Why Stimulus Is No Panacea
I fully support deficit spending as a means to prevent a debt deflationary spiral in a deep downturn. However, there are limits to what stimulus can actually do. Stimulus is no panacea for an unbalanced economy. In particular, when large imbalances build up, deficit spending is limited and can actually perpetuate the existing imbalances and retard a return to a well-functioning, dynamic growth path. I would like to use this post to outline why.
I am going to present the pros of deficit spending first via a bit of Wynne Godley and modern monetary theory’s financial sector balance’s approach. Afterwards, I will use a more Austrian framework to discuss what the limitations are.
What Modern Monetary Theory has taught us
The great British economist Wynne Godley used the sectoral financial balance accounting identities to tell us is that shifts in savings do not happen in a vacuum. The net balances of different sectors move in concert as one person or one sector’s increased savings must be another person or sector’s increased dissavings.
In a world out of balance, this is important because most economic pundits act as if these balances move in isolation. They might tell us the government needs to cut spending or the household sector needs to increase savings without telling us which other sectors of the economy will have to adjust for these things to happen. But because there are two sides to every financial transaction, any net adjustments in one sector of the economy must be met by an equal and opposite adjustment by the rest of the economy. So, if the government reduces deficit (net saves), the non-government sectors must net dissave. See MMT: Economics 101 on government budget deficits as an example of just how this works.
The Tenuous Technical Recovery
I can’t stress enough how important this is at this critical juncture of the business cycle. We are in an incipient recovery that never would have been were it not for large monetary and fiscal stimulus everywhere. Western Europe, China, Japan, and the United States all did a part in reflating the global economy. Yet unemployment and debt levels remain high. Banks are still skittish about lending while debtors are concerned about taking on more debt because of their leveraged balance sheets. Were governments to withdraw stimulus en masse, we would likely relapse into recession. With household debt levels in the west barely below their apogee and unemployment levels significantly higher, debt stress would make a downward spiral of default, bankruptcy, lender loss, and credit contraction inevitable. However, losses have been socialized on a breathtaking scale as governments have run large deficits and run up their debt levels. Economists are now struggling with what to do about this.
The G-20 summit in Toronto highlighted the divide between different policymakers. One side concentrates on the sustainability of government deficits, while the other side concentrates on the need for growth to avoid a downward economic spiral. Clearly, the fact that these debates are ongoing despite the Herculean efforts by government to prevent the worst in 2008 and 2009 tells you that we have been facing a once in a lifetime economic problem.
Cutting Government Deficits Means Cutting Surpluses Elsewhere
Let’s look at this problem from the government deficit angle. I have already given you my view on Europe and why I am siding with the Germans on fiscal consolidation. But, this largely owes to the constraints of the single currency.
Without a common currency, there are many more options available since immediate liquidity risk for sovereign governments issuing debt in the currency they create is not a factor. So, let’s look at this using the sectoral financial balance accounting identities. I am going to borrow Rob Parenteau’s discussion at Naked Capitalism for this since he does a good job of presenting the analysis. I have bolded the most important parts.
Frequently, we are told by neoliberals, who dominate the economics profession and policy making circles, that there is something called the “twin deficits” that must be recognized and addressed in the US. The twin deficit story goes like this: an increase in the fiscal deficit will tend to lead to an increase in the current account (or trade) deficit. Therefore, if reducing the US current account deficit is a desirable if not a necessary policy objective, then it is surely necessary to reduce the fiscal deficit. We have been hearing this story for nearly three decades from the neolibs.
The problem with the twin deficit story is the facts do not seem to bear the theory out. Below you may observe a chart for the US the shows the current account balance as a share of GDP, and the combined government fiscal balance as a share of GDP. You will notice the twins seem unrelated – not even separated at birth.
Specifically, look at the entire decade of the ‘90s, when the twins moved in opposite directions. The fiscal balance increased, while the trade balance fell. This is supposedly impossible under the neoliberal twin deficits story. Then observe the shaded bars, which encompass recessions of the past 45 years. Lo and behold, in nearly each of the recessions of the past nearly half century, the fiscal balance has fallen while the trade balance has risen. The facts indicate the twin deficit story is at best an incomplete or unreliable story (click to enlarge).
Why might this be the case? The neoliberals are not playing with a full deck – or at least they are keeping some cards up their sleeves. In prior articles, policy briefs, and public presentations, we have traced out the fact that while for the economy as a whole, total saving out of income flows must equal total investment in tangible assets (houses, plant and equipment, etc.), this is not true for any one sector of the economy. Breaking the economy down into three sectors – government, foreign, and domestic private sectors – we can derive the following identity which must hold true at the end of any accounting period (we can provide the simple algebra to derive this upon request – it appears in other publications of ours, as well as in much of the research Wynne Godley performed while at the Levy Institute):
Domestic private sector financial balance + government financial balance – current account balance = 0
DPSFB + GFB – CUB = 0
This means in order for the current account (CUB) and the fiscal balance (GFB) to be twins, as the neoliberals often assert, such that a fall in the fiscal balance (say an increase in the fiscal deficit) leads to a commensurate fall in the current account balance (say an increase in the trade deficit), then there must be little or not change in the domestic private sector financial balance (DPSFB). This, it turns out, is empirically false. The DPSFB is rarely stable, especially in the past two decades of serial asset bubbles, when both the household and nonfinancial business sectors have gone deeper than ever into deficit spending territory under the influence of asset prices kiting ever higher.
So what is the true twin of the trade deficit? We can split the DPSFB, as we hinted just above, into the household and nonfinancial business sectors.
DPSFB = HFB + NBFB
When we do so, we notice a new set of twins arises from the historical data. The true twin of the CUB is the HB, or household financial balance. And of course, this makes perfectly good sense since most of the trade deficit is in the area of tradable consumption goods (click to enlarge).
So if we decide the US CUB needs to turn around, we best find a way to increase the HFB, or the net saving positions (saving minus investment) of the household sector. How can this be achieved? Expanding and rearranging the accounting identity above, we find:
HFB = CUB – GFB – NBFB
If we want to get the two true twin financial balances increasing in value (thereby reducing the current account or trade deficit) then we have two choices available. Either reduce the government financial balance (increase fiscal deficits) or reduce the NBFB (get businesses to run down their free cash flow positions by reinvesting more of their profits in tangible capital equipment). If we rule out the former on neoliberal concerns about fiscal sustainability, we are left with but one choice to improve the position of the true twins, and that is a higher reinvestment rate in the domestic business sector.
And this, dear reader, brings us to the heart of the matter. Remember the global savings glut you keep hearing about from Greenspan, Bernanke, Rajan, and other prominent neoliberals? Turns out it is a corporate savings glut. There is a glut of profits, and these profits are not being reinvested in tangible plant and equipment. Companies, ostensibly under the guise of maximizing shareholder value, would much rather pay their inside looters in management handsome bonuses, or pay out special dividends to their shareholders, or play casino games with all sorts of financial engineering thrown into obfuscate the nature of their financial speculation, than fulfill the traditional roles of capitalist, which is to use profits as both a signal to invest in expanding the productive capital stock, as well as a source of financing the widening and upgrading of productive plant and equipment.
Let me summarize what Rob says as bullet points:
- The ‘Twin Deficits" story of a US economy out of balance due to large government deficit spending is empirically false and ignores the sectoral financial balances identity.
- To the degree there are twin deficits, the items at issue are a lack of household savings and current account balances.
- If policy makers want to increase the household sector’s savings (and reduce its debt levels), then we must either increase fiscal deficits or get businesses to reinvest profits in capital spending.
Malinvestment is What is Missing In the Analysis
I think Rob’s analysis is spot on. The real problem in countries with high current account deficits like Spain, Ireland, the UK or the US is the lack of household saving and the accumulation of household sector debt. James Carville would say "It’s the debt, stupid." And I have written two posts with that title in the past, early in 2008 and last September.
However, in reducing household debt levels, the question then goes to which sector makes the offsetting adjustment: government, the corporate sector or both. Do we even get to decide? In 2008 and 2009, it was the government sector which did the adjusting as we saw a bevy of stimulus measures used to prop up the economy. The corporate sector did no adjusting. In fact, net savings increased as profits have soared post-recession.
Rob has three solutions to deal with this problem:
- a prohibitive tax on retained earnings that are not reinvested with a 24 month period after they have been booked;
- a financial asset turnover tax that raises the cost to businesses of playing casino games in various financial asset markets, rather than reinvesting profits in the productive capital stock;
- a reinvigorated public or public/private investment program that helps speed up the shift to, and lower the costs of production of new energy technologies.
These are well worth a look (although I can’t really advocate increasing taxes). They do run into the malinvestment problem. Spain, the US, the UK and Ireland, the four bubble economies with large current account deficits I have highlighted do not have the proper allocation of investment in their economies. Across the board, this past decade there was an excessive reliance on the FIRE (finance, insurance, and real estate) sector which distorted the allocation of profits, investment capital, and labour. No amount of tweaking gets you beyond this. How to deal with this malinvestment is the key consideration that policy makers face.
The BIS, the central banks’ central bank, issued a report today warning that malinvestment is likely to continue in a world of excess monetary stimulus. I have highlighted the key points in the excerpt from the FT below:
The report also comes down firmly on the side of those who argue that in spite of the evident fragility of economic recovery in many industrial nations, governments need to address burgeoning fiscal deficits.
The issue was a dominant one at the G20 meeting over the weekend, with Europe and the US divided over the balance between austerity and fiscal stimulus measures. The gathering ended with all countries agreeing to halve their deficits by 2013 and stabilise the ratio of debt to gross domestic product by 2016.
“A programme of fiscal consolidation – cutting deficits by several percentage points of GDP over a number of years – would offer significant benefits of low and stable long-term interest rates, a less fragile financial system and, ultimately, better prospects for investment and long-term growth,” the BIS says.
It is understood that much of the report was written before heightened fears about sovereign debt in Europe roiled money markets and caused inter-bank lending to seize up. Nevertheless, the BIS makes clear that its concerns remain about the side-effects of a long-term spell of low rates.
Among the distortions associated with rates held low for a long time are asset price bubbles of the type that manifested themselves in the years before the financial crisis, particularly in housing and real estate in many countries. And because low central bank rates lead to low interest rates at the shortest maturities, banks and investors may be encouraged to engage in duration mismatch – borrowing short and lending long – a tactic that can destabilise the financial system if liquidity suddenly dries up.
Moreover, low interest rates make it easier for banks to engage in “evergreening”, the term the BIS uses to describe the practice of rolling over debt to non-viable businesses that can continue on interest payments at low rates but cannot afford to repay principal.
This delays the necessary restructuring not only of the financial sector but also of other, inefficient industries, the report says.
It also notes that low interest rates may inadvertently contribute to instability in financial institutions, which in spite of massive government interventions, remain fragile “Cutting interest rates to record lows was necessary to prevent the complete collapse of the financial system and the real economy, but keeping them low for too long could also delay the necessary adjustment to a more sustainable economic and financial model.”
The report also looks at fiscal deficits in several countries that appear to be spiralling out of control, and in particular, those associated with age-related spending in economies where demographic shifts are tilted towards older adults. It notes that while extraordinary support measures have been necessary to contain contagion across markets, these cannot remain in place for too long.
“Some measures have delayed the needed adjustments in the real economy and financial sector where the reduction of leverage and balance sheet repair are far from complete,” the BIS report says, adding that the effect of this risks undermining confidence.
If anything, the failure to undo extraordinary measures threatens “to send the patient into relapse and to undermine reform efforts”.
Stimulus Is No Panacea
Let’s be clear. Stimulus is no panacea for significant malinvestment. Yes, it can goose the economy over the short-term and it can prevent a debt-deflationary spiral. But the cost is higher and higher debt levels where the marginal rate of GDP return is ever-decreasing. Until the economy restructures and re-allocates resources to more efficient uses, GDP growth will remain low, putting the economy at permanent stall speed and ensuring that business cycles will remain short.
I like the Austrian framework for recognizing this. Here’s how I called it two years ago in March 2008:
- Inflationary monetary policy leads to an expansion of credit throughout the economy, the basic building block for a boom-bust business cycle.
- In a credit boom, less credit is available for productive assets because credit and resources are diverted to marginal debtors and high-growth/high-risk activities. Low interest rates and expansionary credit environment gives the illusion of profitability to unproductive investments and high-risk activities in the economy, that would appear foolish in an appropriate monetary environment.
- Companies, flush with cash, invest heavily to prepare for expected future growth. An investment and capital-spending boom ensues.
- Higher asset prices lower the cost of capital, fuelling a further boom in investment and capital spending, creating overcapacity in goods and services industries.
- The increase in asset prices produces the so-called ‘wealth effect’ for consumers: a decrease in savings and an increase in consumption.
- As the whole episode rests on an excess creation of credit, debt levels increase greatly.
- The inflationary monetary policy is extremely distortionary as it redistributes capital to economic actors whose costs rise after their income from those whose costs rise before their income. Those who live from a fixed and interest income like pensioners find their costs rising with higher inflation while their income decreases in real terms.
- Runaway asset price/consumer price inflation ultimately demands higher interest rates and a contractionary monetary policy, whereupon the whole house of cards collapses.
- When the asset price bubbles pop, revulsion steps in, credit contracts and the bubble currency depreciates, as hot money flees the depreciating assets.
- Eventually, the inflationary monetary policy debases the fiat currency, leading to a relative appreciation of the prices of ‘hard’ assets (like gold and silver and commodities like oil and natural gas) relative to the home currency.
- The result is a wealth effect in reverse, leading to a collapse in consumption, a secular bear market and recession.
- An expansionary monetary policy in a post-bubble environment can cushion a hard landing but does only lengthen the period before full economic recovery.
This is exactly what has happened. The last line is where we are today and what is critical to appreciate. I would expand this to include fiscal policy saying instead "an expansionary monetary and fiscal policy in a post-bubble environment can cushion a hard landing. But in the absence of a purge of malinvestment does only lengthen the period before full economic recovery.
A Few Last Words About The Psychology Of Stimulus
As I led in to this post, I support an active fiscal policy in a deep recession but I am concerned that stimulus is just corporate welfare for crony capitalists; call me a "Resource Hawk, Stimulus Dove." My view is that what invariably leads to the misallocation of resources and an eventual economic calamity like the one we are witnessing is the nexus of easy money, lax regulation and crony capitalism. See these three posts:
- The year in review at Credit Writedowns – Kleptocracy
- The year in review at Credit Writedowns – Crony Capitalism
- A more in-depth description of how elites maintain status quo ante
What happens is special interests with political connections secure a favourable playing field for themselves and siphon off society’s wealth, leaving the economy less fair, less efficient, and prone to instability. The concept that we could stimulate the economy out of a depression without solving this fundamental problem is alien to me.
What we need is a re-allocation of society’s scarce human and financial capital to more efficient and fair uses. This is unlikely to occur when those who benefit from the present arrangement (oil and gas lobby, military industrial complex, healthcare lobby, financial services lobby, real estate lobby) are riding high. Profits are at a record. Do you seriously think, resources are going to go to other parts of the economy when there is a lot of money riding on just the opposite?
This is how these things have played out historically (think South Sea Bubble, Collapse of the Russian Empire, America’s Great Depression; it’s the same every time):
- Insiders tilt the playing field in their direction by either getting government to look the other way or to tip the balance in their favour.
- When profits run up in those areas in favour, investment capital and human resources flock to those endeavours.
- Eventually, investment opportunities dwindle as the favoured sectors suffer overcapacity. Some turn to fraud and obfuscation to keep the gravy train going.
- When the malinvestment can no longer be sustained, souring investment returns are unmasked and wide-scale fraud is uncovered.
- Captured by special interests, the government attempts to revive the status quo ante via stimulus instead of using stimulus as a way of cushioning the downturn as the economy re-balances.
- Inequity is apparent in much starker detail due to the gravity of the downturn and the populace becomes angry. Stimulus is no longer supported.
- Depression ensues. Insiders are prosecuted for malfeasance. Incumbent government is overthrown.
The Obama Administration is resisting this train of events. While they want their actions to be construed as ‘for the people,’ it is clear that insiders have continued to benefit as they did in Administrations prior. This is what I failed to appreciate early in this crisis – the inevitability of government’s allegiance with insiders to maintain the status quo ante despite a deep downturn.
Will this desire to maintain a low savings and highly indebted household sector continue? I believe so. If it does, stimulus is going to be ineffective. The burdens will just be that much greater down the line.
- Parenteau: Marching to Austeria* and Other Neolib Fibs – Naked Capitalism
- Interest rates may need to rise, warns BIS – FT