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Tuesday, July 14, 2020

The Drift To Austerity (Manuscript Excerpt)

Debates about fiscal policy and government debt are arguably what created most of the publicity for Modern Monetary Theory. After the Financial Crisis of 2008, government debt-to-GDP ratios rose, which was a greater concern in the euro area as there was a limit on that ratio within the Maastricht treaty. At the same time, there was popular anger at bank bailouts across the political spectrum – bankers caused the crisis, and then were bailed out by governments. This free-floating anger attached to worries about government debt. As a result, governments implemented austerity packages, which typically consisted of cutting spending on social welfare programmes.

Although this debate helps explain the rise of MMT, one could argue that the consensus has drifted in the direction of MMT. Moreover, the fact that MMTers have been pushing for looser fiscal policy for some time is well known. As such, I am keeping this treatment relatively brief.

[Note: This is an unedited excerpt from my manuscript that discusses MMT and how it relates to the post-virus recovery. This is a section discussing why previous expansions were slow-moving affairs, and hence is largely backward looking.]

The MMT View of Austerity

Worrying about fiscal deficits or the level of governmental debt runs directly counter to the principles of Functional Finance, which lie within narrow MMT. As a result, the popular debates about austerity cemented the importance of narrow MMT with respect to the theoretical project.

For a country with adequate control of its currency (commonly referred to as currency sovereignty), there is no economic force that can cause it to “run out of money.” At most, the central government can run into self-imposed constraints, like the ridiculous American Debt Ceiling Fiasco of 2013. Such a government effectively cannot be forced to default (unlike users of the currency), and even the interest rate paid on government debt is a policy variable. (The argument that nominal bond yields are under the government’s control was heavily disputed by non-MMTers, but the rise of the concept of Yield Curve Control has shown that such objections are on extremely shaky ground, even from a mainstream perspective.)

An important qualification of the previous statements is that a country has a strong level of currency sovereignty. Although some countries are clearly not currency sovereigns – countries that borrow in a foreign currency or peg the value of their currency – other countries lie on a currency sovereignty spectrum. The non-euro developed countries have a high level of currency sovereignty, while many developing countries are in a position where they are extremely sensitive to global capital markets. Many critics of MMT have an exaggerated view of dependence upon capital markets, and often make assertions that only the United States has such sovereignty. This ignores the reality that Canada – with a relatively small economy that is wide open to foreign trade – has floated its currency for almost all the post-1950 period. Other developed countries caught up to Canada starting with the demise of the Bretton Woods system in the 1970s, but some clung to pegged systems (such as the U.K.’s membership of the European Exchange Rate Mechanism before its ejection in 1992).

Although there was no economic logic behind austerity, it was politically attractive to its proponents. It allowed governments to cut social welfare spending, while being able to claim that “bond markets” forced the spending cuts.

Stephanie Kelton outlined the myths that led to the austerity campaign in her best-selling book, The Deficit Myth. They are listed below (with a few wording tweaks to eliminate American-specific terms and switching to Canadian spelling); I refer the reader to The Deficit Myth for more details.
  1. Myth: A currency sovereign should budget like a household. Reality: Unlike a household, a currency sovereign issues the currency it spends.
  2. Myth: Deficits are evidence of overspending. Reality: For evidence of overspending, look to inflation.
  3. Myth: One way or another, we’re all on the hook for government debt. Reality: The national debt poses no financial burden whatsoever.
  4. Myth: Government deficits crowd out private investment, making us poorer. Reality: Fiscal deficits increase our wealth and collective savings.
  5. Myth: The trade deficit means America is losing. America’s trade deficit is its “stuff” surplus.
  6. Myth: “Entitlement” programmes like Social Security and Medicare are financial unsustainable. We can’t afford them anymore. Reality: As long as the central government commits to making the payments, it can always afford to support these programmes. What matters is our economy’s long-run capacity to produce the real goods and services people need.
At present, it is easy to find mainstream (or heterodox) economists that argue that MMT’s views on fiscal policy are not particularly novel. However, this glosses over the reality that the myths referred to by Kelton were being propagated by neoclassical economists for decades. Even if a particular mainstream economist did not subscribe to the myths, other high-profile ones did. The myths outlined by Kelton were arguably consensus views (although this is less true in 2020).

The Effects of Austerity

Chart: Greek Nominal GDP (1998-2019)

 The dismal policy failures after the Financial Crisis was where views on fiscal policy were most obviously negative for growth. The poster child for disastrous policy was in the Euro periphery, as seen in the collapse of Greek nominal GDP (above). Such a contraction in GDP in a developed country with a welfare state was largely though to be impossible, yet the brain trust in Europe managed that feat. Hyman Minsky wrote an essay “Can ‘It’ Happen Again?” (with “It” referring to a depression), and he argued that the modern welfare state made such contractions less likely.

The nature of the euro (an internal currency peg system) made Greece’s fate inevitable given the disregard for the welfare of Greek citizens shown by the euro are authorities. Greece is not a currency sovereign, and so either had to knuckle under to the Troika, or somehow leave the euro. (The euro was designed to make exit extremely painful.) However, even floating currency sovereigns hopped onto the austerity bandwagon for political reasons. Arguing that their country “would become the next Greece,” was an easy way to sell policies that would have otherwise been more unpopular – mainly slashing social safety net spending. These cuts came after the end of the recession, and helped bake in low growth rates.

Even the leading currency sovereign – the United States – was not immune to policymakers that refused to take fiscal policy seriously. In the introduction to The Deficit Myth, Stephanie Kelton describes the Obama administration response to the crisis as follows.
She [Economist Christina Romer] had run the numbers, and she concluded that a package as large as $1.8 trillion might be required to combat the worsening situation. But that option was nixed by Lawrence Summers, the Harvard economist and former treasury secretary who became Obama’s chief economic advisor. Summers might have preferred a bigger stimulus, but he worried that asking Congress for anything close to $1 trillion would provoke ridicule, saying that “the public wouldn’t stand for it, and it would never get through Congress.”
Chart: Government Spending in Canada and Spain
However, austerity policies were not only a factor in the post-Financial Crisis period. In addition to labour market reforms, the 1990s saw a shrinking of the government sector. The chart above shows two well-known examples, being Canada and Spain. It was not purely a question of the role of government shrinking, the mix of spending changed. As became apparent in 2020, very few expenses have been spared in equipping the police, or the military. The political reality in the United States is that “military Keynesianism” is the bipartisan consensus method to create government jobs. The problem is that military equipment is now highly advanced, and so the spending creates a relatively small number of highly paid jobs. Although creating jobs with high pay sounds attractive, this does little for people caught in under-employment, and it creates inflationary pressures in affected occupations (e.g., electrical engineers).

Bidding up wages in occupations already facing capacity constraints was the Achilles Heel of hydraulic Keynesianism, and the theoretical focus on aggregates means that this theoretical blind spot remains. Although MMT critics accuse MMTers of being cheerleaders of government spending, the reality is that MMT is focussed on how governments spend.

Will this Time be Different?

Will there be an austerity backlash in the coming years, citing the rise in government debt-to-GDP ratios? (At the time of writing, those ratios have not yet stabilised, but it seems safe to predict that they will approach peacetime, if not wartime, records.)

It is a very safe bet that free market-oriented parties will make austerity politics a plank in their campaigns. Historically, conservative parties had factions that could accept Keynesian economics – e.g., country club Republicans, the Tory Wets in the U.K., and the Red Tories in Canada – but those are now an endangered (if not extinct) species. That said, politicians have some instinct for self-preservation, and are unlikely to want to push the economy into a deep recession voluntarily. (The European authorities were able to do this because foreigners were the ones disciplining the periphery.) Although there will be political debates about government debt, it is unclear how seriously anyone view them. In any event, no matter what the details of the debates are, the reality is that social programmes have already been cut in previous decades. Just preserving the status quo is enough to ensure that fiscal policy will only act to blunt the worst of the recession, but not be vigorous enough to rapidly reduce the unemployment rate in steady state.

From the perspective of economic theory, the failures of austerity policies were well understood enough that the debate will be the arcane “how is MMT different from neoclassical economics?” (although free market-oriented economists will find reasons to support tighter fiscal policy). This is much more boring than the economic debates in the 2010s. In order for the debates to have substantive value, they will need to be in reference to discussing the details of actual programmes.

References and Further Reading 

  • The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, by Stephanie Kelton. PublicAffairs, Hachette Book Group, 2020. ISBN: 978-1-5417-3618-4
  • Can “It” Happen Again?: Essay On Instability and Finance, by Hyman P. Minsky. M.E. Sharpe, Inc., 1982. ISBN: 0-87332-213-4

(c) Brian Romanchuk 2020

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