What caused the Eurozone debt crisis?

In November, the Australian published an opinion from the Centre for Independent Studies blaming the Eurozone debt crisis on social democrats, who “glossed over [the] inherent contradictions [in social democracy] by running massive deficits.” The Canberra Times also ran an article from the Institute of Public Affairs asserting that the crisis could be blamed on the “welfare state,” which “numerous studies show … impede[s] private sector production and growth by distorting incentives to work and save.” In an article curiously entitled “Eurozone v Australia: why we beat them,” Bob Carr suggests that our means-tested welfare system means Australia is unlikely to suffer a similar fate.

The Opposition warns us that the Government’s “reckless” spending places Australia at risk of a similar crisis. Kelly O’Dwyer thinks Australia’s public debt “rank[s] worse than Spain, Greece and Portugal” — “If this government were a pack of cards, then Wayne Swan would be the joker of deficits. Unlike Peter Costello, who is the king of surpluses, he would be the joker of deficits.” Barnaby Joyce claims that Australia has had the “third-biggest cumulative increase in real public debt since 2007,” apparently referring to this chart from an article in Policy Analyses in International Economics:

Indeed, Australia has the third-longest bar in this chart — because it measures public debt in 2010 as a proportion of public debt in 2007. Hence the “biggest” increases are those in countries which had relatively low public debt prior to the financial crisis, and the “smallest” increase was in Japan, the world’s most indebted sovereign. The trillions of dollars worth of debt issued by Japan since the crisis (around 40% of its GDP) appear relatively insignificant because Japan carried so much debt in 2007.

Australia’s increase in debt is far more modest when measured in gross terms or as a percentage of GDP. Clearly we’re not in the same economic position as the Europeans. But why? Carr cited Sweden as one of several countries with a government sector so bloated it consumes more than 50% of GDP, but the Scandinavian countries are in good financial health compared to the Eurozone.

Sweden, Norway and Denmark all have governments which spend around 60% of GDP. But despite the government’s dominance of the economy, they have relatively modest stocks of public debt (at 35, 11 and 60% of GDP respectively) and AAA credit ratings. Importantly, all three countries have a sovereign currency and run a trade surplus. The IMF doesn’t track the trade balance for individual countries, but it does track the current account balance (a broader measure which includes foreign investment income and international aid). Because current account deficits imply budget deficits, net private dissaving, or both, it is not surprising that many countries with consistently large current account deficits also have large budget deficits. In the following charts, countries are ranked by the indicator’s average over the 12-year period:

Source: IMF World Economic Outlook database, September 2011.

Source: IMF World Economic Outlook database, September 2011.

The “PIIGS” are the large-deficit countries without sovereignty over monetary and fiscal policy: monetary policy is controlled by the ECB, and fiscal policy is supposed to be limited by the Stability and Growth Pact to budget deficits of less than 3% of GDP. In any event, fiscal policy in the Eurozone is limited by the goverment’s ability to convince investors (including the ECB) to purchase its bonds. These constraints do not apply to monetarily sovereign countries like Australia.

The primary objective of the ECB’s monetary policy is to maintain price stability. Such policy, combined with persistent current account deficits in some countries (or, more or less equivalently, persistent surpluses in some countries, since the current account balances must sum to zero over all countries) will inevitably result in a public debt crisis. That countries in a single currency area — an area with a single currency or system of currencies with fixed exchange rates — would suffer periodic balance of payments crises was “patently obvious” to Robert Mundell in 1961, when he published A Theory of Optimum Currency Areas. Then, virtually the whole world was a single currency area under the Bretton Woods system of fixed exchange rates.

To paraphrase Mundell: floating currencies provide a natural role in smoothing out discrepancies between currency areas. Say that Dystopia and Eutopia share a currency area — that is, they use the same currency or fix the exchange rate between their currencies. When demand shifts from the goods and services of Dystopia to Eutopia, there is unemployment in Dystopia and inflationary pressure in Eutopia. To the extent that inflation is limited by monetary policy, unemployment in Dystopia is exacerbated. Conversely, inflation is exacerbated by monetary policy directed towards achieving full employment. In this analogy, Dystopia is the set of Eurozone countries with persistent current account deficits, and Eutopia is Germany. And because Germany’s fiscal strength depends on the rest of the rest of the Eurozone’s weakness — Germany’s trade surpluses imply budget deficits for its Eurozone trade partners — the Eurozone can’t just follow Germany’s example.

Those countries which share a currency area must be prepared to forego the benefits of floating their currencies against each other. In federations like Australia and the USA, a shared national identity makes it politically easier to use transfer payments to prevent differences in productivity between states from causing unemployment. The Eurozone debt crisis is a case study in the political difficulty of effecting such transfers between nations.

Talking money

I’m going to be at GhengisCon next weekend speaking on a panel about digital economies. The topic is “A discussion of digital economies, WoW gold, EVE ISK, Secondlife Lindens, OM$ and bitcoins. How are these changing the way we deal with money and what are the implications?” If the future of money (however distant) is something that interests you then I encourage you to come along and join the fun! It’ll be a relatively interactive, relaxed affair with plenty of time for questions. It’s $10 for a day pass to the convention, which includes a bunch of other activities and panels. You can find out more about what else is on at the GhengisCon website. The details are:

Panel: Digital Economies
Slot: Saturday 21st of January, 13:00
Location: GenghisCon, St. George’s College, Panel Room
Description: A discussion of digital economies, WoW gold, EVE ISK, Secondlife Lindens, OM$ and bitcoins. How are these changing the way we deal with money and what are the implications?

Hope to see you there!

Unemployment, Welfare and Minimum Wage

The most visible indicators of macroeconomic health are related to employment and welfare. A healthy economy is recognisable as one in which anyone willing to work can find a suitable job with a fair wage and no one has to die for lack of access to food, water or shelter. In previous posts I have explained the mechanics of certain abstract macroeconomic phenomena in order to discredit conventional economic theory; in this post I will explain the macroeconomic significance of the familiar mechanics of employment in order to advocate a new policy. I will build on the macroeconomic model from previous posts by introducing the unemployment rate, minimum wage and welfare payments.

To the extent that the central bank is able to influence investment decisions it is also able to influence the unemployment rate: if loose monetary policy encourages building a new factory then labour will be required to build and staff it. The monetarist school of thought that is mainstream throughout most of the developed world asserts that investment (as a function of inflation) is always controllable by monetary policy. Many governments therefore delegate responsibility for maintaining full employment to the central bank. Often unemployment is presented in textbook models as a tool for controlling inflation: when prices begin to rise faster than the desired rate of inflation (because aggregate demand has outpaced the nation’s productive capacity) then tight (also called contractionary) monetary policy is used to create a buffer stock of unemployed people – which softens wage demands and eases upwards pressure on other prices – who can be called upon to work when in the reverse situation the central bank decides to embark upon expansionary monetary policy.

The Paradox of Thrift

If everyone attempts to save more of their income at the same time, there will be correspondingly less income to go around, the attempt will fail and ultimately be harmful to the wider economy as the shortfall in demand costs jobs and discourages investment. Keynes coined the term ‘paradox of thrift’ to describe this situation, though it has been recognised less formally for centuries – Adam Smith coyly questioned the old wisdom that “what is prudence in the conduct of every private family can scarce be folly in that of a great Kingdom.” We have seen some hints that the virtues of saving evaporate if everyone is doing it when we looked at how a negative real interest rate punishes savers when there is a shortage of investment.  This “paradox” represents a formidable challenge for heavily indebted countries: how can there be a concerted effort to lower the debt level when any collective attempt to save must fail?

The production function Y = C + I + (G – T), rearranged so that gross household savings equals income minus consumption expenditure (S = Y – C), tells us that household savings minus investment expenditure (i.e.: net private savings) equals the government budget deficit: S – I = G – T. That means that for a positive change in net private savings in a given time period, there must be a corresponding increase in net public debt. In previous posts we established that it is meaningless for a government to save in its own currency; it follows that running a budget deficit is not incompatible with the notion of everyone trying to save. Mathematically, at least, the paradox of thrift requires only a liberal application of fiscal policy to resolve.

To determine when government spending should be applied to control a paradox of thrift situation, and to what degree, we can look at it as a question of supply and demand. Traditionally the government – which has a monopoly over the supply of net savings – chooses how much and to whom savings are distributed to, and from whom they are taken, in order to meet a budget target. Instead of a budget target, the government could target a desired distribution of wealth in order to match the private demand for savings. The tricky part is working out how to do this.

Consider a private sector that wishes to save. The following happens:

  1. Individuals spend less on consumption and luxury goods, causing reduced income for businesses.
  2. Businesses respond to the fall in income by hiring fewer workers or laying-off existing ones, and new investments are put on hold.
  3. The unemployment rate rises, creating a new incentive to save.

Some proportion of every dollar earned must either be saved or spent. Spent dollars represent dollars earned by the next person. If the private sector wishes to save an additional $15, this comes at the expense of $15 earned by someone – which might represent an hour’s wage by some factory worker. If the private sector wishes to save an additional $30,000 it might represent a worker’s annual salary. We call this relationship the private demand for savings. It is, by definition (and hopefully, soon, by intuition!), impossible to satisfy within the private sector itself; new private savings, net of existing debt, must come from government spending.

Unfortunately it is not a figure that lends itself well to reliable determination from historical data, let alone predicted for current policy. Nor is it clear who should be the recipient of the new savings, or that the political process would be able to respond quickly enough to be effective in preventing a recession. A successful policy approach to meeting the private demand for savings must be long-term, be able to respond quickly to changes in demand, yet must not overshoot the mark and create excess inflation or devalue the currency.

Minimum Wage and Unemployment

The debate around minimum wage suffers the same framing problems as most popular economics, with two roughly defined groups – the political left and right – arguing different sides of same rusted old coin.

On one side are free market advocates and business owners (often grouped under the heading of ‘conservatives’), who argue for reducing or eliminating minimum wage laws. The essence of their argument is that enforcing an artificial minimum wage distorts market outcomes and costs jobs. From this perspective, the jobs that are lost because businesses can’t afford to hire – including many cases where a worker may become worth a higher wage once they’ve built up some experience working more cheaply – will ensure that there is work for everyone and that in turn the overall standard of living will improve too. Market forces will ensure that everyone is paid a fair wage, and in the extreme form of this advocacy, they argue that in a free market those who are unable to command a high enough wage are not making a high enough contribution to society.

From the other side – the political left – comes the argument that minimum wage is necessary and often that it should be raised. The argument is that people on low wages are already being unfairly exploited, that the ‘free market’ does not ensure fair wages because the lowest income earners are often in no position to negotiate pay. Usually they advocate extensive government welfare programs, and intervention to ensure fair hiring policies in corporations. Though few would disagree that a minimum wage may cause some loss of jobs, they believe that this is a lesser evil compared to allowing disadvantaged people to be trapped in exploitative working conditions.

Not everything about the two camps is opposed – mostly importantly both are interested in creating a healthier economy and differ chiefly in their means for doing so. If the debate could be exorcised of its ideological demons we could even see similarities in the differences, in particular that:

  1. The argument between the relative merits of ensuring reasonable wages versus ensuring that businesses can afford to hire implies a shared belief that there exists a trade-off between unemployment and fair pay, and
  2. Changes in the number of jobs available will affect the unemployment rate, and therefore that the unemployed will be ready and willing to work if work was available.

This ideal of the ready and willing to work unemployed person is more or less consistent with the formal definition of ‘unemployment’ used in government statistical releases. Only those actively looking for work are considered unemployed. Those who are not interested in working are not part of the labour force and not counted. Those who might take a job if offered but are not actively searching are considered ‘discouraged workers’, and also not counted. Those who are gaming the system to receive welfare payments but are not truly looking for work appear as statistical anomalies – they are counted in the unemployment rate, and they are without employment, but they are not part of the narrow “buffer stock of unemployed workers” that comprises the official definition, or the people whose jobs are assumed to be created or destroyed by minimum wage regulation.

The “buffer stock of unemployed workers” is the neat and tidy little explanation of what happens when policy decisions create unemployment through diminished investment. The idea is that those left unemployed by contractionary policy will create a pool of workers ready to draw upon when signs of slowing growth call for expansionary policy. Like all neat and tidy models of human behaviour, it fails to capture the messy detail of reality. As anyone who has spent longer than they would like out of work can tell you: being unemployed sucks. The longer the period spent unemployed, the harder it becomes to find work. Employers prefer to hire people who are already working. Long gaps in the resume look suspicious. There is an emotional cost to being unemployed which eventually discourages many from looking for work at all (which makes them somewhat difficult to place in the traditional labour force classification). These social costs of unemployment can be severely problematic to the “buffer stock” that contractionary policy presumes to create.

The Job Guarantee

This is all we need to know to understand how we can begin to build a real solution. We know that the government is the monopoly supplier of net savings and can supply savings in unlimited quantities constrained only by inflation. We know that the private demand for savings manifests as lost private income, and lost jobs, but we can’t precisely measure it. We know that the government tries to create a buffer stock of unemployed people to support expansion when the time is right. We know that the social costs of unemployment make the transitions much less fluid in reality. With these understandings we are finally able to reframe the problem it the full undiluted context of the wider economy: what can the government do to simultaneously eliminate the social problems associated with unemployment, fulfil the private demand for savings, allow mutually beneficial employment arrangements at low wages, prevent anyone being forced to work for an unfair wage, and do it all quickly and responsively enough to avoid these problems getting out of control?

It’s easy: hire them. Instead of creating a buffer stock of unemployed workers, create a buffer stock of employed workers by giving the government the role of employer of last resort. Guarantee a job for all citizens, paying a basic liveable wage indexed to inflation, up to 40 hours per week.  The guaranteed wage could effectively replace the minimum wage, because no one could be forced to work below it, though anyone could choose to work for a private firm at less than this rate if they felt it was worthwhile experience. There would be a similar flooring effect on working conditions for those on low wages. In slow economic periods the government payroll would automatically expand as people who could not find work in the private sector transfer to the public sector, expanding the deficit and creating new net savings. Once the private demand for savings has been satisfied, consumption and investment resume, and the private sector starts competing for labour. This will drive up wages, creating incentives to leave the minimally paying government job, shrinking the government payroll and deficit in the process. These twin behaviours make it a kind of automatic stabiliser – a policy which activates automatically to set in motion stabilising effects on the economy.

It doesn’t have to be useful work – it might be better if it’s not, if you’re afraid of crowding out private business. Those who need a lot of time off to find a new job in their field could work for only part of the week and still earn more than they would have received on welfare payments. Welfare payments would still be available for those with genuine disabilities or other barriers to work, and the scope for gaming the system would be drastically reduced. The programme would have no relative wage effects in the private sector – that is, it would not create upwards price pressure on other wages – because the expenditure on the programme reflects only the private demand for savings, not consumption. On the other hand, it would allow workers who are already at low wages to bargain for higher pay with their employer without fear of losing their job and being unable to pay the bills, since an alternative income stream is always available.

The Job Guarantee was proposed independently by MMT pioneers Warren Mosler in 1997, and Bill Mitchell in 1998. In Australia, the Centre of Full Employment and Equity at the University of Newcastle acts as one of the chief advocates and developers of a complete set of Job Guarantee policies. Several countries have implemented similar schemes with some success, including post-crisis Argentina, India and South Africa. In Australia and soon in the UK, work-for-the-dole programmes are analogous to a weaker version of the job guarantee – the pay is still woefully inadequate, but it works the on the same principle. There are many questions still to be answered. How to deal with underperforming workers (can you be fired from the programme?), what kind of unemployment welfare payments should still exist, what the nature of the work should be – these are all still issues of some contention. These operational questions form most of the work in turning the idea into a workable policy.

Then all we need to do is sell it to the politicians.

The Flow of Funds

I’ve made an diagram of how money flows around in the modern monetary system, and added some MMT propaganda around it for effect. I plan to make reference to it an upcoming post, but for now it’s just a pretty picture for you to look at.

Never a Waste of Taxpayer Dollars (Ever)

If there’s any bad habit that transcends political alignment it is denouncing government projects as a “waste of taxpayer money”. If you’ve been following my posts on deficit spending and inflation you should be comfortable by now with the idea that the only constraint on government spending is the risk of inflation, and it shouldn’t be too much of a jump to see that taxes are not analogous to financing that spending.

Recall that the true purposes of government spending and taxation are to redistribute wealth and counteract inflationary pressures; that the nature of spending is to create money and taxation to destroy it; that inflation is for all intents and purposes an indirect regressive tax on those unable to protect their wealth through safe investment; that in the long run inflation represents more money chasing the same quantity of goods and services. It follows that some form of tax is inevitable: either government-imposed taxation reduces the nominal value of your bank balance, or the “invisible” inflation tax reduces the real value of it. For a given level of output, no amount of tax can change the amount of goods and services that can be bought with it. The uncomfortable conclusion is that in the long run and in aggregate these taxes are equivalent. In the short-run and at the individual level most of us are much better off with progressive government taxation than regressive inflation tax.

It’s not a trick. To the same degree that the tax system is fair, as taxpayers we are simply better off without “our” tax dollars. Rather than taxation removing value from the private sector and spending putting it back in somewhere else, both of these operations have both effects. Taxation does not remove value from the private sector, it reduces numbers in bank balances and can only shift real value around. How the government chooses to spend money is a separate issue – once taxed, the money is effectively destroyed. It cancels out a government bond at the central bank and ceases to exist. Taxation can still be unfairly distributed, too high or too low, and government spending can still be wasteful – but the notion of spending or wasting taxpayer dollars is meaningless.