Monday 4 July 2016

The Incalculable Cost of our Aversion to Government Debt

I was speaking to Tom Streithorst at the FT Festival of Finance last week and he was pointing out that almost every single person there knows that the government needs to run larger deficits and invest more. But what we don't know is how to get that idea into the public consciousness. The public, by and large, along with the departing Conservative administration, see the government budget as like that of a household. One should not live outside of ones means, the argument goes.

It came to me that if I were forced to choose just one thing that I wish could be conveyed and understood, it would be that in a sovereign money state (a state that can print its own currency) the size of the government debt is more or less irrelevant.

Why is this? Simply speaking, a government can print its own money, through its central bank. The government produces money so it can never run out. It has no need to ever default. Assuming that the buyers of bonds have confidence that inflation will not devalue their savings, the government can always borrow to pay the interest and to keep spending. And in the last resort, the central bank can buy the bonds. Markets know this, which is why the interest rate on 10 year UK government debt fell below 1% per year after Brexit. Time and time again, the market proves that credible sovereign governments can borrow as much as they want at a reasonable rate; Japan being the obvious example with over 200% government debt to GDP (note that this is not true in the Eurozone, where the governments negligently gave away their necessary central bank functions to the ECB and now effectively borrow in a foreign currency). Frances Coppola actually argues that more government debt can be actually better than less because it allows savers safe assets to put their savings into.

Does that mean that the government can spend anything it wants? Absolutely not. There is a real resource constraint. In the end, the available labour in a country must be allocated somewhere. If a government, for example, spends more on the NHS then it must take labour from elsewhere. If the government spends too much money overall, then wages will rise and, in turn, so will the price of goods and services; we will get inflation.

But there are two important points here. The first is that the constraint on government spending is only the constraint on inflation. If domestic inflation is under 3% then, although one could argue that the government mis-spends (eg. too much on defence and not enough on education, or that it should spend less and tax less), one should not (in my opinion) argue that the government is running too large a deficit. Whatever deficit exists is a necessary deficit because it keeps enough money flowing through the economy to keep economic activity running smoothly. This idea is explained in more detail in this post.

If one accepts that the size of the debt doesn't matter assuming bond buyers are confident that the government keeps its inflation credibility, then it logically must follow that hitting the inflation target is the right level of borrowing.

Some people worry about huge inflation in the future if we keep borrowing. All this money is produced, they argue, so when people decide to spend it, it will cause hyperinflation. This is to misunderstand what is happening.

The economy is structurally saving money every year due to a large share of the product of the economy going in dividends, rentals and interest to people who save most of their income. A shrinking share is going in wages to workers who spend most of their income. For more money to be spent, this structural shift will have to reverse. This is a very slow process. Hopefully this shift will happen, and at that time the government can reduce its deficits and possibly one day run a surplus again. But there can not be a sudden change where everybody decides to spend all of their money. A possible exception to this would be if everyone expected hyperinflation, but certainly it will not happen if the government keeps its credibility regarding inflation.

The second point is to do with productivity. It is not a zero-sum game. At the aforementioned FT Festival, there was a panel discussing the productivity puzzle, or why productivity has declined. Typically all sorts of reasons can be found, from demographics to the fact that many services are now free (like Wikipedia) which do not show up in GDP. All of these are valid, but at the same time we have great hubs of technology and our world networks are more connected than ever before. Information spreads faster than ever and thus so should the rate of progress. I can't believe that all productivity improvements have been given away for free.

But regardless of what I think about this, I would like to ask you to look at the below graph (from this post on the UK productivity puzzle). It can be clearly seen that productivity, far from slowly declining, was all going well until 2008. Then, suddenly, it stopped. Did suddenly everything become free in 2008? Did everyone become old in 2008? The only thing that really changed in 2008 was that we stopped sending enough money around the system. First with the financial crisis, and then with the austerity imposed.

The gap between where we should be now and where we actually are is huge. The economy could be producing 15% more now if we kept up the trend. I was speaking about this to Steve Keen at the weekend and neither of us can see any reason why, given enough money to keep demand up, the productivity of each working person in the UK should not keep smoothly rising. If there is enough demand, enough money running through the system, then wages will go up and businesses will invest in new technology that increases productivity. If demand is low and wages are low, there is no point in investing in improving productivity. The fact that productivity is so far below trend is a failure of government.

Even now, the technological improvements have happened and a period of sustained investment in the newer technology should see considerable catch-up growth without high inflation.

The departing government claims great success with the economy, citing the lowest unemployment rates in years. But they did not create jobs by increasing demand for labour. They created jobs by a carrot and stick benefits policy forcing people into work at the bottom end of the market. They kept up demand by using monetary policy (lower interest rates and Quantitative Easing) rather than government spending, which gave money to asset holders but not workers. I talk more about why using monetary policy is so bad here. Thanks to austerity there is both a non-growing pie and workers receiving a smaller share of it (due to austerity forcing interet rates down).

So there is low demand because of low government spending and high supply of labour because of benefit sanctions.

The inevitable result of this is a low wage economy. This can be seen in the graph below (not the easiest graph to read, I admit). What it shows is that whilst Gordon Brown's economy pushed wages up and produced jobs above the living wage, the Conservative government actually greatly reduced the number of jobs above the living wage and created millions of jobs below the living wage.
This actually further exacerbates the problems of the economy. It is the reason why Osborne was never going to hit his deficit target. But worse than this, it creates an underclass of millions of minimum wage earners who are struggling to get by.

Even without the help of a scaremongering press and irresponsible politicians, it is not hard for the people on the low wages to make the link between their low wages and rising house prices, and the incoming immigrant population. In 2005, when there was a peak of immigration, wages were still rising. Not so this time. The difference; in 2005 there was enough money flowing through the economy that productivity was rising and wages were rising too. Since 2010 this money has stopped and wages have stagnated.

This is not to talk about the shutting of youth clubs, the cutbacks to education, the university tuition fees leaving our young with large debts, the rising house prices (a consequence of the lower interest rates because of the shrinking growth) and (because house prices are unaffordable) rents, the closing of libraries, the cuts to charities, the struggles of the NHS that is underfunded enough for the Leave campaign to put it on their battle bus.

The economic damage of austerity in the UK is calculable. I would put it at around 15% of GDP. That is to say that we would be 15% richer if productivity growth were to keep going as before. 

But the social damage. That is going to show up in the years to come. The EU referendum highlighted some of the divisions in society. As long as policy is run for the benefit of asset holders and the detriment of workers and the young, the discontent will, I fear, keep rising.

And a sobering thought is that the UK has not suffered the worst of the austerity by a long way. The austerity required by Euro membership is much worse than that in the UK. The Brexit vote is childs play compared to what will happen in the economically less competitive parts of the Euroland.


  1. I agree about govt debt, non-threat of inflation, the productivity "puzzle", and the timing of the Brexit victory being dependent on austerity stoking up the maximum fear about immigration and the EU budget contributions being harmful.

    If Scottish independence is to be averted it will be important to hit the ground running this time and raise the issue of the euro over and over. Currency and EU membership were the questions in 2014. Even if the UK now leaves the EU, it's an open question whether indy Scotland will be required to join the euro as a condition of accession. Remember how protective the Eurozone govts are of the euro and that even the Greeks were too scared to leave. And that any one country can veto Scottish EU membership. If so, the fiscal rules make Osborne look kind and generous. In the Republic of Ireland, which has a balanced budget before the crisis, unemployment peaked at 15% of GDP thanks to the euro. And rather than electing something like Syriza people simple began mass emigration again. 15% of the Irish-born population over age 15 now live overseas.

    Varoufakis told Chomsky that at a meeting with Schauble he asked whether Schauble would sign the austerity package. Schauble said as a patriot, no, but as a European yes. Because if such a straitjacket was imposed on Greece then a similar one could be used on France. You know if that ever happens that Marine Le Pen will become President of France. And now for budget deficit and "competitiveness" (wage costs) reasons, France could soon be fined 0.5% of GDP.

    If it was simply accepted that a stimulus is necessary all round, the political situation everywhere can be fixed. Borrow, spend, stimulate, the deficit will shrink again as proper growth returns. We even have the historical example of the Great Depression. We are paying a huge price due to politicians' fears of not being centrist enough.

  2. You don't need to issue bonds at all. Now we are free of the EU there is no doubt we can just use the Ways and Means Account. After all why pay people interest when the saving they are undertaking is what is causing the problem in the first place. We'd prefer them to spend the money via a taxation point, or invest it.

    Over half the deficit is going abroad. Giving them money on top just exacerbates the problem. There is no need for it and no justification for that level of government spending on corporate welfare. It should be stopped, and the Pension Funds offered alternatives directly with National Savings.

    The period from 2005 to 2008 was a period of massive private debt expansion. The wage growth there was illusionary. Since then private debt has been stable and therefore shrinking as GDP grows. So you see the real wage result after then.

    However you slice it massive unskilled EU immigration does hold down wages for the sub-median wage earner (largely it stops them rising). There is absolutely no reason why we have hand car washes all over the place subsidised by tax credits when we have machines that can do the job for us. And that's just an instance visible in the cities. Go to rural Lincolnshire and watch the people strapped to the back of ancient machines working in appalling conditions.

    If there is any local unemployment and people waiting for housing there is no justification for giving businesses cheap foreign labour just because they moan a lot. They need to be forced to automate or train.

    1. Hi Neil. Obviously I agree that we can issue new money insead of debt and that it is probably preferable (although if the CB pays interest on deposits then maybe it is pretty similar in the end - those will go abroad too). My preference for monetisation is really just because of the optics - people are scared of government debt and not scared of a higher base money level.

      I do disagree about 2005-08. I don't think there is anything illusory about higher wages - just a problem of how it is funded. Private debt funding is a damaging way to increase economic activity, but we would still have had the wage rises if the government had run larger deficits. Just less of a crash at the end.

      EU migration must have had an effect on wages. I agree here. All I am saying is that austerity had a far greater effect IMO. Agree about automation and training. That's why we need rising wages.

  3. Several unrelated points;

    I don't understand why/what government policy destroyed high pay jobs and created low pay jobs?

    I also think that you're missing out the effect of a large build up in household credit from '01 to '08. I think that flatters productivity massively for that period, perhaps the change is really at 2000, not 2008.

    I think if you're advocating this you need to be more explicit about the risk that you're taking, how big it is and who bears it.

    1. 1) Policy of austerity reduced demand in the economy. At the same time, the reduction in benefits and ramping up of sanctions pushed more people into work. If demand is down and supply is up, prices go down.

      2) I look at the economy differently. Because of net saving it needs money added all the time. Where this money comes from may affect certain sectors of the economy - a credit boom will increase spending on housing etc. But overall it allows the economy to grow, and that growth is mostly real growth (with some misallocation due to the boom). Private credit is extremely unstable and costly in the long term because it increases savings rates - but it does not mean that the growth isn't real.

      3) I don't believe that a responsibly applied policy is more of a risk than the alternative. The alternative, which Osborne and the Eurozone have been attempting, is to force use of monetary policy to raise asset prices (and thus stimulate the economy by giving more to richer people). This is much more unstable as a means of growth and is hitting the limits now as interest rates hit zero. The risk of a crash will be borne by the government in the end anyway.

    2. 1) isn't that too much aggregation? isn't the change due to a change in composition rather than the equilibrium point?

      2) Ok, but surely that credit boom pulled demand from 08-12 into 03-07, in which case the dip on your chart would be a bit lower and the peak in 07 lower. In which case '08 isn't the critical point?

      3) Sure I agree I don't think monetary policy is anything other than distortionary and driving inequality higher at this point. I still think its necessary to point out the risk of inflation really picking up and who that falls on because the UK is quite a leveraged economy. I think the line of argument that it doesn't matter because the current path is not working is unpersuasive to people because at the limit it is obviously untrue, particularly for households that have seen high interest rates or remember the UK needing IMF help.

    3. 1) Demand not rising, but being shared between more workers (and wage share not going up) means lower wages (therefore less automation, less growth per worker). I think that it makes sense. The composition changes because the wages are low.

      2) I don't believe in the theory that you bring demand forward or push it back. Demand can exist all the time. It is only our policies that create this pushing/pulling.

      There are always people who would buy more goods if they had more income. The lack of demand is created because we have not allowed people to have high enough income.

      3) I don't think inflation is a risk with a responsible government policy. I don't think that there can be any catalyst for a tipping point and I don't even think a tipping point is possible if the government deliberately targets inflation.

  4. How sad you can believe the problem is that we just have not borrowed and spent enough. In the history of fiat currency, over 6,000 recorded in history, all have failed for this very reason. But somehow we all should trust that the central bankers printing money like never seen in history will not destroy our currency.

  5. I understand the attraction of this money printing argument and see why it is so readily embraced. It's like telling a critically ill alcoholic he can simply drink his way back to health. If anyone wants to see the net economic effect of such proposed policy, one need only look at the Socialist utopia, Venezuela with its 800% inflation.

    All this central bank intervention (money printing) has done is to have blown massive bubbles throughout the economy. We are only one black swan event away from the central banks losing control of the markets.

    The worst part is that the central banks are really a one trick pony. It's only trick is to print money and throw it at problems. Imagine how effective this will be if the country's currency devalues or inflation reaches a point where the public gets outraged.

    This argument of "responsible" central banks is somewhat laughable. Does anyone really believe the Fed will start raising interest rates even in the face of serious inflation if it will collapse the stock market, bond market

  6. No, I believe we are stuck where we are. The governments and central banks will simply deny inflation exists or is a problem until the public gets fed up. Even then, the central banks will say "overshooting" inflation targets temporarily is necessary to prevent deflation (the central bankers self created bogey man).

    It is not a question of whether this money printing or QE is a bad idea. It is only a question of how it will end. It could be a black swan event, a government being overthrown, or even this far fetched idea that destroys the publics belief that inflation is under control. When it happens, all the money printing in the world won't help. It will just be throwing gasoline on the fire (i.e. Venezuela).


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