Fiscal sustainability and ratio fever – Bill Mitchell – Modern Monetary Theory
http://bilbo.economicoutlook.net/blog/?p=9483Fiscal sustainability and ratio fever
I have returned from the US after participating at the Fiscal Sustainability Teach-In and Counter Conference held in Washington D.C. last week. It was a good event and has stimulated a host of follow-up blogs from the activists who promoted the event. On the way home, I read the most recent report from Citi Group (who were saved from bankruptcy by public funds – they were among the first to have their hands out) which is predicting major sovereign defaults. It was clear that Citi Group was advocating very harsh fiscal austerity measures. How often have you heard the statement that the current economic crisis is evidence that “we are living beyond our means” and that the policy austerity that has to be introduced to “pay back the debt” is an inevitable consequence of our proliflacy – both individual and national?
I recall a wonderful section in Theories of Surplus Value – Chapter XVII entitled Ricardo’s Theory of Accumulation and a Critique of it, where Marx confronts Ricardo’s contention that there could never be a general glut in the market (which in modern terminology relates to a deficiency of aggregate demand).
Marx summarised Ricardo’s claim as follows:
more of a particular commodity may be produced than can be consumed of it; but this cannot apply to all commodities at the same time. Because the needs, which the commodities satisfy, have no limits and all these needs are not satisfied at the same time. On the contrary. The fulfilment of one need makes another, so to speak, latent. Thus nothing is required, but the means to satisfy these wants, and these means can only be provided through an increase in production. Hence no general overproduction is possible.
This was the logic behind Say’s Law which posited that “supply brings forth its own demand” and so macroeconomic crises (and unemployment) could not occur. It is also the logic behind the loanable funds doctrine which is still the basis of the claim that rising budget deficits lead to rising interest rates.
In developing his own explanation of how economic crises occur as a result of a failure of aggregate demand, Marx said:
Could there be a more childish argument? … In periods of over-production, a large part of the nation (especially the working class) is less well provided than ever with corn, shoes etc., not to speak of wine and furniture. If over-production could only occur when all the members of a nation had satisfied even their most urgent needs, there could never, in the history of bourgeois society up to now, have been a state of general over-production or even of partial over-production. When, for instance, the market is glutted by shoes or calicoes or wines or colonial products, does this perhaps mean that four-sixths of the nation have more than satisfied their needs in shoes, calicoes etc.? What after all has over-production to do with absolute needs? It is only concerned with demand that is backed by ability to pay. It is not a question of absolute over-production – over-production as such in relation to the absolute need or the desire to possess commodities. In this sense there is neither partial nor general over-production; and the one is not opposed to the other.
In the wider context of the development of economic theory, the development of Marx’s arguments in TSV were prescient indeed. The idea that capacity to pay was the key to understanding crises underpinned the notion of effective demand that appeared in the writings of Keynes and his contemporaries some 70 odd years later. It is the basis of the famous attack against the emerging monetarism of Friedman and others by Robert Clower and Axel Leijonhfuvd in the 1960s where they noted the difference between notional and effective demands and supplies. Marx had worked all that out 100 years earlier.
But the point here is that the deficit terrorists are all claiming we are living beyond our means and that fiscal austerity is the only viable solution. But of-course, as governments implement these austerity drives, their policies will deliberately force increasing numbers of workers to live on even less than they had before while they and available productive capacity sits idle.
That is the irony of the capitalist system that Marx noted 150 years ago – an observation that hasn’t been improved upon since.
But then you consider that the The Sunday Times Rich List reported (April 25, 2010) that “the collective wealth of the 1,000 multimillionaires … [was up by] … 29.9% … easily the biggest annual rise in the 22 years of the Rich List”.
So despite the most significant economic downturn in 80 years and sharply rising unemployment and home foreclosures, the top-end-of-town overall enjoys dramatic improvements in thier fortunes.
As an aside, there is a deeper sense in which the World’s population as a whole is living beyond the capacity of the natural environment to support this lifestyle but that is a separate issue and not germane to the arguments presented by the deficit terrorists.
I was thinking about all that when I read the latest Citi Group briefing – Global Economics View – Sovereign Debt Problems in Advanced Industrial Countries – published on April 26, 2010 and written by their new chief economist Willem Buiter.
Given that the paper is about fiscal sustainability, you might expect some definition of what that terms means being provided at the outset. You would be disappointed. Buiter introduces terms such as “unsustainable fiscal trajectories” and “fiscal unsustainability” without even defining what he means. He uses a table of deficit and debt ratios for many nations to show the ratios are “high” and provides some recent historical narrative to support the data but doesn’t pin any particular meaning to his basic terms.
You get a taste for how inapplicable the analysis is when you read that:
The attention paid to the five fiscally weakest Euro Area member states is rather surprising when it is recognized that the fiscal-financial position of the Euro Area as a whole is stronger than that of the UK, the US and Japan. It is to be expected that markets, commentators and analysts will in due course realize that fiscal unsustainability is not just a problem of a handful of Euro Area members, and that, unless there is a radical change of course by those in charge of fiscal policy in the US, Japan and the UK, these countries’ sovereigns too will, sooner (in the case of the UK) or later (in the case of Japan and the US) be at risk of being tested by the markets and, ultimately, of being denied access to new and roll-over funding, that is, of being faced with a ‘sudden
stop’.
Buiter is falling into the trap of conflating monetary systems without any awareness being provided to his readers as to the validity in doing so.
Greece faces fiscal constraints because it doesn’t issue the currency it uses (the Euro), it doesn’t have a floating exchange rate and its central bank doesn’t set the interest rate. The Greek government has to tax or borrow in order to spend.
All Eurozone governments are in the same straitjacket and face insolvency as a consequence. Most nearly all of the “governments of advanced industrial countries” are not in this situation. And … it is not a matter of degrees. The sovereign governments are not financially constrained in any way although they have erected institutional machinery (debt-issuing agencies with prescribed rules) which make it appear as they have constraints.
However, these voluntary “constraints” are only of a political nature and could be disassembled at any time (with some political narrative to go with it).
Clearly, the “markets” understand this. One might ask when will Japan be tested by the markets and suddenly stopped given it has been running consistent budget deficits and has experienced rising public debt ratios for nearly 2 decades?
The fact is that the basic premise underlying Buiter’s report is flawed at the most elemental level. There is no solvency risk in the US or Japan (or any sovereign nation in terms of debt it has issued in its own currency.
Buiter clearly misrepresents the opportunities and constraints applicable to the government and non-government sectors when he tries to get cute:
The sovereign debt problems encountered by most advanced industrial countries are the logical final chapter of a classic ‘pass the baby’ (aka ‘hot potato’) game of excessive sectoral debt or leverage. First excessively indebted households passed part of their debt back to their creditors – the banks. Then the banks, excessively leveraged and at risk of default, passed part of their debt to the sovereign. Finally, the now overly indebted sovereign is passing the debt back to the households, through higher taxes, lower public spending, the risk of default or the threat of monetization and inflation.
First, what exactly are the “sovereign debt problems encountered by most advanced industrial countries”? Which sovereign governments are finding it difficult to place their debt in the primary markets? I would hazard a guess and say none! There is a huge appetite for public debt at present given the high levels of uncertainty in the corporate capital markets.
So exactly, what is the problem? A rising ratio? Why is that a problem? Buiter doesn’t want his readers to think about those basic issues. He just asserts that a rising raidebt ratio is a problem and a bilarger rise ia a larger proible etc.
Second, the statement that all the crisis has done is replace private debt with public debt is descriptively accurate (to some extent) but does not carry any meaning as an intrinsic proposition because the private and public debt holdings are incomparable. This takes us back to the fallacious analogy that mainstream economics draws between the budget of a household/corporation and the government budget.
However, there is no parallel between the household (for example) which is clearly revenue-constrained because it uses the currency in issue and the national government, which is the issuer of that same currency. The choice (and constraint) sets facing a household and a sovereign government are not alike in any way, except that both can only buy what is available for sale. After that point, there is no similarity or analogy that can be exploited.
It is clear that the excessively indebted households represented a crisis waiting to happen. When governments in nations running current account deficits started to run or attempt to run budget surpluses, it was clear that the private domestic sector would start to move towards and eventually into deficit. The translation of that direction of expenditure flow was the increaseing stock of private debt.
Modern Monetary Theory (MMT) predicted correctly that this period (an unusual one in our recorded history – that is, it was atypical for governments to run surpluses and the private doemstic sector to run deficits overall) would end in strife as private debt mountains collapsed and spending flows dried up.
But the analogue of that observation is the fact that the government sector should have been running consistently larger deficits over this time. How do I conclude that? The persistence of high levels of labour underutilisation in almost every nation tells me that aggregate demand was always deficient over tis period. So given the need for the private domestic sector to reduce their leverage levels and return to a net saving position overall and the presence of current account deficits in most nations, it is clear that the government sector should have been running deficits continuously.
Third, there is no financial necessity for sovereign governments to impose “higher taxes, lower public spending”, “default” or induce “inflation” in the present circumstances. The push for austerity is coming from the ideological motivation of the deficit terrorists who derive their conclusions from faulty macreoconomics models that are inapplicable to fiat monetary systems.
There is no solvency risk for such a government – that is, they can always meet their financial obligations. And the threat of inflation is extremely muted at present. When can Buiter actually point to a time when the governments have deliberately invoked inflation to reduce the real value of their debt obligations? I would imagine the Japanese government would love a little bout of inflation right now having lived through neearly two decades of deflation despite experiencing growing debt ratios.
The Buiter narrative attempts to hit all the known terrorist points. He then claims that Reinhart and Rogoff (2009b) have shown that when public debt ratios are “higher-than-90 percent” there is a “marked negative effect on the growth rate of real GDP”.
If you read the Reinhart and Rogoff paper you will find their principle theoretical authority justifying their “90 per cent rule” claim that higher public debt ratios lead to lower growth is none other than Robert Barro – he of the discredited Ricardian Equivalence Theorem. They say:
Assuming taxes ultimately need to be raised to achieve debt sustainability, the distortionary impact imply is likely to lower potential output.
When has that ever happened? Have they done detailed analysis to show that governments pay back debt by raising taxes? Answer: none at all. Public debt ratios come down historically when economic growth resumes. To
Please read my blogs – Pushing the fantasy barrow and Islands in the sun … – for more complete critiques of Barro’s lunacy. His predictions about tax increases following increases in public deficit were historically wrong. His arguments have no credibility at all in theoretical or empirical terms.
Why does Buiter use authorities that have been discredited so comprehensively?
Further, Reinhart and Rogoff (2009b) also find “no systematic relationship between high debt levels and inflation for advanced economies as a group” a point conveniently ignored by Buiter (although I wouldn’t trust any analysis from them anyway).
Still refusing to define what fiscal sustainability is, Buiter then claims:
… we are getting close to the position where there may no longer be a riskfree security (in the sense of free of default risk and/or of with a safe real rate of return) anywhere in the world … Triple-A sovereign ratings may in the not too distant future be found only in the history books.
So I guess like Japan ignored the rating agencies in 2001 and continued to issue public debt at will at low yields, the other nations will do the same once the credit rating agencies try to broaden their sense of self-importance and downgrade the UK and the US etc.
These ratings are largely irrelevant to a sovereign nation like the US and I predict they will never find any difficulty finding buyers of their debt – downgrade or not.
The markets know that the debt of Japan and the US is risk-free. There is always inflation risk but that is not the point being made by Buiter. There is no risk of deliberate default.
The mainstream logic starts with the condition describing a change in the debt ratio (d) shown as Equation (1). Here s is “the augmented general government primary (non-interest) surplus as a share of GDP, r the effective real interest rate on the public debt, y the growth rate of real GDP, and d the public debt to GDP ratio at the beginning of a period … Δd … [denotes] … the ‘change in’ the public debt to GDP ratio between the end and the beginning of a period”. So the change in the debt ratio will be given by:
Note that this formula assumes that the national government is revenue-constrained and is derived from a more general model used by mainstream macroeconomics – the government budget constraint – which is held out as an a priori financial constraint on government spending. Clearly for a sovereign government the model can only describe an ex post accounting identity – that is, what has to be true from a stock-flow perspective after the fact.
There is no such thing as a financial constraint on a sovereign government which issues its own currency.
Further, the model presented by Buiter is a partial version of the complete model which would also contain a term for high powered money. He clearly is following the mainstream bias (arising out of a false belief that increasing the monetary base is inflationary) by excluding the possibility that a primary deficit need have zero implications for the public debt ratio if the central bank just expands bank reserves (which it can obviously do whenever it wants).
But in accordance with the erroneous logic employed by Buiter (to push his ideological barrow which has become even more pointed since he recently entered the corporate world), Equations (1) and (2) tell us that “to keep the ratio of net public debt to GDP constant, the augmented general government’s primary surplus as a share of GDP has to satisfy” the following condition:
So surpluses have to offset all debt servicing charges at least.
You can use these models to construct all sorts of doomsday scenarios which Buiter does. They all ignore history which tells us that public debt ratios rise and fall largely on the dynamics of economic growth. When growth is strong enough public debt ratios fall. Further, given the central bank sets the interest rate and the government can choose to issue debt at the short-end of the maturity curve, it can guarantee that the debt ratio falls even when they continue to support non-government saving intentions and maintain growth via deficits. But that is not a story that Buiter desires to tell.
After 15 pages of diatribe, in Section 3.1 The Arithmetic of Fiscal Sustainability we finally get an inkling of what fiscal sustainability is. On page 15, he says:
It turns out that the condition for the sovereign to be solvent can be made to look very similar to the condition for keeping the public debt-to-GDP ratio constant given in (2) … Any sustainable fiscal-financial-monetary programme of the sovereign has to satisfy the condition that the outstanding public debt cannot exceed the present discounted value of current and future expected primary surpluses of the augmented general government.
He explains this using the following condition where s bar is the “permanent” primary (non-interest) government surplus as a share of GDP”, y bar is “the permanent growth rate of real GDP”, and r bar is “the permanent effective real interest rate on the public debt”. Buiter claims “(p)ermanent means roughly ‘expected future long-run average'” so the definition is only approximate anyway and when it applies is anyone’s guess – the long-run! When do we reach the long-run? No telling!
“The minimum value of the primary surplus (as a share of GDP) that will ensure solvency for the sovereign” is given by s bar min in Equation (4):
So what does this all mean? So if the “long-run effective real interest rate on the public debt exceeds the long-run growth rate of real GDP” then “any country that has a positive outstanding stock of (net) public debt will have to run, on average, future or primary augmented general government surpluses”.
First, he claims that long-run effective real interest rate on the public debt will exceed the long-run growth rate of real GDP for advanced countries. Why? No evidence is given. This certainly hasn’t been the case historically as strong growth has driven public debt ratios down.
It will be the case if national governments adopt austerity programs and scorch their domestic growth rates and allow their central banks to increase interest rates to fight a non-existent inflation bogey. But if governments act responsibly to ensure high rates of aggregate demand growth in line with growth in real capacity and keep yields on their debt low (which they can easily accomplish) then Buiter’s assertion is likely to be wrong.
The point is that these ratios impose no financial constraints on a sovereign government. There is no need to raise taxes to pay off debt. The government services tis debt in the same way it pays pensions or buys some military equipment – it credits bank accounts. It doesn’t need to raise funds to do that nor it is constrained by what its budget balance was in the last period or the period before that.
The game is given way on Page 29 when Buiter says:
The first point to note is that sovereign default in one of the advanced industrial countries is not inconceivable or impossible. It is true that, since the (West) German currency reform and sovereign default of 1948, there have been no sovereign defaults in Western Europe, North America (excluding Mexico), Japan, Australia or New Zealand. However, as amply demonstrated by Reinhart and Rogoff (2009), sovereign defaults have been common phenomena in the rest of the world.
So no sovereign defaults in the modern era. Yes, the US government could have a brain snap and announce a default for political reasons. So in that sense it is no impossible. But it is inconceivable that they would do that and Buiter knows it.
So why then appeal to the “false authority” of Reinhart and Rogoff and blur the fact that their analysis only applies to public debt held in foreign-currencies by countries with pegged exchange rate arrangements and is therefore totally non-applicable to the US, the UK, Japan etc?
What the Marxists say!
If the Citi Group publication wasn’t enough, I despaired when I read a Marxist take on this Report. The narrative ends with the line “Workers of the world unite you have nothing to lose but your chains”. When you read their analysis you will conclude they are actually advocating more restrictive chains but fail to realise that because they bought the deficit terrorist line hook-line-and-sinker.
The Marxist writer says:
The attention on Greece (and indeed the PIGS)and its economic problems, however, is a convenient distraction for other governments of advanced industrial countries, to ignore their own burgeoning deficits and posit themselves as somehow thrifty and more skilled in economic management; nothing could be further from the truth. The truth is that the advanced industrial countries have run up huge deficits in public finances (pre-dating the financial crash of 2008/09 but certainly exacerbated by it). As Citigroup analyst Buiter’s timely assessment … reveals, most advanced industrial countries are in their worst ever peacetime fiscal position. Indeed, it is Citigroup who describe the modern state as “fiscally challenged”.
So once again the “conflating monetary systems” trap that is common in all financial commentary at present. These characters are blithely unaware of that all Eurozone governments are in the same straitjacket and face insolvency as a consequence. But that most nearly all of the “governments of advanced industrial countries” are not in this situation.
The “truth” is that advanced industrial countries have seen a rise in their budget deficits as the automatic stabilisers reacted to the collapse in private spending. Then discretionary stimulus packages added to the deficits. So what?
The unemployment rates are lower than they otherwise would have been but still too high because the stimulus packages were too small. Economic growth is higher (or less negative) than it otherwise would have been but still too low because the stimulus packages were too small. The rise in budget deficits is coincidental to these real developments.
Why would a Marxist not want to highlight the unemployment rather than buy into Buiter’s blinkered and irrelevant concentration on financial ratios, which are largely beside the point when we are considering a sovereign nation.
As noted above, the only challenges facing our national governments are politicial (with some industrial relations issues!). The political challenges relate to the failure to show leadership in the face of the torrent of deficit terrorism that is now rife in all of our nations. The industrial relations challenges is how to sack all the deficit terrorists on government advisory panels and within government departments.
The Marxist writer then quoted extensively from Buiter without the slightest critical note. This is what revolutionary dialogue passes for these days. Shocking really!
The Marxist writer claims that the austerity that “has” to follow is “but a taste of what other workers around the world are likely to face over the coming years” and while “state expenditure has been keeping Capitalism alive since the 1970’s … its ability to do so is currently compromised”. Why?
Apparently:
State expenditure must now “be balanced” meaning workers will have to suffer cuts to their social wage (health care, pensions, clean air) in addition to cuts in their individual wage. In the absence of generalised conditions for increasing profitability in the Capitalist system, profits have fed into speculation, consumer spending has been fuelled by easier credit not higher wages, home-ownership and higher education have expanded but so has the proportion of household income spent on them (income largely borrowed from banks).
The writers uses Buiter as an authority on the need to “balance” budgets. Well Buiter actually argued for significant primary surpluses but that is a minor issue.
Buiter is then identified as “an apologist for the capitalist system” and the argument then turns on who should bear the pain of the required fiscal adjustment. The workers or the bosses. In good form, the Marxist wants the bosses to bear the brunt of it because they caused it.
But whatever distributional position you want to take, the basic flaw in the whole argument is that the idea that there should be fiscal austerity now to “pay back the debt” and to stop the sovereign debt from exploding is completely nonsensical. Governments should be expanding budget deficits now to ensure their economies do not fall back into recession given the parlous state of private spending at present.
Why would a “left-wing” narrative want to accept the erroneous call for fiscal austerity? Why don’t these progressives educate themselves and realise that we are talking about an ideological attack on governments rather than any intrinsic financial constraints. A sovereign government faces no financial constraints.
Which brings me back to the beginning. The only constraints that sovereign governments face from an economic perspective are the availability of real resources to deploy in their quest to advance public purpose. Given that idle labour is in significant supply at present there is no threat to fiscal sustainability coming from an inability to expand production without generating inflation.
That should be the focus of the progressive narrative. Yet out of (presumably) ignorance, the writer just buys the Buiter line and surrenders all capacity to actually mount a pro-worker narrative. Very sad!
How to bring the debt ratio down
While the public debt ratio is irrelevant in a financial perspective it clearly carries political weight. Given this the easiest way for governments to reduce these ratios yet maintain fiscal support for economic growth and the desire of the non-government sector to save overall is to stop issuing debt altogether.
Some reform of the institutional machinery would be required and some bright employees could be released to study medicine or something and advance humanity more fully in that vocation. But the whole debt-issuance machinery is a hangover from the gold standard/convertible currency era and is thus an unnecessary artefact in the fiat currency system.
The cry would then be “central bank monetisation” and “inflation”. Depending on the monetary policy target, the central bank would have to pay a support rate on the overnight reserves equivalent to the policy rate to de-link the need to conduct open market operations from its monetary policy target. Once that was done, then the central bank could easily honour all government cheques.
As long as nominal demand growth was consistent with the growth in real productive capacity, the deficits would no contribute to inflation. The debt-issuance does not reduce the inflation risk anyway.
Eventually, the headlines predicting hyperinflation would die out as the official statistics revealed strong employment growth, strong income growth and stable prices.
Conclusion
All this mainstream dogma about fiscal sustainability is erroneous and completely misunderstands that a sovereign government is never financially constrained.
For an alternative narrative from a MMT perspective on what fiscal sustainability really means for a sovereign government which issues its own currency please read the following suite of blogs – Fiscal sustainability 101 – Part 1 – Fiscal sustainability 101 – Part 2 – Fiscal sustainability 101 – Part 3.
Digression: Tax reform in Australia
The long-awaited Henry Tax review was released yesterday along with the federal government’s response. Most of the motivation for the Review is based on the false notion that taxation revenue funds government spending and the latter is to become unsustainable due to the forecat of increasing demands on fiscal policy arising from the ageing population.
Please read my blogs – Democracy, accountability and more intergenerational nonsense and Another intergenerational report – another waste of time – for more discussion on why this notion is nonsensical.
Having said that – the Review recommended many changes of which the Government has agreed to adopt hardly any. A lot of effort went into this process but very little will come out of it.
The major item that should have been reformed – such as the significant tax advantages enjoyed by those with investment properties which clearly drives real estate price bubbles – was left alone for fear of upsetting the rentier class in Australia, which is a powerful lobby.
The Resource Rent tax on the mining industry is a good move (taxing “super profits”) and the squealing of the mining lobby already is a joy to watch. These characters are total self-interested creeps.
That is enough for today! Still tired from all the travel last week.
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