Sunday, June 27, 2010

Naked Capitaism: Deficit Doves, the Gift that Keeps on Giving

Deficit Doves, the Gift that Keeps on Giving

The first section of this post is by Warren Mosler, the President of Valance Co. who writes for New Deal 2.0

Deficit doves are doing more harm than the hawks — here’s what they need to know.

The deficit hawks are prevailing. The economy remains an economic and social disaster. Medicare has already been cut by the Democratic majority in the new health care bill. Social security is now under attack by the new bipartisan Congressional Commission on Fiscal Sustainability and Reform. Meanwhile, the media tries to present a balanced approach, pairing deficit hawks with deficit doves.

But the deficit hawks aren’t the problem. They do the best they can with arguments that feature empty rhetoric supported by the underlying assumption that deficits are ‘bad.’

Actually, it’s the well-intentioned but misinformed deficit doves featured by the media that may be doing the most harm. They don’t understand actual monetary operations and reserve accounting, and therefore incorporate the same fundamentally incorrect assumptions as the deficit hawks. They agree deficits are ‘bad,’ but try to argue that’s the case only in the long term. They agree that deficits can be too high, but try to argue they have been higher, particularly in World War II, and therefore larger deficits should be easily manageable, while agreeing there is a level that could not be manageable. They agree markets could be ‘unfriendly’ and a lack of confidence could translate into far higher interest rates, but argue that the current low rates for Treasury securities are the markets telling us that at least for now confidence is high indicating markets are eager to fund current deficits. And they agree that ‘bang for the buck’ matters and support tax cuts and spending increases based on higher multipliers.

The problem is that the two sides of the story are in fact fundamentally on the same side. The media does not feature the true deficit dove story. Nor do any of the true doves have even a small piece of the administration’s ear, or the ear of anyone in Congress willing to speak out. There are maybe a hundred true doves, including many senior economics professors. The problem is this professional, highly educated, highly experienced collection of true doves does not get a fair hearing.

The true deficit dove positions include:

1. Since government spending is merely a matter of changing numbers in bank accounts on its own spread sheet, there is no solvency issue or sustainability issue
2. The right size deficit is the one that coincides with our stated goals of full employment and price stability.
3. Interest rates for government are set by the government, and not by the market place.
4. Bang for the buck considerations are moot as the size of the deficit per se is not an issue.

The answer to why the true doves capable of articulating the above points don’t’ get a fair hearing may be credentials. My BA in Economics from the University of Connecticut in 1971 doesn’t cut it, nor the fact that the very large fund I managed was the highest rated firm for the time I ran it. And my net worth never getting anywhere near a billion hasn’t helped either. Seems billionaires get celebrity status and lots of airtime for just about anything they want to say.

The same is true of the economics professors who’ve got it right. Without being from and at the usual ‘top tier’ schools, none can even get published in main stream economics journals, where submissions featuring obvious accounting realities are routinely rejected. In fact, any economist who states accounting identities and operational realities such as ‘deficits = savings’ or ‘loans create deposits’ or ‘Federal spending is not constrained by revenues’ is immediately labeled ‘heterodox’ and unworthy of serious mainstream consideration. Even the late Wynne Godley, who did have reasonable credentials as head of Cambridge Economics, and was the number one UK economics forecaster, was labeled ‘unorthodox’ because his mathematical models featured the deficits = savings accounting identity.

My three proposals that can immediately turn the tide and get us back to full employment and prosperity remain:

1. A full payroll tax (fica) holiday
2. $150 billion of Federal revenue sharing to the States on a per capita basis
3. An $8/hr Federally funded job for anyone willing and able to work to facilitate the transition from unemployment to private sector employment.

The only thing between today’s state of the economy and unimagined prosperity is the space between the ears of policy makers that’s filled with the deficit hawk rhetoric, and unfortunately further supported by the rhetoric of the deficit doves the media selects to present the ‘opposing view.’

Yves here. Mosler wrote this piece to address the debate over the federal budget deficits in the US, which meant he could skip over some important caveats.

Modern Monetary Theory does describe how the world works in a fiat currency regime, meaning the “government” is the issuer of sovereign currency. Despite all the hyperventilating about default, governments that issue their own currency will never be forced to default (note that Greece, Spain, Ireland, and California are not in this position). They can create a lot of inflation, but that is a separate issue.

The times in the modern era when sovereign states have defaulted is:

1. Under a gold standard

2. When they either are not currency issuers OR have adopted a currency they do not control (eg. countries like Argentina that dollarized their economies)

3. Countries that have overly large banking sectors relative to GDP AND those banks have large liabilities in foreign currencies AND those banks have major solvency problems (Iceland, this would also be the reason for a UK default)

The lone exception is the Russia default of 1998, which remains a bizarre, opportunistic incident. Russia’s sovereign debt was under 20% of GDP, and there was no reason for it to have defaulted, even if its debt levels had been higher.

Now to a general point about MMT. The negative responses to it are almost reflexive, shoot the messenger: deficit = bad, we aren’t prepared to listen to anyone who says otherwise.

Sorry, gang, it IS more complicated than that. We’ve provided this formula before:

Domestic Private Sector Financial Balance + Fiscal Balance – Current Account Balance = 0

Now let’s consider what has happened in the US, and some other advanced economies. Our corporations, in their infinite wisdom, have decided increasingly to offshore and outsource, which means move operations outside the US and to turn big chunks of their operations over to other companies, again often foreign ones.

Let’s go back to the formula. First result is that we have a current account deficit. So that means that the sum of the other two parts of the economy, the private sector plus the public sector will run deficits, as in borrow more than they spend. Maybe one is a net saver, the other a bigger net borrower, or both are net borrowers. But at least one sector will be a net borrower.

But let’s consider another set of issues. The fixation of public companies on quarterly earnings plus the offshoring/outsourcing phenomena have led them to become net savers, even in expansions (see here for a long-form discussion). Normally, the household sector is a net saver (households generally try to save for retirement and for emergencies). Most readers appear to implicitly assume that those funds should be used by business, that government borrowing crowds out private sector borrowing. But while INDIVIDUAL businesses do borrow, recall they also generate cash. The trend, even in periods of growth, when businesses as a whole ought to be borrowing and investing in growth, is instead that they are net savers.

In that scenario, even if the US had no trade deficit, the government would need to run a deficit to accommodate the desire of the private sector to save. The alternative would be that the US would need to go from its assumed trade balance to a trade surplus. That would happen through a fall in prices and wages in its tradeable goods sector (which can happen via domestic deflation, which will make debt burdens worse in real terms, or a fall in the dollar) and/or an increase in productivity so that our exports gained market share.

Now the private sector in the US is deleveraging, which and reducing debt is tantamount to saving. We have pointed out that the euro would likely have to fall to 60 to 80 cents to the dollar to prevent the eurozone from falling into deflation (which will make debt levels in real terms worse and almost certainly precipitate the defaults that the austerity programs being implemented are meant to avoid.

The certain continued fall in the euro (the trajectory is a given, the open questions are how far and how fast), and China’s signaling that it is likely to devalue its currency if the euro falls materially means the dollar is likely to remain strong, Right now, every country with overly high debt levels wants to break glass, weaken currency, and use exports to provide it with some lift to offset the contractionary impact of deleveraging. It appears unlikely that the US will be able to play that game. Odds are high that we will continue to be a net importer.

So, if we decide to run government surpluses now, the result is almost certain to be deflation, at best a Japan-type stagnation with high unemployment (and the US has far less social cohesion than Japan does), at worst a deflationary downspiral. But in either case, austerity becomes self-defeating. The value of outstanding debt rises as prices fall and GDP contracts. Default becomes more likely, and as defaults rise, banks become more impaired, investors more cautious, and the downturn can easily accelerate and become self-reinforcing.

Now some readers are correctly concerned about the wisdom of letting the cohort in DC spend more, given our misadventures in the Middle East, and healthcare “reform” serving as a Trojan horse for further entrenchment and enrichment of Big Pharma and the heath insurers. I am certainly not keen about handing a blank check to the likes of Geithner (oh wait, we did that already, it was called the TARP). We also need to keep pressure high on the need to reform governing structures.

As much as the logic of continued government spending is unpalatable to many, be careful what you wish for. If you think the economy now is not so hot, just wait to see what happens if deflation takes hold.

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