Stephen Kirchner and Robert Carling plead us to give austerity a chance, citing Alesina and Ardgana’s work on fiscal adjustment to show that austerity is as likely as fiscal stimulus to be followed by a period of expansion – a finding which is allegedly incompatible with the so-called Keynesian attitude that austerity is “a formula for a self-reinforcing economic downturn”. Though the empirical portion of Alesina’s work has been relatively solid (though not entirely without issue) the conclusions drawn and subsequently Kirchner and Carling’s interpretation of them range between disingenuous, biased and plain wrong.
In the introduction to their recent paper on fiscal adjustments, Alesina and Ardgana demonstrate from the outset that they don’t understand the modern monetary system:
If agents believe that the stabilization is credible and avoids a default on government debt, they can ask for a lower premium on government bonds. Private demand components sensitive to the real interest rate can increase if the reduction in the interest rate paid on government bonds leads to a reduction in the real interest rate
The authors presuppose here that the interest rate paid on government bonds is reduced by a reduction in the amount of government debt. MMT provides a model for understanding why issuing government debt should in fact quickly cause the interest rate to fall – which, by the way, it does:
The blue line represents the current budget deficit as a percentage of GDP. The red line represents the real interest rate paid on government debt. Observe that the short-term relationship is generally inverse – when the government ramps up spending, the fed funds rate falls almost simultaneously. This is consistent with the MMT assertion that government spending creates more bank reserves to compete for government bonds, pushing the interest rate down in the short term1. It is inconsistent with the idea proposed above that “credible stabilisation” (a fancy term for deficit reduction) will enable market participants to “ask for a lower premium on government bonds” – the reaction is just the opposite.
The paper cites an earlier study by the same authors which examines every period in each of the “major OECD nations” since roughly 1980 of fiscal “adjustment” (deficit reduction) and “stimulus” (running higher deficits, sometimes confusingly referred to as ‘fiscal expansion’) to determine whether they were “successful” (sustained for at least three years) and/or “expansionary” (followed by a period of GDP growth outdoing 75% of the other nations in the study). In their own words, “they define a period of fiscal adjustment as a year in which the cyclically adjusted primary balance improves by at least 1.5 per cent of GDP.”
The “cyclically adjusted primary balance” refers to the yearly government budget deficit (or surplus) before counting interest payments (or receipts), which is then adjusted to negate any changes to unemployment. The purpose of this adjustment is to account for changes in welfare costs and tax revenue that might falsely appear as periods of consolidation or stimulus. It is to avoid selecting periods in which discretionary government spending stays the same but exogenous changes to income or expenditure change the deficit-to-GDP ratio. Alarm bells should be ringing at the idea of abstracting out the effects of fiscal policy on unemployment, but the intent is clear enough. Though a rudimentary and non-standard adjustment for this branch of economics, the authors insist that it is unimportant. They conclude their explanation of the cyclical correction process by saying that “even not correcting at all would give similar results.”
Issues with the mathematical determination of fiscal adjustment notwithstanding, the results seem to be at extreme odds with the conclusion that the authors draw from them. The report finds that “fiscal adjustments on the spending side are almost as likely to be associated with high growth (i.e. a successful episode) than fiscal expansions on the spending side” [emphasis added]. In English, this means that increases to government spending are more likely to be successful at promoting economic growth than spending cuts in the general case.
Though it weakens the argument being presented for austerity, it is not much of a vindication in itself for fiscal stimulus. One reason is that the margin is admittedly close, but more importantly no one is seriously arguing that fiscal stimulus is always the best option for growth. By framing the problem in the broad context of all periods of fiscal adjustment, much of the nuance of the Keynesian argument for fiscal stimulus is lost. Keynes made no general statement about the effect of fiscal adjustment on economic growth; in fact he expended considerable effort detailing the problems with studying parts of the economy in isolation.2 A study in the context of the fundamental problems that stimulus is intended to solve is required to construct a compelling argument for it. The fundamentals for demand-side stimulus include unemployment and the private debt level.
In similar spirit to the deferral of interest rate determination to the exogenous forces of “expectations”, Alesina and Ardgana explain that “politics” and ultimately the expectations of voters are responsible for the fact that 85% of the attempted fiscal adjustments in their study were “unsuccessful” and quickly reversed. The study found just 17 periods of successful fiscal adjustment from a sample of 107 attempts. Far from being a purely political phenomenon, the economics of this trend are simple: if deficit reduction activities damage aggregate demand enough that unemployment rises, the government has simultaneously lost sources of tax revenue and gained new welfare recipients – which has further knock-on effects to aggregate demand. Despite attempting to “cyclically adjust” away the effect of unemployment in their figures the point is not completely lost on the authors, who note with a parenthetical lack of surprise that “the spending cuts which have led to sharper and more permanent debt/GDP ratio reductions are those which have stopped the growth of entitlements”.
None of these mistakes are as egregious or insulting than Kirchner and Carling’s Hoover-esque request that we as voters and commentators should be patient and “give austerity a chance”. It is all too easy to ask those suffering to be patient when you are not among them. For the millions of jobless struggling to make ends meet on inadequate welfare assistance, for the homeowners months behind on mortgage payments facing foreclosure, for the small business owners unable to find enough revenue to continue operating, austerity means one thing: more suffering. The situation can only improve when the people have enough financial security to resume their normal lives. Jobs will only be created after people are spending enough to provide business with the revenue to hire more workers. To a private sector already leveraged to the hilt with debt and increasingly unable to make the payments, the only path to recovery is deleveraging. Austerity can only make this painful process more difficult, a budget surplus makes it virtually impossible. Austerity has had plenty of chances. Let’s try something else.
In the long run, since fiscal expansion may be inflationary, the central bank may respond by raising interest rates. This is the weak correlation between the plotted lines visible over a period of decades.
The concept of the ‘fiscal multiplier’ – sometimes called a Keynesian multiplier – actually has very little to do with Keynes at all. It was first proposed by Richard Kahn in a 1931 publication, and was crystallised in John Hick’s IS-LM model, which was introduced as a mathematical model of Keynes’ central ideas to his General Theory. Hicks’ later admitted that IS-LM was merely one of his own older models, rewritten in Keynes’ unusual (for the time) terminology, but it continues to be representative of “Keynesian economics” today.
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.
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:
- Individuals spend less on consumption and luxury goods, causing reduced income for businesses.
- Businesses respond to the fall in income by hiring fewer workers or laying-off existing ones, and new investments are put on hold.
- 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:
- 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
- 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.
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.
This is the first of a series of introductory posts I would like to make to avoid cluttering future commentary with superfluous explanation.
It is well known but poorly understood that our currency (and the currencies of many other nations) has no intrinsic value; it is not officially convertible to gold or any other commodity. This is not a bug, it’s a feature. Productivity and unemployment suffer badly during periods of price instability, which are prone to happen when prices are tied to the fluctuating value of a commodity like gold. Depressions were more common when currencies were backed by gold. Recessions were deeper and lasted longer. Removing the commodity backing from currencies has generally been successful in enabling monetary policy to stabilise prices. In countries like ours where prices are strongly affected by lending the central bank can buy and sell unlimited amounts of debt in its own currency to control interest rates. In countries like Singapore where most necessities are imported the central bank can stabilise prices by buying and selling unlimited amounts of its currency internationally to maintain the exchange rate. This kind of flexibility is only feasible when the currency issuer has no obligations of convertibility to any commodity, and we are better off for having it. This system of currency is called fiat money, meaning that it is money by order of the government.
The simple difference to older commodity currencies has far reaching consequences, many of which remain unrecognised by policy-makers today. The old economic models treat money as a commodity like any other, a simple abstraction from a direct barter economy, or ignore it completely. To the general public a dollar still does represent a simple unit of exchange – a store of value. To the treasury it represents a means of adjusting the distribution of private wealth. To the central bank it represents a cancellation of part of the debt assets it holds which it paid for by printing that dollar. Usually I will speak of the federal government and the central bank together as “the government”, and use “the treasury” when there is a need to distinguish the federal government from this wider definition. We’ll come back to those interpretations of a dollar later. To understand them we need to first consider how money is created.
Imagine a newly formed nation with a government and a private sector who wish to set up a fiat currency system. The government creates money by spending it in the private sector and destroys it through taxation. By being the sole issuer of the currency the government controls the money supply, and by making it the only way of paying taxes it creates demand. Since it is the origin of money the old mantra of “tax and spend” must be reversed. The government must spend in order to tax. After money enters the private sector by government spending the money supply expands by being lent and re-lent through the fractional reserve banking system, but every positive balance created by this process is balanced by a negative one held somewhere else (actually this is true of all fiat money, since it represents a liability to the central bank, more on this in a future post). Thus the government acts not only the sole issuer of currency, but the sole provider of net savings. If the government were truly to be debt-free and in surplus – to have taxed more of its own currency it has spent – there would be no net savings in the private sector. If all private debts were also settled then there would still be an outstanding debt to the government and not a single note or coin left to pay it.
This relationship between deficits and net savings can readily be shown symbolically with the function for Gross Domestic Product (GDP). GDP is the dollar value of everything produced within a country (not counting things like components of a machine for which the value has already been included in the value of another product) minus all the money that left the country from imports. It is written as:
This function is known as a macroeconomic accounting identity, meaning it is true by definition. C represents spending on private consumption, I represents investment spending on capital, G represents government spending, T represents taxation and NX represents Net Exports, or exports minus imports. Since every dollar spent must also be earned, GDP is sometimes used synonymously with income. There is another way of calculating GDP using incomes directly, but for now it will be sufficient to understand that they are equivalent. Income is written as Y, so we can also write the GDP function like this:
Since every dollar of income earned must either be spent or saved, we can represent net private savings using symbols from this formula as Y – C – I or income minus consumption minus investment. In more elaborate models savings is better defined as Y-C and I includes items ranging from mortgage payments to cash reinvested in the business that earned it. The government budget deficit (or surplus) is government spending minus taxes, or G – T. Rewriting the formula in terms of the deficit gives us:
Meaning that aside from the balance of trade, the change in private net savings is determined entirely by the size of the deficit. When the government runs a surplus the private sector is forced to dis-save. The government hasn’t reduced its liability in any way since it has no obligation to convert the cash to any real commodity. It has simply removed savings from the bank accounts of its citizens.
Update: Someone asked me if the government borrowing from individuals causes this kind of analysis to break down. It’s a good question – the government borrows from the private sector all the time since its debt is the sole type of asset traded in the open market operations system by which monetary policy is enacted. The answer is no. Since the government only borrows to spend, if it borrows directly from the private sector two things happen:
- Savings change hands between lender and the recipient of subsequent spending.
- A debt asset is created in the private sector.
There are a couple of ways of thinking about this: either that debt asset cancels out a debt liability somewhere else in the private sector thus increasing net savings (the net present value method) or the interest payments on that loan will be a steady flow of new savings into the private sector. Either way, net savings have increased. It does not matter who the government borrows from, it creates money when it spends.
Note that “creating money” in this sense is not the same as printing it and indeed usually happens without a corresponding issue of new notes and coins. These two processes are operated separately by the treasury and the central bank respectively. The treasury is ultimately managed by our elected officials and its decisions are referred to as fiscal policy. The central bank (Australia’s central bank is called the Reserve Bank of Australia) is an operationally independent organisation which has been granted the legislative power to manage the nation’s money supply by making decisions called monetary policy. When the treasury creates money (by spending it) it borrows from the central bank at interest. The central bank may choose to issue new notes and coins or may simply debit the treasury’s account electronically and use its existing reserves of cash from the commercial banks that hold accounts there. The central bank chooses when to print new money and at what interest rate to lend it in order to achieve its goal of price stability. The treasury chooses where to spend money and who to tax it from in order to achieve its goal of increasing the well-being of the citizens.
The most important result to note from this is that the government as currency issuer is not like an individual or business in that it does not need to “balance the books” to remain solvent. The notion of a monetarily sovereign government becoming insolvent in its own currency is absurd. The role of the government in spending and taxation should only be to the benefit of its citizens, which is most cases involves two things: ensuring access to essentials and creating a fairer distribution of wealth and income. Pursuing a balanced budget for its own sake is more likely to do harm than good, removing scarce savings from an already over-leveraged, debt-laden society.