As Britain enters a severe recession that will lead to large fiscal deficits and growing public debt, a question presents itself – when are deficits and debt too large?  The question has an apparently simple answer.  The fiscal deficit is too large when it results in the government finding it cannot sustain its servicing (interest charges plus repayment of principle).  That answer opens a further question, when is debt service unsustainable?

This question begins with the recent arguments that if governments have control of national currencies — sometimes called sovereign currencies — they can fund their expenditures through money creation.  This view derives from the argument that taxes do not directly fund spending.  This approach to public expenditure has limited applicability.  While possession of a national currency provides the necessary condition for governments to auto-finance their expenditures, it is not a sufficient condition as a moment’s reflection shows.

The International Monetary Fund has 189 members, 145 of which have national currencies.  Of those 145 no more than a dozen governments could safely and effectively fund their expenditures by money creation.  The ability to do so requires that the currency be safe from speculation against the exchange rate.  That requires either that the national currency serve as an international medium of exchange (reserve currency) or that the government possesses substantial foreign exchange reserves.  Both serve as protection against exchange rate speculation. 

Inspecting the Special Case

Among large countries only the United States and to a much less extent the United Kingdom have reserve currencies.  The Chinese and Japanese governments represent hybrid cases of partial reserve currencies, due to their large trade volumes and substantial foreign exchange reserves.  The Chinese government holds the world’s largest stock of reserves with Japan second, $3.1 and 1.4 trillion, respectively.  No other government holds as much as a trillion. 

A few governments of medium-sized and small countries possess reserves sufficient to protect against speculation, Norway, Saudi Arabia and Switzerland are among the few.  As I pointed out in my recent book, The Debt Delusion, the principle that governments with national currencies can borrow from themselves has such limited applicability that it does not involve theory.  Rather, it involves an empirical relationship of considerable importance but a special case. 

The vast majority of governments would invite fiscal disaster by borrowing from themselves.  Because of the structural characteristics of developing economies monetization of borrowing via selling bonds to the central bank or creation of credit lines in the central bank would provoke excess demand and inflation leading to exchange rate depreciation.  For that reason the vast majority of governments with national currencies borrow in financial markets, nationally and internationally.

Even for the handful of special cases a caveat applies, the sustainability of the debt service.  Further analytical discussion requires that we abandon generality and go directly to specific cases.  The British government can and has engaged in considerable deficit monetization because of two specific characteristics of the economy.  First, the large financial sector encourages capital inflow that weakens the destabilizing effect of exchange rate speculation.  Second, the lingering function of the pound as a currency of international exchange fosters holding of sterling as a reserve by many governments.

Even in the case of Britain, the sustainability of debt service requires the continuation of low interest rates on public bonds, now 0.5% for two year gilts, and a long maturity structure of UK bonds.  The latter at 15.4 years is the longest among OECD countries, all of which have an average of less than ten except for Britain.  The Debt Management Office in the Treasury maintains the stability provided by long maturity borrowing. 

However, interest rates at the present low level are not sustainable.  The British government can avoid speculation that would elevate interest rates because the Bank of England sets rates.  Public bonds serve as a major element in private pension funds, for wealthy and also for the middle class.  If interest rates remained permanently low, that would require a substantial restructuring of pension funds and private portfolios in general.

As a policy rule, the Bank of England should aim to sustain gilt rates in the long term near the economy’s sustainable expansion rate, about 2.5%.  Public debt service is manageable if it declines or maintains a steady share of public spending.  Calculating whether debt service is sustainable involves several key numbers: 1) the level of debt, 2) average interest rate on the debt, 3) fiscal deficit (which adds to the debt), 4) the size and growth of public expenditure, and 5) expansion rate of the economy.

As guidelines we set the economy’s expansion equal to the target gilt rate (2.5%) and set a guideline for public expenditure at 40% of GDP, the share for much of the post-WWII years.  Sustainability of public debt service then depends on two numbers, the fiscal deficit and the initial size of the public debt.  Should the covid-19 depression result in a debt to GDP ratio well over 100% and fiscal deficits to GDP in double figures, debt service sustainability could become a concern.

Summary

In principle governments with national currencies can fund expenditures through money creation.  In practice very few should do so, one of which is the United Kingdom.  We have an empirical possibility to consider, not a theoretical generalization.  At the beginning of 2020 the possibility of the British government incurring an unsustainable debt or deficit remained remote.  The covid-19 economic depression changes that.

Economic recovery will occur from an initial condition with a quite large public debt to GDP and double digit deficits.  When that recovery brings interest rates back to their historically typical level debt sustainability could become a concern.  This does not imply restraining expenditure but quite the contrary.  As shown when George Osborne was Chancellor, budget cuts reduce the Treasury’s tax take by slowing the growth of the economy.  Sustained recovery will require continued management of the maturity the debt and achieving a steady recovery, unlike the near stagnation during 2010-2020 abortive recovery.

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The prevailing image people have of inflation is frequently that of toy boats in a bathtub.  Water is money and the boats are prices.  Turn on the money tap and the boats (prices) rise.  That metaphor is wrong.  Prices are not equally inflatable, do they not all float with the same buoyancy, and money cannot be strictly regulated.  Price increases do follow a general rule, that they result from excess demand for the good or service in question.

Almost all inflationary pressures, a general rise in excess demand, have one of four causes: 1) cycles in internationally traded commodities; 2) exchange rate depreciation; 3) external debt-related excess demand; and 3) sudden loss of tax revenue.  In the United States over the thirty years 1990-2020 almost all of the general increase in the consumer price index of 2-3% annually resulted from changes in international fuel prices (Economics of the 1%, page 148),   The same applies to other developed economies including the UK and major EU states.  While presented as “inflation” in the media, fluctuations in international prices are more correctly viewed as price adjustments responding to the economic cycle. 

Hyperinflation in developing countries frequently results from exchange rate depreciation, which itself follows from large trade deficits.  This type of inflation rarely occurs in advanced countries.  Infamous examples include the Indonesian inflation during the Asian Financial Crisis of the 1990s.  Large external debt payments are a closely related cause of high and hyper-inflation.  External debt service acts as an export for which there is no compensating import.  Exports generate foreign currency which is channelled abroad to pay interest and principle on public debt held by foreigners. 

With no import to absorb the domestic income generated by the export, the national economy suffers from chronic excess demand unless the government runs a budget surplus equal to the debt service.  The budget surplus eliminates the excess demand, but at high social cost.  This process generated high inflation in the deeply indebted Latin American countries in the 1980s and 1990s.  Governments were loath to generate the necessary budget surpluses because of their depressing effect on output and employment.  The German hyper-inflation of the 1920s was a rare case of this process in an advanced country, caused by the large war reparations specified in the Treaty of Versailles and the French military occupation of the Ruhr.

Sudden loss of public revenue is related to debt-related inflation.  Historically this has occurred as a result of looming or actual civil conflict.  Chile in the 1970s and Zimbabwe in the 2000s are obvious examples.  After the election of the progressive Salvador Allende president in 1970 the wealthy in Chile in effect went on strike, not paying their taxes and undermining the expansion of the economy.  The politics of the disintegration of Zimbabwe’s civil society developed in a less clear cut manner, but reflected a process of social disintegration.

In summary, over the last four decades mild inflation occurred in most countries developed and underdeveloped in response to international price cycles, most often prices of hydrocarbons.  In contrast rapid inflation invariably results from one of three causes or the interaction of the three — exchange rate collapse, high external debt burdens and civil strife. 

We should view the role of money in the inflationary process as passive, the policy or systemic response to the deeper causes.  Governments choose to cover strong inflationary pressures with monetary expansion in order to avoid what they consider a worse outcome of collapsing output and employment, even though the resultant hyperinflation may have the same effect.

For most advanced countries the low inflation rates of the last few decades should not fall into inflation terminology.  Price increases of 0-3% reflect international and domestic price adjustments inherent in dynamic economies.  Suppressing those price pressures results in economic stagnation and allocative inefficiency.  Treating any positive change in the consumer price index as inflation is practically and analytically wrong. 

If as some have suggested, the post-corona virus period brings a stronger role for trade unions and more vigorous expansion and innovation-driven productivity growth, we should expect higher rates of price increases, perhaps up to five percent per annum.  Should that happen it will reflect another general rule of market economies, that increased real wages occur during periods of moderate price increases.  That is because economic expansion itself creates upward pressure on prices while simultaneously reducing unemployment and strengthening bargaining power of employees.

Far from a problem, moderate rates of price increase signal a healthy, expanding economy.

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A “rise in the general price level” comes across as the preferred definition, but is ambiguous concept.  In actual economies with their many goods and services, the “general price level” exists as a measurement concept that no one directly perceives.  In addition, we have many statistical measures of inflation.  I focus on the commonly used consumer price index.

If we asked the proverbial person on the street, “are you unemployed”, we are likely to receive one of three replies — no, yes or “between jobs”.  Few if any adults would reply “I don’t know” or none of those”. 

We could ask the same person, “was your standard of living affected by inflation last month”?  There are many reasons why the person may find it difficult to answer.  If the Bank of England through intention or accident kept average price increase close to its 2% target, the rise might prove insufficient for the respondent to notice.  At least three characteristics of the “general price level” reinforce ambiguities of perception:  people have different consumption habits; all prices increases are not inflation; and in practice price determination falls into different processes.

To take obvious examples of the first, someone who rents accommodation will be unaffected by an increase in mortgage rates, changes in the fare for the London tube will go unnoticed by  a rural bus rider, and vegetarians will care little about meat prices. 

More important, consumer price indices use average consumption weights.  The substantial difference between average and median (mid-piont) income implies that the consumption pattern of the typical person differs substantially from the weights used by the Office of National Statistics.  ONS also calculates Indices by income deciles but these are rarely used in the media. Since 2006 when the indices began, average price increases for the population in the second decile (tenth) have differed each month from those of the ninth decile by an annual equivalent of 0.3 percentage points (ONS compares deciles 2 through 9 to avoid extreme values encountered at the ends of the distribution)). 

When people in the high ninth decile show no change, prices for those in the low second decile consistently show a small annual increase (calculated from ONS statistics for 2006-2019).  The distribution bias provides sufficient reason to make individual perception of inflation differ by income groups over several months’ periods of time.  And, of course, higher income groups may not notice small changes at all.

This ambiguity is substantially increased because (my second point), in time of low inflation quality change and new products have a calculated price impact well in excess of inflation itself.  The items people purchase continuously undergo quality change as well as being joined by new products.  Over twenty years ago the United States Congress commissioned a detailed investigation into the effect on inflation measurement of such changes. 

That study, the Boskin Report, concluded that new products and product improvement contribute about one percentage point to consumer prices each year.  While we have no equivalent UK study, the internationalisation of production and consumption suggests a similar impact.  If so, when the ONS reports an annual general price increase of two percent, what we normally mean by inflation — the same thing costs more — is actually one percent or less.

Perhaps the most important problem with measuring the general price level and inflation is a third complication.  The prices in our economy fall into three distinct categories: 1) goods and services who prices are determined in international markets, 2) those whose prices result from contact arrangements of varying time lengths (including public sector prices), and 3) prices determined in short term domestic markets processes (“spot market” prices).

With this complexity of price determination in mind, we can reconsider orthodox monetary policy.  For example if the ONS measured rate of price increases goes to 3.5%, the Bank of England is mandated, on advice of the Monetary Policy Committee, to act to reduce the rate down toward 2%.  An increase in the rate at which the Bank of England lends to private banks provides the conventional tool to archive this outcome.  Finding it more expensive to access funds, banks raise their lending rates.  Businesses then find their operating costs higher and reduce output.  Slower private expansion reduces pressure on wages and prices, bringing inflation down.

If this logic were sound, it would mean that the slow down in price increases would concentrate in domestic markets, leaving international prices such as petroleum unchanged, as well as having little impact on prices under contracts of various lengths.  The most flexible prices arise in markets with unregulated wages, such as retail and wholesale trade, where pay is also quite low. 

Thus, if the logic of conventional monetary policy holds, its distributional effect should prove quite unequal, its burden carried by the lowest pad.  The occasionally encountered argument that inflation disproportionately harms the poor is false; seeking to reduce inflation disproportionately harms the poor.

How did economic policy fall into this commitment to consistently inequitable monetary policy?  The alleged problem, excessive price increases, defies accurate measurement.  We have little evidence that the solution to this alleged problem, central bank manipulation of interest rates, would have any direct effect on it.  As I argued in my previous blog, underlying this mainstream monetary policy we find the belief in automatic adjustment to full employment — market economies naturally seek full employment, and government provoked inflation is the major source of instability.

A specific model of the economy provides the bridge from the belief in self-adjusting markets to mainstream monetary policy, the infamous Quantity Theory of Money.  In its simplest form that theory views the economy as generating one common output and money as created by governments.  In the simple neoliberal monetary world market economies automatically find full employment; only one output is produced; governments control the money supply; and inflation results from too much government created money chasing too little output.

But market economies tend to generate unemployment not full employment.  Real economies produce many goods and services with quite different process of price determination.  Governments and central banks at most influence not determine money in circulation.

Inflation is not the result of too much money.  That is its consequence.  In a third blog I focus on that issue — what causes a broad and persistent increases in prices, when that is a problem, and what policies to manage it.

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Rational Monetary Policy Returns

For decades neoliberal ideology drove discussions and practice of monetary policy.  The essence of neoliberal monetary policy, enthusiastically adopted by neoclassical economists, has a simple premise leading to a simpler policy process. 

The neoliberal approach assumes that market economies tend to automatically adjust to full utilization of resources with a stable price level.  Inflation causes instability and excessive public sector expenditure is the cause of inflation.  Sound fiscal policy requires balanced budgets, and monetary policy reinforces fiscal policy by repressing inflation.  Central banks repress inflation through the management of interest rates.  To achieve successful monetary management central banks must be independent of political influence.

The neoclassicals criticized Keynesians for allegedly unsuccessful attempts to use fiscal policy to manage the economy — fiscal “fine tuning”.  However, neoliberal monetary dogma demanded faith in the monetary equivalent.  If one accepts the questionable claim that inflation causes systemic instability, the neoliberal policy response requires acceptance of a more dubious hypothesis, that small changes in interest rates would have a substantial impact on inflation rates without a substantial impact on output.

So-called inflation targeting set precise and low inflation goals, typically in the 2-3% range (2% or less for the European Central Bank and within one percentage point of 2% for the Bank of England).  The central bank rate served as the instrument to achieve the target.  One must marvel that this simplistic hypothesis reached a level of acceptance to become policy in many countries — that in a complex economy open to international trade and capital flows, small changes in domestic central bank rates would quickly produce predictable changes in the rate of change of the price level.

More importantly, in the neoliberal era monetary and fiscal policy consciously contradicted rather than complemented each other.  To the limited extent that fiscal policy acted in an expansionary manner — before 2008 — monetary policy sought to constrain demand and prices.  After 2010 obsession with balancing budgets constrained recovery, while monetary policy sought ineffectively to stimulate recovery (so-call Quantitative Easing).

Monetization and the Virus Crisis

In early April of this year as the virus raged in Britain, the Chancellor announced further extraordinary budget outlays.  This expansion in spending made FT headlines by the manner in which it would be financed.  Rather than financing through offering public debt in financial markets (“gilts” as the bonds are called for historical reasons), the Treasury would sell the bonds directly to the Bank of England.

This financing arrangement involves an exchange within the public sector.  In a rather strange comment, a former Bank of England official reassured the FT that the financing “was unlikely to turn Britain into Zimbabwe”.  The comment was strange to the point of economic illiteracy because bonds sales by governments to central banks have a long history among advanced market countries.

For example, this April the Federal Reserve System held 15.8% of  the US public debt, while other federal agencies owned an additional 10% (the largest being the Social Security Trust  Fund), for an intra-government total of 26%.  In the United Kingdom the intra-governmental ownership of public debt is higher.  Before the April policy announcement the Bank of England held about 30% of UK debt.

Why Use Monetization

Acceptance of the neoliberal hypothesis and its implied framework of an otherwise stable economic system led to the reduction, trivialization, of monetary policy to interest rate management.  The pre–neoliberal emphasis on central banks buying and selling public bonds faded to obscurity.  This earlier approach derived from an analysis that considered interest rates an ineffective tool for short term economic management.  In place of interest rate adjustment central bank bond transactions sought directly to increase (bond purchases) and decrease (bonds sales) bank liquidity.

The bond transactions could be used to reinforce the effects of fiscal policy, making macroeconomic policy more effective.  As I explain in detail in my new book Debt Delusion, governments “live within their means” by use of taxation and borrowing to fund expenditure.  In a democratic society social necessity determines public expenditure.  Rational governments use taxation and borrowing to fund those expenditures in a manner that maintains economic stability and fullest possible utilization of resources.

In times of extreme economic and social need such as wars, recessions and the current covid-19 crisis, public borrowing serves as a major instrument to maintain stability and protect health and livelihoods.  The role of borrowing involves more than funding, though that is its immediate purpose.  The interaction of spending — fiscal policy — and borrowing — allows monetary policy to play a central role in economic stabilisation.

This interaction becomes clear by inspecting the two vehicles for managing public bond sales, financial markets and the Bank of England.  Current spending needs associated with the health crisis provide an instructive concrete example.  At the end of February 2020 the central government annual budget involved borrowing of about £40 billion or 1.8% of GDP.   Almost all revenue comes from general taxation; there are few taxes “earmarked” for specific expenditures.  Thus, the £40 billion in borrowing and the £790 billion in annual revenue funded composite expenditure. 

Having identified (however accurately) needed expenditure, the government has the choice of what vehicle to use for the borrowing, bond sales to financial markets or to the Bank of England.  At least three considerations influence which vehicle to use.  First, the desired rapidity of fiscal expansion plays a major part in deciding how to finance expenditure.  Bond sales in  financial markets leave the monetary base unchanged; the sale takes money out of circulation and the subsequence expenditure returns it.  A government might prefer this sequence if the economy is near full utilization.

Providing the private sector with a safe asset is second reason for bond sates to financial markets.  Evidence suggests that the demand for bonds by banks and other financial institutions is frequently quite high; indeed, that financial markets could absorb a considerable amount of bonds given the uncertainty caused by the corona crisis.

If the economy is depressed, the combination of a fiscal stimulus and a monetary boost is appropriate.  Selling bonds to the Bank of England combines monetary expansion with a fiscal boost.  The bond sale creates new credit which the government spends.

The regulation of interest rates provides another motivation for monetization.  In the early 2010s several EU governments suffered speculative attacks on their bonds that drove interest rates to unsustainable levels.  This speculation severely undermined the ability of governments to service their debts.  Had EU rules not prohibited it, the governments could have prevented that speculation by selling their bonds to their central banks or directly to the European Central Bank.  The British government faces no effective restriction on sales to the Bank of England.  This implies that monetization provides an effective mechanism for regulating the interest rate on the debt.  If the government offers bonds for sale and private buyers do not purchase them, the Bank of England serves as fault buyer at the prevailing bond rate.

Preventing speculation and complementing fiscal policy provide strong motivations for monetization.  Possible inflationary effects provide the main argument against.  I address that possibility in a separate blog.

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The coronavirus has accelerated this rethink, as shown in a recent Financial Times editorial calling for a new “social contract that benefits everyone”. Such a contract would increase spending to address social inequalities, substantially expanding the public sector.

This fundamental shift in the face of disaster should not surprise us. In 2008, there was much talk of abandoning light-touch banking regulation, though it was later watered down. Will change endure this time?

Wars and spending

It is worth looking at what happened after the two world wars. In 1913, British government spending was 18.5% of GDP. It rose to 59% in 1916. By 1922 it was back to 18.7%, and essentially remained so for the interwar period.

Public spending as % of GDP

Wartime public expenditure peaked at 61% of GDP in 1945. During the Attlee years it settled into the 30% range – over ten points higher than in 1938 – partly spent establishing the NHS. Even when the Conservatives took over in 1951, spending never again fell below 27% of GDP.

Economic growth differed during these two post-war periods. Between 1919 and 1938, it averaged less than 1% a year. After the second world war, there was a decade of 2.5% annual expansion. Contrasting public spending levels were a crucial difference.

UK GDP growth 1899-2019

The next chart looks at these periods’ fiscal deficits, meaning government income minus outgoings. Both war-time deficits reached about 30% of GDP then quickly declined, hitting surplus after eight and ten years respectively.

This happened after the first world war, despite the stagnant economy, thanks to a large reduction in military expenditure. Compare the 2007-09 crisis, whose much smaller deficit has endured longer than it took to return to surplus after either war.

Deficits during crises

There are two reasons. There has been nothing to compare to the cuts in military spending. Yet just like after 1918, there has been weaker growth because austerity has depressed demand and business activity.

Where we’re heading

By one recent forecast, GDP for 2020 could fall 15%. Even the government’s Office for Budget Responsibility (OBR) predicts 13%. If 15% is correct and the 2007-09 collapse is anything to go by, tax revenues might fall 25%. Tax revenues should fall more sharply than GDP because much of the tax system is progressive – for example, no one pays tax on their first £12,500 of annual income, so a 15% drop in the average income will erase more than 15% of the average person’s income tax liability.

By my calculations, a 15% GDP drop plus government recovery spending that I suspect will reach £100 billion will produce a fiscal deficit of 16% of GDP – over £300 billion (the OBR forecasts 14%; several weeks ago, the Institute for Fiscal Studies thought 8% was possible).

Even if the economy quickly returns to 2.5% annual growth, I calculate that public debt will rise to a peak of around 150% of GDP. This is around 50% more debt than the OBR expects, which seems to assume a return to near 2% growth in 2021 without any further recovery spending beyond the initial £70 billion – not tenable in my view.

No doubt some will call for balanced budgets aka more austerity, but I think those favouring increased public spending will probably win out. The UK’s experience after the second world war suggests that such high public deficit and debt levels do not in themselves prevent strong recovery or put an intolerable burden on the state.

Admittedly recovery could be undermined by household and business debt vastly higher than after the second world war. Both have eased since the 2007-09 crisis, per the chart below, but household debt in particular is rising again – driven this time by credit card and student debt rather than mortgages.

Private debt as % GDP

To achieve sustained recovery, the government might need to have household debt partially cancelled. The chancellor’s recovery programme addresses corporate debt to some extent, by providing businesses with loans with generous payback conditions and other support.

A Tory socialism?

Assuming greater government spending leads to a steady recovery, the ideology of balanced budgets as a continuous policy goal is unlikely to return. But this doesn’t mean the global order will be overhauled. Some commentators predict the end of neoliberalism or a broader resurgence of social-democrat policies, but I think this premature. Both world wars exposed ills in the social system, but only after the second world war did a major shift take place.

Britain will have a Conservative government with a large majority for four more years. The Sun may fear a “Tory socialist state”, but I doubt we’ll see any major expansion of public provision or regulation. Four decades of consumerism have instilled an ideology in many people that taxes are a burden that prevent “freedom of choice” through the market.

For this faith in markets to be swept away, the health crisis might have to lead to shortages of necessities, perhaps linked to disrupted international trade. Perhaps even a Conservative government might then introduce rationing and price controls. But this takes us deep into speculative territory, so we will see how things play out.

This piece is cross-posted from The Conversation

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Nature of the Health Crisis

The current health crisis has similarities to the Great Recession of 2008-2009, though fundamentally different.  The crisis ten years ago resulted from collapse of financial institutions, a purely human-made disaster whose solution should have been obvious.  The financial collapse provoked a severe contraction in aggregate demand in household spending and business investment.  The demand contraction led to under-utilisation in most sectors, which a fiscal stimulus would have resolved — inadequate demand, idle production and workers, correctable by the public budget replacing private demand with public demand.

The current economic contraction represents a production crisis, a spreading contraction in output as people self-isolate and the government orders workplace and shop closures.  The essential impact on the economy is the restriction of economic activity leading to a sharp decline in incomes and demand, the opposite causality of 2008-2009.  Some, including Paul Krugman, have called this a “supply side” crisis.  I avoid that terminology because of its unfortunate association with neoliberal ideology, the dogma that deregulation, “supply side reforms”, would stimulate production through increased “efficiency” generated by market competition.

Policy response

A production crisis implies that the policy response must include and go beyond income replacement schemes. The UK government proposed and will implement legislation to replace 80% of the earnings of redundant employees. Payment of a basic income to all citizens represents an alternative viewed by many as more effective. 

Compensating for loss of household income provides a necessary but not sufficient response to the production crisis. People not working by definition means production not realised. Production of essential goods such as food and other household necessities will continue as far as is possible. Three sources of disruption immediately come to mind:

1. spread of illness might create labour shortages in some sectors;
2. transport and delivery systems could reach capacity constraints, and
3. disruption of international trade flows could require greater reliance on national supply.

An increasing number of experts has pointed out that the globalisation created long supply chains render the UK production and supply system vulnerable to disruption. The cost-cutting practice of minimising inventories is also an important source of vulnerability though less fundamental. At the moment domestic production accounts for slightly over half the food consumed by UK households.

The three sources of disruption to the supply of essential production lead to obvious policy steps. First, quantity rationing of essential productions requires urgent consideration and planning. I am careful to use the modifier “quantity” because all market economies enforce rationing — households and businesses ration purchases on the basis of price and income.  The UK government enforced quantity rationing by use of ration books during and after World War II.

Second, rationing implies price controls. In the United States price and profit controls, administered by the Office of Price Administration, supported quantity rationing from the outset in 1941. Prevention of excessive profits, “war profiteering”, was a central part of price administration. Harry Truman obtained the prominence to become Franklin Roosevelt’s vice president in 1945 by his Senate hearings on war profiteering. In Britain quantity rationing continued well after the end of WW II, formally ending in July 1954.

Third, the government should initiate a broad “industrial policy” pointed at increasing domestic production of essential household products and medical equipment. This programme would include credit directed through commercial banks, price subsidies and price guarantees. For agriculture adoption of a variant of pre-EU policy could enhance national production. Stated briefly, the EU Common Agricultural Policy, which the British government joined when it became a member, involved measures to protect agricultural production by holding prices high and absorbing surpluses through official purchases. 

The UK’s pre-1973 agricultural support system kept prices low. The government set a guarantee price, farmers sold on the open market, and were paid the difference between the support price and their market price. The result was low consumer prices as farmers produced up to their limits with no surpluses for the government to absorb.

To be concrete, the UK government could create a Basic Necessities Control Board, with at least three parts, offices of 1) price regulation, 2) production management, and 3) labour supply.  The latter would avoid the suggestion to import 90.000 agricultural workers from Central and Eastern Europe. 

This latter proposal is extremely unwise — during a pandemic importing people from countries desperately struggling to contain the spread of Covid-19. It indicates a lack of common sense. The obvious solution to shortages of agricultural labour — and workers in essential sectors in general — is decent pay and adequate housing for the coming months and training schemes for the longer term. The same policy would act to overcome shortages of health workers. Self-congratulatory references to the large number of non-UK NHS staff fail to mention that active overseas recruitment reflected an attempt to attract cheap labour to the under-funded NHS, with the result of draining essential skilled workers from poor countries.

Longer term responses

Central to my proposal is whether it would represent a transitory crisis response or a fundamental change in policy for the long term.  Changes clearly advantageous for the long term are

1. domestic training of health workers (of residents of all national origins) rather than importing cheap labour from low-income countries,
2. replacement of the EU agricultural support programme with a pre-1973 type system now that we are out of the Union, and
3. legislation to facilitate a Basic Necessities Control Board that the government could initiate in an emergency.

Two major policy changes may seem discretionary but in my view highly desirable. Price control or at least monitoring of basic commodities should become permanent practice, as should public provision of a small number of those necessities, for example heating, electricity and transport.

The recent macroeconomic stimulus and income support programme may mitigate the gathering recession. The government should also address the inevitable production consequence of a lockdown, by purposeful intervention in commodity and service markets.

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Philip Hammond maintained the rhetoric of balanced budgets, although the tensions within his party resulting from Brexit negotiations constrained and guided his choices.

As the first budget by chancellor Rishi Sunak approaches, media commentators have offered their usual speculation on its likely contents. Across the political spectrum, a pejorative view of fiscal deficits, accompanied by value laden terminology has characterised these commentaries. An article in the Observer refers to the government’s plans to “splash cash” in a “spending spree”, while another in the Financial Times invokes the “black hole” metaphor to describe the mundane possibility of a larger than expected deficit.

The Institute for Fiscal (IFS) studies lent superficial respectability to the predilection for balanced budgets, warning of the need to raise taxes to fund new expenditures. The Resolution Foundation, new on the block with fiscal commentary, ominously warned of “big spending plans” that would create a public sector “bigger than at any time under Tony Blair”, reaching 40% of GDP. This near universal use of negative language to describe desperately needed expenditures indicates the continuing power of the austerity dogma that was so successfully sold to the public by George Osborne in the early 2010s.

The Tory election manifesto pledged to cover current (“day-to-day”) expenditure with tax revenues, as did the Labour manifesto. The chart below shows that the current budget has been in surplus for more than two years. During the last six months the current budget maintained an annual surplus of close to £15 billion, while public borrowing for investment was a modest 1.4% of GDP.

UK public sector current deficit and net borrowing

In contrast to the fiscal record, the prospects for the economy as a whole appear dire. While the UK economy has expanded slightly faster than the Eurozone since 2013, growth has lagged behind that of the United States. For at least ten years the Chinese economy has driven the world economy, expanding at over 6% per annual for the decade. It is now in imminent danger of recession due in great part to restrictions caused by the Coronavirus.

Contingencies beyond the control of the new chancellor will likely constrain his budget. Foremost among these are economic shocks due to Brexit uncertainty, urgently needed health expenditures resulting from the Coronavirus and a decade of austerity, and infrastructure necessities resulting from long-delayed flood defences.

Spending to deal with a likely healthcare crisis, plus outlays on infrastructure, would provide the fiscal stimulus to counter the demand shocks coming from the global economy. This would seem to be the obvious focus of the this month’s budget.

To oppose or not to oppose?

If the government comes forth with an expansionary budget, as is expected, the opposition will face a problem. In the British tradition the role of the parliamentary opposition is to oppose. This is in contrast to the German system which is characterised by consensus among the major parties since the end of the Second World War. The great advantage of the former is the near absence of backroom deals that remove policy from scrutiny and debate.

The adversarial system is not without its shortcomings. If the opposition aggressively opposes every government policy, nuance is lost. A good example of a missed opportunity for Labour to apply a more nuanced approach came when Prime Minister Boris Johnson forced out his Chancellor Sajid Javid and replaced him with an ally much closer to his views. The mainstream media interpreted Javid’s departure and his replacement by Rishi Sunak as a “power grab” by the Prime Minster, which is undesirable because it weakens the longstanding independence of the Treasury as Britain’s fiscal authority.

According to the Guardian’s Larry Elliot, many former Treasury insiders believe the power grab is “doomed to fail” because of the institutional power and extensive technical expertise of the Treasury. Of prominent commentators only Robert Skidelsky, cross-bench peer and biographer of John Maynard Keynes, positively assessed the move by the Prime Minister.

Though lacking the German Finance Minister’s legal power to veto departmental budgets, the UK chancellor acts as a restraining influence on the spending plans of the government. More than just “first among equals”, the British tradition assigns the chancellor’s the status as the responsible monitor of spendthrift politicians. The chancellor has played this role for generations, long before the austerity era.

As the fiscal authority, the chancellor serves a conservative if not reactionary function that often conflicts with the principles of representative democracy. Treasury “independence” can have no interpretation other than the power to restrain expenditure of the elected government. In effect it institutionalises austerity in the Treasury. To my knowledge no Chancellor has ever asserted Treasury independence by urging for greater spending.

Those enthusiastic about Treasury independence justify it because of an alleged tendency of governments to overspend. In practice the independent chancellor is a milder alternative to proposals for fiscal boards with veto over “excessive expenditures”, as some economists have advocated. As I argue in my new book, this approach treats informed citizens of democratic countries as self-serving and easily bribed by opportunistic politicians.

Looking forward

Progressives should not join the chorus of condemnation of Boris Johnson’s decision to appoint a “chino chancellor” (chancellor-in-name-only), or more bluntly, complain that Rishi Sunak serves as the Prime Minister’s “stooge”. Johnson has moved to undermine the long-standing power of the Treasury. If a Labour government tried to do so, as Harold Wilson attempted in the mid-1960s, it would face strong criticism for abandoning protection against reckless spending.

It may well be that Rishi Sunak should not head the Treasury because of his past business dealings, as the Shadow Chancellor has suggested. But what is considerably more important is that a Tory Prime Minister has initiated a power shift from the Treasury upon which a future progressive government can build.

Whether the motivation is virtuous or venal, when the government acts in the long-run interest of sound economic policy the opposition should distinguish clearly between the essence and appearance of the change.

It may appear that a reckless and duplicitous Prime Minister made a power grab by installing a stooge to head the Treasury. But the essential effect could be quite different; a step towards weakening what Robert Skidelsky has described as “the oldest and most cynical department of government”.

This piece first appeared in Open Democracy, the original post can be found here. Photo credit: Flickr/Number 10.

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“Economics itself…. has always been partly a vehicle for the ruling ideology of each period as well as partly a method of scientific investigation.”

Joan Robinson

While many consider her greatest work to be in the theory of growth and development (The Accumulation of Capital 1956), I focus on another of her theoretical contributions, the critique of mainstream (neoclassical) economics.

Robinson’s Objections

In Chapter 1 of The General Theory Keynes famously refers to two “postulates of Classical economics”, one of which determines the demand for labour and the other the supply. He states that “I shall argue that the postulates…are applicable to a special case only and not to the general case”, with continuous full employment the “special case” and less than full employment the general case.

In the context of later parts of The General Theory (for example, Appendix on User Cost and Chapter 20 on “The Employment Function”) it is clear that Keynes wrote tactically in accepting the limited applicability of mainstream supply and demand for labour. With an eye to what he considered his important contributions to come later in his book, he apparently decided to not to fight a battle over the theory of the labour market.

Robinson took on this fight with her path-breaking 1953 article, “Production Function and the Theory of Capital”, which initiated what came to be called the Cambridge Capital Controversy. Superficially arcane and esoteric, this controversy goes to the heart of mainstream economics. I do not exaggerate when stating that if Robinson’s critique is correct, mainstream economic theory collapses. In the judgement of prominent economic historian Mark Blaug Robinson won the argument, even that her major opponent “declared unconditional surrender”.

Yet the theory Robinson demolished lives on while she has been relegated to the fringe by the followers of those she demolished. Why and how flawed economics crowded out sound economics tells the non-specialist much about the political and ideological nature of what today passes as accepted economic wisdom. Revealing the why and how requires first the explanation of Robinson’s critique, and second its limited long-term impact on the profession.

Mainstream labour market theory presents the demand for labour by private companies as negatively related to the wage level. Other things equal, employers will increase employment if the wage level falls and vice-versa. Robinson’s critique undermined this apparently commonsense conclusion, which derives from a false comparison with markets for goods and services.

If the price of apples falls, a buyer is likely to purchase more, and purchase fewer if the price rises. The increase in amount demanded occurs because 1) a lower price frees a bit of income (if you buy four apples for one pound at 25p each, at 20p you can buy five for a pound); and 2) with apples cheaper you may substitute them for something whose price has not fallen, such as pears.

The first of these arguments cannot apply to the labour market. Employers hire workers in order to produce a product the employer then sells. A lower wage itself does not increase a company’s anticipated sales. Thus, if a lower wage results in more employment that must result from substitution of labour for other production inputs. The substitution would involve using more labour in place of capital, equipment and machinery, when wages fall, and using more capital in place of labour when wages rise.

The analytical conclusion seems obvious and irrefutable. Wages go up and employers replace labour with capital (production becomes more “capital intensive”). Wages go down and employers replace capital with labour (production becomes more “labour-intensive”). The implications are profound – if workers organize and force wages up, employment declines. For individual companies and the macroeconomy higher wages come at the cost of unemployment.

Obvious as it may seem, this argument is false. It is a non sequitur because, strange as it may seem, for the economy as a whole lower wages need not imply that labour becomes cheaper than capital. In her 1953 article Robinson demonstrated the faulty logic by asking the apparently simple question, how is capital measured? For labour, it is a reasonable simplification to treat it as homogenous and to measure it in hours worked (for example). This is not valid for capital, which is inherently heterogeneous as well as of varying age across the economy.

Robinson pointed out that we must measure capital in prices. Even if we find a suitable way to combine machinery and equipment of different ages and types, an insurmountable problem remains. When wages go up and down, the value of equipment will go up or down depending on the labour cost of the equipment. For example, if wages rise, the cost of a hand-made tool will increase substantially, while equipment largely made by other equipment will be relatively unaffected.

Implications of Robinson’s Critique

In a succinct 25 pages without use of mathematics, Robinson demonstrated that it cannot be proved that an increase in wages results in labour becoming more expensive compared to capital (while not difficult, the algebra of the proof is tedious). The explanation of this apparently paradoxical conclusion is straight-forward. In an integrated production system, increases in wages can increase or decrease the value of the economy’s capital (machinery and equipment) depending on the labour cost of special capital equipment.

The implications of Robinson’s argument are profound to the point of revolutionary. Depending on the production structure of each economy, its technology and product mix, an increase in wages might result in less employment, more employment, or have a neutral impact. For the economy as a whole, we cannot predict the impact of wage changes on employment. This indeterminate outcome applies to conditions of full utilization, Keynes’s “first Classical postulate”.

Keynes demonstrated that the level of aggregate demand determines output and employment for the economy as a whole, not relative prices of goods and services. On the contrary, aggregate demand determines those prices. Robinson took the next bold step and demonstrated that the balance between wages and profits does not rule the labour market.

Immediately after Keynes published The General Theory, his mainstream opponents began their ultimately successful task of reformulating his theory to strip it of its innovative features. In Robinson’s case the mainstream has failed in its attempts to reformulate her analysis in order to rob it of its devastating conclusions.

For that reason, her contribution is ignored, treated as an embarrassment not to mention among the faithful and certainly not to students or the potentially inquisitive layperson. To use her phrase, Robinson’s critique hit too deeply into “the ruling ideology” of mainstream economics.

Photo credit: Wikimedia Commons.

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During the global financial crisis in 2009-2010, the US and UK public sector deficits briefly reached 10% of national income. That deficit looks small compared to the budget imbalances in the USA and UK during 1941-1945. The US federal government deficit ballooned to almost 30% of GDP, and only slightly less for the British government.  American or British politicians did not argue that the war was “unaffordable”; no-one suggested that the deficits were so excessive that governments should capitulate because of reckless expenditure.

Those were literal life or death struggles that justified whatever budgeting measures were necessary to sustain the war effort. Today climate change and inequality are no less pressing on our society than was the armed defense of democracy in the 1940s.

The affordability argument seems reasonable on the surface:  our government has a limited budget and we must live within it. Taxes are the source of our government’s funding.  Spending more than the budgeted amount results in living beyond our means. Any project that over-runs the budget is not affordable no matter how commendable.

This reasoning is wrong. Governments that manage their own currencies do not confront fixed budgets. They create their “means” either through increased tax revenue or borrowing. Expansion of our economy automatically generates more revenue. If the need for greater expenditure is too urgent to await economic expansion, our government can borrow. If immediate borrowing by sale of public bonds in capital market appears unsustainable because the market interest rates would be too high, the Bank of England or the Federal Reserve Bank can act as a backup purchaser (BoE holds 25% of the UK public debt). In fact, borrowing rates are extremely low.

Reflection suggests intention of a deeper meaning of the word “afford”.  An example of the deeper message of affordability begins with the indisputable assertion that in many countries the population is ageing. At some point the income earning of elderly people ends, replaced by public and private pensions.  In the 21^st century, people are living longer, with elderly people living long enough to draw pension payments for an extended period, which is in itself is a good thing. Even though pensions are taxed, the shift of adults from taxpayer to pension recipient impacts on tax revenue. This reduced tax effect goes along with elderly people generating a high demand for public services, especially care services. 

However, in all societies the younger care for the older. As societies become larger and more complex, the elderly receive this care less within the family and more through institutions specifically constructed for that purpose. Looking after elderly people who require specialized medical care tasks occurs partly in families, but in high-income countries this care increasingly occurs in specialized institutions.

These institutions can be public or private. Since an institution will do much the same things whether public or private, the cost is likely to be much the same for a given quality of care. The commitment of a civilized society to provide adequate care for the elderly determines the total cost. The extent to which the public or private sector provides the means to fulfill that commitment is a political decision. 

We can imagine the policy process as follows. First, do we as citizens commit ourselves to ensure that the elderly have a healthy and dignified retirement? The political answer may be, “no, that is the responsibility of each family”.  Most would consider that a callous political choice that results in a rationing of health and dignity by household income. If collectively we make the opposite political decision to honor the social commitment to care for the elderly, a second question arises: to what level of healthy and dignified retirement does society commit itself? Our government will implement that collective commitment through appropriate institutions. Be the institutions public or private, it falls to our government to ensure full and non-discriminatory access, to regulate health and safety, and to monitor performance.    

The political choice between funding by tax or private income has no impact on “saving money” or shifting “burdens”. Consider the example of a family with an elderly member no longer able to carry out the routine of daily life. This elderly person moves into a care home that is funded through taxation. After an election the new government announces that it has sold the care home to a private corporation. In the future the elderly residents must pay for all their care. The consequence of the privatization of elderly care is to change the form of the household’s payments from taxation to direct payment to the private care provider. If household incomes were equally distributed, total care cost were the same for public and private provision, and the quality of care was also the same, a change from taxation to direct private payment would involve a mere shift in funding method.

In no country are household incomes equally distributed. In all wealthy countries the tax system is progressive: the higher the household income, the larger is the share paid in tax.  Taxation provides the vehicle to fund a standard of care that fulfills the commitment of full and non-discriminatory coverage. While it counters the inequality generated by market economies, the shift from public to private funding does not alter the total cost of the commitment to universal coverage. 

Affordability should refer to society as a whole and not merely the public sector. How society divides provision between public and private is a political choice. The appropriate question is not whether we can afford elderly care, environmental protection or a range of public services but “should we pay for that?” If the answer is “yes”, then democratic governments will find the means to pay by taxation or borrowing. 

Occasionally societies face the need to “tighten their belt” and cut back other spending in order to afford a service or policy action. When they do so it should be to achieve a noble purpose, such as saving our planet, not to shirk from the commitment to a just society.  Public debts and deficits are not in themselves problems. On the contrary, they can contribute to the solution of society’s needs.

Professor John Weeks’ latest work The Debt Delusion: Living Within Our Means and Other Fallacies is published by Polity.

This piece is cross-posted from Polity. Photo credit: Flickr/MOD.

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Businesses produce things in order to sell them. The implied causality that spending (demand) determines how much is produced (supply) seems so obvious today after 150 years of boom-and-bust that it is strange that mainstream economics largely ignored it from the 1860s into the 1920s.

Ideological bias offers the most plausible explanation of this avoidance of the demand problem endemic to market societies. Before the 1860s the major thinkers from Ricardo to Marx sought to explain the operation of the emerging market system. Whatever their political predilection, they could not ignore the weaknesses of the increasingly dominant capitalist system if they took the task of explanation seriously.

By the 1860s capitalism clearly achieved its dominance, especially in the United Kingdom. The mainstream of the profession adopted as its task justification and defence not explanation. William Stanley Jevons (1835-1882) took the lead in the canonising of capitalism and its value system, an approach challenged only by a few radicals such as John A. Hobson.

For seventy years after Jevons’ seminal work, A General Mathematical Theory of Political Economy (1862), a highly ideological model of the market system, prevailed in the profession. That model treated market economies as self-adjusting to full utilization of resources if governments did not interfere with its automatic operation. Competition in unregulated markets would eliminate unemployment and generate the most efficient allocation of society’s resources. The great ills of capitalism, unemployment and inflation, resulted from public intervention and trade unions.

John Maynard Keynes (1883-1946) referred to this ideology as classical [economic] theory and to its advocates simply as “the Classics” (The General Theory of Employment, Interest and Money, Preface]. While this creates a potential source of confusion (Adam Smith through John Stuart Mill are usually called “classical” economists), in the late 1930s with an article by Sir John Hicks titled “Mr Keynes and the Classics” (1937 established it as standard terminology.

Effective Demand & its Implications

The presumption of automatic adjustment to full employment, continuous full employment, meant that the Classical analysis did not consider changes in the level of output. The economy was always at full employment making it unnecessary to analyze or devote concern to idle labour or machinery.

In his Preface to The General Theory, Keynes makes a criticism of his own work based on this analytical limitation:

“But my lack of emancipation [in the Treatise on Money 1930] from preconceived ideas showed itself in what now seems to me to be the outstanding fault of the theoretical parts of that work…that I failed to deal thoroughly with the effects of changes in the level of output… This book [The General Theory], on the other hand, has evolved into what is primarily a study of the forces which determine changes in the scale of output and employment as a whole; and, whilst it is found that money enters into the economic scheme in an essential and peculiar manner, technical monetary detail falls into the background.” (The General Theory. Preface).

A few sentences later Keynes uses the phrase “a struggle of escape” to describe his intellectual change, “The composition of this book has been for the author a long struggle of escape…a struggle of escape from habitual modes of thought and expression”. It is one thing to recognize that full employment represents a special case, but much more difficult to specify how to explain why employment goes up and down.

After defining his concepts, Keynes provides the insight to understanding levels of output and employment in Book III of The General Theory, “The Propensity to Consume” (Chapters 8-10). In these chapters Keynes verifies the famous quotation by Albert Einstein, “genius is taking the complex and making it simple”, in this case variations in output is the complex and the “consumption function” provides the key to explaining it simply.

We can understand the basic argument without delving into the technical detail of Keynes’ theory of consumption. A market economy has four types of expenditure on domestic products, household spending (consumption), business spending (investment), government outlays and exports. These are obvious and listing them involves no insight.  Keynes provided insight by focusing on the two major sources of private domestic spending, consumption and investment.

In this simple case of a purely private economy what households and businesses spend determines what business produce. Business investment creates new production facilities and machinery that may last for years. Therefore, businesses do not make the decision to invest on the current health of the economy, but on their expectations for an extended future (discussed in Chapter 12 of The General Theory). While recessions and depressions discourage investment, as during 2008-2010, investment increases because of optimism about conditions well into the future not just this year. Private investment tends to be volatile and unstable like the expectations that so strongly influence it.

We now come to Keynes’ first major conclusion, that changes in employment and production result from the instability of private investment. When expectations by businesses are robust, the economy expands, driving household spending and raising employment and vice-versa. Household consumption, much of it based on immediate need, tends to be stable compared to investment.

The second major insight follows directly from the first. The amount of private investment determines our economy’s production and employment. While investment and the expenditure it generates stabilize the economy, this can occur at less than full employment. A fully employed economy is the special case, and less than full employment the general case (thus, the title of Keynes’ book, The General Theory)).

Economic Policy Revolutionised

Keynes’ basic insights, that private investment stabilizes output and that stabilization typically occurs with idle labour, constitute the core of the “Keynesian Revolution”. The conclusion that idle labour is the usual state of a market economy has profound implications for mainstream theory and policy.

The insights imply that left to its normal operation, the private sector results in an economy characterized by persistent under-utilization of human and material resource. This leads to the obvious economic policy guideline that public sector intervention is necessary in order for the national economy to maintain and prosper at full utilization of its human resources.

The necessity for policy action to achieve and maintain full capacity forms part of a more general and quite far-reaching conclusion. Mainstream economics is the analysis of, science of some would say, the allocation of scarce resources among unlimited desires. Resources are limited and people’s wants are unlimited. This putative tension between the reality of scarcity and subjective desire for abundance is allegedly resolved through the price system. On the basis of market prices people allocate their limited incomes to best satisfy their wants.

If the normal operation of the economy results in idle labour, then resources are not scarce. Idle labour implies for the economy as a whole more can be produced of everything. To the individual resources appear scarce – household income cannot cover the needs of most families. For the economy in its entirety that opposite is the case, chronic unemployment leaves productive resources wasted. Government spending management converts aggregate idleness into full employment, increasing household incomes and reducing household “scarcity”.

Further reading from PEF economists:

• Geoff Tily, Keynes’s General Theory, the Rate of Interest and Keynesian’ Economics, Keynes Betrayed (Houndsmills: Palgrave 2007).
• Robert Skidelsky, The Essential Keynes (London and New York: Penguin 2016).
• John Weeks, Economics of the 1%: How mainstream economics serves the rich, obscures reality and distorts policy (London: Anthem 2016).

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