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.
This was a rather rushed article for a local newspaper. I thought some readers here might be interested too.
In the public debate surrounding Western Australia’s highly regulated retail trading hours one of the chief economic benefits cited by advocates of deregulation has been that longer trading hours create jobs and reduce unemployment. Critics of the theory argue that the retail sector has already exhausted the potential labour pool and that relaxed regulation will simply divert workers from small businesses to larger and more aggressively competitive outlets. In November 2010 the WA government under the direction of Premier Collin Barnett introduced new legislation to lengthen the allowed opening hours for general retail stores by an additional 3 hours on weekdays, allowing shops to stay open until 9pm. One year later critics were quick to point out that the unemployment rate in WA was up by 22 basis points, while others responded that we fared well relative to the overall decline in employment across Australia during that same period, which was 7 basis points higher.
To make any conclusions about how the new trading hours legislation shaped the WA labour market some amount of further examination is required. In 2008 the Australian Bureau of Statistics released a special report on the condition of the retail labour market in WA, providing a basis for comparison in the 12-24 months before and after the new rules were enacted. The ABS also provides a detailed quarterly report on labour markets across Australia compared to which the performance of the WA labour market and the individual industries it comprises can be benchmarked. At time of writing the latest report covers the September-November quarter of 2011, providing a full year of employment data following the 2010 reform.
Taking the data at face value, as at November 2011 there were 3700 fewer workers employed in the retail sector than there were 12 months earlier. Relative to other industries in WA, retail lost half a percentage point of its formerly 10.5% market share, while nationally the retail labour market remained steady at 10.5%. This was not a smooth transition in WA: there was actually a sharp uptick of retail employment share in the six months following the change, obscured in the results by an equally sharp fall from the quarter preceding. This kind of cyclic behaviour makes trends difficult to identify, but in this case even smoothing out the cycles with seasonal adjustments yields, at best, no relative growth in WA’s retail sector since trading hours were extended.
The post-reform declines in both number and relative size of WA’s retail labour market may appear to defy the clear reality that many shops are indeed open later, with supermarket chains such as Coles and Woolworths requiring many workers at each outlet to operate. Identifying the source of this labour requires looking a little deeper, at the composition of employment within the retail sector. ABS data reveals that the extended trading legislation came in the middle of a strong upwards trend in the proportion of retail workers employed full-time. While nationally the retail employment ratio was hovering around 51%, the proportion in WA was racing up from a low of 46% to a peak of over 54% working full-time. Though the total number of retail workers had fallen after the change, there were on average nearly 2,000 more full-time workers during this period. The ABS figures show that full-time employees in retail work twice as many hours as part-time employees, indicating that the nominal loss in employment numbers experienced by the retail sector may be substantially or entirely ameliorated by a large boost to the number of hours worked by the average employee.
Instead of attracting new employees from the outside, when shops were allowed to open later they found the additional labour within their own ranks. Though the effect on unemployment in the state remains unclear, the increased availability of full-time work in the retail sector brings the benefits of greater and more regular income to the wide segment of society employed within in it. Retail in WA employs more workers than any other industry and plays an important role in setting prices for consumer purchases. In the year following the introduction of extended trading hours we have already seen extensive restructuring in the balance between full time and part time employment. The full impact may well be yet to come.
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.
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, 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.
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, 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. 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 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:
- A customer deposits cash into her bank account.
- The bank keeps a percentage in reserves to facilitate withdrawals and satisfy regulations.
- The remaining amount (typically 90%) is loaned to another customer.
- The loaned cash ends up in other bank accounts and the process is repeated.
- 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 (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:
- Demand directly created through spending on public infrastructure projects.
- Demand created by recipients of fiscal transfers (e.g.: welfare recipients) to the extent that this income is spent, not saved.
- 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. 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:
- Assume that the economy begins in equilibrium, i.e.: all private demand for savings has been met.
- Monetary policy increases the size of the money supply, creating new deposits.
- The new money being held is surplus to desired savings; if not saved it must be spent.
- 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.” 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. 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.
 Referring to a collection of economic theories first proposed in Austria. Most Austrian economists today are American.
 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.
 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.
 Another important variable here is unemployment, which will be the topic of a future post.
 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.
 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.
 See: Kuehn, Daniel (2011). “Murphy on the MMTers”.
 See: Bezemer, Dirk J (2009). ““No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models”
The Opposition says that if it is elected, it will retain the Government’s proposed increase to the superannuation guarantee from 9% to 12% of wages. The proposed legislation is integrated into the Government’s mineral resources rent tax package, which the Opposition says it will repeal. The Government says their policy is ‘confusing and chaotic‘ because the Opposition can’t say how it will ‘fund’ the reform.
But what does it mean to ‘fund’ an increase in the superannuation guarantee? Superannuation contributions are part of employers’ wage expenses; they’re not paid for by the government. Increasing the superannuation guarantee means the government mandates that you save a greater proportion of your income for retirement — hardly a policy inspired by the Liberal Party’s belief in “a lean government that minimises interference in our daily lives; and maximises individual and private sector initiative.” Why does the Opposition support this part of the Government’s agenda when it has been so obstinate in blocking the rest of it? And if superannuation contributions are paid for by employers, what does this have to do with the mineral resources rent tax?
What’s not to like about superannuation?
Superannuation is widely credited as one of the “three pillars” of Australia’s retirement income system; a successful product of the Hawke-Keating reform era. (The other two pillars are normal private savings and the means-tested age pension.) Recently, the Association of Superannuation Funds of Australia attributed Australia’s strong economic performance during the global financial crisis to the stabilising influence of the superannuation industry.
Others argue that superannuation is a regressive giveaway to the rich, noting that 50% of the tax concessions on superannuation income go to the top 12% of income earners. Superannuation funds are taxed at a flat 15%, which means contributions attract a tax concession for taxpayers above the 15% marginal tax rate bracket. That means those earning under $37,000 receive no net concession, and those earning under the tax-free threshold actually increase their tax burden by making superannuation contributions. High income earners receive large tax concessions, which they can amplify by using their larger discretionary incomes to make additional voluntary contributions to superannuation.
It is because of this tax expenditure that the Government has linked the superannuation guarantee increase to the mineral resources rent tax. Superannuation tax concessions (including the concessions on the income earned on assets already in a fund) currently cost the budget $27 billion a year — already about as much as the aged pension. According to the explanatory memorandum to the Superannuation Guarantee (Administration) Amendment Bill 2011, the concessions will cost an additional $500 million per year by 2014-15 — when the guarantee has increased to just 9.5%. In subsequent years, the rate accelerates: it begins increasing by 0.5% (rather than 0.25%) per year until it reaches 12% in 2019-20. The explanatory memorandum does not attempt to forecast the cost of the tax concessions so far into the future.
The plurality of superannuation savings (about a third) are held in retail superannuation funds, which perform worse than their non-profit counterparts. Increasing the superannuation guarantee is a subsidy to the financial companies that profit from increased superannuation account balances. And amongst all funds “the best annual returns [are] as high as 7.07 per cent.” Six and twelve month term deposits yielding around 6% have been available to those prepared to shop around for the last few years (although this looks set to change). Does mandatory investment in superannuation funds really offer enough reward to justify the risk of more losses like those suffered in 2008?
Self-managed superannuation funds offer members the ability to take control of their own investments, but the annual administration and tax compliance costs usually amount to a few thousand dollars. This means that self-managed superannuation is only financially viable for those with balances in the hundreds of thousands.
What else does the Opposition support?
The Government’s superannuation legislation involves more than just increasing the superannuation guarantee rate — it also contains a number of initiatives designed to reduce inequality in the superannuation system. The Government proposes to:
- increase the superannuation age limit to 75 (after which employers stop contributing to employees’ superannuation);
- introduce MySuper, an accreditation regime for ‘default’ superannuation products designed to standardise fee structures, making it easier to compare fees and promoting competition; and
- provide a government-funded contribution of up to $500 for low income earners, offsetting the tax disadvantage created by the 15% tax rate.
The Opposition supports abolishing the superannuation age altogether, but its position on the other reforms is unclear. In April 2010 it described MySuper-type reform as an attempt to “dumb down superannuation,” which “could kill the goose that laid the golden egg”. In October 2010 it rightly pointed out that increasing the superannuation guarantee to 12 per cent contradicted the advice in the Henry tax review, which said the superannuation guarantee rate should remain at 9 per cent. It described the effect of an increase as “a 3% cut in take home pay for working families” — yet just three months earlier it said the cost would be borne by employers, citing the Government’s inability to “point to any wage restraint that shows employees are taking superannuation increases instead of pay, that might produce a ‘cost’ to government for missed income tax.” Yet the Opposition has now decided to keep the legislation if elected.
Given its obstructive attitude over the past few months, it is surprising to see the Opposition support Labor’s position on the superannuation guarantee. The case for the superannuation guarantee is much weaker than the economically-straightforward argument in favour of the carbon tax. The Opposition should clarify its grounds for supporting an increase in the superannuation guarantee, and should confirm whether it intends to continue policies such as MySuper or introduce ways to make the taxation of superannuation more equitable.