capitulated’; in fact, bond yields steadily declined from 1991 to 2016
and are still currently very low. The ‘secret’ to this is that the Central Bank
of Japan buys back 70% of its own bonds, while much of the rest is purchased by
Japanese banks and trust funds, insulating the yields of such bonds from the
international bond market and the effects of credit ratings agencies. The credit ratings agencies truly had no effect on
Japan (in fact, more or less a reverse effect):
on May 31, 2002, Moody’s Investors Service cut Japan’s long-term credit rating way
down to A2 – below that given to Botswana, Chile and Hungary – but bond yields
didn’t go up at all. As the well-known MMTheorist and blogger Bill Mitchell
points out here [http://bilbo.economicoutlook.net/blog/?p=28918], any country
could decide to manage the yield of bonds if it wanted to by carrying out the
buybacks that Japan has done, and without causing a great increase in inflation
(because, as we’ll see, the “quantity theory of money” is completely wrong; it
matters how and to whom money is spent (extra bank reserves contribute nothing
to inflation, which is why QE hasn’t caused any inflation)); and any country,
if it so desired, could stop issuing bonds completely. This latter reform
would, however, require the end of central bank independence. It is to this
possibility we turn next.
Part II: On Whether We Should End Central Bank
Independence and Accept a Permanent Zero Interest Rate
Like several other prominent MMTheorists (Warren Mosler,
Randy Wray), Bill Mitchell has made the case that we should end central bank
independence, make fiscal policy the only means by which governments manage the
economy and accept a permanent zero
interest rate policy. In this blogpost (http://bilbo.economicoutlook.net/blog/?p=31715),
he makes the case for the end of debt issuance (which entails the end of
central bank independence and the takeover of fiscal policy) and here, he makes
the case for a permanent zero interest rate (http://bilbo.economicoutlook.net/blog/?p=4656).
I’ll say more about what I think about these radical proposals later, but for
now I’ll simply outline his arguments, using quotes from these two blogposts.
First the case for the end of
debt issuance.
Mitchell believes that, in order to
achieve maximum financial stability: “(a) the key financial institutions must
be stable and engender confidence that they can meet their contractual
obligations without interruption or external assistance; and (b) the key
markets are stable and support transactions at prices that reflect fundamental
forces.” He gives a sevenfold list of “essential requirements” of a “stable
financial system” (I assume he means “as stable as can be”, not truly “stable”;
if he doesn’t mean this, he is not on the same page as Steve Keen (following
Hyman Minsky) and me (following Keen)). This list is as follows:
1. Clearly defined property rights;
2. Central bank oversight of the payments system;
3. Capital adequacy standards for financial institutions;
4. Bank depositor protection;
5. An institutional lender-of-last resort when private institutions refuse to lend to solvent borrowers in times of liquidity crisis;
6. An institution to ameliorate coordination failure among private investors/creditors;
7. The provision of exit strategies to insolvent institutions.
2. Central bank oversight of the payments system;
3. Capital adequacy standards for financial institutions;
4. Bank depositor protection;
5. An institutional lender-of-last resort when private institutions refuse to lend to solvent borrowers in times of liquidity crisis;
6. An institution to ameliorate coordination failure among private investors/creditors;
7. The provision of exit strategies to insolvent institutions.
He claims that “none of these requirements rely on the
existence of a viable government bonds market”.
He puts his call-to-arms to the
vested interests who benefit from the ‘free lunch’ in the following sardonic
fashion (mocking their pretense to truly love the free market, rather than
worship greed and their own self-interest): “The burden of proof falls on those
arguing in favour of such issuance to show that the market in question is
incapable of viable operation without government intervention and will,
unassisted, produce outcomes detrimental to the macro priorities we discussed
earlier – full employment etc.”
He rejects the argument that
public debt issuance is needed to support “the yield curve” with a crucial use by
financial markets as “the benchmark risk free asset, which provides a benchmark
for pricing any other debt security”. He points out that there are clear
alternatives for pricing debt securities, of which he gives two examples:
“1. The market could price
securities against other securities with similar characteristics.
2. Market participants could
price securities with respect to the interest rate swap curve.”
He rejects the argument that
public debt is needed to provide a long-term investment vehicle. Proponents of
this objection argue, he says, that “if superannuation and life companies were
unable to purchase government debt then they would struggle to match their
long-dated liabilities with appropriate returning assets”, and that
“eliminating the government bonds market would deny workers of a risk free,
dollar-denominated asset to invest there [sic] savings in”, thereby making
retirement planning “highly uncertain”. But while “he is supportive of workers
being able to save (risk manage their futures) in a safe way”, he thinks that
clearly doesn’t justify “the massive corporate welfare that accompanies the
issuance of public debt.” He points out that “government bonds are in fact
government annuities”, and thinks it is clearly a bad thing that the private
sector has “access to government annuities rather than […] directing real
investment via [eg] privately-issued corporate debt”. He notes that by
“facilitating portfolio diversification”, government bonds help private
profit-seeking investors. This, he claims, “interferes with the investment
function of markets” and contradicts the notion that direct government payments
should “be limited to the support of private sector agents when failures in
private markets jeopardise real sector output (employment) and price stability.”
He then points out that there are
clear alternatives. The claim that bond issues are essential for long-term
investments for workers’ retirement schemes “requires a comparison of this
method of retirement subsidy against more direct methods involving more
generous public health and welfare provision and pension support” – and yet this
is not given. He himself believes that “there is a much more effective way to
provide a risk-free savings vehicle for workers”, as follows:
“The government could create a
National Savings Fund, fully guaranteed by the currency-issuing capacity of the
government, which could provide competitive returns on savings lodged with the
fund. There would be no public debt issuance (and the associated corporate
welfare and government debt management machinery) required.”
He rejects the argument that
government debt is needed to provide a ‘safe haven’ for investors in times of
financial instability or strife. He observes that “The ‘flight to quality’
argument suggests that it is beneficial to the macro economy for investors to
have a risk free domestic asset available to avoid capital losses on other
assets.” But, in addition to his objections, outlined above, to subsidy through
government annuities, he also notes that “government bonds compete directly
with these other assets, thereby driving down their prices and exacerbating
matters during ‘flights to quality’.” In a monetary economy, he claims, “investors
can always hold money balances by increasing actual cash holdings or banking
system deposits”. Furthermore, if we imagine a system which possesses
characteristics 4.) and 5.) of his “stable financial system”, so that people
have effective “deposit insurance”, then “bank deposits would be equivalent to
holding government bonds anyway for all practical purposes.” He points out that
“this also passes the ‘risk’ to private banks when they select their assets”.
Overall, he doesn’t believe there is any “compelling real macroeconomic reason
why risk and return decisions by private maximising agents should be ‘further
protected’ by retreat to a market distorting government annuity.”
The final argument he rejects is
one that we’ll be familiar with: that debt issuance is needed for implementing
monetary policy. Now, as I’ve already made clear, Mitchell ultimately advocates
the total abandonment of monetary policy and the permission of the interest
rate to settle at a permanent zero level (and we’ll get to his argument for
that in a few paragraphs’ time), but he also holds that, even if you want a
non-zero interest rate, that can be achieved without debt issuance, “through
the use of the support rate on excess reserves”. The way this would work, I
think, is this:
If the level of spending over
taxation is not super high (so that at least some banks have deficit reserves),
and if surplus banks have a support rate and if the central bank is no longer
offering debt to the deficit banks, then the surplus banks will set a rate
higher than the support rate for loans to the deficit banks (because they want
the best deal) and the deficit banks will accept it (because there is no
alternative). The higher the support rate is set the higher will be the
overnight rate. If, on the other hand, there are no deficit banks, then the
support rate will simply determine the interest rate.
Mitchell also has a significant
positive argument for abandoning debt issue: that ending it, and all that goes
along with it, will retrieve a lot of resources that could be put to far more
productive use. As he puts it:
“The opportunity costs in terms
of the labour employed directly and indirectly in the public debt ‘industry’
are both real and large. The ‘cottage industry firms’ that characterise the
public debt industry use resources for public debt issuance, trading, financial
engineering, sales, management, systems technology, accounting, legal, and
other related support functions. These activities engage some of the brightest
graduates from our educational system and the high salaries on offer lure them
away from other areas such as scientific and social research, medicine, and
engineering. It could be argued that the national benefit would be better
served if this labour was involved in these alternative activities. Government
support of what are essentially distributional (wealth shuffling [sic])
activities allows the public debt market to offer attractive salaries and
distorts the allocation system.
While this labour may move within
the finance sector if public debt issuance terminated, the Government [sic]
could generate attractive opportunities by restoring its commitment to adequate
funding levels for research in our educational institutions.
On balance, public debt markets
appear to serve minor functions at best and the interest rate support can be
achieved simply via the central bank maintaining current support rate policy
without negative financial consequences. The public debt markets add less value
to national prosperity than their opportunity costs. A proper cost-benefit
analysis would conclude that the market should be terminated.”
Now onto his case for a permanent
zero interest rate.
Mitchell begins his case for a permanent
zero interest rate in the blogpost I linked before by mounting a case against
the neoclassical-economics construction of the “neutral rate of interest”
(sometimes called the “equilibrium interest rate”) – the default intellectual
weapon that an opponent would invoke if someone were to bring up the idea of
establishing a permanent interest-rate level. The idea of a neutral interest
rate is, in fact, very important to our discussions because it underpins three
beliefs of mainstream economists used to justify central bank independence: “the
belief in the primacy of monetary policy as the preferred counter-stabilisation
tool”; the belief “that the central bank can maximise real economic growth by
achieving price stability”; and the belief “that when the central bank target
interest rate is below the “neutral rate of interest”, inflation will break out
(eventually) and vice versa [with deflation].”
The best known
exposition of the idea of the neutral interest rate can apparently be found in
the 1898 book by Swedish monetary theorist Knut Wicksell (1851-1926). Mitchell
claims that “Wicksellian thinking is very influential among central bankers.”
In his classic
book Interest and Prices, Wicksell
apparently defined a “natural interest rate” as follows:
“There is a
certain rate of interest on loans which is neutral in respect to commodity
prices, and tend neither to raise nor to lower them. This is necessarily the
same as the rate of interest which would be determined by supply and demand if
no use were made of money and all lending were effected in the form of real
capital goods. It comes to much the same thing to describe it as the current
value of the natural rate of interest on capital (emphasis in
original).” [1936 edition: 102].
Mitchell
explains: “Consistent with the view held in those times that the loanable funds
market brought savers together with investors, the natural rate of interest is
that rate where the real demand for investment funds equals the real supply of
savings.”
Mitchell
describes how Wicksell differentiated “the interest rate in financial markets
which is determined by the demand and supply of money and the interest rate
that would mediate “real intertemporal transfers” in a world without money”,
and stipulated that the “natural interest rate” reflects only “real (not
nominal) factors”. Wicksell thus agreed with the (completely false) classical
idea that money is a “veil over the economy”, only affecting the price level.
In the book referenced earlier, he writes:
“Now if money
is loaned at this same rate of interest, it serves as nothing more than a cloak
to cover a procedure which, from the purely formal point of view, could have
been carried on equally well without it. The conditions of economic equilibrium
are fulfilled in precisely the same manner.”
Money affects
the precise level in Wicksellian thought in the following way:
“The deviation
between the interest rate determined in the financial markets and the natural
rate impacts on the price level. So when the money interest rate is below the
natural rate, investment exceeds saving and aggregate demand exceeds aggregate
supply. Bank loans create new money to finance the investment gap and inflation
results (and vice versa, for money interest rates above the natural rate).”
Mitchell
describes exactly how this leads to policy conclusions:
“With the
natural rate of interest an unobservable imaginative construct, Wicksell
claimed that the link between price level movements and the gap between the two
interest rates provided the clue for policy makers.
He wrote
(p.189) that:
“This does not
mean that the banks ought actually to ascertain the natural rate
before fixing their own rates of interest. That would, of course, be
impracticable, and would also be quite unnecessary. For the current level of
commodity prices provides a reliable test of the agreement of diversion of the
two rates. The procedure should rather be simply as follows: So long as
prices remain unaltered the banks’ rate of interest is to remain unaltered. If
prices rise, the rate of interest is to be raised; and if prices fall, the rate
of interest is to be lowered; and the rate of interest is henceforth to be
maintained at its new level until a further movement of prices calls for a
further change in one direction or the other.(emphasis in original).””
The key point
about this, as Mitchell notes, is that “to advocate Wicksell’s theory you have
to buy into the whole theoretical box-and-dice – in all its inanity and
inconsistency.” You have to believe that “markets equilibrate through price
adjustments and the economy tends to full employment (meaning there cannot be a
deficiency of aggregate demand). So if consumption falls (because saving
rises), the interest rate (in the loanable funds market) falls (excess supply
of loans) and investment rises to fill the gap left by the fall in consumption.
This is Say’s Law which is restated as Walras’ Law when
multiple markets are introduced.”
This ultimately
leads to the following absurd claims:
“The interest
rate adjusts to the natural interest rate where the full-employment level of
savings equals investment and all is well. There is never a shortage of
investment projects but their introduction is impacted upon by the cost of
funds. There is never [involuntary] unemployment!”
I will now
quote from my 67-Page Dismantling of Mainstream Economics [http://writingsoftclaitken.blogspot.com.au/2016/02/a-67-page-dismantling-of-economics-of.html]
where I quoted from Keen to explain what Say’s Law is, and why it is false:
“[The pre-Great
Depression classical economists] believed that individual markets might be out
of equilibrium at any one time, but the overall economy, the sum of all those
individual markets, was bound to be balanced. As Keen explains, “The basis for
this confidence was the widespread belief, among economists, in what Keynes
termed Say’s Law.” This Law essentially stated that ‘supply creates its own
demand’. More precisely, it is defined by Steve Kates (the strongest modern-day
proponent of the Law), as the proposition that “the sale of goods and services
to the market is the source of the income from which purchases are financed”.
(What this actually means, in practical terms, is that slumps
can never be caused by an overall deficiency in demand, but are always due to
sectoral imbalances.)
Amidst the
devastation and misery of the Great Depression, Keynes challenged this
principle. Keynes’ critique of Say’s Law was what he himself described as “the
essence of the General Theory of Employment”. […]
Keen gives a
simplified version which is easy enough to understand:
“Keynes divided
all output into two classes: consumption and investment. If the economy was in
equilibrium, then Say’s Law would argue that excess demand for consumption
goods would be zero, and likewise for investment goods.
Keynes then
imagined what would happen if demand for consumption goods fell, so that excess
demand for consumption goods was negative (supply exceeded demand). Say’s Law
would argue that demand for investment goods would rise to compensate: notional
excess demand for investment goods would be positive.
However, as
Keynes argued extensively throughout the General Theory, demand
for investment goods is driven by expectations of profit, and these in turn
depend heavily upon expected sales to consumers. A fall in consumer demand now
could lead entrepreneurs to expect lower sales in the future – since in an
uncertain environment “the facts of the existing situation enter, in a sense
disproportionately, into the formation of our long-term expectations, our usual
practice being to take the existing situation and to project it into the
future.”
Dampened
expectations would therefore lead entrepreneurs to reduce their demand for
investment goods in response to a reduced demand for consumer goods. Thus a
situation of negative excess demand for consumer goods could lead to a state of
negative excess demand for investment goods too – a general slump.”
In an earlier
draft, Keynes also had another, more straightforward critique of the Law. He
seems to have omitted it because it originally came from Marx. This critique is
also worth outlining and can be explained in the following way.
Say’s Law
begins from the abstraction of an exchange-only economy: an economy in which
goods exist at the outset, but where no production takes place. This led
economists to believe that if an agent desired to and did accumulate wealth,
that would make them a “thief”. However, Marx observed – famously – that
production enables agents to accumulate wealth without aspiring to be thieves.
Marx formulated this analysis in terms of two ‘circuits’: the ‘Circuit of
Commodities’ and the ‘Circuit of Capital’.”
In the Circuit
of Commodities, things are as Walras imagined them: people come to market with
commodities, which they exchange for money to buy other commodities. Marx
stylised this as C – M – C.
In the Circuit
of Capital, however, people come to market with money, with the intention of
turning this money into more money. “These agents buy commodities –
specifically, labour and raw materials – with money, put these to work in a
factory to produce other commodities, and then sell these commodities for
(hopefully) more money, thus making a profit.” Marx stylised this as M – C – M+
As Keen puts
it, “These agents wish to supply more than they demand, and to accumulate the
difference as profit which adds to their wealth. Their supply is the
commodities they produce for sale. Their demand is the inputs to production
they purchase – the labour and raw materials. In Say’s Principle’s terms, the
sum of these, their excess demand, is negative. When the two circuits are added
together, the sum of all excess demands in a capitalist economy is likewise
negative.””
Mitchell
himself observes that “it was exactly these issues that Keynes tackled in The General Theory. He quotes Keynes in
Chapter 14, a chapter on the classical theory of interest. Mitchell’s quote
shows that, for Keynes, once one accepts the claim that there is a ““natural”
or “neutral” […] or “equilibrium” rate of interest, namely, that rate of
interest which equates investment to classical savings proper without any addition
from “forced savings” one has put oneself “in deep water.” As Keynes poetically
puts it:
“The wild duck
has dived down to the bottom — as deep as she can get — and bitten fast hold of
the weed and tangle and all the rubbish that is down there, and it would need
an extraordinarily clever dog to dive after and fish her up again.
Thus the
traditional analysis is faulty because it has failed to isolate correctly the
independent variables of the system. Saving and Investment are the determinates
of the system, not the determinants. They are the twin results of the system’s
determinants [aggregate demand]. The traditional analysis has been aware that
saving depends on income but it has overlooked the fact that income depends on
investment, in such fashion that, when investment changes, income must
necessarily change in just that degree which is necessary to make the change in
saving equal to the change in investment.”
Mitchell
translates:
“In other
words, the orthodox position that the interest rate somehow balances investment
and saving and that investment requires a prior pool of saving are both
incorrect. We learned categorically that investment brings forth its own saving
through income adjustments.
What drives all
this is effective demand – spending backed by cash (Marx definitely wrote about
that in Theories of Surplus Value). The 1930s totally discredited the
Wicksellian ideas about the dynamics of the economy and the centrality of
interest rate adjustments in stabilising the economy.”
We’ll also see
later, when I discuss the substantial macroeconomic constraints on government
spending and we get to price theory, that the idea that interest rates are key
to prices (inflation, deflation) is not a good theory.
After
Mitchell’s done dismantling this Wicksellian notion, he gets onto the positive
case for having a permanent zero interest rate. His sole argument is that
monetary policy is “a poor tool for counter-stabilisation” because “it is
indirect, blunt and relies on uncertain distributional behaviour.” He claims
“It works with a lag if at all and imposes penalties on regions and cohorts
that may not be contributing to the price pressures (for example, when Sydney
property prices were booming all of regional Australia[,] which was not[,] was
[nevertheless] forced to bear the higher interest rates).” Fiscal policy, by
contrast, is “powerful because it is direct and can create or destroy net
financial assets in the non-government sector with certainty [, not relying] on
any distributional assumptions being made.”
Phillip
Pilkington, in this post (http://www.nakedcapitalism.com/2012/12/philip-pilkington-monetary-policy-and-metaphysics-how-economists-try-to-naturalise-terrible-policies-and-disappear-into-their-own-theories.html),
explicates similar arguments in much more depth:
“The simple
fact is that the era of interest rate targeting has been, well, something of a
disaster. That this would have been the case would not have surprised the old
Post-Keynesian economists. As Steve Randy Waldman has pointed
out over at his excellent Interfluidity blog, the Polish economist Michal
Kalecki predicted what would likely happen should central bank’s begin to rely
on monetary policy as their primary tool of choice. In 1943 – yes, 1943! –
Kalecki wrote:
“The rate of
interest or income tax [might be] reduced in a slump but not increased in the
subsequent boom. In this case the boom will last longer, but it must end in a
new slump: one reduction in the rate of interest or income tax does not, of
course, eliminate the forces which cause cyclical fluctuations in a capitalist
economy. In the new slump it will be necessary to reduce the rate of interest
or income tax again and so on. Thus in the not too remote future, the rate of
interest would have to be negative and income tax would have to be replaced by
an income subsidy. The same would arise if it were attempted to maintain full
employment by stimulating private investment: the rate of interest and income
tax would have to be reduced continuously.”
And after 1982
when interest rates began to be used to stimulate economic activity this is
precisely what happened. Waldman provides us with this rather stark graph in
order to illustrate the confirmation of Kalecki’s thesis:
Yes, the
Federal Reserve was able to keep the economy on a growth path – albeit one that
was vastly inferior to that during the Keynesian era – but in order to do so
they basically had to keep dropping the interest rate after every recession and
not bring it back to its previous level after the recovery had set in. What we
got then was seriously diminishing returns from monetary policy right up until
after the 2008 financial crisis when interest rate targeting became completely
ineffective as a means to return the economy to anything resembling full
employment.”
“One of the
other, often overlooked, negative consequences of using monetary policy as the
key tool of macroeconomic stabilisation is that it is, by definition, a tool
that uses instability to try to generate stability and this has serious
consequences for economic development. Whereas fiscal policy seeks to glide the
economy to full employment through delicately balancing effective spending,
monetary policy relies on “shocking” the economy in the desired direction.
Naturally, this greatly heightens uncertainty amongst the business community.
Imagine a
representative firm earning a rate of profit on their investments of 8% per
year. Now, if the central bank raises interest rates to stall the economy this
will have two negative consequences for the firm in question. First of all, any
outstanding debt that the firm has will cost more to service. Secondly, and
perhaps more importantly, their prior investments will start looking a lot less
promising. If the interest rate is set at, say, 3% then the firm could make 3%
merely by buying perfectly safe government bonds. Now, the spread between their
rate of profit and this rate of interest – in our example, 8% – 3% = 5% – may
be sufficient to compensate for any risk the firm incurs through its
investments. But if the rate of interest rises to, say, 4%, these investments
may no longer appear worthwhile because the spread between the rate of profit
and the risk free rate of interest will be only 4%.
What this means
is that firms have to price into their investments the likelihood that the
central bank will raise interest rates in the coming year. Thus, as the British
Post-Keynesian economists Nicholas Kaldor knew well, if an economy is being
stabilised through interest rate manipulation alone, firms will be far more
cautious about making real productive investments and will favour speculating
in bond and other financial markets. Kaldor put it as such in his seminal 1958
paper “Monetary Policy, Economic Stability and Growth”:
If bond prices
were subject to vast and rapid fluctuations [due to the central bank
manipulating the interest rate to steer the economy], the speculative risks
involved in long-term loans of any kind would be very much greater than they
are now [i.e. in the Keynesian era], and the average price for parting with
liquidity would be considerably higher. The capital market would become far
more speculative, and would function far less efficiently as an instrument for
allocating savings – new issues would be more difficult to launch, and long-run
considerations of profitability would play a subordinate role in the allocation
of funds. As Keynes said, when the capital investment of a country “becomes a
by-product of the activity of a casino, the job is likely to be ill-done”.
And things have
gone exactly as Kaldor predicted that they would. In our era of monetary policy
primacy investors have become far less inclined to pour funds into real
investment, as can clearly be seen in the case of the US in the below graph.
The reader can
probably make out from that chart that prior to 1969 the average growth in the
rate of investment (red line) was significantly higher than after 1969 when
monetary policy (blue line) became an increasingly important tool to manage the
economy. The average growth in the rate of investment between 1947 and 1968 was
1.31% per year while the average growth in the rate of investment between 1969
and 2012 was 0.9% – a decline of over 31%. If we take the monetary policy era
as having started in 1979 rather than in 1969 – we mention this only because it
is the typical periodisation, whereas if we look at the data it’s clear that
monetary policy came into favour in 1969 – but if we take the year 1979 as our
starting point we achieve broadly the same, if not an even more dramatic,
result: between 1947 and 1979 the average growth in the rate of investment was
1.25% per year, while between 1979 and 2012 it was 0.78% – a decline of over
37%.
Meanwhile, the
capital markets have indeed turned into a giant speculative casino. Interest
rate targeting is, of course, not wholly to blame for these shifts, but it
absolutely is a key factor. And indeed, most economists and policymakers would
claim that this era’s prosperity (or lack thereof), which they refer to as the
“Great Moderation”, is a result of the new “scientific” interest rate targeting
policies. In reality, by using monetary policy shocks to steer the economy
central banks are driving out the good investment and encouraging speculative
Ponzi rubbish in the financial markets.”
“If the economy
were consistently run at zero-level interest rates, investors would be forced
to invest in real goods and services rather than in government and related debt
instruments. Given that the economy would also be being run at close to full
employment the risks that potential real investors would have to bear would be
substantially lower as they could be sure that the government was always
guaranteeing that there would be a market for their goods and services.
Finally, the interest repayments on borrowing by productive investors would be
extremely low, giving even more of an incentive to invest in tangible goods and
services.”
Pilkington does,
however, suggest that it might not be a good idea to cement the interest rate
completely, and in this regard cites the inflation-based argument of one of the
major influences of the post-Keynesian tradition, Nicholas Kaldor:
“The other
approach that might be taken to monetary policy in a society not run by
metaphysicians and haruspices would be the “Kaldorian” or “fine-tuning”
approach. In his previously cited 1958 paper, Kaldor noted that although
Keynesian policies were extremely good at maintaining a steady rate of
investment and growth, they could not deal with fluctuations in the level of
inventories.
Capitalists
tend to increase investment in inventories when they think an uncertain event
might be around the corner – the simplest example of this being a rise in the
price of raw materials due to weather conditions. This would cause them to
borrow at the short-term rate of interest in order to avail of the lower prices
of production, increase their holding of inventories and buffer themselves
against future rises in production costs. The problem with this was that if the
economy was running close to full capacity (i.e. full employment) any sudden
increase in production needed to build up inventories would lead to a squeeze
on resources and possible inflation.
Kaldor thus
suggested that because capitalists borrowed almost exclusively at the
short-term rate of interest to build inventories, it could be increased at
times when central banks thought that capitalists were about to build inventory
while the economy was at full capacity. Kaldor wrote:
“[The] function
of credit control [i.e. monetary policy] should be sought in stabilising
investment in stocks (i.e. in offsetting spontaneous tendencies to instability
in inventory investment), and not in the control of investment in fixed capital
or the control of consumption which can far more appropriately be secured by
other instruments.”
Kaldor’s
comments can be seen today in light of the fact that it was indeed an external
shock to the prices of raw materials (oil) which in the 1970s set off an uncontrollable
inflation. But even in his classic essay he remained sceptical that monetary
policy alone could secure price stability in case of rises in the price of raw materials.
For this reason he also advocated that countries work together to secure buffer
stocks of raw materials in case of shortfalls. Today, in light of the events
that took place in the 1970s, he might have added policymakers should be
mindful of the domestic economic effects their foreign policy decisions might
have.”
My overall conclusion
is as follows: in an ideal world, we would end central bank independence,
perhaps gradually phase out bond issues, but possibly still do some interest
rate management such as Kaldor suggested.
Substantial Macroeconomic
Constraints on Government Spending:
A standard response to the claim
that deficits are good is that inflation will break out if the government
prints too much money; the especially vulgar critics seem to think that if
governments abandon the goal of running surpluses, it will only be a matter of
time before hyperinflation breaks
out, Ã la Weimar Germany or Zimbabwe (this (http://theconversation.com/printing-more-money-isnt-the-answer-to-all-economic-ills-71334),
for example, is one of the stupidest articles I’ve ever read, savaged by Bill
Mitchell here: http://bilbo.economicoutlook.net/blog/?p=35234).
Meanwhile, the majority of mainstream economists believe in something called the
“NAIRU”, the Non-accelerating Inflation Rate of Unemployment”, meaning that
there is a level of unemployment below which you inevitably get an inflation
outbreak.
Marc Lavoie
summarises the mainstream view in chapter 8, “Inflation Theory”, of Post-Keynesian Economics: New Foundations:
“In mainstream
economics, price inflation is essentially an excess demand phenomenon. In its
simplest form, excess demand arises from an excess supply of money, or rather
from an excessive growth rate of the money supply. This is the quantity theory
of money in its various incarnations, including monetarism. In its Wicksellian
version, associated with the New Consensus, excess demand arises from a market
rate of interest that is too low compared to the natural rate of interest. More
precisely, a negative discrepancy between the market and the natural rate of
interest opens up an output gap that leads to an acceleration of the inflation
rate, supported by growth in the money supply. This is akin to the accelerationist
thesis and the vertical Phillips curve, based on the natural rate of unemployment
or the non-accelerating inflation rate of unemployment (NAIRU). Whenever the
actual rate of unemployment is below this rate, wage and precise inflation
speeds up. The change in the rate of inflation is thus determined by the level
of the rate of unemployment relative to its presumed natural value. There are
other incarnations of this accelerationist thesis, tied to the rate of capacity
utilization, with a steady-inflation rate of capacity utilization (SIRCU).”
[2015 edition: 541]
The highly
socially right-wing but seemingly incredibly (economically) well-read guy on
the internet who calls himself “Lord Keynes” and runs this blog (http://socialdemocracy21stcentury.blogspot.com.au/),
gives some more detail on these theories and explains why they’re wrong in this
post (http://socialdemocracy21stcentury.blogspot.com.au/2014/04/bob-murphy-on-1970s-inflation.html)
and discusses post-Keynesian inflation theory in greater generality in this
post: (http://socialdemocracy21stcentury.blogspot.com.au/2011/06/stagflation-in-1970s-post-keynesian.html).
These are must-read analyses. I would simply quote extracts from them like I
have done with Bill Mitchell’s and Phillip Pilkington’s blogposts, except that
I think that there’s nothing to leave out (what is the point of pasting an
entire blogpost?).
As for this
notion that hyperinflation would be a serious prospect if a First World country
with idle resources and labour ramped up spending on useful projects which had
a multiplicative effect throughout the economy, Mr. Wray addresses this head-on
in this post (http://www.economonitor.com/lrwray/2011/08/31/not-worth-a-continental-how-modern-money-theory-replies-to-hyperinflation-hyperventilators-part-2/),
by examining the specific constellation of factors which lead to hyperinflation
(collapse of output because of some war or disaster, necessity to pay significant
external debts, etc). I will now extract the key section of this post:
“It is
important to examine the relation between budget deficits and high or
hyperinflation. When Luiz Carlos Bresser-Pereira was finance minister
for Brazil during a high inflation period he provided an insightful analysis of
the alternative. In an important sense, tax revenues are “backward-looking”,
based on past economic performance. Income taxes, for example, are calculated
and collected with a rather long lag. Even sales taxes are collected with a
lag. When inflation is running at 2% per year, the lag does not matter much;
but if it is running 10% or 50% per month, even a short lag makes a big
difference. Government spending is more contemporaneous—as prices rise,
government pays more.
Of course, this
effect will depend on indexing—how often are the wages, prices, and transfer
payments increased as prices rise. In countries, like Brazil, with high
inflation, the reset period for indexing tends to fall—so that government
spending rises nearly as fast as inflation. With tax revenues growing more
slowly, a budget deficit is created. Of course, indexing also tends to build-in
inertial inflation (a wage-price spiral is created as rising prices trigger
wage increases that induce firms to raise prices to cover costs). Bresser
realized that the way to reduce growth of the deficit and to cut inflation was
to check indexing. While it is painful, if government can postpone the
increases to wages, welfare payments, and prices paid by government, it can
reduce inflation pressures and at the same time reduce the budget deficit.
The important
point to note, however, is that budget deficits are at least to some degree an
effect, not a cause, of inflation. Still, it is true that if government reduces
its deficit (by eliminating indexing, for example) it will reduce inflation
pressures. To be sure, it can achieve the same result through draconian tax
hikes. Note also that this policy recommendation is not inconsistent with the
conventional view that fiscal austerity can reduce high inflation. Indeed,
MMTers have always agreed that one way to fight high inflation is to cut
government spending or to raise taxes. What they reject is the Monetarist
belief that the cause of high inflation is a simple matter of “too much money”.
There is a link
among high (or hyper) inflation, budget deficits, and “money supply”—although
it is not a simple Monetarist dynamic. As discussed, government always spends
by “keystrokes” that credit accounts, and taxes (or sells bonds) by reverse
keystrokes that debit accounts. Deficits mean government credited more to
accounts than it debited, so that government IOUs have been net created in the
form of “high powered money” (HPM or reserves plus cash) and treasuries (bonds
and bills). As discussed above, in high or hyper- inflation periods, taxes
(debits to accounts) grow more slowly than government spending (credits to
accounts) so we expect deficits to result—which means government IOUs
outstanding (HPM plus Treasuries) grow.
This is not the
simple Monetarist story in which government “prints too much money” that causes
high inflation, but rather a more complicated causal sequence in which high
inflation helps to create deficits—that by identity equal net credits to
balance sheets. Matters are made worse if a high interest rate policy is
pursued by the central bank. This is because government typically sells a lot
of treasuries as its deficit rises (sometimes this is actually required by
operating procedures adopted, or it is due to a policy of setting the overnight
interest rate target above the support rate—in the US this would be a case
where the Fed’s fed funds target was above the rate it pays on excess
reserves), and interest payments on treasuries add to government spending. If
the central bank reacts to growing deficits by raising interest rate targets,
it helps to fuel growth of the deficit and also adds demand stimulus to
the economy.
Stopping the
inflation (for example by eliminating indexation of government spending) will
probably reduce the deficits and the growth of HPM and treasuries outstanding.
(That will also reduce interest payments by government, slowing growth of
nongovernment incomes and depressing demand.) Alternatively, accelerating tax
collection would achieve the same goal. Lowering the interest rate target could
also help.
Let us turn to
historical episodes with hyperinflation. America has had two such well-known
experiences: the “Continentals” and the Confederate currency (we still have the
phrase, “not worth a Continental”). In the pre-revolutionary period, the
American colonies actually experimented fairly successfully with paper “fiat”
currencies. To some extent, this was emergency behavior–they were prohibited by
the Crown from coining currency. Some commentators at the time—including Adam
Smith—noted that even though these notes were not redeemable for precious
metal, they maintained their value so long as the issue was not too excessive
relative to total taxes. As MMTers say, “taxes drive money”—so long as paper
IOUs of government are accepted in tax payment, they will be accepted in
payment. Still, their value will be determined by “how hard” they are to
obtain. If money “grew on trees” (as our mothers used to say), it would be
worth only the effort required to pick it. If colonial governments spent too
much into existence so that it was easy to obtain paper notes to pay taxes,
then they would circulate at lower value.
Both the
Continentals and the Confederate currency shared common defects. First, the
requirements of wars (Britain vs the colonies, North vs South) made the
currencies overly abundant. Certainly there is nothing new about that—wars
generally do experience inflation as government spending ramps up demand,
causes shortages, and chases prices up. However, that was also true of the
currency issued in the Union—which suffered from very high inflation, but not
nearly so bad as that experienced in the South. The difference was
taxes—essentially there were no taxes backing either Continentals or the
Confederate currency. In the first case, the loose confederation of the
colonies did not have sufficient authority to impose and enforce taxes; in the
second, the representatives of the Confederate states believed that the
population was already suffering too much from prosecuting the war of
rebellion—so did not want to add the burden of taxation. By contrast, even
though the North ran large deficits, it retained a tax system to drive the
currency and thus avoided hyperinflation. While it might be thought that the
South’s much worse experience can be attributed to pessimism over its prospects
of winning, that does not seem to be the case. Even near the end of the
war, when prospects were bleakest, the Confederacy was still able to float
bonds at relatively low interest. (For those who are interested in these
cases, see my book, Understanding Modern Money for more
discussion.)
Today, the best
known cases of hyperinflation occurred during the Weimar Republic and more
recently in Zimbabwe. (Less well-known but more spectacular was the Hungarian
hyperinflation.) The best analyses of these that I have seen are by William
Mitchell (at billyblog: http://bilbo.economicoutlook.net/blog/?p=10554; http://bilbo.economicoutlook.net/blog/?p=13035), Rob
Parenteau http://www.nakedcapitalism.com/2010/03/parenteau-the-hyperinflation-hyperventalists.html,
Cullen Roche http://pragcap.com/hyperinflation-its-more-than-just-a-monetary-phenomenon ,
and at http://rabble.ca/print/blogs/bloggers/progressive-economics-forum/2011/08/mythologies-money-and-hyperinflation. Cullen
actually looked at 10 modern (post 1900) hyperinflations and found several
common themes. First, most of the ten occurred during a civil war, with a
regime change. A majority also occurred with large debt denominated in foreign
currency (this included Austria, Hugary, Weimar Germany, Argentina, and
Zimbabwe). I am not going to reproduce these excellent analyses, but let me
just very quickly summarize key points about the Weimar and Zimbabwe
hyperinflations to assure readers these were not simple cases of too much
“money printing” to finance government that was “running amuck”.
The typical
story about Weimar Germany is that the government began to freely print a fiat
money with no gold standing behind it, with no regard for the hyperinflationary
consequences. The reality is more complex. First, we must understand that even
in the early 20th century, most governments spent by issuing
IOUs—albeit many were convertible on demand to sterling or gold. Germany had
lost WWI and suffered under the burden of impossibly large reparations
payments—that had to be made in gold. To make matters worse, much of its
productive capacity had been destroyed or captured, and it had little gold
reserves. It was supposed to export to earn the gold needed to make the
payments demanded by the victors. (Keynes wrote his first globally famous book
arguing that Germany could not possibly pay the debts—note these were external
debts denominated essentially in gold.)
The nation’s
productive capacity was not even sufficient to satisfy domestic demand, much
less to export to pay reparations. Government knew that it was not only
economically impossible but also politically impossible to impose taxes at a
sufficient level to move resources to the public sector for exports to make the
reparations payments. So instead it relied on spending. This meant government
competed with domestic demand for a limited supply of output—driving prices up.
At the same time, Germany’s domestic producers had to borrow abroad (in foreign
currency) to buy needed imports. Rising prices plus foreign borrowing caused
depreciation of the domestic currency, which increased necessitous borrowing
(since foreign imports cost more in terms of domestic currency) and at the same
time increased the cost of the reparations in terms of domestic currency.
While it is
often claimed that the central bank contributed to the inflation by purchasing
debt from the treasury, actually it operated much like the Fed: it bought
government debt from banks—offering them a higher earning asset in exchange for
reserves. For the reasons discussed above, budget deficits resulted from the
high and then hyper- inflation as tax revenue could not keep pace with rising
prices.
Finally in 1924
Germany adopted a new currency, and while it was not legal tender, it was
designated acceptable for tax payment. The hyperinflation ended.
To say that
Weimar’s hyperinflation simply came down to a matter of government “printing
money” is obviously far too simple. Let us turn to Zimbabwe. Here is a country
that was going through tremendous social and political upheaval, with
unemployment reaching 80% of the workforce and GDP had fallen by 40%. This followed
controversial land reform that subdivided farms and led to collapse of food
production. Government had to rely on food imports and IMF lending—another case
of external debts. With food scarcity and government and the private sector
competing for a much reduced supply, prices were pushed up. This was also
another case in which government could not have raised taxes, for both
political and economic reasons. Again, to label this a simple Monetarist case
of government “printing money” really sheds no light on Zimbabwe’s problems.
My point is not
to argue that greater constraints on government spending (or greater capacity
to increase taxes) might not have successfully prevented inflation. However, as
one studies specific cases of hyperinflation one recognizes that it is not a
simple story of government adopting a fiat money and suddenly it finds itself
printing so much that it causes hyperinflation. There are probably many paths
to hyperinflation, but there are common problems: social and political upheaval;
civil war; collapse of productive capacity (that could be due to war); weak
government; and foreign debt denominated in external currency or gold. Yes, we
do observe rising budget deficits and (really by identity) growing outstanding
government IOUs. But we also find banks creating money (more next week) to
finance private spending that competes with government to drive up prices. And,
yes, tighter fiscal policy would have helped to reduce inflationary pressures.
This probably would not have reduced overall suffering, since a common cause of
hyperinflation is some kind of supply constraint on output.”
Recently, the
investor Richard Vague and colleagues undertook a massive study, using a
database of 47 countries from 1960 to 2015, on the link between “rapid money
supply growth” and inflation (as well as looking specifically at the role of rapid
growth in government debt, declining interest rates, and rapid Increases in a
central bank’s balance sheet). Their overall conclusion was as follows: “In the
majority of cases, it was not. In fact, the opposite was true—a large
percentage of the cases of high inflation were not preceded by high money
supply growth. These 47 countries all rank within the top 70 largest economies
as measured by GDP and include each of the top 20 countries. If a country was
not included, it was because we could not get a complete enough set of
historical data on that country.” The paper can be read here: http://evonomics.com/moneysupply/.
Once more, here’s my overall conclusion: First
World countries would not face a hyperinflation risk if they were more fiscally
expansive and tried to kickstart their ailing economies with a Sanders-type
programme. If a country like the US implemented a major infrastructure now,
using entirely public funds – spending tens of billions of dollars in one go – there
would still be not a chance in hell of excessive inflation. There may well be some
increase in inflation, because of the big leap in employment, but this stimulus
would have effects throughout the economy, increasing general demand, leading
to more and more economic activity and more and more production. This kind of
spending, unlike QE, would have a true ‘multiplier effect’.
It is true that
inflation is the big domestic constraint on wanton government spending, and it
is true that if there is a high-level of employment and wage claims become too
high, then inflation becomes a problem. But this in itself does not show that
the inflation-targeting-regime which followed the Neoliberal assault of the
late 1970s has been in any way a sound compromise. It has been entirely the
opposite (and we’ll discuss this more when we get to the end, and our final
appraisal of the question of how governments should run themselves).
Apart from
inflation, the other major macroeconomic constraints on government spending are
related to trade: they come from consideration of the exchange rate and the
current account balance of a nation. These are, in fact, quite significant
constraints (though their significance varies massively by country, with
America in the least constrained position, for reasons we’ll see).
As Mr. Wray explains
here (http://neweconomicperspectives.org/2011/11/mmp-blog-25-currency-solvency-and.html
(though he is guilty of underemphasising this problem, and the US’ uniqueness,
as articulated here: http://nakedkeynesianism.blogspot.com.au/2012/07/spurious-victory-of-mmt.html)),
“If a nation
runs a current account deficit, by identity there must be a demand for its
assets (real or financial) by someone with foreign currency. (A foreigner could
either demand the nation’s currency for “direct investment” that includes
buying property or plant and equipment, or the foreigner could demand financial
assets denominated in that currency.) If that demand for assets
declines, then the current account deficit must also decline.”
For many reasons – not least that the US
dollar is the international reserve currency – US dollar-denominated assets are
highly desirable around the globe. To a lesser degree, the financial assets
denominated in UK Pounds, Japanese Yen, European Euros, and Canadian and
Australian dollars are also desired. For the US, it is very easy to run
persistent current account deficits (and they have been doing so since Nixon) –
this helps fund their massive imperialist projects abroad. For the countries
mentioned, current account deficits are also not a major problem (though none
of these other countries could have run the persistent current account deficits
of the US).
In stark
contrast, however, many developing nations cannot find a foreign demand for
their domestic currency liabilities. As Wray puts it,
“Indeed, some
nations could so constrained that they must issue liabilities denominated in
one of these more highly desired currencies in order to import. This can lead
to many problems and constraints—for example, once such a nation has issued
debt denominated in a foreign currency, it must earn or borrow foreign currency
to service that debt. These problems are important and not easily resolved. […]
If there is no
foreign demand for IOUs (government currency or bonds, as well as private
financial assets) issued in the currency of a developing nation, then its
foreign trade becomes something close to barter: it can obtain foreign produce
only to the extent that it can sell something abroad. This could include
domestic real assets (real capital or real estate) or, more likely, produced
goods and services (perhaps commodities, for example). It could either run a
balanced current account (in which case revenues from its exports are available
to finance its imports) or its current account deficit could be matched by
foreign direct investment.
Alternatively, it
can issue foreign currency denominated debt to finance a current account
deficit. The problem with that option is that the nation must then generate
revenues in the foreign currency in order to service that debt. This is
possible if today’s imports allow the country to increase its productive
capacity to the point that it can export more in the future—servicing the debt
out of foreign currency earned on net exports. However, if such a nation runs a
continuous current account deficit without enhancing its ability to export, it
will almost certainly run into debt service problems.”
One might
wonder how directly this relates to government spending. The problem is as
follows:
A government
deficit can contribute to a current account deficit if the budget deficit
raises aggregate demand, resulting in rising imports. By fuelling import
growth, this plunges the current account into further deficit which then leads
to depreciation (if the exchange rate is floating) or a foreign reserve drain
(if it is pegged). This, in turn, leads to expectations of further
depreciations and the currency is sold short by hedge funds. This creates
disaster.
This is not to
say that the MMTers haven’t replied to this worry. Bill Mitchell replies
directly to it here (http://bilbo.economicoutlook.net/blog/?p=5644).
One extract from this post is particularly relevant:
“But a nation
might have a food supply problem just because of location. Then they have to
import food. For example, in Kazakhstan where I am working at the moment, they
face really significant problems in winter getting fresh vegetables and fruits.
Many of these nations also have very little that the World wants by way of
their exports. The fact that such a country’s national government is sovereign
in its own currency and can spent how ever much it likes in that currency will
not solve the problem – there is not enough goods and services (in this case)
food for the sovereign government to purchase.
In those
situations, a country requires foreign goods and they need to export to get
hold of foreign currency or receive development assistance from the rest of the
World. In the latter case, I see a fundamental change is required in the role
of the IMF (more or less back to what it was intended to do in the beginning).
Where are [sic] country is facing continual current account [sic] and currency
issues as a result of the need to import essential goods and services, the IMF
might usefully act to maintain currency stability for that country.
So as well as
the Tajiks desiring their own currency the IMF might also stockpile it in order
to stabilise the exchange parity. If this policy was pursued then much of the
fears that are raised about currency runs and whatever would be allayed.”
He also points out
that the people who draw attention to this (real problem) never really say the
same thing about private investment boom which suck in imported productive
capital: “Somehow adding productive capacity in the private sector is ‘more
efficient or more productive’ than, for example, a large-scale public education
policy which increases the capacities of the population in both the workplace
but also general life.”
Ultimately,
though, it remains true that, as Lord Keynes explains here (http://socialdemocracy21stcentury.blogspot.com.au/2012/07/some-serious-criticism-of-mmt.html
) and here (http://socialdemocracy21stcentury.blogspot.com.au/2016/02/limits-of-mmt.html),
the idea that governments should open their purses until they reach full
employment is probably only a sensible prescription for the following countries/regions:
(1) the
US,
(2) those
nations with strong trade surpluses (Germany (if it were outside the EU), Switzerland,
Japan, South Korea or Tawain),
(3) those
nations that seem to run near perpetual current account deficits but attract a
lot of foreign capital (say, Australia), and
(4) the
Eurozone, if it were suitably reformed with a union-wide fiscal policy
In a later instalment
of this series of economics, I will examine the question of whether Keynes’ proposal
for the ‘Bancor’, a supra-national currency, and an International Clearing
Union – a proposal that the Chinese government supports – is a superior system
for our global economy than our current system where major economies largely
operate with floating exchange rates. Keynes’ proposal is something that all
the prominent MMTers seem to disagree with about as vehemently as the
America-orchestrated international trade system that was actually set up after
World War II. Ultimately, however, I will argue that they’re wrong to have this
attitude, because Keynes’ system would probably be better for the world as a
whole.
Final Appraisal: Deficits or
Surpluses?
Contrary to the ‘conventional wisdom’ of the ideologues, shills and buffoons who make up much of the financial and economic commentariat, for a sovereign country to run an overall surplus (as opposed to a current account surplus, obviously) is a bad idea, in general. It is impossible to run a surplus when things are going really bad (because of “automatic stabilisers” like the fact that you take in less revenue when people are losing jobs, welfare payments are rising and stimulus packages/bailouts have to be introduced), which means that surpluses can only be run in conditions of relative economic health or ‘stability’ (bear in mind that national economies are complex, dynamic systems so there’s no such thing as true stability). Yet by running surpluses in conditions of relative economic health, governments guarantee future economic sickness.
Contrary to the ‘conventional wisdom’ of the ideologues, shills and buffoons who make up much of the financial and economic commentariat, for a sovereign country to run an overall surplus (as opposed to a current account surplus, obviously) is a bad idea, in general. It is impossible to run a surplus when things are going really bad (because of “automatic stabilisers” like the fact that you take in less revenue when people are losing jobs, welfare payments are rising and stimulus packages/bailouts have to be introduced), which means that surpluses can only be run in conditions of relative economic health or ‘stability’ (bear in mind that national economies are complex, dynamic systems so there’s no such thing as true stability). Yet by running surpluses in conditions of relative economic health, governments guarantee future economic sickness.
To understand
why, you must think in terms of sectoral balances and you must understand the
nature of money creation. There are only two institutions which create money in
society: the government and private banks. As I have gone over previously, banks
do indeed create money through loans in a perfectly straightforward sense;
credit is money, albeit money that is destroyed when it is paid back. When a
government runs a surplus, what this means – as I’ve also explained – is that
it takes more money out of the economy than it puts in. Quite apart from the
terrible long-term social and cultural costs that typically result from
surplus-motivated government ‘cost-slashing’ on education, the arts, health,
public amenities, infrastructure and so on (and governments never ‘fix’ their
budgets by ending corporate subsidies for their pet industries or raising taxes
on the superrich, they always attack the things that bind societies together
and make life worthwhile), running a surplus inevitably leads to banks taking
on a bigger role through their powers of credit-creation: thus private debt-growth accelerates
and asset bubbles inflate. Clinton’s surpluses from 1997 to 2001, peaking at
$236 billion in 2000, directly paved the way for the Dotcom bubble and were
undoubtedly the most high-level factor in helping to inflate the massive US
housing bubble that ultimately led to the subprime loan crisis and the GFC. John Howard’s surpluses in Australia helped
massively pump up the housing bubble in Australia, paving the way for today’s obscene
house prices and our crisis of private-indebtedness, which has created a genuine
generational apartheid, with the vast majority of people under 30 literally forced to make a choice between leeching off their parents or
renting in mouldy decrepit hovels. Australia is now at the
point where household debt is 125% of GDP (the highest in the world) and private
debt to GDP is over 220%. And recession is coming.
The neverending
EU crisis is perhaps the greatest illustration of the truth that, unless they
are massive exporters with a world-class manufacturing sector like Germany, nations
cannot survive unless they are allowed to run deficits. Indeed, the number of
children living with their parents is highest among EU countries, as you can
see from the figures on the graph here: http://www.smh.com.au/comment/chart-watch/australian-twentysomethings-join-the-worldwide-trend-of-living-with-mum-and-dad-20161114-gsovsd.html.
This review of recent books by Yanis Varoufakis, James Galbraith and Joseph
Stiglitz on the EU just about sums it up: https://www.yanisvaroufakis.eu/2016/10/19/europes-ugly-future-a-review-of-varoufakis-galbraith-stiglitz-foreign-affairs/.
Just about every
major industrialised/ ‘post-industrial’ country in the world right now, in our
debt-deflated, stagnant global economy, would benefit from greater government
spending. Deficits are a good thing. That’s a fact.
