Archive for August, 2010

Understanding basic macroeconomics is important, and what’s more, it’s easy. Without macroeconomics, we can’t hope to understand the ‘budget cuts’ debate. Yet one of the most difficult issues to put over to the voting public is precisely the question of whether budget cuts are necessary? The typical voter thinks they are—-and that in hard times, everybody (households and governments alike) must tighten their belts.

‘It’s only common sense’ you may think, but the common sense tells us the earth is flat. In truth, if the economy is to grow when households tighten their belts, governments must spend more, not less. Moreover, this follows from basic macroeconomic principles—about which more below. But first, how did we get into this mess?

Bailout and recession
Everybody agrees that in the run-up to the credit crunch in 2008, the main Western economies, starting with the USA and the UK, had been on a spending binge. Ordinary folk who wanted to spend more than their income re-mortgaged their houses in the expectation that the endless rise in house prices would pay for ‘lending to myself’. As we know, the process was fomented by bank lending for new houses as ‘teaser’ rates, rates which mysteriously doubled or trebled soon after the mortgage was granted to buyers who had precious little income and no collateral. Banks could do this because they could bundle and resell these mortgages in the form of collateralised debt obligations (CDO), thus passing on the risks to others.

And it was not just mortgages but car loans, credit card loans and loans of every description that were bundled and resold. When the bubble burst, banks and other financial institutions—not just in the US and the UK but throughout the OECD—found themselves with loads of dodgy assets on their books. Moreover, households and even firms—traditionally society’s savers—were seriously in the red. Had it not been for the quick action of governments, the world’s main economies would have seized up, and we would now be in a far deeper depression than experienced in the 1930s

Recession and budgets
As we now know, business did not stop dead—but it slowed sufficiently to throw the OECD economy into a slump. It was only at the end of last year that a glimmer of growth reappeared—even so, it is currently questionable whether we’ll continue to grow, or whether there will be a second contraction or ‘double dip’. Moreover, it is governments that are the big debtors now. Why? It’s not because they lent too much money to the banks. Rather, it’s because the credit crunch threw the ‘real’ (ie, non-financial) economy into reverse gear. As economic growth slows and unemployment rises, two things happen to government finances. First, tax receipts decline quickly; secondly, governments must spend more on unemployment benefit and the like. It is this—not lending to the banks per se—which creates the so-called ‘black hole’ in government finances, the deficit.

The other important feature of a recession is that households and firms (ie, the private sector) spend less and save more. In Britain, for example, the private sector has moved from spending more than it earns to spending less than it earns; ie, from deficit to surplus. Economic actors in the private sector who previously were in massive debt—both households and firms—are paying down debt, or ‘deleveraging’ as they say in financial circles. And here is where the basic principles of macroeconomics come into the picture.

The Savings Balances
For those readers who have ever done economics, you’ll remember things like Y = C + I + G + (X-M). Or perhaps you won’t, because nothing so puts off the ordinary reader as a bit of algebra. So I’ll spare you the algebraic definitions and derivations of the savings balances. You’ll simply have to take it on faith that, at any moment in time, the sum of the private and public sector surpluses (the difference between income and spending) must equal the external current account, or what is commonly know as the extenal balance. Economists and national accountants write this in shorthand:  (S-I) + (T-G) = (X-M).

Put most simply, the sum of the two internal balances—those of the private and public sectors—must equal the external balance. It should be intuitively obvious, for example, that if we import more than we export, the country’s external balance must be in the red. This in turn means (by definition) that, internally, either the private or the government sector (or both) must be in the red to a corresponding degree—since internally we are spending more on imports that we are earning from our sale of exports. In order to carry on doing so, we must borrow from abroad.

This is in essence what economists mean when they say that the USA’s trade deficit with China can only be sustained by China agreeing to hold an ever growing pile of dollar denominated IOUs, typically US Treasury bills. And of course, if (for the sake of argument) China refused to hold more dollars, adjustment would take the form of a devaluation of the dollar and US economic contraction. At some point, the contraction in US income would shrink US imports enough to re-establish external balance.

Now what happens if a country (say, Germany) wants to run an external surplus? Clearly, the above logic dictates that either the private or public sector (or both) must spend less than it earns. In essence, it is for this reason that German wages have been held flat for so long and pari passu why Angela Merkel wants the public sector to move from deficit to a balances budget. Perfectly rational? In normal times perhaps, but these are not normal times.

Exporting Deflation

Next, for simplicity’s sake, let’s assume that the economy is already in external balance and we’d like it to stay there. If the private sector is being thrifty and spending less than it earns (which is true at the moment), then if things are to remain in balance, the government must do exactly the opposite; ie, it must run a deficit if national income is not to fall. If government does not use a deficit to offset the private surplus, national income and employment must fall, dragging down tax receipts until a counterbalancing deficit exists.

The fact that government tax receipts fall and social outlays rise when national income falls helps the economy—-it provides what are known as ‘automatic stabilisers’. Since the 1930s, all advanced economies have relied on such stabilisers to cushion their economies against business cycles and other shocks.

The problem at present is that Angela Merkel, like David Cameron, is trying to override the automatic stabilisers by insisting on large cuts to balance the budget quickly. Such cuts are almost certain to prove counterproductive, all the more so because if all advanced countries cut their budgets at the same time, this results in the export of deflation—the present-day equivalent to the beggar-my-neighbour competitive devaluations of the 1930s.

None of the above is particularly ‘Keynesian’; rather, what I have set out is the logic of basic national accounting identities. It’s time our leaders learned a bit more about macroeconomics.