On the first day of Spring, when the sun shines and the flowers bloom, the IMF decide to poison the world with some more ideological positioning masquerading as economic analysis. I refer to their latest Staff Position Note (SPN/10/11) which carries the title – Fiscal Space. I think after reading it the authors might usefully be awarded an all expenses trip to outer space. It is one of those papers that has regressions, graphs, diagrams and all the usual trappings of authority. But at its core is a blindness to the way the world they are modelling actually works. I guess the authors get plaudits in the IMF tea rooms and get to give some conference papers based on the work. But in putting this sort of tripe out into the real policy world the IMF is once again giving ammunition to those who actively seek to blight government intervention aimed at improving the lives of the disadvantaged. The IMF know that their papers will be picked up by impressionable journalists who are too lazy to actually seek a deeper understanding of the way the monetary system operates but happily spread the myths to their readers.
So already today I read a report in the Sydney Morning Herald (September 2, 2010) – Australia well-placed to handle any shocks: IMF – which claims that upon the basis of the IMF paper that:
Australia is among only a handful of major economies where the government’s budget is best placed to deal with “unexpected shocks”, an International Monetary Fund (IMF) report says …
In an analysis of 23 advanced economies, the Washington-based institution examined a country’s “debt limit” based on its historical track record and its current debt level, which it describes as the “fiscal space”.
“Among the advanced economies, Australia, Denmark, Korea, New Zealand and Norway generally have the most fiscal space to deal with unexpected shocks,” the report says.
But it said these countries must be mindful of future fiscal pressures.
In contrast, Greece, Italy, Japan and Portugal have the least fiscal space, while Iceland, Ireland, Spain, the UK and US are also restrained in their degree of “fiscal manoeuver”, it said.
“An absence of fiscal space should not be taken to mean that some form of fiscal ‘crisis’ is imminent, or even likely, but it does underscore the need for credible adjustment plans,” the IMF said.
The AAP story was published by the SMH at 6.50 this morning so they didn’t waste any time getting in spreading the lies.
I particularly liked the last sentence in the above quote. The IMF claimed that nations had run out of fiscal space but that didn’t mean that a crisis was about to occur. They know damn well that there will never be a crisis of solvency for governments such as Japan, the UK and the US.
The SMH report writer didn’t have the acumen to also point out that the comparison between countries that run sovereign monetary systems and countries that are within the Eurozone and have abandoned their sovereignty as a result is invalid at the most elemental level.
Whether the IMF authors appreciate the difference is another matter. I suspect they do not and have just come through graduate training via a mainstream economics program that fails to provide students with the capacity to actually understand how real world monetary systems operate and the crucial differences that exist between say the EMU and the arrangements that exist in say the US or Japan.
But the point is that the press uncritically pass this nonsense on to the unsuspecting public and to policy makers within government. It wouldn’t matter if there wasn’t a lot at stake.
To appreciate what is at stake we just need to think about our Celtic brothers and sisters who are now into their 20th odd month of austerity and the latest data suggests things are getting worse there rather than better. That should come as no surprise but it does provide further real world evidence that should be used in show trials for notable austerians who should be charged with crimes against humanity.
Here is an interesting Bloomberg report – Austerity Hawks Lose Their Celtic Poster Child – that briefly analyses the latest situation in Ireland. I have also been monitoring events there and will probably write a more detailed statistical analysis of what is happening in the coming days.
Last year I gave a presentation at a UNDP meeting in the US and I recorded my thoughts on the audience reaction and my reactions to other papers presented at the meeting in this blog – Bad luck if you are poor!.
While the main focus of the UNDP workshop was employment guarantees (which is something to be happy about), there was still a lot of talk about fiscal space. Any of the presentations that dealt with macroeconomics (other than my contribution and the contribution of fellow MMT traveller Jan Kregel) introduced the concept of fiscal space as if it mattered.
The UNDP appeared to be obsessed with the concept and it conditions the way they think about macroeconomics and constrains the way they construct their economic development assistance agenda. I formed the conclusion that the constraints that this erroneous thinking places on their policy vision goes a long way to explaining why there has been no significant increase in standards of living in the poorest nations.
Countries will never be able to create the requisite number of jobs necessary to fully employ the available labour while they are being advised by “experts” who operate in the mainstream macroeconomic paradigm.
It is clear that the UNDP constructs its development objectives (including job creation) within a macroeconomic context – see Making fiscal policy working for the poor, which is a UNDP publication published in 2004 and that their blighted notions of fiscal space condition their approach to development.
The IMF defines fiscal space as:
… room in a government´s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy. The idea is that fiscal space must exist or be created if extra resources are to be made available for worthwhile government spending. A government can create fiscal space by raising taxes, securing outside grants, cutting lower priority expenditure, borrowing resources (from citizens or foreign lenders), or borrowing from the banking system (and thereby expanding the money supply). But it must do this without compromising macroeconomic stability and fiscal sustainability – making sure that it has the capacity in the short term and the longer term to finance its desired expenditure programs as well as to service its debt.
You might also like to read this March 2005 IMF paper – Understanding Fiscal Space.
The UNDP has a special WWW Page devoted to fiscal space. This document – Primer: Fiscal Space for the MDGs – is particularly interesting as it juxtaposes the IMF approach with the approach taken by the UNDP. Perceptive readers will realise quickly that at the heart of the matter there is not much difference at all between the two. So the “higher moral ground” that the UNDP attempts to claim is illusory.
The UNDP definition (taken from their Primer) of fiscal space:
… is the financing that is available to government as a result of concrete policy actions for enhancing resource mobilization, and the reforms necessary to secure the enabling governance, institutional and economic environment for these policy actions to be effective, for a specified set of development objectives.
Spot the identical starting point. They both assume that the government has the same constraints that restricted governments during the gold standard when currencies were convertible and exchange rates were fixed. These definitions, despite their subtle differences, could have been written in 1950.
In a fiat monetary system, these concepts of fiscal space are seriously deficient and completely ignore the main points which are:
- a sovereign government is not revenue-constrained which means that fiscal space cannot be defined in financial terms.
- the capacity of the sovereign goverment to mobilise resources depends only on the real resources available to the nation.
At the meeting last year, I was astounded that the UNDP officials seemed to oblivious to these fundamental points. I can accept that many nations struggle with currency sovereignty. Those that have ceded their sovereignty by entering currency zones; by dollarising their currencies; by running currency boards; and similar arrangements clearly are not sovereign and face the same constraints that a country suffered during the gold standard era.
My advice to them would be to implement a plan to remove themselves from these arrangements as quickly as possible. The responsible conduct of the IMF and other agencies would be to help them achieve currency sovereignty as soon as possible.
I also accept that the Eurozone nations are not sovereign and so there are financial dimensions to how we might define the fiscal space their governments enjoy.
But there are hundreds of advanced and developing countries that do have currency sovereignty which means they can enforce tax liabilities in the currency that the government issues. It doesn’t matter if other currencies are also in use in those countries, which is common in many developing nations. For example, the USD will often be in use in a LDC alongside the local currency and be preferred by residents in their trading activities. But, typically, the residents still have to get local currency to pay their taxes. That means the government of issue has the capacity to spend in that currency.
So the point is that as long as there are real resources available for use in a country, the government can purchase them using its currency power.
The current data shows their are millions of people across the “sovereign” world who are unemployed. They represent real resources which have no “market demand” for their services. The government in each country could easily purchase these services with the local currency without placing pressure on labour costs in the country.
So that is background for the latest IMF attempt to comment on how much fiscal space governments currently have.
The current IMF paper claims:
A key issue confronting the global economy today concerns the degree to which countries have room for fiscal maneuver – fiscal space – and, relatedly, the extent to which adjustments in fiscal policies are necessary to achieve/maintain debt sustainability. Financial markets have brought fiscal concerns to the front pages, and a more general reassessment of sovereign risk across a number of countries – given the fiscal legacy of the global financial crisis and looming demographic pressures – remains a palpable threat to the global recovery.
The key issues confronting the global economy are not these at all. For sovereign countries like Australia, the US, Japan, the UK etc if the politicians are spending time addressing non-issues such as these then they are failing in their leadership function.
The key issues are all real – persistent and devastatingly high unemployment; poverty; social dislocation; mental illness; child abuse; environmental degradation and the like.
Further, much of the shift in budget positions across the world has been driven by the automatic stabilisers which will reverse when growth returns. The authors are oblivious to the fact that the only thing that has supported the tepid growth we have seen in the last 12 months has been fiscal policy.
The underlying theme of the paper is that the financial markets don’t like deficits so they will undermine (in some way? how?) future growth. They fail to recognise that the deficits are providing sovereign bonds to the markets who cannot get enough of the paper and bond yields and long-term interest rates generally are falling not rising.
After nearly 2 years of crisis and rising debt ratios, when are the financial markets going to attack the US or Japan? Answer: not in our lifetime.
You also see that the IMF is perpetuating the myth that changing demographics somehow alter the capacity of a sovereign government to credit a bank account. It is just asserted that if there are increased demand for public health that the government will not be able to afford to provide it.
Yes, if there is a shortage of titanium for replacement hips and knees then the government will not be able to purchase the appropriate health care. But as long as there are real resources available for sale in the currency of issue then that government will be able to “afford” them. Whether it wants to buy the goods and services will be a political question. It certainly will never be a financial issue.
So from the outset, the premise of the IMF paper is deeply flawed and warrants the paper being scrapped and the research officers released for sub-standard economic analysis. If that occurred then the whole IMF staff would be unemployed. I don’t support that because I hate unemployment. But I do support re-training for obsolete skills or low-skills and I would recommend that happen. Concerned readers please write to the IMF and urge them to retrain their low skill economics staff (the entire workforce) starting with Blanchard at the top.
The footnote to this opening IMF paragraph said that “(b)y fiscal space, we mean the scope for further increases in public debt without undermining sustainability” – so they are maintaining their earlier definition noted above.
The paper introduces a framework which is summarised by their Figure 1 (reproduced as follows).
… the solid line is a stylized representation of the behavior of the primary balance as a function of debt. At very low levels of debt, there is little response of the primary balance to rising debt. As debt increases, the balance responds more vigorously, but eventually the adjustment effort peters out as it becomes increasingly more difficult to raise taxes or cut primary expenditures further. The other line represents the effective interest rate schedule, given by the interest rate-output growth rate differential multiplied by the debt ratio. At low levels of debt, the interest rate is the risk-free rate and, assuming that output growth is independent of the level of public debt or the interest rate, this schedule is simply a straight line with slope given by the risk-free interest rate-growth rate differential.
The IMF is employing the standard mainstream macroeconomics textbook analogy between the household and the sovereign government whereby it is asserted that the microeconomic constraints that are imposed on individual or household choices apply equally without qualification to the government. The framework for analysing these choices has been called the government budget constraint (GBC) in the literature.
The GBC is in fact an accounting statement relating government spending and taxation to stocks of debt and high powered money. However, the accounting character is downplayed and instead it is presented by mainstream economists as an a priori financial constraint that has to be obeyed. So immediately they shift, without explanation, from an ex post sum that has to be true because it is an accounting identity, to an alleged behavioural constraint on government action.
The GBC is always true ex post but never represents an a priori financial constraint for a sovereign government running a flexible-exchange rate non-convertible currency. That is, the parity between its currency and other currencies floats and the the government does not guarantee to convert the unit of account (the currency) into anything else of value (like gold or silver).
This literature emerged in the 1960s during a period when the neo-classical microeconomists were trying to gain control of the macroeconomic policy agenda by undermining the theoretical validity of the, then, dominant Keynesian macroeconomics.
Within this model, taxes are conceived as providing the funds to the government to allow it to spend. Further, this approach asserts that any excess in government spending over taxation receipts then has to be “financed” in two ways: (a) by borrowing from the public; and (b) by printing money.
You can see that the approach is a gold standard/convertible currency approach where the quantity of “money” in circulation is proportional (via a fixed exchange price) to the stock of gold that a nation holds at any point in time. So if the government wants to spend more it has to take money off the non-government sector either via taxation of bond-issuance.
However, in a fiat currency system, the mainstream analogy between the household and the government is flawed at the most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.
From a policy perspective, they believed (via the flawed Quantity Theory of Money) that “printing money” would be inflationary (even though governments do not spend by printing money anyway. So they recommended that deficits be covered by debt-issuance, which they then claimed would increase interest rates by increasing demand for scarce savings and crowd out private investment. All sorts of variations on this nonsense has appeared ranging from the moderate Keynesians (and some Post Keynesians) who claim the “financial crowding out” (via interest rate increases) is moderate to the extreme conservatives who say it is 100 per cent (that is, no output increase accompanies government spending).
So the GBC is the mainstream macroeconomics framework for analysing these “financing” choices and it says that the budget deficit in year t is equal to the change in government debt (ΔB) over year t plus the change in high powered money (ΔH) over year t. If we think of this in real terms (rather than monetary terms), the mathematical expression of this is written as:
which you can read in English as saying that Budget deficit (BD) = Government spending (G) – Tax receipts (T) + Government interest payments (rBt-1), all in real terms.
However, this is merely an accounting statement. It has to be true if things have been added and subtracted properly in accounting for the dealings between the government and non-government sectors.
It never enters the IMF analysis that governments would consider using the ΔH route. They have erroneously constructed that option as being always inflationary – the demonised “printing money” option – so it is always assumed that governments will continually to (unnecessarily and voluntarily) use debt issuance to match $-for-$ their budget deficits.
More sophisticated mainstream analyses focus on the ratio of debt to GDP rather than the level of debt per se. They come up with the following equation – nothing that they now disregard the obvious opportunity presented to the government via ΔH.
So in the following model all net public spending is covered by new debt-issuance (even though in a fiat currency system no such financing is required). Accordingly, the change in the public debt ratio is:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.
A growing economy can absorb more debt and keep the debt ratio constant. For example, if the primary deficit is zero, debt increases at a rate r but the debt ratio increases at r – g.
Thus, if we ignore the possibilities presented by the ΔH option (which is what I meant by current institutional arrangements), the proposition is true but largely irrelevant.
So the IMF Figure 1 that follows is based on this framework with the primary balance and the (r-g) on the vertical axis and the debt ratio on the horizontal axis.
The IMF describe the model in this way:
The lower intersection between the primary balance and the interest payment schedules defines the long-run public debt ratio to which the economy normally converges. This equilibrium is conditionally stable: if a shock raises debt above this point (but not beyond the upper intersection), the primary balance in subsequent periods will more than offset the higher interest payments, returning the debt ratio to its long-run average, d*.
The upper intersection (at d_bar – the bar is the line on top of the d) describes:
… a debt limit … above which debt becomes unsustainable: if debt were to exceed this point, it would rise forever because (in the absence of extraordinary adjustment) the primary surplus would never be enough to offset the growing debt service. Therefore, public debt is unsustainable and, in effect, the interest rate becomes infinite as the government loses market access and is unable to roll over its debt.
So the upward bend in the red line is attempting to capture what the IMF claim is the reaction by the financial markets in search of a risk premium as debt levels rise.
Once the economy goes beyond d_bar the IMF claim “there is no sequence of positive shocks to the primary balance (in the absence of an extraordinary fiscal effort) that would be sufficient to offset the rising interest payments. Therefore, debt becomes unsustainable, and the interest rate effectively becomes infinite”.
So fiscal space is defined within this framework as:
… the difference between the current level of public debt and the debt limit implied by the country’s historical record of fiscal adjustment.
I will leave it to interested readers to work out how they come up with their results. Briefly, they run some very dubious panel data regressions (with major endogeneity problems – for those technically minded) to estimate two relationships which form the basis of their subsequent analysis.
The first relationship is what they call the primary balance reaction function which is a regression estimating how the primary budget balance (that is, the difference between government spending and revenue excluding debt servicing payments) as a percent of GDP reacts to the debt to GDP ratio. This is the thick black line in the figure.
The second relationship is the interest rate schedule (the red line) which is similarly estimated by panel regressions with country-specific fixed effects.
The regressions have serious issues and basically conflate countries with monetary systems which render them non-sovereign and sovereign countries. They ignore a range of other factors including the capacity of the central bank to control the yield curve.
So all they do is run a few regressions (with minimal reporting about the diagnostics the econometricians such as myself use to judge how robust the results are), fudge some of the future observations out to 2015 (see next), and then do some subtractions to get a figure of fiscal space. Absolutely no understanding of how currency systems operate.
It is important to understand that in computing their estimates the IMF:
… replaces historical averages with IMF projections of long-term government bond yields and for GDP growth (WEO). With minor exceptions, projected interest rate-growth rate differentials are considerably less favorable than historical differentials, reflecting the expectation of both higher interest rates and lower real GDP growth rates.
So while anchoring the lower intersection point on the basis of historical data they decide for projections to make up long-term bond yields and future growth rates. The model they used to do that is of-course the flawed mainstream framework. Not only have they consistently projected higher yields when the reality is that long-term yields remain low and are falling.
How do they cope with the two-decade low yields for Japan which has the highest debt-ratio of any nation? So essential data being fed into their modelling is just fabricated by the institutional which has demonstrated an appalling forecasting record in the past.
The IMF failed to see the crisis, underestimated the severity in the early period and has consistently overestimated the interest-rate effects of deficits.
In applying their definition of fiscal space they compute it as the:
… difference between the debt ratio projected for 2015 and the debt limit … [d_bar]
After all the statistical gymnastics the IMF staff try to tell us how important their results are:
… a key issue for policymakers is to have information about where the danger points are as far as public debt sustainability is concerned, so that timely action can be taken to steer the economy away from possible limits on public debt. A second issue relates to situations in which the economy—as a result of some shock – actually finds itself on an explosive debt path, and the options for restoring fiscal sustainability in such situations. This note aims to shed some light on both questions.
If the IMF results had any meaning or applicability at all the Japanese government would have severely cut its discretionary budget some years ago during the period when fiscal policy was propping up its ailing economy. Not only would this have pushed the budget further into deficit via the automatic stabilisers but the economy would have been plunged into a depression.
The same applies to all sovereign countries. Following the IMF approach would severely damage their real economies and fail to reduce the debt-ratio anyway.
The IMF also claim that their “analysis does not take account of rollover risk” and so (allegedly):
governments will typically want to keep their debt well below the estimated limit, to ensure that fiscal space remains comfortably positive …
Which is the ideological message that the IMF wants to pump into the policy space.
In other words, the government should be duty bound to run what may be very tight fiscal positions in situations where the other macroeconomic parameters such as private saving ratios etc are causing aggregate demand to fall and output and employment to contract.
Never mind worrying about full employment or other dimensions of public purpose which should drive the implementation of fiscal policy.
Further, the fiscal positions might be the result of sharp shifts in the automatic stabilisers as private spending collapses but still the government should resist allowing their deficits to expand beyond some mythical frontier defined by the IMF.
Finally, there is zero rollover risk for a sovereign government. It can always service its interest payment obligations and debt maturity payments. When has an advanced sovereign nation (that is, one which issues its own currency and floats it in foreign exchange markets) ever defaulted on its debt repayments or debt-servicing payments? Answer: Never for financial reasons.
The suite of blogs – Fiscal sustainability 101 – Part 1 – Fiscal sustainability 101 – Part 2 – Fiscal sustainability 101 – Part 3 – shows how we might better assess the concept of fiscal space and fiscal sustainability.
I note some commentators here consistently claim I am soft on the debt-issuance by sovereign governments as if I think it might be useful. I would have thought the message I provide is to the contrary. Debt-issuance by a sovereign government is primarily an act of corporate welfare. It is unnecessary and does nothing to reduce the inflation risk of net public spending.
No sovereign government should issue any debt at all!
However, I consider the dynamics of debt-issuance regularly because the political reality is that governments are caught in the neo-liberal spell which has somehow persuaded them that gold standard/convertible currency practices remain relevant in a fiat currency system.
Postscript to Australian National Accounts data
In yesterday’s blog – Australia continues to grow but the signs are not all good – I noted that the June quarter growth figures announced by the Australian Bureau of Statistics were positive but there were warning signs that the growth was due to unsustainable factors.
Part of the growth was due to the strong trade performance in the June quarter. I noted that this would slow as the year progressed due to the likelihood that the booming terms of trade would subside.
Remember that National Accounts data tells you what happened some months ago which is interesting but not necessarily a sign of what is currently happening. The most recent labour market data which I covered in this blog – Labour market – going backwards now – tells us that in July full-time employment growth was negative and overall total employment growth was not sufficient to absorb the labour force growth. As a result unemployment rose and given the dominance of part-time employment, underemployment also would have risen.
Today, the ABS released the trade data for July which tells us the trade surplus fell by nearly 50 per cent as a result of an absolute fall in exports and a slight increase in imports.
The bank economists were once again caught up in their own boom rhetoric and had predicted a surplus of $A3.1 billion whereas the ABS reports that it was $A1.89 billion down from $A3.44 billion in June.
One month’s data is nothing to hang a story on but what this result tells us is that when the National Accounts are compiled again for the September quarter the trade contribution to real GDP growth is likely to be smaller than it was in the June quarter.
Combined with the reduction in government contribution as the fiscal stimulus wanes and the pursuit of (manic) surpluses begins, real GDP growth is unlikely to be as strong as it was in the June quarter.
After reading the paper published by the IMF’s Research Department on fiscal space I suggest it would be more appropriate to rename that Department the Propaganda Bureau.
That is enough for today!