Moving on from the household budget analogy: part 1

Both sides of Australian politics are wedded to an analogy which relates fiscal policy to everyday household budgeting. In this world, “responsible economic management” means the consistent delivery of budget surpluses — or at least “balancing the budget over the business cycle.” Deficit spending is the government “drawing on the nation’s credit card,” and an ever-increasing public deficit is a “burden” to be borne by our grandchildren. Therefore, the government should “tighten its belt” and “live within its means” …

These claims are repeated by mainstream media outlets as though they are supported by reliable evidence. In fact, this view of the economy contradicts empirical evidence and is not shared even by the majority of economists.

In modern monetary theory, there are two fundamental differences between government and household budgets.

  • Governments don’t need to earn before they spend. A household which spends more than it earns will face bankruptcy once its savings and credit limit are exhausted. In contrast, government spending creates currency, and the government can run budget deficits indefinitely — especially when the economy is growing.
  • Governments cannot accumulate savings. Households usually invest their unspent income in the financial sector, because they need to accumulate wealth before they can spend it. When the government taxes more than it spends, the surplus is removed from the economy — unless the government spends it on infrastructure or a sovereign wealth fund. But governments don’t need surpluses to finance investment.

This post is the first in a series. To start with, I’ll describe a model for thinking about macroeconomics that replaces the household budget analogy. In later posts, I’ll use that model and ideas from modern monetary theory to justify the two claims above.

But first, a disclaimer: this discussion applies only to governments, like those in the the US, the UK and Australia, which are monetarily sovereign. Things are different when the government’s ability to spend its own currency is limited by a gold standard, fixed exchange rate or currency union. I discussed this previously in What caused the Eurozone debt crisis?

The pie model: an intuitive way to think about macroeconomics

At the level of the individual household and business, ‘responsible economic management’ means accumulating money, or nominal wealth. Nominal wealth is closely related to real wealth — the subjective value of real land, goods, labor, buildings, machines and experiences. Macroeconomics has a lot to say about how that relationship can change, but at the household level it’s relatively stable (most of the time). Households accumulate nominal wealth by spending less than 100% of their nominal income.

A change of perspective is needed to understand things at the macroeconomic level, because unlike households, governments can create nominal wealth. We need a new definition for ‘responsible economic management.’

Responsible governments should try to maximise the growth and stability of real wealth by controlling the quantity and distribution of nominal wealth.

You can think about the effect of government policy (and private sector behaviour) by using the mental image of a divisible pie that changes in size. The size of the pie represents national (or global, or regional) real wealth. The segments represent units of nominal currency (dollars, or billions or trillions of them circulating in the economy).

This $40b economy experienced real GDP growth of $8b (20%) and inflation of 5%, becoming a $50 billion economy. (Each segment represents $1b.)

Households always want to minimise spending, because it removes segments from their pie. Government spending is different: it increases the total number of segments in the pie (taxation removes segments). The link between the number of segments and the size of the pie is very complicated. A given level of government spending could increase real wealth in some circumstances and decrease it in others.

This is not to say that the government can or should control the economy. The private sector’s behaviour is probably even more important than the government’s in determining the size of the pie and distribution of the segments — and in endogenous money models the private sector can change the number of segments (money supply) too. We focus on the government not because it should control the economy, but because we can control the government.

All government action (and inaction) has some effect on the distribution of wealth. For example, deficit spending increases the number of segments in the pie. Economists who support government stimulus in recession conditions argue that because productive capacity is going unused, increasing the number of segments will increase the size of the pie.

On the other hand, if the behaviour of the private sector is already enlarging the pie as quickly as possible, adding more segments would increase inflation. Everyone has more money, but life isn’t actually any better. If the private sector was allocating spending more productively than the government, this would reduce the rate of growth of the pie, too.

When the government taxes more than it spends (fiscal surplus), some segments are removed from the pie. Since there are fewer dollars chasing after the same quantity of real wealth, we’d expect deflation. And if the private sector allocates spending more productively than the government, the pie should grow even faster.

Even if the budget is always strictly balanced, by deciding who is taxed and who receives the benefits of spending, the government alters the distribution of wealth. And because of feedback loops and changing trends in private sector behaviour, the distribution and growth of real wealth seems to be unstable anyway, meaning that by remaining neutral, the government endorses the changes it allows to go unmitigated.

We can think about the effect of government policy and private sector behaviour by adding ‘layers’ to the pie model which represent the distribution of wealth when the economy is divided into different sectors. We can divide the economy however we like: by industry, by income quintile, or even by gender. We can even define ‘the economy’ differently: usually as real national GDP, but the model applies equally to global GDP, the stock of national wealth, or the share of wages. The important thing is that we don’t mix up stocks and flows, that segments add up to 100%, and that we can find reliable data that measures the quantities we’re interested in. (Mathematically, we must define a partition of the ‘economy’ we have chosen.)

Layers showing the size of Australia's government in 2010-11 (in red, left) and Australia's income distribution by quintile in 2009-10 (right).

The government can use fiscal and monetary policy to change the number of slices the pie is divided into (mainly with monetary policy) and the number of slices controlled by different groups of people or industries (mainly using fiscal policy). Of course, what we really want the government to do is make the pie bigger, but both:

  • the way that government policy affects the number and distribution of slices (nominal GDP and income distribution); and
  • the way the number and distribution of slices affects the rate of growth of the pie (real GDP growth)

are poorly understood by governments and economists. All economic models are incomplete, and in most cases, they are also inconsistent both internally and with empirical data. That is okay, because economics is a complex science in its infancy — but politicians and economists frequently get away with using incomplete and inconsistent arguments to justify controversial policy decisions.

In the next post, I’ll look at why governments don’t need to earn before they spend, and consider when fiscal policy decisions like large budget deficits become unsustainable. If you’d like to jump ahead, you might want to read Bill Mitchell’s introduction to modern monetary theory using the business card analogy at Barnaby, better to walk before we run.

Data sources

  • Size of Australia’s government as proportion of GDP in 2010-11: A perspective on trends in Australian Government spending, Australian Treasury (pdf at p 29).
  • Distribution of Australia’s income by quintile in 2009-10: Household Income and Income Distribution, Australian Bureau of Statistics, 2011 (pdf at p16).

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.

Why increase the superannuation guarantee?

The Opposition says that if it is elected, it will retain the Government’s proposed increase to the superannuation guarantee from 9% to 12% of wages. The proposed legislation is integrated into the Government’s mineral resources rent tax package, which the Opposition says it will repeal. The Government says their policy is ‘confusing and chaotic‘ because the Opposition can’t say how it will ‘fund’ the reform.

But what does it mean to ‘fund’ an increase in the superannuation guarantee? Superannuation contributions are part of employers’ wage expenses; they’re not paid for by the government. Increasing the superannuation guarantee means the government mandates that you save a greater proportion of your income for retirement — hardly a policy inspired by the Liberal Party’s belief in “a lean government that minimises interference in our daily lives; and maximises individual and private sector initiative.” Why does the Opposition support this part of the Government’s agenda when it has been so obstinate in blocking the rest of it? And if superannuation contributions are paid for by employers, what does this have to do with the mineral resources rent tax?

What’s not to like about superannuation?

Superannuation is widely credited as one of the “three pillars” of Australia’s retirement income system; a successful product of the Hawke-Keating reform era. (The other two pillars are normal private savings and the means-tested age pension.) Recently, the Association of Superannuation Funds of Australia attributed Australia’s strong economic performance during the global financial crisis to the stabilising influence of the superannuation industry.

Others argue that superannuation is a regressive giveaway to the rich, noting that 50% of the tax concessions on superannuation income go to the top 12% of income earners. Superannuation funds are taxed at a flat 15%, which means contributions attract a tax concession for taxpayers above the 15% marginal tax rate bracket. That means those earning under $37,000 receive no net concession, and those earning under the tax-free threshold actually increase their tax burden by making superannuation contributions. High income earners receive large tax concessions, which they can amplify by using their larger discretionary incomes to make additional voluntary contributions to superannuation.

It is because of this tax expenditure that the Government has linked the superannuation guarantee increase to the mineral resources rent tax. Superannuation tax concessions (including the concessions on the income earned on assets already in a fund) currently cost the budget $27 billion a year — already about as much as the aged pension. According to the explanatory memorandum to the Superannuation Guarantee (Administration) Amendment Bill 2011, the concessions will cost an additional $500 million per year by 2014-15 — when the guarantee has increased to just 9.5%. In subsequent years, the rate accelerates: it begins increasing by 0.5% (rather than 0.25%) per year until it reaches 12% in 2019-20. The explanatory memorandum does not attempt to forecast the cost of the tax concessions so far into the future.

The plurality of superannuation savings (about a third) are held in retail superannuation funds, which perform worse than their non-profit counterparts. Increasing the superannuation guarantee is a subsidy to the financial companies that profit from increased superannuation account balances. And amongst all funds “the best annual returns [are] as high as 7.07 per cent.” Six and twelve month term deposits yielding around 6% have been available to those prepared to shop around for the last few years (although this looks set to change). Does mandatory investment in superannuation funds really offer enough reward to justify the risk of more losses like those suffered in 2008?

Self-managed superannuation funds offer members the ability to take control of their own investments, but the annual administration and tax compliance costs usually amount to a few thousand dollars. This means that self-managed superannuation is only financially viable for those with balances in the hundreds of thousands.

What else does the Opposition support?

The Government’s superannuation legislation involves more than just increasing the superannuation guarantee rate — it also contains a number of initiatives designed to reduce inequality in the superannuation system. The Government proposes to:

  • increase the superannuation age limit to 75 (after which employers stop contributing to employees’ superannuation);
  • introduce MySuper, an accreditation regime for ‘default’ superannuation products designed to standardise fee structures, making it easier to compare fees and promoting competition; and
  • provide a government-funded contribution of up to $500 for low income earners, offsetting the tax disadvantage created by the 15% tax rate.

The Opposition supports abolishing the superannuation age altogether, but its position on the other reforms is unclear. In April 2010 it described MySuper-type reform as an attempt to “dumb down superannuation,” which “could kill the goose that laid the golden egg”. In October 2010 it rightly pointed out that increasing the superannuation guarantee to 12 per cent contradicted the advice in the Henry tax review, which said the superannuation guarantee rate should remain at 9 per cent. It described the effect of an increase as “a 3% cut in take home pay for working families” — yet just three months earlier it said the cost would be borne by employers, citing the Government’s inability to “point to any wage restraint that shows employees are taking superannuation increases instead of pay, that might produce a ‘cost’ to government for missed income tax.” Yet the Opposition has now decided to keep the legislation if elected.

Given its obstructive attitude over the past few months, it is surprising to see the Opposition support Labor’s position on the superannuation guarantee. The case for the superannuation guarantee is much weaker than the economically-straightforward argument in favour of the carbon tax. The Opposition should clarify its grounds for supporting an increase in the superannuation guarantee, and should confirm whether it intends to continue policies such as MySuper or introduce ways to make the taxation of superannuation more equitable.