Austerity Policies are the Wrong Way to Integrate Conventional Wisdom Into Macroeconomic Policy, Ignore the Role of Money Within the Economy, and Mock Family Budgets

Austerity Policies are an irresponsible, potentially harmful, way to transpose family budgeting wisdom to Public finances. A country needs to live within its means, but first we need to understand the role of money within the economy. Unlike a family, a country’s expenditure will directly affect its income.
Money transaction aided by a wallet, banknotes being stored or taken out as income is earned or spent

Austerity Policies are Irresponsible, Dangerous, Ignore the Role of Money Within the Economy and Mock Family Budgets, but…

Living within Our Means: Responsibility or Ruin

A family needs to live within its own means unless it wants to end up in ruin. This is widely accepted conventional wisdom. The conviction that this holds true also for a country’s economy has been central to justify the austerity policies imposed throughout many countries, especially following the financial crisis of 2009, but is it actually true?

A Caring Father will run the family budget responsibly

A family needs to live within its own means unless it wants to end up in ruin. Constantly spending more than it earns, will cause the family to eat up its accumulated savings, liquidate the family heirlooms, and subsequently be forced to take on debt. As a family disposes of its assets it might be undermining its future earning potential. Debt accumulation will hatch additional expenses.

Short-term “savings subterfuges” like skipping meals, switching to cheaper but unhealthier food, and shirking on medical expenses could lead to health issues making things even worse. Eventually, if the situation is not remedied, the family’s financial situation will spiral down to a point at which it is irreversible. Once the lenders realise that the piled up debt has become unpayable, they will refuse to lend more money and the family will go bankrupt.

Austerity Policies as a Responsible Way to Manage a Country’s Budget

The state implementing a prudential fiscal policy is often described as a sign of responsibility. The need for a state to not spend (much) more than it collects in taxes and actively pursue a balanced fiscal budget, or even a surplus, is often marketed as a requisite for a strong and stable economy. Austerity is portrayed as a wise economic policy carried forward by responsible politicians through the analogy of a caring father exercising disciplined financial management on the family’s budget.

The responsible father will sometimes have to be make tough decisions, prioritise some expenses over others, and won’t always be able to buy his kids all the toys they want. Rigorously enforcing planned spending caps can feel harsh at time, but ultimately it is all for the long-term benefit of all the family. A little sacrifice today will safeguard the sustainability of the family’s ability to afford, or improve, its current standard of living; hence avoid much more severe problems in the future.

Macroeconomic Perspective

On the other hand some economists, especially from the Modern Monetary Theory school of thought, have argued that what is good for the goose is not necessarily true for the herd. When the economy as a whole is concerned we need to keep in mind that aggregate expenditure has to be equal to aggregate income; a person’s expenditure is another person’s income. Indeed the Gross domestic product (GDP) can be calculated both as the sum of all the expenditure within the economy, and as the sum of all the income earned within the same economy.

AE ≡ AY

  • AE = Aggregate Expenditure
  • AY = Aggregate Income (output)

Another aspect to consider is money’s vital function in the economy in its role as a means of exchange. The value of all transactions occurred in the economy is equal to the cumulative amount of (net) money that “changes hands” in each transaction being carried out. Aggregate expenditure is the amount of money that exist in the economy (money supply) multiplied by the average number of times it is spent.

AE ≡ M×V

  • M = Quantity of Money (i.e. Money Supply)
  • V = Velocity of the Circulation of Money (the number of times money changes hands)

The nominal value of the aggregate output is equivalent to the quantity of products and services produced multiplied by the average price at which they are sold.

AY ≡ P×Q

  • P = Average Price Level in the Economy
  • Q = Volume of Transactions of Goods and Services in the Economy

These mathematical identities bring forth the dual nature of the hidden underlying role of money in the economy

  1. The balances of the various participants within the economy are linked together, and ultimately have to balance with each other;
  2. The effective total supply of money (Amount of Money × Velocity of Circulation) is identical to the nominal value of all the goods and products purchased within the economy.

Aggregate Income and Aggregate Expenditure have to balance with each other

Since aggregate expenditure is equal to aggregate income, the balances of the various actors within the economy have to balance with each other. A person’s income is another person’s expenditure. In order for a participant in the economy to receive an income higher than their expenditure, someone else has to spend more (into that same economy) than they are earning. For someone to run a surplus, someone else has to be running a deficit.

AE = C + G + I +X – M

  • AE = Aggregate Expenditure
  • C = Consumption
  • G = Government Expenditure
  • I = Private (real) Investment
  • X = Exports
  • M = Imports

Above is the formula which is used to calculate gross domestic product (GDP) through the expenditure method, while below is the one used for the income method.

AY = T + W + R + i + PR

  • AY = Aggregate Income (output)
  • T = Taxation
  • W = Wages
  • R = Rental Income
  • i = interest
  • PR = Profits

Every person, family, and firm has its own balance, whether they keep account of it or not, as the difference between their revenue and their expenditure. However these individual actors can also be grouped in broader categories. For the purpose of macroeconomic analysis it is most useful to categorise into three main sectors: Public Sector; Private Sector; and Foreign Sector.

For one of the main sectors of the economy to run a surplus it has to be offset by an equivalent deficit in the other two sectors’ combined balance. If one sector runs a deficit, it will subsidise a surplus in the other two. If someone tries to improve its own balance by cutting on its own expenditure it would be reducing someone else’s income, hence worsen someone else’s balance.

If everyone tries to improve their balance at the same time they would cause the aggregate demand to collapse, hence also reduce the aggregate income within the economy. The probable result will be everyone ending up worse off than they started. This is called the paradox of thrift.

The Supply of Money, Economic Growth, and Inflation

The effective total supply of money (Amount of Money × Velocity of Circulation) is identical to the nominal value of all the goods and products purchased within the economy.

M×V ≡ P×Q

  • M = Quantity of Money (i.e. Money Supply)
  • V = Velocity of the Circulation of Money (the number of times money changes hands)
  • P = Average Price Level in the Economy
  • Q = Volume of Transactions of Goods and Services in the Economy

Therefore a change in the effective total supply of money will also cause an identical change in the nominal value of all the goods and products purchased within the economy. On the flip side it also means that for a change in the nominal value of all the goods and products purchased within the economy to occur, it has to be supported by an equivalent change in the effective supply of money.

This means that in order for the real economy to grow, it needs to be accompanied by an expansion in the money supply, unless we envisage economic growth to happen within a deflationary environment. On the other hand, it also implies that a growth in the money supply which is not matched by an equivalent increase in real output poses the risk of inflation. Alternatively an unmatched money supply growth could be absorbed by international financial flows, through an expansion of the current account deficit.

Therefore the money supply is directly related to economic growth, inflation, and international financial outflows. Growth in the money supply is essential to fund investments and to fuel economic growth, but also crops up the looming spectre of inflation. Equilibrium is achieved if:

Quantity of Money × Velocity of Money = Price level × Volume of transactions of goods & services = Total spending = Total Income = GDP

Sources of Change in the Money Supply

There are three avenues through which the total money base can grow:

  1. The central government putting it in circulation ;
  2. The banking system creating it through lending money;
  3. Positive cash-flow from the international financial markets, mainly through a current account surplus or International grants.

State: Fiscal Deficit, Central Bank Printing It

For (non-commodity) money to come in existence, someone has to have issued it. This is normally done by a sovereign Nation; either directly, or indirectly by delegating this authority to a competent institution (normally a central bank). A group of sovereign countries can also come together to back a supra-national monetary union (like the Euro area). A sovereign Nation can support its currency by declaring it legal tender, and create demand for its legal tender by imposing taxation which can be paid exclusively in that currency.

The state has two main avenues through which it can inject money in the economy: fiscal, and monetary policy. Through fiscal policy the state can increase the money supply by buying goods and services from the private sector in exchange for its legal tender (i.e. money). Monetary policy can expand the money supply by encouraging more money to be credited to firms’ and individuals’ private bank accounts, normally through the banking system. However most Central bankers prefer to control the money supply through Open market operations; whereby they buy and sell government-issued bonds on the secondary market.

The state is the only one which can increase the supply of money unilaterally. Additionally it can decide how to allocate the money it issues. A monetarily sovereign Nation can never be forced into bankruptcy, because it has the power to print its own money. It can fail to defend the credibility and value of its currency, it can voluntarily choose to default on its debt, but not be forced to.

Banking System: Money Multiplier, Money Creation, and Credit

The exact process through which the banking system de-facto increases the supply of money in the economy is an area of contention within the field of economics. The orthodox view held in mainstream economics is that this is achieved through the money multiplier mechanism. This view is the most widely supported one, the one you’ll find in textbooks and be taught at almost all universities.

However a few rebel heterodox economists posit an alternative view and claim that banks actually create money out of thin air. The latter has been recently endorsed by the Bank of England and the Bundesbank. While these views lead to radically different conclusions on the consequences of private loans; both maintain that the size of the effective money supply can be affected by a process of the banks issuing loans.

To issue money banks require a third party to be willing to take a loan and agree to its terms. Additionally a bank cannot unilaterally decide how to allocate these funds – just refute certain allocations. All ‘new” money generated requires an equivalent credit of assets and debit of liabilities to all involved parties.

International Financial Flows

Money acquired when an economy consumes less than it produces, and manages to sell its surplus to a foreign economy. For a country to run a current account surplus, another country has to be running an equivalent current account deficit. Money injected this way into the economy has to have had been created in a foreign economy through one of the previous methods. For the money supply to grow this way in one country it must shrink in another.

Integrating Conventional Wisdom And Macroeconomic Insight

The analogy between the government and family budget and both needing to live within their means is not wrong, it is just misapplied. A monetarily sovereign country still has to live within its means. However, unlike a family, these restrictions are not determined by money, as it can just print that; but by the output which it can produce.

Drafting An Integrated Model

A country’s constraints are not determined by its government’s fiscal revenue, but by the resources it possesses and the efficiency at which it is able to use them. A country’s means are its labour, capital, natural resources, technology it has access to, level of education and skill of its workforce, complementarity of its resources, and the entrepreneurial spirit to bring them together. For a country’s lifestyle to be sustainable it has to be within the limits of the value which it can produce itself in the long-run.

An increase in the money supply could result into:

  • The market demanding more goods and services to purchase, which could be achieved through either
    • an increase in domestic production or
    • a deterioration in the current account balance through domestic consumption of otherwise-exports, or increase in imports;
  • An  increase in leakages (or slowdown in the velocity of money):
    • increase in savings,
    • extinction of debts,
    • improvement in the government’s fiscal balance;
  • A generalised increase in prices
    • inflation,
    • asset bubbles.

If we define a country’s “means” as production capability than all the identities paralleling those of the family should hold true. In order for a country to consume more than it produces it would need to receive international financial aid, grants, or income from assets held abroad; dissave from its reserves; sell assets to foreign owners; or take on debt. Even so there are still cases which could give grounds for a country to consume more than it produces, but the methods of financing it shed light on the circumstances that would justify it.

Sometimes a Country Should Live Beyond Its Means

Following natural disasters or war a country might be the beneficiary of international solidarity aimed at lifting a country’s output potential back to what it used to be. Developing countries might be the recipients of international aid intended to help them live up to their potential much earlier than they would otherwise. Such grants could be motivated by sincere international solidarity, geopolitical interests, the acknowledgement that prosperity and stability spills over international borders, or an implicit hope that the favour would be returned in times of need.

Rents on investments held abroad – as a result of past savings – could provide a source of revenue to finance consumption over and above current output. This would make most sense in the case of income from one-off, or limited-time, events like the exploitation of natural resources. However this is advisable only if no productive domestic investment alternative which could yield a higher rate of return is identified.

Real Economy Application

Government should undertake supplementary expansionary policy only if the country has excess capacity to produce real value which can back the value of the money spent. It should actively invest in improving the country’s future production capability, and guarantee that enough value will be available in the future to back up the currency’s value. At the same time the government should refrain from encroaching too much on the private sector’s space and leave enough room for.the market’s flexibility.

A primary focus of government’s policy should be to prevent the deterioration of the Nation’s productive assets.

Long-term Unemployment, Labour Deterioration and a National Job Guarantee

A prolonged period of unemployment can cause people to fall into poverty, experience social exclusion, develop physical and mental health issues prejudicing their long-term earning potential. When workers remain unemployed for too long they could become unemployable, or too discouraged to keep looking for a job. Meanwhile frictional unemployment constitutes the market from which private firms recruit their labour inputs.

Hence a National job guarantee scheme for people who have been unemployed for more than a year or two could protect workers from enduring unnecessarily hardships, safeguard the skill-pool in the labour market, while not chocking the private sector’s access to input markets. Such schemes should focus on fulfilling four main objectives.

  1. audit and upgrade the job-seekers’ skills in line with the labour market’s current and foreseeable future demand,
  2. guarantee a basic income to all participants,
  3. employ them in productive work,
  4. aim to eventually transition the workers into the regular employment

Capital Accumulation, Productive Assets, and Technological advancement

Abandoned buildings & infrastructure not receiving proper maintenance might become derelict at a faster rate. Unused machinery will still become obsolete. While simplification and basic economic models can be a very powerful tool to understand the complex world they represent, we need to always keep in mind that in the real world “capital” is made up by a myriad of specific productive assets.

Public infrastructure often results in external economies, providing society at large with more economic benefits than those its owner can reap, additionally their benefit will depend on the level of economic activity at the time of their realisation. Public infrastructure also tends to involve longer time-horizons and higher risk than what private investors are usually willing to endure. Public expenditure on infrastructure, besides affecting aggregate demand, may also act as expectation signalling.

Capital is accumulated when a share of aggregate income(output) is saved instead of being consumed. Investment is undertaken when entrepreneurs expect its return to exceed the initial outlay. Return on investment will depend both on its cost, mainly interest, and its revenue, mainly from sales less production costs. Hence investment is a function of current income twofold; as the latter fuels both the source of financing, and the expectations of the returns on the former.

Technological breakthrough requires a willingness to charter the unknown that private enterprises, which need to recoup their investment to avoid bankruptcy, may not be willing to leap into. However public expenditure, which does not incur the risk of bankruptcy, can afford to be more adventurous. While the private sector can be (and has been) crucial to introduce “last mile” innovation; this was mostly built on top of technological platforms which were originally developed through public funding.

Concluding Remarks: We Chart Our Own Future

A sovereign government is not merely the administrator of a fiscal budget, but of a whole economy’s productive resources (and distribution of their output). The fiscal budget is just a tool to manage, expand and ensure the sustainability of the economy’s production possibility frontier.

There are 2 kinds of barriers limiting what we can accomplish; real limits imposed by physical constraints, and psychological ones which we impose on ourselves. By misunderstanding how our conventional family-budget wisdom translates to National ones; we are foolishly bridling ourselves to artificial limits. Reluctance to open our minds and shift our views will keep us stuck way below our economic, social, and scientific potential; shutting down our children’s opportunity of a better future.

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Angelo Dalli is the founder and owner of Forbidden Economics

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