Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 22 May 2012

Nonsensical Austerity


Even though the backlash against austerity has gathered momentum, the political leaders of the uprising hardly inspire confidence. They seem to believe that a free money tree grows in the Black Forest which can easily pay for their structurally inefficient state’s spending. This is highly unfortunate since the dogma of austerity is going to bring about a great depression. The last time such economic dogma prevailed was in the 1930s with catastrophic consequences.

Part of the reason why austerity is so appealing is that it is an easy concept to communicate to the masses. In the age of the 5-second soundbite, advocating austerity makes today’s glib and vapid politicians appear statesmanlike. Every man and Swabian housewife understands that one cannot live beyond one’s means. Ergo, the government must balance its budget despite the pain and suffering it might entail. As John K. Galbraith said, “Few can believe that suffering, especially by others, is in vain. Anything that is disagreeable must surely have beneficial side effects.”

This facile comparison of government finances with those of a household is flawed on two levels. First, the government is completely unlike a typical household which has a budget limit. Second, the whole concept of government austerity suffers from the fallacy of composition.

The government differs from a household in that it has the power to change its income at will. Apart from the coercive power to raise taxes and seize assets, a government also has the capability to create money. Thus the government is not restricted as a housewife managing the household finances. A better comparison would be with a housewife whose husband runs a counterfeiting operation on the side. Such a housewife does not face a budget constraint determined by the legitimate income of her husband. She only needs to tell her husband how much money to counterfeit to satisfy any additional spending. However, the amount of money that the husband can safely counterfeit is not infinite. Counterfeiting carries the risk of being caught by the authorities and the risk increases with the amount of counterfeit money printed. In reasonable amounts no one notices but in large amounts detection, arrest and imprisonment become inevitable.

Now if the husband’s legitimate income reduces due to a recession should the housewife pull their children out of school and cut their meals to keep within the budget constraint? Unless she has a masochistic streak, the obvious solution is to increase the counterfeiting income while cutting optional luxuries. It enables investment in the family’s future while largely maintaining the family’s standard of living. Once the economy improves and legitimate income rises, counterfeiting activity can be stopped or even reversed by buying back counterfeit notes.

At this juncture, critics will cry out that counterfeiting is illegal and morally reprehensible. If every household indulged in it, the economy would collapse. This is where the fallacy of composition comes in. What is correct at the household level is not necessarily correct at an aggregated level. The paradox of thrift is part of this fallacy. If everyone in the economy saves and no one borrows, the economy would descend into a deflationary spiral1. Therefore at the aggregate level there must be at least zero saving. When the private and household sector as a whole is saving, government must step in to spend to prevent deflationary collapse. It is unique in being the only economic actor which does not face a hard budget constraint.

Sceptics will counter the last assertion by pointing out the long list of sovereign defaults and the current Greek and European situation. This counterargument glosses over two major details. The first, as pointed out above, is that a government does not have an infinite capacity to increase spending and debt. Like the counterfeiter, if they get too ambitious they get caught and hard default, restructuring or inflation follows. However, despite the scaremongering by the high priests of the cult of austerity, this limit is far away for governments with control of their monetary policy and currency.

This leads to the second detail that many defaults are due to the government surrendering its sovereignty in some way. Hence its ability to avoid default is severely curtailed. Bond issuance in foreign currencies and foreign law jurisdictions cedes sovereignty. It artificially imposes a hard budget constraint thereby leading to disaster when the domestic economy takes a leg down. History is fairly clear on this: Latin American crisis was on dollar bonds; East Asian crisis was due to foreign borrowing. In the extreme case, a complete loss of monetary sovereignty results from a peg or monetary union and the eventual bust is more catastrophic. Argentina is testament to this and the European Union soon will be.  
       
Does this mean that indebted nations with control of their monetary policy and currency like the US and UK should engage in fiscal expansion? The answer is unequivocally in the affirmative. In the short-term it will increase public debt and lead to a deterioration of debt ratios but it will prevent a depression. The current debt ratios are sunk costs and should not enter into policy calculations. Once growth restarts debt will be brought down. And growth will restart eventually. Not even the most austere austerity proponent argues against that2.

Unfortunately political leadership is sorely lacking. Instead of leaders of the stature of FDR, opinion-poll-following politicians have been inveigled by austerity proponents to rush headlong into a depression. The greater tragedy is that the leaders of the anti-austerity brigade, especially in Europe, seem to be delusional. They want to play on voter angst without offering a credible plan. Everyone wants the trappings of office without shouldering the responsibility which comes with power. Therefore economic suffering looks set to continue.


1 Very simplistically: since any saving is income not spent on goods and services, a net saving leads to unsold goods and services. This leads to price reductions (reduction in value produced) and labour retrenchment. This leads to reduced total income in the economy in the next period which implies lower spending on goods and services. Saving leads to unsold goods and services again. The cycle repeats.

2 Those who quote Japan seem to have missed the small demographic difference between Japan’s and US/UK’s population pyramid and growth. They have also missed the adherence to neoclassical dogma and the hesitant pump priming which has accompanied Japan’s lost two decades. The VAT rise of 1997 leading to a renewed slump being the most cited example.

No comments:

Post a Comment