Governments should spend more and tax less to reduce their deficits.

There’s no mistake in the title! To understand economics as it works at the macroeconomic level means we cannot just assume that what works for us as individuals or households also works for currency issuing governments like the UK, the USA and Australia. At first look,  it’s almost as if we have gone down the rabbit hole and we really are in a parallel universe. It is tempting to quote Lewis Carroll’s Queen in “Through the Looking Glass”:

“Why, sometimes I’ve believed as many as six impossible things before breakfast.”

But Alice was quite right in saying:

 “one can’t believe impossible things.” 

We just need to look at the problem from the right perspective to make sense of it all. Any currency issuing government, such as the USA, the UK, or Australia  need never have a Greek type debt problem providing it understands how its own economy works.

The government deficit can be expressed as:

Govt Deficit = Savings of Everyone Else = Private Domestic Savings + International Savings

or

Govt Deficit = Private Domestic Savings + BOP deficit(trade)

In other words, if everyone else in the world wants to save in US dollars, UK Pounds or  Australian dollars which they must if want to sell these countries more stuff than they buy from them, then the governments, or the Private Domestic Sectors in these countries, have to run a deficit.

If the Governments try to reduce their deficits by cutting spending and raising taxes then all they will do is force their economies into recession or even depression.

If they do really want to reduce their deficits, they would have to discourage everyone else saving. In the UK, that would include overseas trading partners who sell to the UK more than they buy from the UK and save the difference.

The way to do that would be to keep interest rates low and engineer some inflation, just a few % should be enough,  into the system – by increasing government spending and reducing taxation. So, perhaps counter intuitively, the way to reduce the government’s deficit in the longer term is for it to spend more and tax less in the shorter term.

Note: I’m not arguing that governments should make deficit reduction a primary object of economic policy. The government’s fiscal policy should always be aimed at steering a sensible middle course between having too much inflation on the one hand and too much unemployment and too many business failures on the other.

But, inevitably, there will always be those neoliberal types  who focus on the government’s deficit. They always seem bewildered that it doesn’t change in the way what they expect it to, and this article is an attempt to explain why.

 

Is a Happy New Year Possible for 2016?

In April 2014 I wrote:   Stand by for the next UK crash! ETA 2016

I didn’t use my crystal ball which has never proved very reliable, in any case, when it comes to forecasting football scores or racing results. The reasoning was based  on the rate of fall in the financial position of the UK private domestic sector. It was obvious, then, that serious private sector debt problems would start to arise in mid to late 2015 if government policies carried on as they were.

Two recent articles by Owen Jones in the Guardian and Nigel Morris in the Independent  bear this out. Government policies have indeed been carried on as they were.

There is a very real danger of an economic crash as Owen Jones argues although he doesn’t have quite the right explanation. It’s really not much to do with the need for increased industrial productivity. The productivity of  UK and European industry is higher than it has ever been. Yet the economic problems are worse than they have been since the 30’s. Clearly Owen Jones, much as we might admire his political stance,  is barking up the wrong tree.

Simply, if the UK wants to run a 5% of GDP deficit in its Current Account Balance of Payments, someone has to fund that by borrowing. Usually it is government which has assumed that role but increasingly the burden is being shifted onto the Private Domestic sector.

It may work in the short term but soon the private sector will be increasingly unable to raise the necessary loans especially if there is a fear of higher interest rates, and a general credit crunch in the economy. The words ‘credit crunch’ started to become a cliche of all 2008 financial commentary  just prior to the GFC. We are starting to hear them again on a more regular basis.

It’s not looking good!

PS/Edit

The graphical basis of my concern. A modified screen shot from Neil Wilson’s blog “3poken”.

Germany vs Greece. The end game?

It looks like it’s crunch time. Either there will be some last minute cobbled together agreement to prolong the agony, or Greece will be forced to leave the Eurozone. Most neo-liberals take the simplistic view that Greece borrowed the money and has an obligation to repay come what may.

When bankers issue loans they have to be sensible and only issue loans to creditworthy customers. If the customer cannot repay the days when they were placed in a debtors prison are long gone. In any case we should not look at macroeconomic problems in microeconomic  terms. Germany has a net annual surplus of over €200 billion which, by definition, it is not re-spending. Another few billion euros, extracted under duress from Greece, would make no difference whatever to the living standard of German workers – many of whom are not at all well paid.

It would make much more difference if Germany moved to abolish its trade surplus. That would certainly increase living standards in Germany and also allow Greece and others to trade their way out of their debt problem.

Germany has been foolish in several ways. Foolish to lend the money, but also foolish in not understanding the basics of macroeconomics. Prof. Yanis Varoufakis reports that he’s done his best to explain some basic theory to their supposed brightest and best but the more he tries the more upset they become!

Simply, they don’t understand that there are consequences to running an annual surplus of over €200 billion. Where do the Germans think those euros come from? They cannot print them themselves like they could with the DM. They cannot come from the UK or USA. They pay for German exports in £ and $.

They have to come from other euro using countries which means they don’t have enough euros left to run their economies properly. It’s not just Greece. Albeit to a slightly lesser extent it’s Italy, Spain, France etc too.

Alternatively, they have to be created by the ECB or by the Bundesbank  with ECB approval. So if the ECB can do that for Germany, why not for Greece?

Muddled Thinking Watch #7: Chuka Umunna on Labour’s pre-GFC Deficit

Chuka makes some valid points in his recent Guradian article:

http://www.theguardian.com/commentisfree/2015/may/09/labours-first-step-to-regaining-power-is-to-recognise-the-mistakes-we-made

For example he acknowledges that:

” First, we spoke to our core voters but not to aspirational, middle-class ones. We talked about the bottom and top of society, about the minimum wage and zero-hour contracts, about mansions and non-doms. But we had too little to say to the majority of people in the middle.”

Partially right. “The majority of people” are in the middle. So, in a democracy, to win elections, you have to not only speak to, but also win support from,  “the majority of people”. There’s no getting away from that.

Whether Labour spoke to its core voters is a matter of opinion. I’d argue they may have spoken to them, but they didn’t listen, which is slightly different.

He also makes some invalid points. He says:

“Of course, the last Labour government should not have been running (an albeit small and historically unremarkable) deficit before the financial crash. “

The last Labour government certainly made more than a few mistakes. George Brown famously  made the ludicrous claim that he’d abolished “boom and bust”.  The period  of the Labour government  (13 years) consisted of mainly years of boom, which enabled it to achieve electoral success,  except the last 2 years were years of bust, or trying to recover from the 2008 bust, which brought about its downfall.

But did they make a mistake about the government’s deficit? The boom was caused by too much credit being created by the private sector. I don’t believe there is any dispute on that point. That credit inflated asset prices, firstly shares in the dotcom boom and then property prices in the years up to 2008.  With the benefit of hindsight what should they have done to prevent that credit bubble? They, or their so-called “independent” Bank of England,  should have increased interest rates.  If there’s too little saving and too much borrowing then interest rates should rise. Is there any dispute on that point? That would have stopped the credit bubble. No problem.

But if they’d done that there would have been a problem of the £ appreciating in value. Exports would have become uncompetitive. That, and the reduction in domestic borrowing, and therefore, spending, would have led to less economic activity. Business failures and unemployment would have risen.

So what else would the Labour Government have had to do to compensate? Run a tighter fiscal policy, with a lower deficit, or a looser fiscal policy with a higher deficit?

If you think you know the answer, please email it, with an extremely simple to understand explanation,  to:

chuka4streatham {at} gmail(.)com

PS  I’ll ask Chuka if he can provide a small cash prize for the best answer. 🙂

Why not give control of the fiscal deficit to the Bank of England?

In a democratic society, I would argue that decisions regarding interest rates, both long and short term, should be made by the elected government. They used to be. However, for nearly 20 years, short term rates in the UK have been set by the BoE. The level of short term interest rates is important and it can be adjusted to stimulate a slowing economy or slow an overstimulated economy. But there are other adjustments that can be made too.

Just as a pilot has all the control levers at his disposal when he’s flying a plane (if he, or she, does hand over to the co-pilot it would be all the controls not just one) then all the controls need to be either in the hands of government or the hands of the central bank.

But just who has the controls when it comes to controversial policy decisions like QE? Does an  independent Bank of England decide, all on its own, to buy up £375 billion of government securities from the private financial sector? I don’t think so!

QE is no big deal. That’s not a common view, I’ll agree, but from a scientific perspective, there seems to be no reason why the issue of government , or the BoE if you prefer, IOUs in the form of cash should be any more or less inflationary to the economic system than the issue of IOUs in the form of gilts (treasury bonds). If it is necessary to buy back gilts from the private sector to control longer term interest rates then that’s what needs to happen.

So why not give control of the fiscal deficit to the BoE too? The BoE could calculate the best combination of fiscal and monetary policy, including whatever level of QE is needed, and tell the government what it needs to do. Arguably the government could decide to raise income tax a bit here or reduce VAT a bit there , etc, but it would not have complete control of fiscal policy as it now does.

This is not my favoured option BTW. But, if the pilot is going to hand over the (macroeconomic) controls to his or her co-pilot it should be all the controls and not just one.

Unfunded Promises? No such thing!

All Govt spending  comes back as taxation eventually. Where else can it go? So, there’s no such thing as “unfunded promises” or “unfunded spending”.  Now that the UK’s election campaign is well underway we are hearing  accusations along the lines that their opponent’s sums “don’t add up” ,  or “they haven’t done their costings properly” . It is  from both sides. It’s not just the right wing that doesn’t understand how money flows in the economy. Labour is just as bad, and maybe even worse, than the Tories at the present time.

Money arrives in the economy when government spends it in and leaves the economy when government taxes it out. More can’t leave than arrive for other than a limited amount of time. It’s physically impossible.

The government doesn’t tax it out because it needs the money. Why would it? It’s created it in the first place. The UK government hasn’t adopted the euro, the UK government still has total control over the issuance of its own currency. It’s like saying a theatre needs to collect its theatre tickets because it needs the tickets. Or the Post Office needs to collect back its stamps because it needs the stamps.

The government imposes taxes to cancel its stamps and tickets – effectively. It does that to prevent high inflation in the economy. So, providing inflation is under control, government spending can be allowed to rise – especially if there is slack in the economy and there is an unemployment and underemployment problem. If inflation isn’t under control spending needs to be trimmed back or taxation increased.

If we are worried about the future economy that our children will live in, we only need think about the one we live in now to know what the real worries should be. What do we thank or blame our predecessors for? We thank them for the railway network, the road system, the health service , the education system etc. We blame them for some of their past environmental practices which mean that rivers have to be cleaned up, buildings which should be white are actually black with accumulated soot, some of their slipshod practices over the disposal of nuclear waste etc.

Do we worry about the ‘debts’ they accumulated? Not at all. They are of no consequence to us now.

Are Government Bonds Just Another Form of Money?

Most mainstream economists would argue they are not. They would say  cash and bonds are not economic equivalents.  They would argue that issued money wasn’t debt but issued bonds were. A common counter argument would run as follows:

“This idea  falls apart at the local gas station…  you can’t go shopping, bar-hopping, or on vacation to Miami with a bunch of T-bills and not notice the difference compared to cash…therefore, they are NOT ECONOMIC SUBSTITUTES. Let’s be very clear here: nominal financial *value* DOES NOT EQUAL purchasing power.”

I’ve quoted here from an on-line discussion I’ve just had on this same topic.

The argument on whether bonds are, or can be considered to be money, has perhaps to be considered on several levels. Of course if we need to pay a £9 grocery bill a (genuine) £10 note will be very acceptable  to the cashier. A £10 bond, were it to exist in paper form wouldn’t be. Neither of us would know exactly what it was worth at the time. If it was close to maturity it could well be worth something close to £10 but if not, it might not be enough to cover the £9 bill. That’s the only difficulty.

The acceptability argument, though, would also fail €500 notes in Europe. They aren’t easy to spend! No-one wants them.  Does that mean they aren’t cash or even money? The best way to get rid of them is to take them into a bank where you have an account and pay them in. The cashier will probably take a note of the serial number in case there is any problem. In that respect a €500 note is no more useful than a paper bond. We’d be able to pay that into our bank account too.

To answer the question we need to consider what money is and why it has a value. To fit in with the concept of financial sector balances, money has to be classed as a liability or a debt to the issuer and an asset to the holder.

So, if we have a closed system of say 100 currency users and their ‘government’ issues 10 currency units to each, the government then has a fiancial debt/liability of 1000 currency units and the users have total assets of 1000 currency units.

The users later switch half their assets to bonds. Say they each buy, at auction, 5 cu of bonds from their government (on the promise that they will be worth, say, 10 cu at some future time) their total assets are still 1000 cu as they can trade the bonds for exactly what they paid for them between each other or even sell them back to the government, if it should have a policy of QE!

The government still has total liabilities of 1000 cu. The fact that it created new IOUs (bonds) and swapped them for its previously issued IOUs (Cash) is of little signficance. If the effective interest rate on those bonds is zero, then zero significance.

The commonly held view that cash and bonds are somehow fundamentally different probably is a hangover from gold standard days. If the government had a policy of backing its cash IOUs but not its bond IOUs with gold,  it would make some significant difference. If gold held in bank reserves by government was counted as a financial asset, then issued money wouldn’t represent any net debt, providing it was always on a strict 1:1 basis.

Of course it is arguable that gold is just a commodity like all the other commodities owned by the government and shouldn’t be counted. But if the mindset is that MONEY=GOLD it’s possible to see the logic of the alternative argument.

Balancing the Budget !

As election time draws near in the UK , and the US presidential election campaigns start to get underway across the Atlantic,  we’ll no doubt hear a lot about this topic shortly, if we haven’t already.  Apologies if you’ve heard this all before but the political and economic mainstream still don’t grasp it. Political parties will accuse their opponents of making “unfunded promises”, and of having “black holes” in their budgets etc . Nations’ finances will be likened to a household.

Except that Sovereign Governments, like the USA and UK are issuers of currency. They aren’t at all like a household. If a household has a deficit of say £10k pa then, generally speaking, spending cuts of £5k coupled with an extra £5k of earnings will fix the problem. How many times do we see see the same logic applied to countries too? It never works. It can’t work. Governments afterwards wonder why. It isn’t difficult to understand:

Money coming into the Private Domestic Sector , which is essentially what we all think of as “the economy” can only be from two sources. Government spending directly into it (Gsp) , and payments from overseas for exported goods and services. How can anyone possibly think that reducing Gsp isn’t going to affect Taxes paid? Every £ or $ collected in tax originally comes from Govt spending.

The ability of the economy to deliver taxes to the government has to be directly related to its income. Reducing its income will  make us all poorer and reduce our ability to deliver those taxes.  Spending cuts won’t do anything like as much towards reducing that deficit as is usually supposed.

How much simpler could it be?

And yet if the “balanced budget” cretins get their way what will happen?  The government will makes cuts, tax revenue will fall and the deficit will end up not much different to what it was previously. The cretins will then argue they didn’t make enough cuts and that they’ll need to make more on the second round. And so it will go on, with increased levels of unemployment and business failures at every stage.

We just can’t let this happen. It’s madness.  Instead of forcing the budget to “balance”, we should should look at balancing all the money flows to maximise our economic potential.

Eurozone electors have been sold a lemon!

Being sold a lemon means you have been tricked into buying something which is seriously defective. When you say that something is a lemon it implies that it is useless because it fails to work properly.

That’s a pretty good description of the the German dictated piece of financial engineering known as the Euro. It must rate as one of their worst ever engineering efforts. Even the much maligned East German Trabi is an engineering marvel by comparison.

Unlike the euro system, the Trabi has a starter motor to re-start the engine  after it has stalled!

The Euro, and the GSP rules that go with it, is clearly not fit for purpose. The Greek electorate is more than justified in demanding it be fixed under warranty. However, the makers have just declined, and are even insisting that the problems are all of the customer’s own making. No-one else has reported any problems! Except the Spanish, the Irish…….

There has to come a time when the buyer has to consider a  “lemon” is much more trouble than it is worth. The buyer  needs to stop making any further payments,  ask for a refund, ask for damages too,  and ultimately get rid of it.

Germans don’t understand how currency unions need to function.

The economic clash between Greece and Germany is invariably portrayed as a clash of cultures. The majority of Germans resent what they see, and are assured by those who should know better, as a bailing out, at their expense, of those in the southern peripheral European countries who appear to be unable to manage their economic affairs as well as they can.

      

That seems a perfectly commonsensical point of view but raw ‘common sense’, as always, in economics cannot be relied upon to be the best guide. Our common sense is invariably derived from our own micro-economic experience. The principle that it is better to be in surplus than deficit, for example, works fine for us as individuals in the micro world, but taking a wider view, that commonsensical notion is inconsistent with the basic accounting principle that for every asset there has to be a debt. For every surplus there has to be a deficit. Not everyone can be in surplus and not everyone can be in deficit.

So we need to correct our ‘commonsense’. Physicists, like Angela Merkel who therefore can have no excuse,  are used to doing exactly that. They know that their commonsense viewpoints of the world will only take them so far. It fails completely after that. Anyone who has studied Maxwell’s equations, Quantum Mechanics or Einstein’s Relativity knows that these subjects can make your brain hurt! After a while, we have to come to the conclusion that it is better to try to understand via the mathematics of it all rather than understand completely.

It is nowhere near as bad in economics,  but still just a little lateral thought is required. The easiest way to understand what needs to happen in the single currency eurozone, is to make a comparison with what already does happen in a successful currency union.

Let’s take a look at how it all works in the USA. The United States has, as we all know,  a common currency but also  a Federal Government to conduct macroeconomic policy, and transfer surpluses from the wealthy parts of the US to the poorer parts. It transfers surpluses. It does not arrange loans, except perhaps for special projects. If it did, the wealthier parts of the USA would end up as massive creditors. The poorer parts would end up as massive debtors. There would be clashes between New Jersey, the wealthiest state, and Mississippi the poorest.  I had to look this up , by the way. I suspected that Mississippi might be the poorest but I had no idea which was the wealthiest. I had thought maybe California. That’s as it should be. It should not be like it is in the Eurozone where the wealthy states never tire of letting everyone else know who is paying the bills.

So, imagine New Jersey  providing big loans to an impoverished Mississippi, dictating that it implement  privatisation of public assets at knock down prices and drastic cuts to state spending, pensions, its education service etc to be able to repay those loans.  The Mississipians and the New Jerseyites would be saying exactly the same things about each other as the Germans and Greeks are saying now!

So, just as any transfer of funds between New Jersey and Mississippi has to be just that, ie a transfer and not a loan,  so too it needs to be between Germany and Greece in the Eurozone.

The German taxpayers may well not like that idea. It certainly would not have been properly explained to them just what they were letting themselves in for when the Euro was created. No politician in any of the Eurozone countries would have dared make that explanation! It would have been career suicide. There were economists around who did their best to explain it all but they weren’t listened too.

It is too late for that now, but the reality of what has been created, in their name now needs to be recognised and understood by all. Some rethinking is in order. That has to start with the Germans,  then the Dutch and then everyone else too. The sooner the better.