Thursday, January 28, 2010

Reducing the deficit too early will damage recovery? Poppycock !

It is currently popular to claim that reducing the deficit or repaying the national debt too early will hinder recovery. The argument presumably being (though this rarely seems to be spelled out) that repaying this debt involves collecting taxes (or reducing government spending) so as to get the funds with which to do the “repaying”. And collecting taxes/cutting public spending is deflationary. Therefore this policy will hinder the recovery. This is a grossly over simple and flawed argument.

The basic flaw.

The basic flaw in this argument is that while the above policy is deflationary, this can perfectly well be counterbalanced by a very simple reflationary policy: printing the necessary extra money. It is true that there are book keeping entries in central banks corresponding to this extra money which are classified as “debt”. But this is one big nonsense: this is not debt in any normal meaning of the word.

However, that is still an over-simplification of the issue. So let’s look at the national debt in more detail.

The two different types of national debt.

“National debt” is commonly regarded as some sort of homogenous lump. It is actually made up of two very different forms of debt, which have very different characteristics, as follows.

The bulk of the national debt is of what might be called the “Keynsian borrow and spend” type: that is, money owed by government to people or institutions. In contrast, there is a smaller proportion (roughly a quarter in the UK, as far as I can make out) which is not of this nature at all: it is money owed by the Treasury to the Bank of England. This is not “national debt” in any real or proper sense of the phrase. Effectively, this is simply a book keeping entry or a pile of gilts corresponding to the additional money that has been printed during the recession. This is an IMAGINARY debt.

A further complexity is that national debt is owed partially to British nationals and partially to foreigners. Let’s look at foreign creditors first.

Foreign creditors.

Repaying foreigners involves a real standard of living cut for UK citizens: this is a transfer of real wealth to foreigners. This is simply the reverse or counterpart of the initial standard of living BOOST which occurs if one borrows with a view covering the difference between one’s spending and income where the former exceeds the latter.

However, this standard of living cut DOES NOT preclude full employment or recovering from the recession. The only barrier to full employment is inflation. I.e. this repayment of foreign creditors which will doubtless have a deflationary effect can perfectly well be counter balanced by money printing and/or interest rate cuts (or abstaining from interest rate increases).

(Strictly speaking there is another possible constraint on achieving full employment, which might occur where other countries reflate to an inadequate extent. Were the UK to reflate too much under these circumstances, the result could be a catastrophic collapse in the pound rather than the controlled reduction in its value, which has actually taken place (and congratulations to the authorities for at least getting this one right). Samuel Brittan I seem to remember referred to this “pound” constraint in a recent article in the Financial Times. However, this “pound” constraint exists ANYWAY: that is, it is not a problem specific to attempts to reduce the national debt. Thus this point is not really relevant here.).

Creditors who are UK nationals.

As regards repaying creditors who are UK nationals or institutions, and in relation to the “borrow and spend” part of the national debt, there is a slight problem: to what extent is the well known problem with borrow and spend, namely “crowding out”, a real problem? Let’s take one extreme first and assume that crowding out is so serious that borrow and spend is totally ineffective so far as reflating an economy goes.

In this scenario, borrow and spend has no effect. Thus the opposite – paying back the debt – has no effect either !! The debt can be repaid with impunity: that is, there will no deflationary effect from repaying the debt!

Now let’s take the opposite extreme and assume that crowding out has no effect. In this scenario, borrow and spend is highly effective, and likewise, repaying the debt will be deflationary. But is this a big problem? The answer is no, and for the following reason.

If crowding out has no effect, this implies that borrow and spend involves taking idle bank balances, and spending same, which has a reflationary effect. Thus the reverse of this operation must involve repaying debt to the latter bank balance owners, who then (as before) do little or nothing with said money (for reasons best known to themselves).

So what’s the solution to this monstrous non-problem. The answer is to print even more money: but please, please DON’T hand it to “Wall Street”. Hand it “Main Street”: the latter is much more likely to spend the money, which will stimulate demand and create jobs.

The net effect of the latter operation is to convert a chunk of the national debt which is real debt into a chunk which is better described as imaginary debt. In other words this is an effective reduction in the national debt.

Having considered two extremes in relation to crowding out, the truth is doubtless somewhere between the two extremes, neither of which are a big problem. Thus a position somewhere between the extremes is presumably not a problem either.

The imaginary portion of the national debt.

The above paragraphs dealt the REAL portion of the national debt: the portion that involves a debt, in the normal sense of the word debt, owed by government to people or institutions.

In contrast, as mentioned above, there is the portion corresponding to recent monetary base increases. There is a very simple way of getting rid of this portion: just tell the governor of the Bank of England to tear up the relevant gilts!

This portion of the national debt is ONE HUGE NONSENSE ! Or as Hilliger (p. 22) put it, this is a “merry go round”.

However, there is SOME SENSE in preserving this nonsense: it helps keep a distinction between a central bank and a government. Giving politicians DIRECT access to the printing press is certainly dangerous.


The rate at which we go for “fiscal consolidation” or “repaying the national debt” or “reducing the structural deficit” is independent of, or can be made to be independent of the reflationary/deflationary stance that government and central bank want to take, bar a couple of caveats, as follows.

To the extent that a country repays foreign creditors, this involves a standard of living hit, but it NEEDN’T involve slowing down the speed of exit from the recession (in the sense that the speed with which we revert to full employment needn’t be hindered).

Second, reducing the national debt probably to some extent involves replacing this debt with an expanded monetary base. The latter can be construed as “national debt”, but this use of the word debt is pretty nonsensical.

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