It’s Hard Being a Bear (Part Six)?Good Alternative Theory?

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If the econ­o­my does in fact recov­er from the Glob­al Finan­cial Cri­sis—with­out pri­vate debt lev­els once again ris­ing rel­a­tive to GDP—then my approach to eco­nom­ics will be proven wrong.

But this won’t prove con­ven­tion­al neo­clas­si­cal eco­nom­ic the­o­ry right, because, for very dif­fer­ent rea­sons to those that I put for­ward, mod­ern neo­clas­si­cal eco­nom­ics argues that the gov­ern­ment pol­i­cy to improve the econ­o­my is inef­fec­tive. The suc­cess of a gov­ern­ment res­cue would thus con­tra­dict neo­clas­si­cal eco­nom­ics just as much—or maybe even more—than it would con­tra­dict my analy­sis.

The actu­al rea­sons for this belief are arcane, but this choice quote from lead­ing neo­clas­si­cals Thomas Sar­gent and Neil Wal­lace puts the dom­i­nant neo­clas­si­cal case in a nut­shell:

In this sys­tem, there is no sense in which the author­i­ty has the option to con­duct coun­ter­cycli­cal pol­i­cy. To exploit the Phillips Curve [a rela­tion­ship between unem­ploy­ment and infla­tion], it must some­how trick the pub­lic. But by virtue of the assump­tion that expec­ta­tions are ratio­nal, there is no feed­back rule that the author­i­ty can employ and expect to be able sys­tem­at­i­cal­ly to fool the pub­lic. This means that the author­i­ty can­not expect to exploit the Phillips Curve even for one peri­od. Thus, com­bin­ing the nat­ur­al rate hypoth­e­sis with the assump­tion that expec­ta­tions are ratio­nal trans­forms the for­mer from a curios­i­ty with per­haps remote pol­i­cy impli­ca­tions into an hypoth­e­sis with imme­di­ate and dras­tic impli­ca­tions about the fea­si­bil­i­ty of pur­su­ing coun­ter­cycli­cal pol­i­cy.’ (“Ratio­nal Expec­ta­tions And The The­o­ry Of Eco­nom­ic Pol­i­cy”, Jour­nal of Mon­e­tary Eco­nom­ics, Vol. 2 (1976) pp. 177–78; emphases added)

The neo­clas­si­cal con­fi­dence that the gov­ern­ment can’t ben­e­fi­cial­ly affect the econ­o­my is thus based on the insane assump­tion of “ratio­nal agents” who live in a world that is per­ma­nent­ly in equi­lib­ri­um, and whose expec­ta­tions about the future are accurate—something that Ross Gittins’s recent col­umn did a good job of cri­tiquing. The real world is inhab­it­ed by real, fal­li­ble human beings, who are prone to bouts of irra­tional exu­ber­ance, sus­cep­ti­ble to Ponzi Schemes dis­guised as invest­ment, and who live in a world in per­ma­nent dis­e­qui­lib­ri­um and with an uncer­tain future, in which their expec­ta­tions are almost always wrong. They are there­fore inca­pable of pre­dict­ing and there­fore neu­tral­iz­ing the impact of gov­ern­ment pol­i­cy, as neo­clas­si­cal the­o­ry assumes that “ratio­nal agents” do.

There are oth­er strands in neo­clas­si­cal the­o­ry that argue there is some role for the gov­ern­ment in con­trol­ling the economy—notably the so-called Tay­lor Rule which argues that the Cen­tral Bank can con­trol the econ­o­my by fine tun­ing the inter­est rate. Tay­lor him­self is argu­ing that devi­a­tion from his rule—when the Fed­er­al Reserve under Greenspan held inter­est rates at near zero after the burst of the Dot­Com bub­ble in 2000 – is what caused the cri­sis. I dis­agree, but that’s a top­ic for a lat­er day.

The gen­er­al propo­si­tion remains that in its over­all bias, neo­clas­si­cal the­o­ry argues that the gov­ern­ment can’t ben­e­fi­cial­ly influ­ence the economy—and there­fore that if there is a gen­uine, sus­tain­able recov­ery as a con­se­quence of the gov­ern­ment stim­u­lus pack­ages, that con­tra­dicts neo­clas­si­cal eco­nom­ics even more than it would con­tra­dict my approach.

That means that if there is a “win­ning” eco­nom­ic the­o­ry out there, then it must be one that argues that gov­ern­ment action alone can help an econ­o­my recov­er from a cri­sis, and indeed main­tain out­put growth at a lev­el that will main­tain full employ­ment.

There is one “neo­clas­si­cal” the­o­ry that argues this, which most economists—reflecting their non-exis­tent train­ing in the his­to­ry of their own discipline—actually think is Key­ne­sian. This is the so-called “IS-LM” mod­el, which argues that the gov­ern­ment can manip­u­late employ­ment via fis­cal pol­i­cy. Neo­clas­si­cals are like­ly to retreat to this model—and declare them­selves “Born Again Key­ne­sians” in the process—without real­iz­ing that the orig­i­na­tor of this mod­el, John Hicks, reject­ed it on very sound grounds almost 30 years ago.

Hicks real­ized that his mod­el attempts to rep­re­sent the econ­o­my using just two markets—goods and money—when there is of course anoth­er impor­tant mar­ket: that for labour. He omit­ted the labour mar­ket from his mod­el on the basis of what neo­clas­si­cal econ­o­mists call “Wal­ras’ Law”. This is the propo­si­tion that, if all but one mar­ket in an econ­o­my are in equi­lib­ri­um, then that final mar­ket must also be in equi­lib­ri­um.[1]

Writ­ing in 1979 in the non-ortho­dox Jour­nal of Post Key­ne­sian Eco­nom­ics, Hicks real­ized this flaw (and sev­er­al oth­ers) in this log­ic: it can apply only when the econ­o­my is in equilibrium—when both the goods mar­ket AND the mon­ey mar­ket are in bal­ance. That, in terms of the mod­el, is where the two curves cross. But the mod­el is used to sim­u­late what is sup­posed to hap­pen when one or both mar­kets are not in equi­lib­ri­um, or when one curve—normally the IS curve—is shift­ed by delib­er­ate gov­ern­ment pol­i­cy, such as run­ning a deficit dur­ing an eco­nom­ic cri­sis. There­fore it is used to try to describe what hap­pens in dis­e­qui­lib­ri­um.

But in disequilibrium—anywhere on the dia­gram apart from where the two curves cross—Walras’ Law can’t be used to ignore what’s hap­pen­ing in the labour mar­ket. So even work­ing from Hicks’s mod­el, neo­clas­si­cal econ­o­mists would need to con­sid­er dis­e­qui­lib­ri­um dynam­ics of 3 or more mar­kets. Hicks damn­ing­ly con­clud­ed that:

the only way in which IS-LM analy­sis use­ful­ly sur­vives — as any­thing more than a class­room gad­get, to be super­seded, lat­er on, by some­thing bet­ter — is in appli­ca­tion to a par­tic­u­lar kind of causal analy­sis, where the use of equi­lib­ri­um meth­ods, even a dras­tic use of equi­lib­ri­um meth­ods, is not inap­pro­pri­ate. (Hicks, J. 1981, ‘IS-LM: An Expla­na­tion’, Jour­nal of Post Key­ne­sian Eco­nom­ics, vol. 3, no. 2, p. 152; my empha­sis)

Yet as Git­tins point­ed out, and as Paul Krug­man him­self recent­ly con­firmed, neo­clas­si­cal econ­o­mists are so obsessed with equi­lib­ri­um meth­ods that they will shy away from think­ing in dis­e­qui­lib­ri­um terms. As Krug­man put it, right after cri­tiquing neo­clas­si­cal eco­nom­ics for being brain­dead, “I, for one, am not going to ban­ish max­i­miza­tion-and-equi­lib­ri­um from my tool­box”.

I’m sor­ry Paul, but stick with those tools and you’ll nev­er come to grips with Min­sky’s Finan­cial Insta­bil­i­ty Hypoth­e­sis, let alone the actu­al dis­e­qui­lib­ri­um dynam­ics of the real econ­o­my.

So there is no coher­ent neo­clas­si­cal the­o­ry that can take solace from the suc­cess of the gov­ern­ment stim­u­lus pack­ages, should they avert a deep reces­sion and cause a sus­tained recov­ery with­out a rise in the pri­vate debt to GDP ratio.[2] If there is to be a win­ner in this debate, it has to be a non-neo­clas­si­cal school of thought.

There is such a school of thought which has devel­oped in Post Key­ne­sian lit­er­a­ture recent­ly. Known as Char­tal­ism, it argues that the gov­ern­ment can and should main­tain deficits to ensure full employ­ment.

Char­tal­ism rejects neo­clas­si­cal eco­nom­ics, as I do. How­ev­er it takes a very dif­fer­ent approach to ana­lyz­ing the mon­e­tary sys­tem, putting the empha­sis upon gov­ern­ment mon­ey cre­ation where­as I focus upon pri­vate cred­it cre­ation. It is there­fore in one sense a rival approach to the “Cir­cuitist” School which I see myself as part of. But it could also be that both groups are right, as in the para­ble of the blind men and the ele­phant: we’ve got hold of the same ani­mal, but since one of us has a leg and the oth­er a trunk, we think we’re hold­ing on to vast­ly dif­fer­ent crea­tures.

That said, I do have numer­ous issues with the Char­tal­ist approach, but I haven’t stud­ied its lit­er­a­ture close­ly enough yet to write a cri­tique. [3] I also could have dis­tort­ed their argu­ments if I had attempt­ed a sum­ma­ry of their views. So what I decid­ed instead to do is to ask a lead­ing Char­tal­ist, Pro­fes­sor Bill Mitchell from the Uni­ver­si­ty of New­cas­tle, to write a pré­cis of the Char­tal­ist argu­ment (Bill also has a blog on this approach to eco­nom­ics).

This pré­cis fol­lows. I empha­sise in clos­ing my own com­ments that, if there is a gen­uine recov­ery not involv­ing ris­ing pri­vate debt to GDP lev­els, then Char­tal­ism is the only the­o­ry left stand­ing. Neo­clas­si­cal eco­nom­ics is dead.

The fundamental principles of modern monetary economics, By Bill Mitchell, Professor of Economics, University of Newcastle

The fol­low­ing dis­cus­sion out­lines the macro­eco­nom­ic prin­ci­ples under­pin­ning mod­ern mon­e­tary the­o­ry (some­times referred to as Char­tal­ism).

The mod­ern mon­e­tary sys­tem is char­ac­terised by a float­ing exchange rate (so mon­e­tary pol­i­cy is freed from the need to defend for­eign exchange reserves) and the monop­oly pro­vi­sion of fiat cur­ren­cy. The monop­o­list is the nation­al gov­ern­ment. Most coun­tries now oper­ate mon­e­tary sys­tems that have these char­ac­ter­is­tics.

Under a fiat cur­ren­cy sys­tem, the mon­e­tary unit defined by the gov­ern­ment has no intrin­sic worth. It can­not be legal­ly con­vert­ed by gov­ern­ment, for exam­ple, into gold as it was under the gold stan­dard. The via­bil­i­ty of the fiat cur­ren­cy is ensured by the fact that it is the only unit which is accept­able for pay­ment of tax­es and oth­er finan­cial demands of the gov­ern­ment.

The anal­o­gy that main­stream macro­eco­nom­ics draws between pri­vate house­hold bud­gets and the nation­al gov­ern­ment bud­get is thus false. House­holds, the users of the cur­ren­cy, must finance their spend­ing pri­or to the fact. How­ev­er, gov­ern­ment, as the issuer of the cur­ren­cy, must spend first (cred­it pri­vate bank accounts) before it can sub­se­quent­ly tax (deb­it pri­vate accounts). Gov­ern­ment spend­ing is there­fore the source of the funds the pri­vate sec­tor requires to pay its tax­es and to net save, and it is not inher­ent­ly rev­enue con­strained.

So state­ments such as “the fed­er­al gov­ern­ment is spend­ing tax­pay­ers’ funds” are total­ly inap­plic­a­ble to oper­a­tional real­i­ty of our mon­e­tary sys­tem. Tax­a­tion acts to with­draw spend­ing pow­er from the pri­vate sec­tor but does not pro­vide any extra finan­cial capac­i­ty for pub­lic spend­ing.

As a mat­ter of nation­al account­ing, the fed­er­al gov­ern­ment deficit (sur­plus) equals the non-gov­ern­ment sur­plus (deficit). In aggre­gate, there can be no net sav­ings of finan­cial assets of the non-gov­ern­ment sec­tor with­out cumu­la­tive gov­ern­ment deficit spend­ing. The fed­er­al gov­ern­ment via net spend­ing (deficits) is the only enti­ty that can pro­vide the non-gov­ern­ment sec­tor with net finan­cial assets (net sav­ings) and there­by simul­ta­ne­ous­ly accom­mo­date any net desire to save and hence elim­i­nate unem­ploy­ment. Addi­tion­al­ly, and con­trary to main­stream eco­nom­ic rhetoric, the sys­tem­at­ic pur­suit of gov­ern­ment bud­get sur­plus­es is nec­es­sar­i­ly man­i­fest­ed as sys­tem­at­ic declines in pri­vate sec­tor sav­ings.

We often read that the appro­pri­ate fis­cal stance is to bal­ance the fed­er­al bud­get over the busi­ness cycle. Some econ­o­mists claim the goals should be to run a sur­plus on aver­age over the cycle allow­ing for deficits in extreme down­turns. Both goals would be fis­cal­ly irre­spon­si­ble in Australia’s sit­u­a­tion where our cur­rent account is typ­i­cal­ly in deficit. If the gov­ern­ment bal­anced the bud­get on aver­age and the cur­rent account deficit was in deficit over the busi­ness cycle then the pri­vate domes­tic sec­tor would on aver­age be in deficit (dis-sav­ing) over that cycle. The decreas­ing lev­els of net pri­vate sav­ings financ­ing the gov­ern­ment sur­plus increas­ing­ly lever­age the pri­vate sec­tor. The dete­ri­o­rat­ing debt to income ratios which result will even­tu­al­ly see the sys­tem suc­cumb to ongo­ing demand-drain­ing fis­cal drag through a slow-down in real activ­i­ty.

In oth­er words, adopt­ing a growth strat­e­gy that relies on increas­ing­ly lever­ag­ing the pri­vate sec­tor is unsus­tain­able. The only way the pri­vate domes­tic sec­tor can save if there is a cur­rent account deficit is for the gov­ern­ment sec­tor to run deficits up to the desired pri­vate sav­ing. Gov­ern­ment deficits “finance” pri­vate sav­ing by ensur­ing that aggre­gate spend­ing is suf­fi­cient to gen­er­ate the lev­el of out­put and income that will bring forth the pri­vate desired sav­ing lev­els.

Unem­ploy­ment occurs when net gov­ern­ment spend­ing is too low. As a mat­ter of account­ing, for aggre­gate out­put to be sold, total spend­ing must equal total income (whether actu­al income gen­er­at­ed in pro­duc­tion is ful­ly spent or not each peri­od). Invol­un­tary unem­ploy­ment is idle labour unable to find a buy­er at the cur­rent mon­ey wage. In the absence of gov­ern­ment spend­ing, unem­ploy­ment aris­es when the pri­vate sec­tor, in aggre­gate, desires to spend less of the mon­e­tary unit of account than it earns. Nom­i­nal (or real) wage cuts per se do not clear the labour mar­ket, unless they some­how elim­i­nate the pri­vate sec­tor desire to net save and increase spend­ing. Thus, unem­ploy­ment occurs when net gov­ern­ment spend­ing is too low to accom­mo­date the need to pay tax­es and the desire to net save.

How large should the deficit be? To achieve full employ­ment net gov­ern­ment spend­ing has to be equal to the non-gov­ern­ment desire to net save to ensure there is no aggre­gate demand gap. Unlike the main­stream rhetoric, insol­ven­cy is nev­er an issue with deficits. The only dan­ger with fis­cal pol­i­cy is infla­tion which would arise if the gov­ern­ment pushed nom­i­nal spend­ing growth above the real capac­i­ty of the econ­o­my to absorb it.

If gov­ern­ments are not rev­enue con­strained why do they bor­row? We have to dif­fer­en­ti­ate vol­un­tary con­straints gov­ern­ments impose on them­selves (which reflect ide­o­log­i­cal dis­po­si­tions) from the under­ly­ing mechan­ics of the bank­ing sys­tem in a fiat mon­e­tary sys­tem.

In terms of the lat­ter, while the fed­er­al gov­ern­ment is not finan­cial­ly con­strained it still might issue debt to con­trol its liq­uid­i­ty impacts on the pri­vate sec­tor. Gov­ern­ment spend­ing and pur­chas­es of gov­ern­ment bonds by the cen­tral bank add liq­uid­i­ty, while tax­a­tion and sales of gov­ern­ment secu­ri­ties drain pri­vate liq­uid­i­ty. These trans­ac­tions influ­ence the cash posi­tion of the sys­tem on a dai­ly basis and on any one day they can result in a sys­tem sur­plus (deficit) due to the out­flow of funds from the offi­cial sec­tor being above (below) the funds inflow to the offi­cial sec­tor. The sys­tem cash posi­tion has cru­cial impli­ca­tions for the cen­tral bank, which tar­gets the lev­el of short-term inter­est rates as its mon­e­tary pol­i­cy posi­tion. Bud­get deficits result in sys­tem-wide sur­plus­es (excess bank reserves).

Com­pe­ti­tion between the com­mer­cial banks to cre­ate bet­ter earn­ing oppor­tu­ni­ties on the sur­plus reserves then puts down­ward pres­sure on the cash rate (as they try to off-load the excess reserves in the overnight inter­bank mar­ket). So bud­get deficits actu­al­ly put down­ward pres­sure on short-term inter­est rates which is con­trary to all the claims made by main­stream eco­nom­ics.

If the cen­tral bank desires to main­tain the cur­rent pos­i­tive tar­get cash rate then it must drain this sur­plus liq­uid­i­ty by sell­ing gov­ern­ment debt. In oth­er words, gov­ern­ment debt func­tions as inter­est rate sup­port via the main­te­nance of desired reserve lev­els in the com­mer­cial bank­ing sys­tem and not as a source of funds to finance gov­ern­ment spend­ing.

How­ev­er, the cen­tral bank could equal­ly just pay the com­mer­cial banks the tar­get rate of inter­est on all overnight reserves which would achieve the same end with­out the need to issue debt. So there is no intrin­sic rea­son for a sov­er­eign gov­ern­ment to bor­row to “finance” its net spend­ing.

The real­i­ty is, how­ev­er, that the neo-lib­er­al era has forced the gov­ern­ments to adopt vol­un­tary con­straints on its fis­cal activ­i­ty which are tan­ta­mount to those that oper­at­ed dur­ing the gold stan­dard peri­od.

So the fed­er­al gov­ern­ment now issues debt to the pri­vate mar­kets via an auc­tion sys­tem $-for-$ with net gov­ern­ment spend­ing (deficits). This alleged­ly impos­es “fis­cal dis­ci­pline” on the gov­ern­ment (it is total­ly unnec­es­sary from a finan­cial per­spec­tive) because the ris­ing debt becomes a polit­i­cal issue. In con­clu­sion, much of the deficit-debt hys­te­ria that defines the cur­rent macro­eco­nom­ic debate is based on false premis­es about the way the mon­e­tary sys­tem oper­ates and the finan­cial con­straints on gov­ern­ment spend­ing.

Mod­ern mon­e­tary the­o­ry pro­vides a sound basis for under­stand­ing the intrin­sic oppor­tu­ni­ties avail­able to gov­ern­ments in a fiat mon­e­tary sys­tem and expos­es most of the con­straints that are imposed on the con­duct of fis­cal pol­i­cy as being of an ide­o­log­i­cal ori­gin.

[1] I reject this argu­ment, but again that’s a sto­ry for anoth­er day.

[2] There is one Neo­clas­si­cal School that Krug­man believes is val­i­dat­ed by the suc­cess of the stim­u­lus pack­ages, so called New Key­ne­sian­ism. Yet again I think that’s wrong, and yet again it’s a top­ic for anoth­er day.

[3] This cri­tique by a Span­ish aca­d­e­m­ic indi­cates that Char­tal­ism is dis­put­ed with­in the broad Post Key­ne­sian school of thought; how­ev­er I should note that some Char­tal­ists regard this cri­tique as a car­i­ca­ture of their views.

PS if you’d like this essay in PDF for­mat, click here.

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