On the matter of my beliefs. Krugman's quote from me was this:I have, of course, copied this over as James Galbraith should be in a position to set the record straight on what his actual views are.
"So long as U.S. banks are required to accept U.S. government checks — which is to say so long as the Republic exists — then the government can and does spend without borrowing, if it chooses to do so … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system."
Read it again with the *very next sentence* included:
"So long as U.S. banks are required to accept U.S. government checks — which is to say so long as the Republic exists — then the government can and does spend without borrowing, if it chooses to do so … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system. The actual risks in this system are (to a minor degree) inflation, and to a larger degree, depreciation of the dollar."
Does this help resolve what I "appear to believe."? I trust so. What I actually believe is now so thoroughly on the record, there really is no excuse for writing about it without getting it right.
Thank you. James Galbraith
Tuesday, July 20, 2010
Saturday, July 17, 2010
So there is a maximum level of debt you can handle. In practice, if it makes sense to say such a thing with regard to a stylized model, at some point lower than the critical level implied by this model the government would decide that default was a better option than hyperinflation.Krugman is responding to Jamie Galbraith, who appears to believe that money printing and deficit spending can resolve all ills (a regular commentator on the blog appears to hold similar beliefs). I must also add Krugman's caveat to his acceptance that massive deficit spending and money printing might cause hyperinflation:
Now, I’m sure I’m about to get comments and/or responses on other blogs along the lines of “Ha! So now Krugman admits that deficits cause hyperinflation! Peter Schiff roolz” Um, no — in extreme conditions they CAN cause hyperinflation; we’re nowhere near those conditions now. All I’m saying here is that I’m not prepared to go as far as Jamie Galbraith. Deficits can cause a crisis; but that’s no reason to skimp on spending right now.I highlight this from Krugman, as his analysis is very interesting, and I would recommend reading the article in full. It has a few equations, but is largely user friendly. When you are finished reading, you can come back to this post.
The reason I highlight this is that Krugman accepts the principle of seigniorage, an inflationary taxation, and accepts that (somehow) 'the government must persuade the private sector to release real resources'. However, there is an almighty assumption in the entire article that he is looking at a closed system, one in which the resources are closed. He does not exclude the consideration that the 'private sector' might include overseas provider of resources, but seems to believe that they will accept the seigniorage that those within the country might accept. He also fails to note that, even those within the country indulging in money printing have an option of moving their funds to a currency that is not subject to seigniorage.
Here is the problem for, for example, the United States. About $US 4 trillion of US government debt is held overseas, and the US is reliant on continued overseas provision of 'resource' being funded by overseas creditors. If these creditors believe that seigniorage will result in inflation, a tax on their holdings of $US, they will start to find better investments, unless the interest rate offered exceeds the seigniorage. At present, the US has been benefiting from the safe haven/reserve currency status to offset these fears in troubled times. However, as I have long argued, this can only last so long. This view is now starting to become mainstream. This from HSBC (1):
It’s not hard to see how in six months time we will all say it was obvious that the dollar would eventually fall. The US has a highly indebted economy, the global imbalances needed to unwind as the US needs to export more, and EM countries need to import more. Meanwhile, the Europeans have aired their dirty debt in public and taken some measures to address it, whilst the US has not. By this time everyone would have forgotten about the risk on/ risk off fad just as quickly as Dubai disappeared off our radars. As the US economy slows and others in the world raise rates to fend off inflation the dollar will come under pressure. The euro break up premium is coming out and the next phase in this rotation will be a weaker USD and we very well may have seen the first signs of this – the worm is turning.In this scenario, of a falling $US, the US is left in the uncomfortable 'Chimerica' system, in which China continues to fund deficits in order to keep their export machine turning. Again, as I have long argued, China will eventually reach a limit, the point at which they will no longer continue to subsidise the US with credit that will never be fully repaid (or paid at all?). This is the real 'resource' that Krugman is discussing. Having a borrower tax you on your lending to the same borrower is not really a very attractive prospect, especially where the tax leaves you lending at real negative interest rates.
Then we come to the creditors within the US economy (see graphic here). Just over 60% of US government debt is held by the Federal Reserve and 'intragovernmental holdings', and a further 6.2% held by state and local governments. We then have the curiosity of the circularity of government taxing other branches of government with seigniorage. All I can say to such an idea is 'Huh?'
Then there are the other domestic holders of US government debt, such as pension funds, mutual funds and so forth. If they are lending money to the US government, they do so in the interests of their own investors. Just as with overseas lenders, they might reasonably expect a positive real return on their investments, and there is no real block to moving their investments into currencies that might offer such a real return, except habit and a fear of greater risks in overseas investments. The point at which fear of domestic risk is enough to overturn fear of overseas risk and habit is a difficult one to pinpoint, but nevertheless there is such a point - it is just a question of where? Volatility in world markets has served to reinforce fears of overseas investment, but expectations for the US economy, and US government policy, are a factor in the volatility. It would not take much for a panic to commence.
To put this into context, China is once again pulling back on investments in treasuries:
China reduced its holdings of U.S. Treasury debt in May as total foreign holdings of government debt posted a slight increase.There is increasing speculation that the Federal Reserve is about to restart the printing presses, and this will only serve to undermine confidence in the $US, as this means more seigniorage:
China's holdings fell by $32.5 billion to $867.7 billion, the Treasury reported Friday.
For the moment, lets play with the scenario that just overseas creditors stop the purchases of treasuries, and that the 'resources' of these overseas lenders will not be available in the US economy. The first impact will be that the demand for US dollars will fall, and with it the value of the $US. This will, of itself, be an inflationary impetus, as all imported goods, services and commodities will increase in price. The second impact will be that, the resources which were formerly entering the US economy (as a result of overseas credit) will no longer be available within the economy. You then have a situation within the economy of a greater supply of money, and less resources available within the economy.
The US Federal Reserve has already pumped some $1.2 trillion (£780bn) into the US economy to try to promote recovery.
The continued fall in prices will add to pressure on the central bank to take further unconventional measures to push inflation into positive territory.
These measures may include increasing the money supply via further quantitative easing or intervening in the US government bond markets to hold down long-term interest rates.
In recently released minutes from the Fed's June meeting, policymakers raised the possibility of further action later this year, if the economy slows down further.
As an offsetting factor, the supply of credit within the economy may be contracting at the same time, due to a wider reluctance of overseas creditors to provide credit in the US economy, except at interest rates that might offset the devaluation of the $US. However, that reluctance will further fuel inflation by reducing demand for $US for private lending into the US economy (further devaluation), and by increasing the cost of credit more broadly within the economy.
All of this will take place whilst the US economy is working under a burden of the existing debt, meaning that a proportion of internally generated resource will be needed to service the existing overseas debt. Even if the size of the debt is being diminished by inflation, there will still need to be an extraction of that internally generated resource to provide payments for overseas debts, and that will be proportional to the level of inflation. The relationship is this; the more resources going to overseas, the higher the inflation in the economy, the higher the inflation in the economy the less resource will be extracted to overseas. Whichever way it is regarded, it is an inflationary impetus - at least until the debt is repaid.
Now let's add in the private domestic investors in government debt. If they start to worry about achieving such poor returns on government debt, they may overcome their fear of overseas investments. In this case, we have an additional problem of capital flight. US dollars will appear in larger numbers on the currency markets, and further depress the $US, and this will provide a further pressure for devaluation of the $US. Likewise, private investment overseas will appear more attractive, depressing investment in private businesses, which will already be suffering from the withdrawal of the use of overseas resource in the economy, due to the lack of credit being provided to the US government. In other words, there will not be credit available to expand the resource generated within the US economy, and make up for the shortfall of resource that was previously provided from overseas.
The only answer for the government is to print yet more money, which will short term ameliorate the problems, but will medium term just heighten the problems. The problem is that it is only possible to go so far with massive deficits and printing money. The US economy is currently reliant on a combination of habit and fear, the 'safe haven' effect, and the inherently unstable 'Chimerica' system.
Krugman is right that there is a limit. The key point in his analysis is he has accepted something close to my own analysis, that money must relate to the provision of privately provided 'resource'. In other words, he seems to accept one of the key arguments of this blog; which is that abstracting money from real goods and services is delusional. In so doing, he is accepting that, in the long term, currency valuations and wealth must be determined by output within an economy. He simply fails to see that, in a world of mobile capital, that there is no such thing as domestic policy acting in isolation. As long as investors have choice, they will seek the best or safest returns.
Real negative interest rates for investors are the danger for economies indulging in deficit spending and money printing, as investors will only accept these up to a point. Words like 'safe haven' and 'reserve currency' are evaluations, and evaluations might change. I recall some time back, an analyst suggested that the $US was nitroglycerin, and we are seeing the US government packing ever more explosive under their currency. In reality, the $US has been nitroglycerin for a long time. It seems that it has just taken more of the explosive to be added for analysts to realise the dangers. Who knows, perhaps even Krugman might get there?
I have been noting that there has been ever more widespread talk about a Chinese property bubble, and this was something I discussed in July of 2008. I can not find an article that mentions this, but I have recently read about the problem of investors keeping apartments empty, and this reminded me of one of my first commentaries on China. I went back to the original article, and found this:
My essay was focused just on the UK and one of the assumptions was that the UK was going to suffer more than any other economy in the current downturn. I knew that the US was going to hurt, and hurt badly. However, the US economy has greater flexibility than the UK, and I therefore expect the pain to be shorter lived, albeit it will still be very bad indeed. I believed Germany and France would hurt, but not too badly. For Italy, I believe that they will suffer very badly indeed. They no longer have the freedom to use their currency to save their economy, and many of their businesses are facing tough competition from the emerging economies. They lack the flexibility or will to rise to this challenge, and will need a crisis before they can even think of rebuilding their economy.I was wrong about the US, whose policy has gone in the opposite direction to that which I expected. As for the other points, I think I have mostly been right (but missed Greece entirely). With regards to China, I elaborated in the promised later post (again July, 2008) with the following:
As for Spain, this country was largely off my radar. I was aware that their economic growth was largely built on construction. However, I did not realise how reliant. I read an article in the Telegraph which suggests that Spain may be a candidate for the hardest hit in the current turmoil. It seems that they have allowed a property and construction bubble to rage out of control, and the popping of the bubble will be catastrophic.
Japan I will leave for one side, as I plan to talk about it more at a later date. I also plan to discuss China at a later date, but will just mention a couple of points for the moment. The first point is that it is quite possible that China has a construction bubble. Whilst I was in China I noted that there were lots of apartment blocks being built, and that it was very popular for these to be purchased by investors. In many cases the investors were leaving the apartments empty (Chinese people like to buy property brand new, once it has been lived in the value falls), and they were holding on to the apartments in an expectation of increases in value. In addition to this there has been a boom in the construction of shopping malls, and I noted that they were already (back in January) starting to exceed demand. If the Chinese economy is pulled back due to world demand for exports dropping, it is likely that such investments will lead to a bust. It is also worth considering the state of the Chinese banks. If they are lending into construction in this way, will there be a repeat of the previous Chinese bad lending problems of a few years ago? What other bad lending is buried in their books?
Set against this is that the finances of the Chinese government are very healthy, as are the levels of savings in China. The real question with China is how much their continued growth is reliant on exports, and how much growth can be sustained within China. I will readily admit that I am not sure on this at all. I am not sure that anyone is. My best guess is that China will also hurt, and hurt badly, with a significant potential for civil unrest as a result.
So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before.However, I should also mention that I expected a $US collapse a long, long time ago, and was absolutely wrong (the optimism expressed in the first post quoted above rapidly dissipated in the face of actual US policy responses). However, the reason I gave for the problems with the $US are exactly the reasons that analysts are now discussing. As for Japan, I struggled for a long time to 'get' Japan, and never delivered on the article. Perhaps some time in the future....as I think I do now have a rough handle on the Japanese economy.
(1) HSBC Global Research, July 2010, Currency Outlook.
Sunday, July 11, 2010
I am aware that this is a difficult idea to grasp, but it is nevertheless the case. The first way in which the individual is spending borrowed money is that they are not actually paying the correct level of taxes to support government expenditure. In simple terms, if the government was not borrowing, but still providing the same services, the tax rate would be far higher. As it is, the government borrowing is the borrowing of the individual, as that individual will, at some future point in time, have to pay higher taxes than they would otherwise have done. This means that, as they make each purchase, a proportion of that purchase is paid for by money the individual is indirectly borrowing through too low taxation.
The second way in which the person is spending borrowed money is somewhat more complicated. For the sake of ease, we will just look at government borrowing, but a similar situation applies for private borrowing. If we return to our individual paying cash, and imagine that he is buying a car, part of his payment comes from borrowed money indirectly derived from government borrowing. When the car dealership accepts the money from the individual, they will have increased revenue, and that revenue will pay for many other things, such as their staff salaries. A proportion of the money indirectly borrowed by the individual making the purchase then ends up in the hands of the staff of the car dealership. The dealership staff will then go on to spend the borrowed proportion of the money, and that will then be used by whichever organisation is in receipt of the money from the staff.
In other words, the money that was originally borrowed by the government percolates through the economy, and it becomes ever more difficult to separate the borrowed money from the money earned as 'real' income. As the borrowings of the government are transmitted through the economy, it becomes apparent that what appear to be 'cash' sales actually are always utilising borrowed money.
As I have said, it is a difficult idea. You may wish to see my first post on the subject, 'The Cigarette Lighter Problem' as I was just starting to grasp at the concept, and it may therefore help in understanding the ideas behind it. The reason for my return to this subject is the curious case of Greece. This is a commentary on the subject:
Since 2000, Greek unit labour costs have risen by almost 40pc. Meanwhile, German unit labour costs have barely risen. This loss of competitiveness by the southern countries is central to their current poor economic performance and their lack of viable prospects for the future.
If governments are obliged to cut back and consumers and/or companies are lumbered with excessive debts, it is to exports that these countries must look for salvation. For the eurozone as a whole to achieve prosperity and economic success, accompanied by stability and sustainability, will require the solution of both these problems. But are they simultaneously soluble within the current financial framework?
If the southern members – "Club Med" – are to regain competitiveness within the euro, the only way is for their costs and prices to increase more slowly than costs and prices in the remainder of the eurozone, led by Germany. (Let us call these countries Germany.) If costs and prices in Germany are barely rising at all, then Club Med must regain competiveness by deflating – ie. costs and prices actually falling.
The answer is that there was a mass of borrowed money percolating through the economy, pushing up activity, wages and employment, as well as providing employment for a larger workforce. This is an example of how an economy might become distorted as it becomes structured around deficit spending.
This is why the only real solution for Greece is to lower wages and costs throughout the economy. When the borrowed money disappears, the Greek economy is left with a structure in which wages are too high, and that is because the borrowed money created wage inflation. Everyone in the whole economy were laying their hands on borrowed money, even if they were apparently spending cash earned from income. In essence, it is the reality of the 'Cigarette Lighter Problem' with a harsh spotlight shining on it.
What we see in the case of Greece is the illusion of wealth appearing over all of the statistics, and this is partly why Greece managed to appear to be in a sustainable position for so long. Many of the statistics appeared to be positive, but they were only positive because they were not accounting for the borrowed money that every individual in Greece included in their spending. The borrowed money allowed the rapid wage inflation that is reported in the article. And the lesson from the case of Greece and the Cigaretter Lighter Problem - I will let you draw your own conclusions.
Friday, July 9, 2010
The trouble is that this is an analysis which only goes so far. When these private sector organisations hit a brick wall, they will, in turn, hurt other private sector companies that provide goods and services for them. And then there is the withdrawal of the money from the economy as many of these workers, both directly and indirectly employed by the government, move from having employment income to unemployment income. In other words, the cuts in government expenditure will ripple out through the wider economy.
"We are concerned that the levels of business distress will increase again, potentially from the first half of 2011, once the full effects of the coalition government's fiscal tightening measures impact the economy and particularly amongst those private sector businesses most dependant on public sector contracts," said Ric Traynor, executive chairman of Begbies Traynor.
"It will not be until after the Government's Comprehensive Spending Review in October that we will know for certain the allocation of spending cuts, but there is a growing risk that, even if the UK avoids a double dip recession, it could develop a twin track economy, with public-sector dependent industries facing higher levels of financial distress than sectors which are less directly linked to government spending cuts."Those sectors most heavily dependent on public sector spending include construction, IT, recruitment, advertising and business services.
Is this a reason not to cut?
Some might argue that the knock on effects presents an argument not to cut. Better to keep on spending, as the consequences that ripple through the economy are too hard to contemplate. The problem with this view is that, somehow, somewhere, all of the activity of the people working for the government, and the businesses that service the government, must have an origin in productive output from the private sector.
This is not an easy concept to deal with, as the interaction of the public and private sector results in complex relationships. For example, a nurse working in the NHS represents a consumption of resources, but has a real output in terms of health outcomes for patients. This output is real, and might mean a worker being able to work and originate more added value within the economy. However, if we imagine that the nurse was not employed in the NHS, and instead worked in the private sector in another role, then that nurse would be creating an output that might be an origin of the added value that might pay for other nurses.
However, life is not that simple. We do not think of nurses just as adding value in the economy, but performing a role that is rooted in a sense of justice. i.e. many of us think that all people should have access to health care. As such, we do not restrict the activity of nursing to just help people who might go on to add value within the economy. In light of this, the NHS represents a net consumption of added value generated elsewhere in the economy. In order to pay for this, we must be generating sufficient added value elsewhere. Each nurse, for example, will consume goods and services from their pay, and those goods and services may originate from within the economy, or from an external economy.
When the nurse does her shopping, she may buy an avocado imported from another country, and that must be paid for from goods and services exported from the economy. Likewise, when the nurse drives to work in her car, that car may may be imported and somebody somewhere must be providing goods and services to allow for that import. If the nurse buys a domestic good, it may well be that the manufacturer of that good needs to import raw materials, and those must also be paid for from the export of goods and services. There are very few economies that even start to have the potential for autarky and, in the UK, autarky is an impossibility (if the UK is to maintain a reasonable standard of living/quality of life for the people).
Within this nurse example there is a balance at which there will be the 'right number' of nurses to ensure that there is the maximum value creation in the economy to pay for the health services. If there are too many nurses, there will not be enough creators of value to pay for the nurses...of course, it is the aggregate of all people employed in government consumption of value added in the economy that matters, and that is the question of priorities (e.g. the choice between one nurse versus one policeman).
The point that I am making here is that, overall, government is a net consumer, and is entirely reliant upon the added value that is generated within the private sector to fund this consumption. The amount that a government might sustainably consume is entirely dependent upon the amount of added value that is created in the private sector, and this is an unavoidable reality. The problem that arises in government consumption is that, in order to consume, there is an opportunity cost. If worker 'x' is employed in government activity, they are not employed in potential added value creation in the private sector. Likewise, if a company is utilised in supporting government consumption, the workers in that company are involved in that net consumption, rather than the creation of added value which might pay for that government consumption.
Somebody, somewhere, somehow, must be producing goods and services for export (and internal use) in order to support an economy, unless that economy is autarkic. That means that they must have an output which not only provides for domestic needs, but also a surplus to sell at a profit to other countries. Furthermore, the more added value that these enterprises create per unit of labour, the more goods and services that will be available for consumption within the economy, and the more available for export.
It is here that we meet the relationship between government net consumption and the wider economy. Government consumption must not reach a point at which they are consuming so much that there is insufficient surplus to pay for the imports of the country, as the country is not autarkic. If a country is autarkic, the amount consumed by the government is a splitting of resource between private and government consumption, and that is a political question. In the case of a country that needs/wants to import, it is a question of economic necessity that the country produces sufficient surplus of added value which is available to pay for the imports. The greater the consumption of the government, the less surplus is available for export.
We can see this in taxation. If a government is over-consuming relative to the private sector output, there will be higher taxation (or government borrowing). Taxation is the removal of added value in the economy into the hands of the government for government consumption of that added value, meaning that the added value is not available for export. The situation is somewhat confused by the fact that, for example, government employees are taxed, but the origins of the added value is in the private sector. In the case of government borrowing, this just means a deferral of the removal of that added value for consumption now.
What we have is a basic reality that the extent of government consumption is, in the long term, going to be constrained by the opportunity cost of employing 'x' number of people in servicing that government consumption. The principle is simple. If a person is employed as a result of net consumption of the government, they are not employed in creating the added value for the government to consume. In practical terms, this is the constraint upon government; that constraint is, in the end, determined by the absolute numbers of the workforce creating added value in the private sector, and the productivity of those workers.
If an economy is exceptionally productive, it is possible for the private sector to give an absolute greater amount of their added value to the government, and still be able to succeed in competition with others, but the total added value taken from the private sector must be determined by the relative productivity of the total number of workers within the private sector (excluding those supporting government consumption). The question for each economy is how productive the private sector is - or how much added value each worker produces. Fantastically productive workers, in relation to other countries, will allow for a larger public sector than those other workers (whether a large public sector is ever a 'good thing' is debatable, and not the subject of this post).
We can now return to those private sector workers who are (potentially) going to lose their jobs as a result of cuts in government expenditure. As they lose their jobs, some will still be in receipt of government money, in the form of unemployment benefits, but their net consumption from the economy overall will be reduced. They will be consuming less, and will therefore overall contribute to a lessening of the proportion of government consumption within the economy. They are being paid less, and all of the other expenses that surround each employee's activity disappear.
Furthermore, the skills and experience of that employee will become available to the private sector where they might contribute added value that might support government spending overall. Indeed, some employees made redundant will make this transition without any recourse to further government expenditure of overall resource. They will switch into new jobs straight away.
Buried within this scenario, of course, are the personal consequences for those that do lose their jobs. For some, this will be a major problem, and will be distressing. They will be angry at the government that has made the cuts. However, I would argue that this is a misplaced anger. The anger should be directed at a government that created an unsustainable job in the first place or, put another way, a government that sought to consume more overall than the economy could sustain. In over-consuming the resource of the country, they structured the economy in a way which was unbalanced, encouraging workers into sectors and activities that could not be sustained.
For the individuals who took work that was rooted in over consumption by the government, they had no way of knowing that their position could not be sustained over the long term. It really is not their fault that they lose their jobs, but the fault of a government that created an unsupportable structure. This is cold comfort for those workers. Likewise, the businesses that will go bust structured themselves to support the over-consumption, and it is not the fault of the proprietors that they have gone bust. They were incentivised by the government to direct their resources to unsustainable government consumption. Again, this is cold comfort when the axe falls upon their head.
The problem of austerity is that, whatever happens, the shift from government consumption of resource means that those employed in activities to support that consumption are going to be hurt, whether now or later. Someone must be hurt by a transition back to a sustainable path. That this is not their own 'fault' does not alter the absolute necessity of change. The best that can be done is to try to ameliorate the effects. We can all agree on the fact that this is unfair for the businesses and individuals involved, but to place blame on the 'cutters' is to place the blame on the wrong people. It was those that distorted the economy onto an unsustainable path that shoulder the responsibility.
I will end this post with a quote from an interview with the Chief Executive of HSBC, who seems to grasp the point:
"The reality is that is may be good to have full employment, but if that employment is driven by public employment it's telling you something very clearly... something is not functioning in your society."In this quote, he is grasping the essential reality. Something is wrong when government consumption exceeds the ability for the economy to pay for the consumption.
Note: Over consumption in the private sphere offers similar problems, but the purpose of this post is to discuss government austerity measures.