Wednesday, 06/30/2010 – 11:16 am by Marshall Auerback |

Governments are increasingly getting bullied into adopting austerity measures, apparently thinking it will help their economies grow. A number of us who oppose this approach suspect that the austerity measures now being demanded (and implemented) will undermine growth, and when growth finally returns it will be tepid as a result of other factors unrelated to the austerity. In the meantime, there will be massive casualties among the poor and disadvantaged. Ireland is exhibit A.

In April 2009, the Irish government forecasted a decline in Gross Domestic Product (GDP) of 7.7 percent in 2009, and a contraction of 2.9 percent next year, before returning to growth of 2.7 percent in 2011. It had originally projected GDP to shrink by 6.75 percent. There is no sign of growth on the horizon.

“Fiscal adjustment” (as the weasels euphemistically call it now) does not generate growth. It comes WITH growth. The raison d’etre of fiscal policy is to support growth when private spending is undermining it, and to constrain growth when private spending is supporting it. With high unemployment, high public deficits are inevitable. The only choice is between an active deficit, incurred by putting people to work or otherwise serving national needs — such as providing a decent retirement and health care to the aged — and a passive deficit, incurred because tax revenues necessarily fail to cover public spending at high unemployment. Cutting public spending or raising taxes, now or in the future, by any amount, cannot reduce a deficit due to high unemployment. The only fiscal effect is to convert an active deficit into a passive one — with disastrous economic and social effects. Ireland’s experience, captured in a recent New York Times article, vividly demonstrates this point:

As Europe’s major economies focus on belt-tightening, they are following the path of Ireland. But the once thriving nation is struggling, with no sign of a rapid turnaround in sight.

Nearly two years ago, an economic collapse forced Ireland to cut public spending and raise taxes, the type of austerity measures that financial markets are now pressing on most advanced industrial nations.

“When our public finance situation blew wide open, the dominant consideration was ensuring that there was international investor confidence in Ireland so we could continue to borrow,” said Alan Barrett, chief economist at the Economic and Social Research Institute of Ireland. “A lot of the argument was, ‘Let’s get this over with quickly.’ “

Rather than being rewarded for its actions, though, Ireland is being penalized. Its downturn has certainly been sharper than if the government had spent more to keep people working. Lacking stimulus money, the Irish economy shrank 7.1 percent last year and remains in recession.

Read the full article here.

Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator.

ireland-200Responding to Barry O’Leary (IDA), Marshall Auerback argues that austerity measures in Ireland will drain demand, weaken private spending, and actually worsen the deficit.

Barry O’Leary argues that in contrast to the other PIIGS, Ireland will be able to make the adjustments that the EMU is demanding and by cutting “fiscal spending sharply … [to] … pull themselves out of this mess through austerity”. He’s wrong.

People calling for fiscal austerity assume that major cuts can be made in public spending at a time when private sector spending has collapsed, confidence is at a low, and foreign direct investment is weak and paralysed by uncertainty. They also think that you can increase taxes (that is, reduce private demand further) and cut wages (and hence private incomes) and not expect major multiplier effects to make things significantly worse.

The Irish also seem to have bought the IMF line that the fiscal multipliers are relatively low and that the automatic stabilisers (working to increase deficits as GDP falls) will not drown out the discretionary cuts in net spending arising from the austerity packages.

The overwhelming evidence shows that the implementation of policies based on this way of thinking causes generational damages in lost output, lost incomes, bankruptcy and lost employment (especially in denying new entrants from the schooling system a robust start to their working life).

The following graph is taken from the latest Irish National Accounts which cover up to the fourth quarter 2009. Flash estimates for the first quarter 2010 are available but not broken down like this.
ireland_gnp_gdp_growth_rates

The graph shows the difference between Gross Domestic Product (which counts all output produced) and Gross National Product (which exclude the profits of foreign residents) for Ireland. Once you make that correction, then you can see how much worse the domestic contraction has been in the Irish economy.

So GDP was 7.1 per cent lower than in 2008 while GNP was 11.3 percent lower than in 2008.

Once you adjust for this (ignore these transfers) by using Gross National Product (GNP) which “excludes the profits of foreign residents, then Simon Johnson (amongst others) concludes that the “budget deficit was about 17.9 percent of G.N.P. in 2009, and … will be roughly 14.6 percent in 2010 and 15.1 percent in 2011″. They say that “(t)hese numbers make Ireland look similarly troubled to Greece, with a much higher budget deficit but lower levels of public debt”.

However, I part company with Johnson when he argues that the Irish government has to persist with the “tough fiscal steps” and take advantage of the IMF and EU bailout funding to “bridge the tough journey of fiscal cuts ahead”.

From a Modern Monetary Theory perspective, all this is doing is insulating the government from being 100 percent exposed to the private bond markets. It doesn’t stop the demand drain arising from the austerity and the already weak private spending.

It will also not allow the government to reduce its deficit very quickly at all — indeed, as we have witnessed, the budget deficit gets worse and places further strains on the government funding crisis. This vicious circle can only eventually collapse in default (a la Argentina). The same goes for Greece.

The problem is that the Irish government has no real options while they remain constrained by the Maastricht Treaty and their lack of sovereignty. As noted above, while the Prime Minister might define economic sovereignty as the avoidance of default in a fixed exchange rate world, this is far removed from what true currency sovereignty constitutes. The design of the monetary system in which the Irish find themselves is incapable of delivering sustained prosperity and is crisis-prone when there is a major asymmetric aggregate demand shock experienced across the member nations. All the bailout packages and other add-ons will not change that.

Either they have to enter a fiscal union to support the monetary union or the nations should exit the system.

And also, in the specific case of Ireland, I don’t see how they can make credible their guarantee to back all of the country’s deposits, which are 600% of GDP. And they’ll get little help from the Germans who view the growth of their financial services industry to be a form of regulatory and tax arbitrage, which undermined the German economy.

……Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nations around the edges of Europe to justify their actions. And it’s true that bond investors have turned on governments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face of a depressed economy reassures investors. On the contrary: Greece has agreed to harsh austerity, only to find its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to be treated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard-liners’ medicine.

It’s almost as if the financial markets understand what policy makers seemingly don’t: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.

So I don’t think this is really about Greece, or indeed about any realistic appreciation of the tradeoffs between deficits and jobs. It is, instead, the victory of an orthodoxy that has little to do with rational analysis, whose main tenet is that imposing suffering on other people is how you show leadership in tough times. (link to full article)

…Clearly we are nearing the end of the “Phoney War”, that phase of the global crisis when it seemed as if governments could conjure away the Great Debt. The trauma has merely been displaced from banks, auto makers, and homeowners onto the taxpayer, lifting public debt in the OECD bloc from 70pc of GDP to 100pc by next year. As the Bank for International Settlements warns, sovereign debt crises are nearing “boiling point” in half the world economy. (link to full article)

…On the vertical axis we track the fiscal balance, and on the horizontal axis we track the current account balance. If we rearrange the financial balance identity as follows, we can also introduce the domestic private sector financial balance to the map:

Domestic Private Sector Financial Balance = Current Account Balance – Fiscal Balance …

..Or to put it more bluntly, if European countries try to return to 3% fiscal deficits by 2012, as many of them are now pledging, unless the euro devalues enough, then either a) the domestic private sector will have to adopt a deficit spending trajectory, or b) nominal private income will deflate, and Irving Fisher’s paradox will apply (as in the very attempt to pay down debt leads to more indebtedness), thwarting the ability of policy makers to achieve fiscal targets. In the case of Spain, with large private debt/income ratios, this is an especially critical issue.

The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. We remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe’s tradable products, but it is also said that necessity is the mother of all invention (and desperation, its father?). Pray there is life on Mars that consumes olives, red wine, and Guinness beer.

Rob Parenteau, CFA
MacroStrategy Edge
February 22, 2010
* This article originally appeared on NakedCapitalism

Score another one, then, for the high priests of fiscal rectitude. Harsh cuts, tax increases — this is by no means a recovery policy. The capital markets have got their pound of flesh. But Greece is no more able to reduce its deficit under these circumstances than it is possible to get blood out of a stone. Politically, it means ceding control of EU macro policy to an external consortium dominated by France and Germany. Greece becomes a colony.

Nor will the policies work, as the ’strict enough conditions’ imposed will further weaken demand in Greece and, consequently, the rest of the European Union. Furthermore, the rapidly expanding deficit of Greece has benefited the entire EU because it supported aggregated demand at the margin, and the sudden reversal contemplated by this package will reverse those forces.  (link to article)

Check out the discussion following the post by ‘Art’ and ‘Reality’ and Marshal Auerbach himself for a succinct overview of Neo Keynesian v Neo Liberal  viewpoints.

Here is a snippit

Reality, you should only retract government spending when it becomes inflationary, not because of some arbitrary idea that it somehow “distorts” the free market. The point I was making in the previous article on Greece was that the choice of these voluntary “funding” arrangements for governments that are not intrinsically revenue-constrained is always political and never financial. I argued that if citizens realised these were political choices only (reflecting ideology) then they would be better able to compare them with other political decisions such as the austerity measures. In making this point, I argued that once citizens had a better comparison and were not forced into thinking that the financial constraints were real then governments might be more carefully scrutinised and forced into making better decisions with advance public purpose rather than simply fall prey to the notion that the “markets are always right” and “always determine interest rates”.the notion of a “government budget constraint” only applies ex post, as a statement of an accounting identity that has no significance as an economic constraint. In an accounting sense, it is certainly true that any increase of government spending will be matched by an increase of taxes, an increase of high powered money (reserves and cash) and/or an increase of sovereign debt held. But this does not mean that taxes or bonds actually “finance” the government spending. They do not!See this if you want an explanation. Then you’ll be approaching your ‘nom de plume’ , “Reality”:

• http://bilbo.economicoutlook.net/blog/?p=1266

NB: By all accounts, Greece has an uneven taxation collection system and a crazy pensions policy both of which need reform.  But the case for not using savings from cuts in these areas to make productive public investments or for the pre-distribution of an emergency per capita payments has not been made by any commentator. Borrowing to spend on such a fair stimulatory package – following public sector and payments reform – could be justified and might even be supported by the bond market.

The very same critique could be made of the current discourse re Irish government policy. Why are the options only A) maintaining excessive public and semi-state salaries, pensions and consultants fees (promoted by the Unions) versus B)  cuts to the above (promoted by the employers and government). Smart Taxes want to  explore C) which is B) plus major public investment programme and an emergency citizen dividend.

Having said that, Marshal’s plan should be also be considered under whatever scenario A, B, and C.

This short precis (reprinted below but without diagrams) of the paper by New Zealander Lowell Manning (hat tip to James Robertson), explains in economic speak how the current money creation system is the fundamental cause of recessions and depressions.  In revising one of the fundamental equations of contemporary economics concerning money supply, Manning explains why public debt grows inexorably and gives the solution to reducing it without crippling taxation or socially destructive services cuts.

James Robertson says of Manning’s work…

I hope Manning’s work will come to be accepted as important for economists, as the need for monetary reform belatedly penetrates their professional minds.

One practical conclusion is that:

“the effect of unearned interest on deposits is to transfer claims on the real wealth of the nation from those who produce the economic output to those in the investment sector who produce nothing. Houses and other assets become more expensive in terms of the inflated prices in the investment sector but must be bought using the less inflated money of the productive sector.

Unless inflation in the investment sector and the productive sector are equalised, there must be an ever-widening gap between debt-bound wage and salary earners on the one hand and the participants in the investment sector with net deposits in the banking system on the other.”

SUMMARY “THE RIPPLE STARTS HERE”

1694-2009: FINISHING THE PAST

Paper presented at the 50th Anniversary Conference New Zealand Association of Economists (NZAE) 2nd July, 2009

by Lowell Manning.

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“The Ripple Starts Here” revises the Fisher Equation of Exchange first put forward by Irving Fisher in 1911.

The original Fisher equation said simply that the amount of money M in circulation times its speed of circulation V must equal the gross Domestic Product PQ where P is the overall price level and Q the total volume of goods and services produced.

MV = PQ

In Irving Fisher’s time his equation could not be easily checked because much of the information needed to do so was unavailable.  He spent a good deal of his subsequent career developing indices and associated data bases to better measure the economy. In Fisher’s day most economic transactions contributing to the economy were still made in cash and his equation took no account of either Domestic or foreign debt. These days in “modern” developed economies almost all transactions are debt based and cash is all but irrelevant.

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The debt model presented in the paper changes Irving Fisher’s equation to a debt-based equivalent;

MdVp = PQ + (Ms + Mv)Vp

Where Md is the total debt in the economy (each dollar of debt is a dollar of money somewhere), Vp is the speed of the productive debt giving rise to PQ, Ms is the accumulated unearned interest on all bank deposits, and Mv is debt borrowed for speculation.

In the debt model Vp must be 1, because debt can only be spent once. The model can be visualised as millions of separate transactions where the money to produce the goods and services is borrowed during the production phase and then repaid when the product is consumed. The revised debt version of the Fisher equation of exchange then reduces to:

Total debt Md = PQ + (Ms+Mv)

As a first approximation Md is very nearly the country’s Domestic Credit plus its accumulated Current Account Deficit (In the paper, the accumulated Current Account Deficit is the total of all the annual deficits since 1954). Ms is the accumulated interest paid by the productive sector to the investment sector as unearned income.

Ms is really the seigniorage of the modern debt economy that began with interest paid on unproductive debt by the English Crown to the directors of the Bank of England in 1694. That debt and the associated introduction of fiat currency (banknotes) allowed the Crown to avoid politically dangerous tax increases to pay for its war costs. Ms broadly represents the “gap” so often referred to in monetary reform literature.

In New Zealand, Ms has been increasing exponentially at the rate of about 11.2% per year for decades whereas Md has been increasing exponentially at 8.6% per year.

Ms is inherently inflationary because, leaving aside any productivity changes, it means more and more debt has to be used for the same amount of production. In practice the productive sector usually borrows the extra debt each year to fund the unearned income and, by and large, passes on in its prices to consumers any change in its resulting costs.

Mv is the infamous investment “bubble” that grows and decays during each business cycle. When times are “good” the banks lend extensively to investors directly on the assumption that next week’s investment sector prices will be higher than this week’s prices. The banks do this because they increase their profit if they lend more.

Mv bubbles are typically liquidated during recessions and the year or two after they end.

In the revised Fisher equation, Md, PQ and Ms are readily available from statistics, and that means the bubble Mv can for the first time, be accurately quantified.

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The new debt model for New Zealand 1979-2009 is shown in the following figure.

The first and most relevant feature of the model is that all the curves are exponential. To keep afloat, the debt economy is locked into exponential growth of debt and GDP.

The second most relevant feature is that the exponential for the investment sector Ms (11.2%) is much greater than that for the total debt Md (8.6%). That means present and past monetary policy necessarily produces a rapid transfer of wealth from the productive sector to the investment sector. Wage and salary earners are fundamentally disadvantaged relative to those with deposits in the banking system who receive a “free-lunch” in the form of unearned income merely because they have those deposits. Producers get ever less while non-producers get more and more. There is a large, structural and on-going transfer of wealth taking place from the poor to the rich in society. In the present system that transfer in wealth can only be offset through large-scale income redistribution.

The third most relevant feature is that the current financial “architecture” is quite unsustainable. Economic “crashes” become unavoidable as investment sector expectations literally drown the ability of the productive sector to satisfy them.

The model suggests the only way to remedy that fundamental contradiction (assuming we persist with the current system) is for the investment sector to expand at the same rate as the productive economy. That in turn means that both the price and quantity of new debt have to be managed by the government or the reserve bank . Centuries of evidence show that private issue of debt for profit is diametrically opposed to such price and quantity controls. Banks earn more by lending more.

The most recent and classic case is the “meltdown” in the US where a whole raft of derivatives was designed to allow unrestrained and irresponsible lending to patently uncreditworthy customers. Such “pass the parcel” transfers of toxic debt accentuated the underlying systemic risk instead of reducing it. On such grounds alone there is a powerful case for public control of the issue of new debt (and money in the form of electronic cash) and public control of deposit interest rates.

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The debt model offers valuable insights into other areas of major interest to economists.

First, It provides a specific and rational definition of recessions and depressions.

A depression occurs when the change in the total debt over time is less than what is needed to service the unearned interest that has to be paid to the investment sector Ms plus any increase in speculative investment Mv; that is, when there is no provision for either inflation or growth.

A recession occurs when the change in total debt over time is less than what is needed to service the financial system costs, being the unearned interest that has to be paid to the investment sector Ms, plus speculative investment Mv, plus inflation.

Secondly, New Zealand has borrowed ALL of its nominal GDP growth for decades. The accumulated current account deficit is about NZ$100 billion higher than it otherwise would have been, and savings and wealth in the country about NZ$ 100 billion lower. The paper introduces the concept of system liquidity, Mcd, being the GDP less the accumulated current account deficit. Mcd represents transaction account balances plus earned savings. The paper shows Mcd is dangerously low in New Zealand and that there are few earned savings left in the system. Mcd, the debt actually used to produce domestic goods and services, times its speed of circulation Vcd equals the domestically produced GDP. Until quite recently Vcd was reasonably close to what V is thought to have been in the original Fisher equation. The level of earned savings is defined primarily by the debt system mechanics and the current account deficit rather than by individual savers.

Finally, in the absence of tax or other incentives to encourage traditional savings, there is an inherent conflict of interest between increasing productive GDP output and households still holding debt. Economic efficiency will usually induce households to retire expensive debt instead of saving. In the debt model debt retirement reduces economic output.

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The debt model does not, of itself, distinguish between “good” and “bad” GDP but it recognises implicitly that new debt creation should focus on productive activity. To achieve this there is good reason to reserve to the government the issue of new debt, with that debt being spent into circulation in the form of investment in education, health, research, infrastructure and business development.

Following first use of new domestic debt by the government the corresponding deposits would appear in the banking system from where the banks would on-lend it according to monetary policy guidelines published from time to time.

In its 78th annual report (p137) the Bank for International Settlements (BIS) wrote of the current turmoil in the world’s financial centres “A powerful interaction between financial market innovation, lax internal and external governance and easy global monetary conditions over many years has led us to today’s predicament.”

Presently the financial system itself is structured to not only allow, but to encourage those human and institutional failings to which the BIS properly refers. Those failings are largely driven by self interest and greed that are part of human nature. Since human nature is unlikely to change, the world financial architecture needs to be remodelled to keep sticky human fingers out of the global money pot.

Lowell Manning 5/7/09  (Link to paper)

Experimenting with Negative Interest Rates
James Picerno | Aug 31, 2009
As the world’s original central bank, it’s fitting that Sweden’s Riksbank has become the first to breach the zero-bound line by lowering one of its key interest rates to negative 0.25% since July 8.

The drop in the price of money below zero is reportedly the first of its kind. The dip refutes the idea that the zero bound was a barrier for monetary policy beyond which no central bank could tread. Back in 2004, Fed Chairman Ben Bernanke (a Fed governor at the time) co-authored a research paper that advised that “the nominal policy interest rate may become constrained by the zero lower bound.”

Well, so much for a constraint at zero. The Riksbank dropped rates below zero in early July with no more effort than falling out of a chair. Granted, Sweden’s -0.25% deposit rate (the rate that banks receive on accounts held at the central bank) isn’t the main tool of monetary policy in the country. That’s reserved for the repo rate (the Riksbank’s Fed funds equivalent) and it remains at a positive 0.25%, or roughly in line with the current Fed funds rate. Nonetheless, the precedent has been set. Dropping rates below zero has come and gone in the modern age of central banking and the financial world is still standing. In practical terms, the Riksbank’s -0.25% deposit rate means that banks with accounts at the central bank are paying Riksbank 0.25% in interest to keep deposits at the institution. In effect, the arrangement turns the concept of a bank account on its head. Instead of earning interest, depositors are paying the bank to maintain the accounts.

The rationale for the policy is that the negative interest rate will create a disincentive to hoard money, which creates an additional layer of headwind for an economic recovery. In these precarious economic times, that’s considered a risk worth avoiding.

To be sure, there are hazards in going negative. For instance, as Wolfgang Münchau notes in today’s Financial Times, central bankers worry that 1) negative interest rates as a broadly used policy tool remain experimental with unknown consequences; 2) breaching the zero bound might destroy the money market business; 3) negative rates might inadvertently promote speculative activity above and beyond the normal incentives offered in the private sphere.

On the other hand, negative interest rates may be a potent weapon in combating deflation and otherwise promoting economic recovery in the face of an extraordinary economic contraction. ( link to article)

My goodness, our Liquidity Network idea is beginning to look a tad boring and lacking in ambition…

….All three ideas are based on a theory concerning interest rates and the concept that a nominal rate of zero — as Japan has now lived with for much of the past decade — may be too high. In Japan’s case, the theory would suggest that nominal rates of -4 per cent might be closer to what is required to rescue the economy from another deflationary spiral. Having agreed that this might be necessary, the next question is how it could be imposed.  Link to article

The Irish government could copy that strategy to maximise taxpayers contributions, both current and that committed in the future by the sale of bonds.

Inflation as she explains will not be a problem when conventional banks cannot lend to fill the void left by the shadow bankers strike. Therefore there is no danger of too much money chasing too few goods and services.