[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.

Never a Waste of Taxpayer Dollars (Ever)

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

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

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

Why increase the superannuation guarantee?

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

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

What’s not to like about superannuation?

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

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

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

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

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

What else does the Opposition support?

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

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

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

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