The Summer(s) of Our Discontent

The late 90s surpluses were not the reason for that period's prosperity. The surpluses are what ended the prosperity. And until the public understands this, we should expect no fundamental improvement in economic policymaking.
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Virtually every profile on Larry Summers tells us that he one of the most brilliant economists of his generation, celebrated for having allegedly helped to create the boom of the 1990s. Statistical maven at age 10, the youngest tenured professor at Harvard, chief economist of the World Bank, this is a man whom the French would surely call "un homme serieux."

But after reading his latest defense of President Obama's fiscal policy in Monday's Financial Times -- "America's Sensible Stance on Recovery" -- one wonders. Only Robert Rubin and Alan Greenspan played a more important role than Summers in promoting the deregulation and lax oversight that laid the foundations for the current crisis. Certainly the plethora of innocent frauds that the Director of the National Economic Council peddles in Monday's Financial Times calls his economic perspective into question. In addition to the usual apologia of the Clinton Administration's budget policies, the latest FT defense reflects Summers's fundamental lack of understanding of modern money. Contrary to his view, the late 90s surpluses were not the reason for that period's prosperity. The surpluses are what ended the prosperity. And until the public understands this, we should expect no fundamental improvement in economic policymaking from the Obama Administration.

Let's go to the article concerned itself. To begin with, Summers first takes issues with critics, who "have complained that the continued commitment by the administration of President Barack Obama to support recovery in the short term and also to reduce deficits in the medium and long term constitutes a 'mixed message'". In fact, he goes on to argue: "The only sensible course in an economy facing the twin challenges of an immediate shortage of demand and a fiscal path in need of correction to become sustainable."

In this instance, Summers reflects the usual deficit dove position that budget deficits are fine as long as you wind them back over the cycle (and offset them with surpluses to average out to zero) and keep the debt ratio in line with the ratio of the real interest rate to output growth. In so doing, he violates one of Abba Lerner's key laws of functional finance: a government's spending and borrowing should be conducted "with an eye only to the results of these actions on the economy, and not to any established traditional doctrine about what is sound and what is unsound." In other words, Lerner believed that the very idea of what good fiscal policy means boils down to what results you can get -- not some arbitrary notion of "fiscal sustainability."

Deficit cutting, whether now or in the future, is not a legitimate goal of public policy for a sovereign nation. Deficits are (mostly) endogenously determined by the performance of the economy. They add to private sector income and to net financial wealth and, in any case, decisions by the non-government sector to increase its saving will reduce aggregate demand and the multiplier effects will reduce GDP. If nothing else happens to offset that development, then the automatic stabilizers will increase the budget deficit (or reduce the budget surplus). This is the kind of insight that Summers should be sharing with the readers of the FT if he were to demonstrate the economic leadership we need.

Then we get this misguided statement:

"A range of other considerations -- including the crowding out of investment; reliance on foreign creditors; misallocation of resources into inefficient public projects; and reduced confidence in long-run profitability of investments -- all make a case in normal times for fiscal prudence and reduced budget deficits.

And there are numerous examples, notably the US in the 1990s, where reducing budget deficits contributed to enhanced economic performance."

Where to begin? The "crowding out" thesis was discredited by Keynes over 70 years ago! The basis of the "crowding out" claim is that such government spending causes interest rates to rise, and investment to fall. In other words, too much government borrowing "crowds out" private investment. Because investment is important for long-run economic growth, government budget deficits reduce the economy's growth rate.

Summers's argument reflects a complete misunderstanding of government spending. Increases in the federal deficit tend to decrease, rather than increase, interest rates. In reality, fiscal policy actions are those which alter the non-government sector's holdings of net financial assets. This is because deficit spending leads to a net injection of reserves into the banking system. (And big deficits imply big injections of reserves.) When the banking system is flush with reserves, the price of those reserves -- in the U.S. the federal funds rate -- is driven to zero in the absence of countervailing measures (such as bond sales). Unless a zero-bid is consistent with Fed policy, the central bank will begin selling bonds in order to drain excess reserves. The bond sales continue until the fed funds rate falls within the Fed's target band.

It is also questionable whether budget deficits do, as Summers suggests, reduce confidence in long run profitability in all investments. In fact, the historical record suggests that given spare capacity, public expenditures are not only productive but also foster additional activity in the private sector. In a study of a century of UK macroeconomic statistics, Professor Vicky Chick and Ann Pettifor provide very compelling evidence illustrating that active fiscal policy promoted economic growth and helped to REDUCE the UK's public debt to GDP ratio. By contrast, periods during which the single-minded focus on debt and deficit reduction became the main focus on policy, economic growth slowed and the UK's debt to GDP ratio rose.

This study validates one of Keynes's central conclusions: "For the proposition that supply creates its own demand, I shall substitute the proposition that expenditure creates its own income" (Collected Writings, Volume XXIX, p. 81). Summers ought to read the study before he perpetuates myths to the contrary which continue to be used by unscrupulous people, to support cuts in Social Security and Medicare that can neither be justified by economic logic, nor empirical evidence.

Nor do we rely on foreign creditors, notably China, to "fund" our spending, another horrible, but eminently predictable canard trotted out by Summers. The folklore he is trying to etch firmly into the public debate is that when China finally sells of its US bond holdings, those yields will sky-rocket, no-one else will want the debt and it will be the end America as we know it. But Summers has the causation all wrong: government spending comes first and debt (in the form of bond sales) only comes afterward. Bonds are issued as an interest-maintenance strategy by the central bank. Their issuance has no correspondence with any need to fund government spending. The denomination of the debt, NOT the denomination of the debt holder, is the key consideration. China can only do what the Americans and everyone else it trades with allow them to do. They cannot sell a penny's worth of output in USD and therefore accumulate the USD which they then use to buy US treasury bonds if the US citizens didn't buy their stuff.

As Bill Mitchell has argued repeatedly, Americans buy imported goods made in China instead of locally-made goods because they perceive it is their best interests to do so. By the same token, America's current account deficit "finances" the desire of China to accumulate net financial claims denominated in US dollars. The standard conception is exactly the opposite -- that the foreigners finance the local economy's profligate spending patterns. Unfortunately, people like Summers apparently believe the latter, and they allow Beijing to play us for fools.

Good for China. They are playing a weak hand very skillfully. We, by contrast, are being played for patsies. The Federal Reserve sets the key interest rate in the U.S., and it can always hit any nominal interest rate it chooses, regardless of the size of the budget deficit (or debt). And this isn't just true of the Fed, but of any central bank which issues its own free floating, non-convertible currency.

Of course, an article from Larry Summers wouldn't be complete if he didn't repeat the usual claims of virtually all the Clintonistas -- namely, that reducing budget deficits and running 4 consecutive years of budget surpluses contributed to enhanced economic performance.

No, it didn't. The government budget surplus meant by identity that the private sector was running a deficit. Households and firms were going ever farther into debt, and they were losing their net wealth of government bonds. Growth was a product of a private debt bubble, which in turn fuelled a stock market and real estate bubble, the collapse of which has created the foundations for today's troubles. This destructive fiscal policy eventually caused a recession because the private sector became too indebted and thus cut back spending. In fact, the economy went into recession within half a year after Clinton left office.

No criticism of the government deficit is ever complete without the usual invocation of concerns for our grandchildren and the omnipresent threat of "intergenerational theft", and here again, Summers does not disappoint: "Fiscal responsibility is not only about our children and grandchildren. Excessive budget deficits, left unattended, risk weakening our markets and sapping our economic vitality." As we have argued before, forget about future public debt service becoming a yoke around the neck of future generations. A person plunged into long-term unemployment in the US faces a high chance of becoming poor (relatively in this sense) and losing a significant proportion of the assets they had built up while working (housing etc), largely as a consequence of the types of myths championed here by Summers. Their children also inherit the disadvantage that they grew up with and face major difficulties in later life because the retired and retiring baby boomers want their high nominal fixed incomes plus purchasing power preservation (if not deflation) now and until the day they die. But the youth want jobs and the prospects of a life worth living, which they won't get if we cut expenditures today on things like education and proper job training.

Fiscal hawks and deficit doves alike are strangling the baby in the crib today by denying a sensible fiscal response for the current generation's plight, while hyperventilating that fiscal deficits will do the strangulation of the next generation tomorrow. That, in a nutshell, is what is truly sapping our long term economic vitality. The only way to avoid this ongoing plight is to champion a return to full employment policies, and stop being enslaved by the economic shibboleths which people like Larry Summers and his ilk continue to champion recklessly.

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