Helicopter money: an operational view

Much has been written about Adair's Turner suggestion that central banks should consider financing public spending but I thought this short exchange between Adair Turner and economist Mario Seccareccia at an INET conference in 2011 is worth pointing out.

Here's Adair Turner's question:

[About Japan]...why wouldn't it been better still to do what Friedman said was the correct policy post facto in the 1930s, which is "helicopter money". Why wouldn't a better policy had been for the Japanese government to simply run fully, overtly, monetized deficits so that the last [inaudible] percent of GDP was not in the form of a debt contract held by the Japanese private sector but was in the form of absolute, categoric fiat money? (at 2:30 here)

This is Mario Seccareccia's response:

[About the] issue which had been raised about fiscal policy and the "helicopter drop" [vs conventional deficit spending]. That's a false dichotomy. I mean, deficit spending is -- in a sense -- monetization all the time. [Bond issuance is] how the central bank then behaves to clear or sterilize -- so to speak -- those reserves in the system in order to meet its interest rate policy. Period. There is no such thing as a "helicopter" doing this. It's always done through deficit spending fundamentally, I would argue. (at 9:00 here)

The point to remember when thinking about a central bank's ability to inject exogenous increases in reserve balances is that in a monetary regime such as Japan (and the UK for that matter) where the central bank targets an interest rate and the remuneration rate on reserves balances isn't set at the same level as its target interest rate, the central bank can't conduct offensive open market operations aimed at increasing the amount of reserve balances without simultaneously frustrating its goal of keeping its benchmark interest rate on target. Under such a regime the central bank's ability to control money growth is essentially limited to conducting defensive open market operations aimed at keeping its interest rate on target.

UPDATE: A very detailed look at the "helicopter drop" issue is found in Scott Fullwiler's article "Helicopter drops are fiscal operations" (2010). For a general discussion on offensive vs defensive open market operations, see Lombra, Herendeen and Torto, Money and the Financial System, page 425, 1980.

Steve Keen on interest and capitalism's main dilemma

A few fine words from Steve Keen:

Interviewer: On a broader topic, is interest a kind of rent in the classical sense? Is it income without a cost of production?  

Steve Keen: Absolutely. This is why...I see the main dilemma in capitalism as being the conflict between financial capital and industrial capital. Industrial capital is ultimately productive. And if you look at workers and capitalists, they both ultimately benefit out of the technological developments over time and demands over wages. If unemployment is not gigantic, they benefit out of the improvements in current technology and out of productivity at the time as well. The real albatross around the neck of capitalism is financial capital [inaudible] when you let it get beyond the level necessary to simply finance working capital in some new investment. And it’s what happens every time capitalists take over...

...The thing I think we’re both in agreement on is we have to stop people, and particularly social classes, becoming dependent upon unearned income. Ultimately the only way to get a functioning capitalist society—or a society in general—is to have one where the source of income is earned, not unearned. And when you look at land speculation, or you look at any other form of speculation, people are trying to get income without earning it. That’s the real dilemma in capitalism. And if we direct ourselves toward that particular principle then we’re both on the same side. (Renegade Economists, April 21, 2010, at 13:30)

There's lots of good insight here. A fine glimpse of "Keensian" economics.  And I totally agree with the general point of the last sentence: "...then we're both on the same side". There's plenty of commonalities out there. We just need to focus on these.

PS: I'm entering a busy period at work. Posting will be limited and mainly consist of short thoughts on and snippets from economists I find interesting.

Does the endogenous nature of money weaken the case for NGDP targeting?

One charge that's often directed against those who espouse nominal GDP targeting within a quantity theory framework (e.g., market monetarists) is that they fail to take into account the endogenous nature of money in their analyses.

In my view, such a charge is misplaced, as there are economists within the quantity-theory tradition who support NGDP targeting and who acknowledge the endogenous nature of the money supply.

Take, for instance, Robert Hetzel, senior economist at the Federal Reserve Bank of Richmond and a strong advocate of NGDP targeting (and sometimes considered a precursor of today's market monetarists).  Hetzel has a deep understanding of the operational aspects of central banking and recognizes the implications for policy formulation posed by the endogenous nature of money.  Consider the following:

First, Hetzel understands that credit creation is at the root of deposit creation (i.e., "loans create deposits") and that the supply of reserve balances is demand-determined in a monetary regime where the central bank targets an interest rate.  Here is an excerpt from Hetzel's 1986 paper "A Critique of Theories of Money Stock Determination":

Deposits and reserve demand are determined simultaneously with credit creation. As a consequence of defending its rate target, the monetary authority, by creating an infinitely elastic supply of reserves, accommodates whatever reserve demand emerges...In a regime of rate targeting, neither the quantity of reserves nor the desired reserves-deposits ratio of the banking system exercises a causal role in the determination of the money stock (1986:6)

Second, Hetzel recognizes the inapplicability of the textbook money multiplier model of money stock determination in monetary regime where the central bank targets an interest rate and understands that the main constraint imposed on banks (for credit creation) under such a monetary regime is the price of reserve balances set by the central bank rather than their quantity:

Interest rate smoothing by the monetary authority makes reserves and the money stock endogenous...Since [Chester] Phillips (1921), reserves-money multiplier formulas have been derived from a model of the banking sector summarized in the multiple expansion of deposits produced by an injection of reserves.  The existence of markets for bank reserves, however, renders this model untenable.  Phillips' model assumes that the individual bank is constrained by the quantity of its reserves and that its asset acquisition and deposit creation are driven by discrepancies between actual and desired reserves.  Given the existence of markets for bank reserves, such as the fed funds and CD markets, however, individual banks are constrained by the price, rather than the quantity, of reserves they hold. (1986:20) (emphasis added)

Third, Hetzel recognizes the operational implications of endogenous money for monetary control. Consider the following excerpt from his 2004 article "How does the central bank control inflation?":

Because the Federal Open Market Committee (FOMC) uses the funds rate rather than the monetary base or bank reserves as its policy variable, money is endogenously determined. (2004:48) 

Stated differently, Hetzel recognizes that when the central bank uses an interest rate instrument the central bank cannot exogenously control the money supply:

[W]ith an interest rate as the policy variable, monetary control does not imply an exogenous money stock. (footnote at 48)...In the case of an interest rate instrument, the central bank privatizes control over reserves provision by turning the decision on the quantity of reserves over to the financial market...It takes direct control over the setting of the interest rate (55)

Finally, Hetzel understands that central bank purchases of government debt is not in itself inflationary.  Consider the following statement made recently by Hetzel during a presentation in Europe:

Somehow the Buba has this idea that if you buy government debt, that in itself is inflationary. Well, you gotta buy something to be able to create the monetary base that sustains money creation. So you gotta buy something. And you can buy baskets of government debt. But buying government debt is not inflationary. That's pursuing it far too much. (75 minutes)

So what differentiates Hetzel's views from the one of Keynesian-inspired economists who accept the endogenous nature of money (such as post-Keynesians)?

To answer this question and better understand how Hetzel is able to reconcile the above views with his attachment to the quantity-theory tradition, it's important to understand that Hetzel's framework for analyzing monetary policy relies on a natural rate (of interest) model, in which monetary control depends on how well the central bank can adjust its interest rate in a manner that tracks the natural rate of interest (i.e., the real interest rate that would exist in the absence of monetary disturbances*).  This is where Hetzel differs entirely from post-Keynesians.

In Hetzel's view, as mentioned above, in a context of endogenous money, the central bank doesn't control money creation via the textbook money multiplier process or by exogenous injections or withdrawals of base money.  Rather, Hetzel views money creation as the consequence of the central bank keeping its interest rate below the natural rate.  The reverse, money destruction, occurs when the central bank keeps its interest rate above the natural rate.  Hetzel explains the difference between his and the old monetarist description of money creation as follows:

The real world counterpart to the quantity theory conceptual experiment of an exogenous increase in money is a failure by the central bank to move its interest target in a way that tracks the natural rate (2004:51).

In other words, in Hetzel's quantity theory framework, money creation and the monetary transmission mechanism has little to do with adjusting the size of the monetary base or manipulating the textbook money multiplier in such a way as to expand the money supply by means of a multiple expansion of deposits.  (One exception is in today's case, where the Fed has the ability to control the amount of reserve balances.  In such a context, Hetzel considers the money multiplier model of money stock determination as relevant given that the money supply expands as a result of open-market purchases.)

So if it's not the money multiplier, what's the monetary transmission mechanism then?

Another point of divergence between Hetzel's view and the post-Keynesian view -- and this is important for understanding his framework for boosting NGDP (and thus enabling the central bank to hit its NGDP growth target) -- is that he holds a view emphasizing the central bank's ability to force portfolio rebalancing by the public and thereby control the public's dollar expenditures.  Liquidity or portfolio rebalancing involves the purchase by the public of illiquid assets such as consumer durables, equities, real estate, etc.  Hetzel explains the central bank's ability to foster portfolio rebalancing as follows:

Assume that the central bank purchases an illiquid asset, for example, shares in a mutual fund holding equities.  The public will rebalance its portfolio through the purchases of physical assets like land and equities.  The rise in their prices will raise their value as collateral and this facilitates the access to credit of the holders of these assets.  Increased liquidity from increased access to credit augments the portfolio rebalancing effect by decreasing the demand for the liquidity services of money.  The increase in the price of physical capital relative to its replacement cost stimulates investment. (2004:56)

There is no need to get into the other aspects of Hetzel's framework in support of NGDP targeting (e.g., role of central bank credibility and inflation expectations, establishment of a monetary rule...) since it is not altogether relevant to the basic point of this post, which is to say that the arguments about the irrelevance of the money multiplier or the endogenous nature of money that are sometimes made to counter the case in favor of NGDP targeting don't get to the core aspects of the debate, such as the issue of the natural rate.

Conclusion

The point of this post is simple: the arguments concerning the endogenous nature of money and the irrelevance of the textbook money multiplier do very little to challenge the case in favor of NGDP targeting (or inflation targeting, for that matter) and the general theoretical construct used by market monetarists.  As I've shown, the case for NGDP targeting can be made (at least theoretically) using a quantity theory approach that is consistent with the endogenous nature of money.

Therefore, from a debating standpoint, those who support a functional finance approach to economic policy (as I do) would gain more by focusing their efforts on challenging notions such as the natural rate of interest and in demonstrating the inadequacies of an approach to monetary policy whose monetary transmission mechanism relies largely on the portfolio balancing effect.  While the issue of the natural rate is largely a theoretical problem (Does it exist? Can it be measured?), the question of the portfolio balance effect is essentially an empirical issue (Is the portfolio rebalancing effect substantial? Can the central bank control it for policy purposes?)

As for the bloggers and economists who think that post-Keynesians and MMT economists are wrong about the endogenous nature of money and its implications for central bank operations, I would suggest they review the work of Robert Hetzel.  His take on these matters is in line with the post-Keynesian/MMT view.

* Another definition is "the real rate of interest consistent with keeping real aggregate demand in line with potential output" (see here).  Without getting into too many theoretical details, from a practical standpoint, central bankers tend to interpret decreases in rates of resource utilization (increases in the unemployment rate) as indicative of a real interest rate in excess of the natural rate (and vice-versa).

References

Hetzel, R., A critique of theories of money stock determination, Working Paper, Federal Reserve Bank of Richmond, 1986

Hetzel, R., How Do Central Banks Control Inflation?, Federal Reserve Bank of Richmond, 2004

Federal Reserve Bank of San Francisco, The natural rate of interest, FRBSF Economic Letter, October 2003

Fiscal austerity: A solution looking for a problem

Since the release earlier this month of the paper by IMF economists Olivier Blanchard and Daniel Leigh, I've noticed a lot of comments on blogs and news websites suggesting that the IMF economists and their inability to properly measure the size of the fiscal multiplier earlier are to blame for making political leaders believe that fiscal austerity could be expansionary and for misleading them into enacting austerity measures within their respective nations.

That's nonsense.  As if the decision to go down the road of austerity depended on a technical detail such as the potency of the fiscal multiplier.  Such a statement is as implausible as suggesting that some of the ill-advised military interventions in the Middle East during the last decade would have been prevented had those leaders who decided to enter those wars had been provided better intelligence.

Those looking to blame someone for the current disaster created by fiscal austerity should instead turn to the real culprits, the politicians themselves, as well as their horde of political aides who recommended a course of action that flies in the face of both common sense and empirical evidence.

As I discussed in an earlier post, the case against expansionary austerity was well established even before nations decided to enact austerity measures.  And amazingly, the empirical evidence against expansionary fiscal austerity stems from one of the most highly circulated economics papers of 2009, which, ironically, was branded as supporting the case for expansionary fiscal austerity.

This paper is the study by Alberto Alesina and Sylvia Ardagna, which found that the combination of austerity and growth occurred in 25 percent of the relevant episodes recorded by the OECD between 1970 and 2007 (2009, Data Appendix:Table A2).

In other words, the study demonstrated that the odds of successfully reducing public debt levels and achieving increased growth through austerity were 1 in 4.  As far as empirical support in favor of expansionary fiscal austerity goes, that's pretty weak.  With such information available, going ahead with austerity was tantamount to someone deciding to intentionally leave their umbrella at home knowing that there is a 75 percent chance of rain that day.  So much for the theory of the rational decision-maker!

And now economists are to blame?

The bottom line is that the disaster of austerity is not about economists getting it wrong.  Rather, it is a typical example of a policy-making failure: policymakers making decisions without regard for the facts.  But, more importantly, fiscal austerity was a prepackaged "solution to a problem" that fits with today's dominant policy-making ideology, which holds that governments have little or no purpose other than catering to financial interests and leaving the path clear for free-market actors to find solutions to every problem facing society.

To conclude, fiscal austerity is simply another example of a "solution looking for a problem", an empty and empirically ineffectual idea with no clear rationale other than giving the appearance that "something is being done".  In this sense, fiscal austerity joins the list of other well-known solutions looking for problems that have been tried and failed in the last thirty years such as deregulation, privatization, supply-side economics and so on.

References

Alesina, A and Ardagna, S., "Large Changes in Fiscal Policy: Taxes vs Spending", NBER Working Paper No. 15438, October 2009

Blanchard, O. and D. Leigh, "Growth Forecast Errors and Fiscal Multiplier", IMF Working Paper WP/13/1, January 2013

Evsey Domar's "On Deficits and Debt": A survival guide for making sense of today's economic challenges

As I look back to 2012, I'm reminded about how relevant the work of economist Evsey Domar, the late Professor of Economics at MIT and previously a Federal Reserve staff economist, is for making sense of the predicament facing the US and the world economies today.  Three news stories during the last year provided a good backdrop for presenting Domar’s views on public debt, budget deficits and economic growth.

First, there was the surprising about face during the summer months when European leaders switched from advocating austerity to voicing their support for actions that promote growth.  Professor Domar would have most likely approved of this change of heart by Europe’s ruling elite given that, many decades ago, Domar authored “The Burden of the Debt and National Income” (1944), a paper which argues that “the problem of the burden of the debt is a problem of achieving a growing national income” rather than one associated with the size of the budget deficit or national debt.

E. Domar

Specifically, in his paper, Domar demonstrated that, in the long run, the ratio of debt to GDP will gradually approach the ratio of the fraction of GDP borrowed each year to the rate of growth of GDP.  So, for instance, the US federal government borrowed approximately 7 percent of GDP in 2012.  If the borrowing continued at the same rate and the GDP (in money terms) grows at 2 percent per year, the ratio of debt to GDP will approach 3.5; with a 3 percent growth, it will be 2.3.

Thus, Domar showed that "less attention should be devoted to the problem of the debt and more to finding ways of achieving a growing national income" (1945:415)

According to Domar, attempting to reduce the public debt by cutting government expenditures (thus removing a significant source of income and growth from the economy) is largely self-defeating and exactly the wrong course of action if undertaken when the economy is struggling.

Then, in the fall, there was the debate among economists and bloggers about the intergenerational burden of the public debt.  Had he been around, Professor Domar would have probably been disappointed to learn that issues addressed (and, for many, put to rest) decades ago are still being debated.

And now we're facing the so-called ‘fiscal cliff’, a metaphor depicting the slowdown facing the US economy as a result of the expiry of tax breaks enacted at a time when the US federal fiscal budget situation was in better shape.  In the face of such a situation, Domar would have understood that the last thing policymakers should do when the economy is weak is to increase taxes which take away purchasing power from the economy.

As we enter a New Year, it is worth remembering Domar’s views on these and other related issues.  And nowhere are these matters best addressed than in his short, three-page article “On Deficits and Debt” published in 1993.  In this article, Domar challenges many of the widely held beliefs about debt and deficits. 

First, the article begins by taking on the popular view that considers the US federal government debt as analogous to household debt:

Our old puritanical injunctions against running into debt remain valid when applied to a private person. He or she can disregard them only at his or her peril.  A large corporation has more leeway: it can borrow by issuing bonds, and replace them with new ones when they fall due. If many large corporations simultaneously decided to pay off their debts, our economy would collapse: it is based on credit, the inverse of debt. Still any corporation, however large can go bankrupt...But, the Federal government is in a class by itself: so long as its debt is expressed in dollars (which fortunately is the case), it can always print as many dollars as it needs to pay the interest, though nowadays it would issue bonds, sell them in the market and, if necessary, have the Federal Reserve repurchase them. The Federal government, the creator of the Federal Reserve System, is its own banker.

Then, Domar describes the merits of a budget deficit:

By definition, a budget deficit means that the government spends more money then it receives, or, in other words, that it creates more purchasing power by its expenditures than it destroys through taxes.  Is this good or bad? It depends. If the economy is working to capacity, the creation of extra purchasing power will do little good and much harm: it will cause an inflation, which is easy to start and hard to stop. But when the economy has plenty of unused resources, the additional purchasing power is welcome. At such a time, we should rebuild our physical infrastructure, improve our education, health, and environment, and intensify our scientific and industrial research efforts, without raising taxes and without reducing or eliminating other needed services, always keeping a watchful eye on economic barometers to make sure that we do not overdo it.

All this sounds nice and easy, perhaps too easy to avoid suspicion. Are we to get something for nothing, as the old saying goes? Is there such a thing as a free lunch, after all? The offer of a free lunch is strictly temporary; it lasts only so long as unused resources, and particularly unemployed labor, are available, because they can be put to use with little, if any, social cost. But one they are gone government expenditures, however, desirable, must be matched with revenue.

Later in the article, Domar explains that the true burden of the national debt is distributional in that it involves a transfer of resources from one group to another group within the economy:

Some early proponents of fiscal policy argued that the size of the debt and of interest payments on it are not important because “ we owe it to ourselves”...There is some truth in this argument, but it should not be exaggerated. Even if all the Federal bonds were owned by Americans and all interest on the debt received by them, problems created by the existence of a large debt and by the need to transfer [billions of dollars] from the taxpayers to the bondholders would remain...

On the other hand, this does not mean that the...interest paid on the debt represents a net loss to the country...[T]hat interest go to other Americans, directly or not and that much of it is subject to Federal income taxes. President Eisenhower, who disliked deficits and debts, is reported to have said, shortly before he left the White House, that every American baby born at the time carried on its neck a tag indicating its share of the Federal debt. Perhaps it did; but it must have also borne a second tag showing its share of the value of the Federal bonds.

The article then presents some interesting views about whether the country’s ratio of debt to GDP is an appropriate indicator of the state of the economy:

Does the ratio of the debt to GNP matter? Yes, it does. Other things being equal, I would prefer a smaller rather than larger ratio...Other things are not equal. There are times and conditions calling for a deficit. Without it, unemployment may rise and the GNP may fall, thus raising, rather than lowering the debt burden.

The article concludes with a comment on how to best address the “debt problem”:

The proper solution of the debt problem lies not in tying ourselves into a financial straight-jacket, but in achieving faster growth of the GNP, a result which is, of course, desirable by itself. To the Republican and other politicians who are hell-bent on reducing the deficit and even repaying the debt, I would like to address a very short and simple question: Why? Are we suffering from an excess of purchasing power now?

As we head into the New Year and get ready to face many of the same concerns as in 2012, I think it would be a good idea to keep in mind these points.

On that note, I wish all readers of this blog a very Happy New Year!

UPDATE: The third paragraph was revised on January 12, 2013.  It originally indicated that Domar demonstrated in his 1944 paper that the ratio of deficit to GDP would equal the ratio of the fraction of GDP borrowed each year to the rate of growth of the economy.  Rather, Domar focused on the ratio of debt to GDP.  I also added a subsequent paragraph (after paragraph 3) which includes a reference to Domar's article "The Burden of the Debt: A Rejoinder" (1945).

References

Domar, E., "The Burden of the Debt and the National Income", American Economic Review, 34(4), December 1944

Domar, E., "The Burden of the Debt: A Rejoinder", American Economic Review, 35(3), June 1945, pp. 414-418.

Domar, E., "On Deficits and Debt", American Journal of Economics and Sociology, 52(4), October 1993, 475-478.

Behind the deficit: high interest rates and recessions

As a follow-up to my previous article, I thought I would post this chart:

Primary government balance, Source: Statistics Canada

It shows Canada's consolidated government financial balance with and without interest on the debt.  The government's primary budget balance (i.e., current revenue less spending excluding interest on debt) is a good indicator of the magnitude of fiscal policy, declining during downturns and rising when real GDP increases. (Refer to this Statistics Canada table to view the relevant data)

The chart shows a few things.  First, it shows that interest on the debt (and the Bank of Canada's high interest rate policy in the 1980s) was an important contributing factor to the size of the deficit in the 1980s and early 1990s.  Notice how the gap between the two series shrinks as we move towards the 1990s.

Second, it drives home the point that recessions have a significant impact on the size of the government budget deficit by increasing the use of automatic stabilizers (i.e., unemployment benefits and other expenditures) and reducing government tax revenues.  Note that the primary government balance reached a surplus during the late 1980s as a result of the deficit reduction efforts of the federal Tories under Mulroney and of the provinces (see arrow).  The primary government balance only declined again as a result of the recession of the early 1990s.  The end of the recession restored the primary surplus.

Third, it makes it clear (given the above) that the series of government surpluses that Canada witnessed starting in the mid- to late-90s had their roots in the fiscal policy measures of the 1980s (e.g., tax increases and spending cuts) rather than solely in the cutbacks of the 1990s under the federal Liberals and of the provinces.  This is a point that very few commentators in Canada appreciate.

But the main lesson to take away from the above is that the large budget deficit of the early 1990s was caused by the recession. It was not a consequence of 'out of control' government spending, as most are led to believe.

Austerity in Canada: Then and Now

Canada's economic accounts for the third quarter of 2012 were released last week.  They show a very weak quarter.  Real gross domestic product barely stayed positive, growing by a mere 0.1 percent (see chart 1).  The details can be found here, courtesy of Statistics Canada (click on charts to expand).

Chart 1 Real GDP growth, quarterly % change

Many reasons have been given to explain the economy's weak performance, including the slowdown in China, the fiscal and financial situation in Europe, as well as tepid growth in the US during the summer months.

Of course, as usual, no one is pointing to the fact that Canada is currently undergoing its second most important (i.e., longest and sharpest) bout of public sector austerity in half a century.  One would think that commentators would highlight this reality in their analyses.

As you can see from the chart below, real (consolidated) government expenditure (excluding transfers) has been in decline since the fourth quarter of 2010.  Historically, such a decline in real government spending has only occurred once: during the period of fiscal restraint of the mid-1990s.

Chart 2: Real government expenditures, Source: Statistics Canada and author's calculations

The reason why commentators don't think of austerity as the potential cause of the current weak performance is that Canadians live under the illusion that government spending cuts have little or no impact on the economy.  This stems from the fact that the fiscal austerity put forth during the 1990s gave Canadians (and especially their political leaders) the false impression that cuts in government spending generally help to boost the economy.

Visually, this is how most commentators interpret Canada's experience with austerity in the 1990s (note: I'm not seeking to show a correlation between the two series. I'm simply overlapping both sets of data on a common timeline):

Chart 3: The vanishing deficit and the road to surpluses, Source: Statistics Canada

The standard view holds that fiscal austerity during the 1990s helped to shrink the deficit, thus enabling Canada to run a series of budgetary surpluses throughout the early- to mid- 2000s.  Also, this view holds that fiscal austerity played a crucial role in helping Canada recover from the recession of the early 1990s and contributed to Canada's strong economic performance during the period from the mid-1990s until the financial crisis. 

The problem with this interpretation is that it completely disregards the fact that the Canadian economy during the mid-1990s was impacted by a massive increase in demand stemming from the domestic household and external sectors.  Consider the following charts showing that, as fiscal austerity was undertaken, net borrowing by both the household and external sector exploded in Canada during that period:

Chart 3: Household sector falls into net financial deficit, Source: Statistics Canada and author's calculations

Chart 4: Increased foreign demand to the rescue, Source: Statistics Canada and author's calculations

Net borrowing is the difference between a sector's total spending and income.  It is a key indicator of the demand generated by any sector of the economy. 

Supported by a much easier monetary policy and falling exchanging rate (a consequence of US President Clinton's desire to "have a strong dollar"), the increased net borrowing generated by these two sectors was effective in offsetting the decline in net borrowing of the government sector caused by fiscal austerity.

The increase in net borrowing by the household sector between the mid-1990s and the mid-2000s was unprecedented.  Between 1995 and 2007, net borrowing by the household sector increased by close to 10 percent of GDP (see arrow going down).  As for net borrowing of the foreign sector, it increased by approximately five percent of GDP.  Combined, this additional demand was more than sufficient to offset the decline in demand caused by fiscal austerity.

Today, unlike in the 1990s, the household sector is seeking to reduce its level of borrowing.  And the foreign sector, due to the strength of the Canadian dollar and the weakness of the world economy as a result of global austerity, cannot be a significant source of demand at this time.*

As a result, any attempt by Canada's policymakers to balance the budget in such a context is self-defeating and actually exacerbating the problem given that it is taking away purchasing power from households and firms.  And, as we are witnessing now, it is taking its toll and slowing GDP growth as a consequence.

Economist James Tobin said it best several years ago:

Deficit reduction is not an end in itself. It's rationale is to improve productivity, real wages and living standards of our children and their children. If the measures to cut deficits actually diminish GDP raise unemployment, and reduce future-oriented activities of government, business and households, they do not achieve the goals that are their raison-d'être; rather, they retard them. This perverse result is likely if deficit reduction measures are introduced while the economy is as weak and as constrained by effective demand as it is now.

It's time to think more clearly about these issues.  What "worked" in the past need not be the appropriate course of action today.  The Canadian economy now is not like the one that existed back then.  It's time to move forward.  Trying to relive the "success" of the 1990s will only make matters worse. 

Update:

Chart 2 should be entitled "Real consolidated government expenditures (all levels of government) (millions of chained 2002 dollars)". The title and headings in charts 3, 4 and 5 are accurate.  All data comprises expenditures on goods and services, as well as on capital formation. They exclude transfers.


*  The critical point to remember is that, as I've explained before, the government deficit cannot be reduced in isolation from the other sectors of the economy.  Public sector deficits are from an accounting standpoint the equivalent of surpluses in the private sector, plus additional net imports.  The reason for this is that government deficit spending adds to the net accumulation of private holdings of households and businesses (and/or the foreign sector, where applicable).

In other words, any reduction in government spending or tax increase has a direct impact on the financial position of the private sector.  To believe otherwise is wishful thinking.  If external demand and/or increased demand from another domestic sector (households or businesses) are not high enough to offset the demand shortfall created by reduced government expenditures, continued attempts at fiscal austerity will impose additional deflationary pressure on the economy.

Reference

Tobin, J., "Thinking straight about fiscal stimulus and deficit reduction", Challenge, March 1, 1993

Old Keynesian themes in Modern Monetary Theory

Readers of this blog know I'm generally supportive of the views espoused by proponents of Modern Monetary Theory (MMT). The reasons are fairly simple. First, MMT considers unemployment to be an important problem that must be quickly and effectively addressed by the government authorities.  I agree with that.  Also, MMT makes a good case on the important role of fiscal policy in ensuring stable and equitable economic growth.  Again, I agree with that.

But there is another reason I'm generally in agreement with MMT on many issues.  This has to do with the fact that MMT builds on some pretty solid economic thinking, much of which was well understood and accepted by earlier generations of Keynesian economists.  As someone who has a lot of respect for and who finds much insight from this earlier Keynesian tradition, I'm quite pleased to see MMT, a more recent school of thought, disseminate these views.

I was reminded of some of these - let's call them - "Old Keynesian" tenets in a recent blog post by Paul Krugman, in which he discusses a trifecta of issues relating to (1) the benefits of monetary sovereignty (i.e., where a nation issues and uses its own currency), (2) the debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance and (3) the recent controversy regarding the potentially expansionary consequences of a "loss of confidence" in US government bonds by international investors .

The first of these views concerns monetary sovereignty, a central MMT theme.  This was also a well understood concept by earlier Keynesian economists.  For instance, monetary sovereignty was a key aspect highlighted in the work of economist Robert Eisner, who brilliantly described in his book The Misunderstood Economy (1994:74) why the US greatly benefits from being a currency issuing nation:

[One] point that is widely misunderstood or unrecognized is that this debt, relatively small as it is, is all owed in its own currency, US dollars.  We pay interest and principal in US dollars.  And our Treasury and Federal Reserve can always create all the dollars we need.  One may object that such money creation or the monetization of the interest-bearing debt may have undesirable consequences, particularly greater inflationary pressure.  But it may also have the desirable effect of stimulating the US economy if that is in order. In any event, the fact that US debt held by foreigners is virtually all denominated in US dollars rules out the possibility of unvoluntary default on US government obligations.

We are not in the position of many third world or other debtor nations that sadly had obligations in foreign currencies, frequently the US dollars.  The only way they could service their debt was to obtain foreign currencies. [...]

The "world's greatest debtor nation" gave the American public visions of the US going bankrupt.  Since the debt was essentially in our currency, however, this made no sense.  We could "print" out own money to pay it off or, in more sophisticated fashion, have the Federal Reserve create the money. (1994:74)

Several other Keynesian economists also held similar views, including economist Lorie Tarshis who emphasized this point in Elements of Economics (1947), the first Keynesian textbook to be published in the US.

Secondly, concerning the ever-lasting debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance, MMT considers that the latter should be viewed as more inflationary than the former since the interest payments paid by government on its debt results in a greater expansion in the money supply (in the long run) than if the deficit is financed by money creation.

On this point, it may be instructive to recall that economists Alan Blinder and Robert Solow demonstrated long ago that the "potency" of deficit spending via money creation or bond issuance is not strictly related to the manner of financing.  In fact, Blinder and Solow demonstrate in "Analytical Foundations of Public Finance" (1974) that deficit spending financed via issuance of bonds has under normal, steady-state equilibrium conditions a greater fiscal multiplier than deficit spending via monetary financing in the long run:

When we correct an oversight committed by almost all previous users of the government budget constraint, a still more odd result emerges.  The error has been to ignore the fact that interest payments on outstanding government bonds are another expenditure item in the budgetary accounts. [...]

Under a policy of strict monetary financing, [in a stable system, the long-run government expenditure multiplier is simply the reciprocal of the marginal propensity to tax].  But the issuance of new bonds means a greater multiplier in the long run. (1974:50). (original emphasis)

Finally, as for Krugman's contention that a loss of confidence in US government bonds by investors may have potentially expansionary consequences for the US economy, economist Bill Vickrey presented a similar argument in his article entitled "Fifteen Fatal Fallacies of Financial Fundamentalism" (1996).  On whether a sell-off of US government bonds by foreign investors would have a detrimental effect on the US economy, Vickrey suggested the following:

It is not intended that the domestic government debt should be held in any large quantity by foreigners.  But should foreigners wish to liquidate holdings of this debt or any other domestic assets, they can only do so as a whole by generating an export surplus, easing the domestic unemployment problem, releasing assets to supply the domestic demand, and making it possible to get along with smaller deficits and a less rapidly growing government debt.  The same thing happens if domestic investors turn to investing in foreign assets, thereby reducing their drain on the domestic asset supply.

All that to say that, in my opinion, both Paul Krugman and proponents of MMT stand on solid ground regarding these issues.

References

Blinder, Alan and Robert Solow, "Analytical Foundations of Fiscal Policy," in A. S. Blinder, et. al., The Economics of Public Finance, The Brookings Institution, 1974, pp. 3-115.

Eisner, Robert, The Misunderstood Economy: What counts and how to count it, Boston: HBSP, 1994.

Tarshis, Lorie, The Elements of Economics, New York: Houghton Mifflin, 1947.

Vickrey, William. "Fifteen fallacies of financial fundamentalism: A disquisition on demand-side economies", Proceedings of the National Academy of Sciences of the United States of America, Vol. 95, No. 3, February 1998, pp. 1340-1347.