[Don’t] Give austerity a chance

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.

[1] 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.

[2] 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.

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.

Deflating the inflation fear: an introduction to inflation in the modern monetary system

I explained in my last post the zero-sum relationship between net savings, public debt and the balance of trade, and that since government budget deficits do not need to be financed the only danger of deficit spending is high inflation. In this post I expand on that claim, introducing the widely misunderstood causes and effects of inflation and some of the dangerous misconceptions held by policymakers and reproduced in the media. This post is necessarily long, because to understand inflation requires an understanding of the monetary system; to understand where mainstream economics went wrong requires an understanding of the theory underlying it; to recognise good policy you must be able to recognise bad policy. To limit the length of what was becoming a very long post (which suddenly looks a lot shorter when transcribed from a word document into this blog theme!) I have not made direct reference to economic data sources. If you would like any claim in this article substantiated please ask me in the comments. The central banking model I present makes some minor departures from the system implemented in Australia by the RBA, more information on the Reserve Bank’s version of fiat money can be found on their website.


Almost all surviving schools of economic thought define inflation as an overall increase in prices, for varying interpretations of “overall”. Economists often use core inflation as a benchmark rate as it includes only goods and services with relatively stable prices. Volatile items including most consumer goods are excluded. One notable exception to the price level definition of inflation is used by economists of the Austrian school[1], which has maintained the classical tradition of defining inflation as an increase in the size of the money supply. Superficially these definitions may appear approximately equivalent: more money chasing the same quantity of goods will surely result in higher prices. In the long run and for carefully chosen interpretations of what counts as “money” this may prove true, but we are creatures of the short-run where factors of supply, demand and power are the main determinants of prices. In the short run the distinction is very important.

The precise relationship between the rate of money supply growth and the rate of inflation is hotly debated between competing economic schools. The dominant mainstream view today is called monetarism, which was developed most famously by economist Milton Friedman and influenced the economic policies of Jimmy Carter, Margaret Thatcher and Ronald Reagan, as well as Reagan’s appointed Chairman of the Federal Reserve Alan Greenspan and his successor Ben Bernanke, who continues to hold that position today. The monetarist position is that “inflation is always and everywhere a monetary phenomenon” (Friedman, 1970); it asserts that the powers of monetary policy – the central bank’s access to the printing press – are always sufficient to control price level growth.

Central Banking

The central bank is an organisation operated independently of the government which has been granted special legislative powers to control the money supply under the dual mandate of ensuring price stability and (in some cases) full employment. The privilege of being able to print money comes with the limitation of never really being able to spend it. Money printed by the central bank is only spent on loans[2], and only to the most creditworthy parties. The loans take the form of certificates called bonds, which are essentially fixed-term loans to be repaid to whoever holds the certificate. Traditionally central banks have only purchased bonds issued by the government, though more recently many have begun to accept bonds issued by highly creditworthy corporations under strict repurchase agreements[3]. As creditor for all currency in circulation the central bank is almost guaranteed to be profitable, though after all operational expenses have been paid the profits are usually paid back to the government to avoid the interest on the public debt rising forever.

Each of the major commercial banks has a reserve account at the central bank in which it must keep a portion of every deposit. These accounts pay zero or very low interest rates, so banks try to keep these the balance in these accounts as close to the regulatory minimum as they can. The government also keeps its accounts there, and it is through a trading platform at the central bank that government bonds are auctioned. The central bank also acts as a lender of last resort, buying bonds at the going rate plus a small penalty, if there are no other buyers for the debt. A commercial bank may borrow from the central bank overnight to meet reserve requirements if it is unable to borrow from other banks. Most reserve imbalances simply reflect transactions between customers at different banks, so the banks are usually able to meet their reserve requirements and offload excess reserves by lending amongst themselves. Banks may also buy government bonds with any excess reserves they might have, and the interest rate they charge on interbank lending is usually competed down to just above the interest rate they could receive by buying government bonds instead.

By participating in this market with unlimited buying power the central bank is able to exert influence over interest rates. Once it has decided on the base interest rate (called the cash rate in Australia) it announces the decision and then buys or sells government bonds as necessary to set the going rate. If it wants the rate to fall, it buys up any offer of bonds at a higher rate until only lower-yielding (i.e.: more expensive) bonds remain on the market. If it wants the rate to rise, it sells its holdings of government bonds until they are so prevalent that sellers must offer bonds at the desired higher yield (i.e.: lower cost) to successfully sell them. The interbank lending rate soon follows, since no bank will lend to another for a lower rate than it could earn buying government bonds yet any bank will accept even slightly more than that. Eventually the effect trickles down to retail interest rates, since being able to borrow more cheaply means that a bank can also afford to lend more cheaply.

By influencing the cost of borrowing money and the return from lending it monetary policy is able to encourage or discourage investment projects on the cusp of being profitable. If loose monetary policy over a period reduces interest rates by 2%, the revenue required for a million dollar business project to break even falls by $20,000. If the project goes ahead it generates demand for goods, services and labour, bidding the cost of these resources upwards through competition, hence creating an inflationary pressure. It is through this channel of interest rates and investment[4] that monetary policy attempts to control inflation.

Nothing in this article so far should be controversial. The model of central banking I have described is simplified but basically factual and resembles the textbook model taught in schools. Everything that follows is contested, though the textbook model which I will continue to describe is held by most of the economics profession (and many policymakers who studied economics) to be, as with the above description of central banking, simplified but basically factual.

Monetarism and the Mainstream Model

The fractional reserve banking system in the way it is usually taught expands the money supply through the following process:

  1. A customer deposits cash into her bank account.
  2. The bank keeps a percentage in reserves to facilitate withdrawals and satisfy regulations.
  3. The remaining amount (typically 90%) is loaned to another customer.
  4. The loaned cash ends up in other bank accounts and the process is repeated.
  5. After several iterations the lending capacity of the original deposit is exhausted.

At the end of the process the summed balances of all deposit accounts is much higher than the original deposit; the ratio between the larger amount (sometimes called ‘broad money’) and the original deposit (sometimes called ‘base money’) is called the money multiplier. Every new dollar of base money that enters the banking system is subject to this process of multiplication. The central bank encourages investment by buying up government bonds held by banks, which puts more reserves in bank vaults and enables them to make more loans before they reach the minimum reserve ratio. This is essentially the rationale behind conventional monetary policy: the key to stimulating economic activity is to “get banks lending again”.

If monetary policy has pushed interest rates to zero and still not achieved the desired level of investment – as it had in Japan in the mid-1990s and the US since 2008 – it must alter its approach. From the monetarist school of thought comes quantitative easing, wherein the central bank purchases a wider range of financial assets (debt) from banks and decides on a quantity of money to inject into bank reserves rather than a target interest rate. Since banks do not like to sit on idle reserves it is expected that this move will encourage them to extend more loans to investors and the general public.

Quantitative easing is not working. Neither Japan nor the US has yet been able to kick-start production, despite increasingly large injections of money by quantitative easing. Asset holdings at the US Federal Reserve have increased more than 280% since the quantitative easing programme began, rising from $700 billion to over $2 trillion in three years. Real GDP growth meanwhile has hovered between zero and one per cent since mid-2009 after spending most of the 18 months prior in decline.

The Truth about Bank Lending

The key insight to the failure of monetary policy to get the economy moving again comes from an off-mainstream school of thought called Modern Monetary Theory[5] (MMT), which emphasises accounting and certain operational realities of the banking system that have been ignored or forgotten in the mainstream. The reality MMT reminds us of is that bank lending is never constrained by reserves – at the end of the day a bank can always borrow from other banks or the central bank to meet its reserve requirements. If a loan is expected to be profitable the bank will make it, safe in the knowledge it can always find more reserves later – if not from the banks that now have excess reserves after the loaned funds have been disbursed, then from the central bank. This is a reversal of the traditional model, where deposits create loans until the reserve limit is met. In reality, loans create deposits until the demand for loans is met.

Quantitative easing is a solution to a problem that never existed. Trying to “get banks lending again” by making credit cheaper is like trying to get restaurants cooking again by giving them good deals on ingredients – if people aren’t hungry, it’s not going to work. The lack of hunger for loans in the US can be observed through the relationship between interest rates and inflation. The difference between them (interest minus inflation) is called the real interest rate and it represents the financial reward for saving. When the real interest rate is positive, money is in such high demand that investors must compete for the privilege of borrowing it from savers and willingly agree to pay more back in real terms than they borrowed. When the real interest rate is negative (as it is in the US), money is in such low demand that savers must compete for the privilege of lending it to investors and willingly agree to receive less back in real terms than they lent – any interest is better than full exposure to the erosive force of inflation.

The greatest failure of monetarism is that it sees aggregate demand (and hence inflation) as purely a function of the supply of money. Based on the same faulty model of bank lending, monetarists further insist that governments do not attempt to manage demand with fiscal policy. When the government wants to run a deficit it raises the cash by selling bonds on the open market, i.e.: by borrowing from banks. The monetarist position is that this is not expansionary because it merely ‘crowds out’ private investment: the government competition for funds pushes up the price of credit, raising interest rates and discouraging private borrowing. In reality two things happen when the government spends (the order is not important): the treasury issues bonds to the value of the spending it wishes to make, and that balance is credited at the central bank to the reserve accounts of the banks at which the recipients of that spending hold accounts. The banks find themselves with excess reserves that they cannot get rid of by lending amongst themselves, so instead they will attempt to buy government bonds, bidding the interest rate down in the process. This is why deficits do not need to be ‘financed’ – the injection of new reserves into the banking system generates a corresponding demand for government debt automatically.

Though monetarists usually deny that fiscal policy can be inflationary due to the crowding out effect, another perspective from the neoclassical school that monetarism belongs to is that fiscal policy will be excessively inflationary due to the money multiplier effect. Like other predictions that assume banks are waiting on more deposits with which to create new loans, it is bunk; like other mainstream economic theory there is a kernel of truth in the outcome, if not the reasoning that arrived there. There are three channels through which fiscal policy can be inflationary:

  1. Demand directly created through spending on public infrastructure projects.
  2. Demand created by recipients of fiscal transfers (e.g.: welfare recipients) to the extent that this income is spent, not saved.
  3. New income streams (interest payments on government debt) boost net private wealth, inflationary to a similar extent as above.

To understand the last point recall the relationship between net savings and government spending explained in my last post. Debt service payments are merely another form of government spending, contributions to net savings. This is an important nuance in the more comprehensive model used in this post: although monetary policy only creates credit and debt in equal amounts, the means for conducting it also create and destroy income streams in the form of interest payments, which affect fiscal outcomes. The same logic can be used to show an inherent limitation in the ability of monetary policy to create inflation without fiscal cooperation in the form of increased government spending: monetary policy may encourage business investment funded by credit money, but the profits will be taxed with real money, pulling net savings from the private sector and reducing net income. Fiscal policy must work with expansionary monetary policy to prevent this deflationary force from counteracting investment gains.

The Only Thing to Fear

Before going any further we need to be sure what kind of outcome we actually want. Living in a world where we are conditioned to be consumers it is easy to forget that we are merchants of our own labour. All prices are subject to inflation, including our wages: the price of our time. A common misconception is that inflation makes things more expensive. In fact there is no relative effect on the cost of goods in terms of other goods, except perhaps in the short-term before wages can adjust to a shock in some other part of the economy. There are some costs to particularly high rates of inflation: “menu costs” of keeping up with inflation, analogous to restaurants frequently reprinting menus with new prices, and “shoe-leather costs” of managing accounts, analogous to a store manager walking to and from the bank several times a day to deposit cash. People with lots of debt actually benefit from high inflation, because it reduces the real value of their loan and makes it easier to pay off. After the period of hyperinflation in Germany, and when inflation peaked at 25% in the UK in the 1970s, many homeowners found themselves with mortgage burdens much relieved or even paid off completely.  In this way high inflation can be viewed as a wealth transfer from (mostly rich) creditors to debtors[6]. At the lower end (below 5%) inflation serves an essential purpose for money: it encourages people to either spend their earnings or lend it to someone else who will – anyone who tries to keep their money to themselves finds its value eroded away over time.

There is a human factor to inflation which is far more powerful than any combination of monetary and fiscal policy. Expectations – the way confidence and uncertainty manifest in market behaviour – are the entry point for “real economics” into what has so far been largely an accounting model of the macroeconomy. They are the result of the tendency for people to try and stay ahead of the market and all too often their prophecy is self-fulfilling. When the inflation rate is high, expectations of higher costs in the future may result in merchants trying to stay ahead by raising prices a little more today. Since they have all done it the prediction is correct, and the cycle continues, potentially leading to hyperinflation if the supply of savings is sufficiently large, as it is when the public debt is very large relative to GDP. During the height of hyperinflation in Germany (so the story goes) you could leave a wheelbarrow full of money out on the street at night and come back to find someone had dumped out the cash and stolen the wheelbarrow. Hyperinflation is difficult to control, but it is only a danger to countries running very high deficits – usually, when a government fighting a losing war on home turf decides that high inflation is preferable to defeat.

Though inflation must be high and out of control to be problematic, the danger is asymmetrical. Even a miniscule amount of deflation, if it triggers deflationary expectations, will be much worse: with prices falling, any nonessential spending is likely to be put off, since it is expected to be cheaper in the future. Employers who expect reduced demand in the future are less likely to hire new workers and more likely to lay off existing staff, since it is virtually impossible, politically, to reduce workers’ nominal wages even if deflation keeps the real wage growing. Borrowing for investment becomes impractical too, as deflation adds to the real interest rate of the loan and weak demand makes it more difficult to earn sufficient revenue.

It is through this channel of expectations that monetarism brings substance to the claim that inflation can always be controlled with monetary policy. The reasoning is complex and internally (mostly) logically consistent. It works something like this:

  1. Assume that the economy begins in equilibrium, i.e.: all private demand for savings has been met.
  2.  Monetary policy increases the size of the money supply, creating new deposits.
  3. The new money being held is surplus to desired savings; if not saved it must be spent.
  4. Expectations of future demand cause business to respond to loose monetary policy with expansion and investment.

Note here that the use of expectations negates in step four effectively negates the problems we identified earlier in the efficacy of monetary policy in step two. Though unappealing at face value to accept a theory which appears to require a kind of circular logic, begging the question of why loose monetary policy is expected to be expansionary in the first place, the point is moot; the most damning problem is in the very first assumption – in fact, the first assumption of all neoclassical economics – that the macroeconomy is ever in a state of equilibrium. A thorough breakdown of the concept of equilibrium is beyond the scope of this post, but the essence of the idea – the state where forces of supply and demand are balanced across the whole economy – even at a casual glance seems antithetical to the need for monetary intervention at all. Though general equilibrium has been shown to be unstable or infeasible in both academic and professional publications, proponents of neoclassical and monetarist methods have clung to it, asserting that a model should not be judged by the realism of its assumptions but by its experimental performance. Evaluating the performance of the monetarist approach in the current economic climate is left as an exercise for the reader.

This article barely scratches the surface of the complex phenomenon of inflation – but if you have read this far and followed along then you are already at an advantage compared to most political and economic commentators, who view government spending through the same lens as the spending of an individual. They see a balanced budget as the paragon of fiscal responsibility and when the powers that be fail to restart the faltering economies in the US, the UK and Europe they write that no one knows what is going on. The reality is that the answers are out there for those willing to listen. Economist Robert P. Murphy rejected the insights of Modern Monetary Theory on its basis in accounting, stating that “it’s bad economics to confuse accounting identities with behavioural laws […] economics is not accounting.”[7] And yet in a study that found only 13 people who had accurately reasoned and predicted the financial crisis of 2008, the common theme in all their work was an accounting emphasis[8]. I hope that by sharing some of their insights I can help demystify the mystic depths of macroeconomics for others, and with enough time and luck perhaps shift the focus of political debate from the imaginary economic problems prevalent in contemporary discourse to real ones.

[1] Referring to a collection of economic theories first proposed in Austria. Most Austrian economists today are American.
[2] For the purposes of monetary policy. The central bank may purchase currency and other assets outright, e.g.: when it chooses to participate in foreign exchange to set the exchange rate.
[3] Also known as repo contracts, these are agreements that the seller of a bond (not necessarily the issuer) will buy it back after a certain period.
[4] Another important variable here is unemployment, which will be the topic of a future post.
[5] Modern Monetary Theory is one incarnation of the branch of macroeconomics known as chartalism (from the Greek ‘charta’, meaning ‘token’). It is the study of ‘token currencies’ as distinct from currencies made from or backed by commodities.
[6] The reverse situation of deflation, rising real value of debt can trigger mass default. This could also be viewed as a wealth transfer from creditors to debtors, albeit with a much more damaging aftermath.
[7] See: Kuehn, Daniel (2011). “Murphy on the MMTers”.
[8] See: Bezemer, Dirk J (2009). ““No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models

The Origin of Currencies (or: the deficit-savings equality)

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:
GDP = C + I + (G - T) + NX
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:
Y = C + I + (G - T) + NX
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:
G - T = (Y - C - I) - NX
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:

  1. Savings change hands between lender and the recipient of subsequent spending.
  2. 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.