Category Archives: Fiscal Policy

Eight body problem in economics

Physicists and mathematicians have puzzled over the three-body problem – the question of how three objects orbit one another according to Newton’s laws. No single equation can predict how three bodies will move in relation to one another and whether their orbits will repeat or devolve into chaos.

John Mauldin of Mauldin Economics wrote about the eight-body problem in economics in which we cannot predict how the economy will react when eight variables change. He lists the following:

What is certain is that as government fiscal intervention starts to lose its effectiveness it will be inevitable that monetary policy will continue to remain very accommodating with bond buybacks and record low interest rates. COVID-19 has turned conventional economic thinking upside down.

Equity / Efficiency trade-off

Covered this online with my A2 class this week – Unit 3 of the CIE course. The efficiency losses when the government raises taxes  and pays transfers means that interventions to improve equity have a cost. Income can only be taken away from the rich and given to the poor in a leaky bucket. The ‘leaks’ are efficiency costs represented by the lost incentive to work and produce caused by the taxes taken and the transfers given. The lost output means that there is less to share out.

The size of the leaky bucket effect is one about which there is considerable disagreement. The New Right for instance, argue that the efficiency losses associated with redistributive policies are very large indeed. Government, too, has considered the problem and tax changes made in New Zealand in the eighties have been designed to minimise the efficiency cost of taxes. The marginal rate of tax on income had been brought down from 66 per cent to 33 per cent because it is believed that high rates on high incomes have very bad side-effects. Not only do they discourage work effort, but they also encourage speculative activity and tax evasion.

The equity and efficiency trade-off may be shown in a very abstract way by a frontier such as the above. At a point such as A, the economy is highly efficient but there is a very unequal distribution of income so that equity is low. To improve equity and achieve a point like B. income must be transferred and in the process some efficiency is lost. Equity gains are at the expense of efficiency. As more and more equity is pursued, the steepness of the efficiency/equity frontier increases as the efficiency costs become higher and higher.

As in production possibility analysis, if the economy is not on the equity/efficiency frontier but inside it at a point such as C, then it should be possible to have more of both equity and efficiency. If jobs can be found for the unemployed, the use of the additional scarce resources should improve efficiency and the distribution of income.

The New Right not only argue that the trade-off is a poor one as the efficiency losses from redistribution are very large, but also feel that the goal of more equality is not very desirable in any case.  Those who put the case for equity- i.e., the Social Left take the view that concern about the ‘leaky bucket’ or the efficiency costs is not justified. They argue that people work for a whole host of reasons including pride in doing a good job and are not much affected by high marginal tax rates. For them, the goal of more equality is highly desirable.

Macroeconomic Policy – where we’ve been and where are we going?

The Economist ‘Briefing’ recently looked at what now for macroeconomic policy in the global economy. The GFC of 2008 and outbreak of COVID-19 has got policymakers scratching their head as what can be done to stimulate aggregate demand.

Keynes’ ideas of government involvement in managing the economy in the business cycle – spend in recessions and pay of debt in booms – was flavour of the month in the post-war period. However by the1970’s this policy was in trouble which the spectre of stagflation – high inflation accompanied by high unemployment. According to Keynes the two variables should move in opposite directions. In 1976 the UK Prime Minister James Callaghan in his speech at the Labour Party Conference said:

We used to think that you could spend your way out of a recession, and increase employ­ment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of infla­tion into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment.

The 1980’s saw monetarist ideas enter the scene with a focus on the control of inflation though constraining the money supply. University of Chicago economist Milton Friedman and US Federal Reserve Chairman Paul Volcker knew that in order the get inflation down that the economy would have to go through a recession and very higher unemployment in the short-run. However once inflation started to drop the Central Bank could relax monetary policy (interest rates) and then encourage more economic activity in the economy and thereby reducing unemployment. Previously policy had focused on equality of incomes which had a large impact of economic efficiency. Price stability was now the primary focus of a central bank and it was in New Zealand with the 1989 Reserve Bank Act that the first central bank became independent from government. Gone were the days where the Minister of Finance could get on the phone to the Reserve Bank Governor to change interest rates. Central banks had inflationary targets whilst fiscal policy was to keep government debts low and to redistribute income as the government saw fit.

This policy came unstuck after the GFC as central banks dropped interest rates to record levels and implemented a series of quantitative easing (QE) measures to no avail. Growth was stagnant for a long time but eventually demand for labour picked up. This would have normally been accompanied by higher inflation but it wasn’t the case. Just like in the 1970’s inflation and unemployment were not behaving according to the theory but at this time both were favourable – low inflation and low unemployment. However inequality was now gripping the attention of economists and there was concern about the monopoly position of some firms. The rich have a higher tendency to save rather than spend, so if their share of income rises then overall saving goes up and lower interest rates and QE were driving up inequality by increasing house and equity prices.

Once COVID-19 hit it was government’s fiscal policy which has been used to try and stabilise the economy and boost growth. Fiscal stimulus – government spending with running up large deficits might be required for a long period of time in order to support the economy. This is more acceptable amongst economists as low interest rates enable the government to service much larger debts and with such low inflation it is unlikely that rates will increase anytime soon. This resembles Modern Monetary Theory (MMT) – the situation where the government can create its own money therefore:

  1. Cannot default on debt denominated in its own currency;
  2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
  3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
  4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
  5. Does not need to compete with the private sector for scarce savings by issuing bonds. Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

Negative interest rates

Some governments have gone the way of negative interest rates (see graphic) to try and stimulate more aggregate demand. This would discourage saving and see a potential withdrawal of cash from the banking system leaving less money to lend out. Avoiding this scenario might involve abolishing high-denomination bank notes and making the holding of large amount of cash expensive and unfeasible. However in order to keep money in the banks might renege on interest rate cuts as customers might move their money to rival banks therefore high negative interest rates would severely dent banks’ profits.

The current economic environment may make negative interest more plausible as:

  • Cash is in decline.
  • Banks are becoming less important to finance.
  • Central bankers are looking at creating their own digital currencies

Final thought

Greater government intervention is what the majority of economists want but it does carry with it risks of significant debt and high inflation. There is an opportunity to rethink the economics discipline and as stated in The Economist:

A level-headed reassessment of public debt could lead to the green public investment necessary to fight climate change. And governments could unleash a new era of finance, involving more innovation, cheaper financial intermediation and, perhaps, a monetary policy that is not constrained by the presence of physical cash. What is clear is that the old economic paradigm is looking tired. One way or another, change is coming

Sources:
The Economist – A new era of economics – July 25th 2020
http://www.britishpoliticalspeech.org/speech-archive.htm?speech=174

Covid-19 and GDP components in New Zealand

New Zealand has been seen by many as a country which has so far done well to restrict the spread of Covid-19 and hopefully limit the longer term impact on the economy. Like many countries the economic consequences have been significant with the contraction of GDP and rising unemployment. New Zealand is now in a deep recession – negative GDP for two consecutive quarters – with GDP set decline by 17% through the six months of the year. By comparison NZ only fell by 2.7% during the GFC in 2008 and part of 2009.

The graph (from Westpac) below shows the importance of government spending in 2020 and continuing into 2021. But the reduction in household spending, residential construction and business investment are a major concern and invariable this will lead to a further loss of job. However the forecast for GDP in 2021 is more promising with household spending and government consumption being the engines of growth. Although some are saying that the recovery will be faster than after the GFC one has to remember that the GDP figures will be a lot higher as they coming from a very low base – even negative. So even a small increase in economic activity will give you a very large percentage change from the previous year. The government have spent approximately $22bn in support measure which is equivalent to around 7% of annual GDP and no doubt there is more to come.

Source: Westpac Economic Overview – Covid-19 Special Edition May 2020

Aggregate demand is crucial here and it is important for both Cambridge and NCEA students to understand its components and how it generates growth – see midmap below.

Adapted from Susan Grant – CIE A Level Revision

Macroeconomic Policies – Mind map

Just covering macro policies / conflicts with my A2 Economics class and produced this mind map in OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4.

My question would be what policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives?

Adapted from Susan Grant – CIE AS and A Level Revision

Modern Monetary Theory (MMT) and Covid-19

Modern Monetary Theory says that you can basically print your own currency by having your own central bank, run large deficits, have full employment, have no inflationary pressure and do this year after year. Nouriel Roubini (see video below) warns that while large deficits and monetary stimulus make some sense during a short deflationary economic contraction, sustaining those policies for years, as he expects will happen, will lead to inflation and economic stagnation – stagflation.

However in a time of crisis like Covid-19 there seems to be a lot more justification for this type of policy over the short-term – when you have a collapse of economic activity, a recession, deflationary concerns and a major reduction in the velocity of circulation of money (MV=PT) – a sort of stag-deflation. At this time a ‘helicopter drop’ makes sense because we have a massive fall in supply as well as demand. But monetising fiscal deficits over a number of years produces a negative supply shock that reduces potential output and increases costs ending up with stagflation like in the 1970’s.

Background to MMT

MMT has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.

MMT states that a government that can create its own money therefore:

  1. Cannot default on debt denominated in its own currency;
  2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
  3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
  4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
  5. Does not need to compete with the private sector for scarce savings by issuing bonds.

Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

How does it differ from more mainstream monetary policy – see table below.

Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.

Post coronavirus: putting more V in MV=PT

Governments around the world introduce unprecedented fiscal stimulus packages to compensate those who have been impacted by the enforced lockdown. In New Zealand Finance Minister Grant Robertson announced a $12.1 billion stimulus package to support New Zealanders and their jobs from the global impact of COVID-19 – the largest in the world on a per capita basis. The money is hopefully going to bring as many businesses back from the brink of closure but the crucial aspect of this injection is that it actually does stimulate demand and generate additional spending. Businesses that survive this pandemic and open their doors again will need the demand side of the economy to do its bit.

Demand side

The lockdown has badly affected the demand side of the economy and it won’t revert back to the way it away was overnight. Will people venture back into areas with large crowds – bars, restaurants, hotels etc? It is essential that demand makes a return in order to inject some inflation into the economy. But with such uncertainty consumers will want to put off a lot of non-essential purchases. Many economists are also concerned with the “output gap.” — the difference between what the economy could produce and what it was producing. The solution to this output gap, particularly one caused by collapsing economic demand, is to invest in infrastructure projects and give consumers cash. If consumers don’t spend then the government should step-in and spend on their behalf to create the demand necessary to return the economy to some sort of normality. One indicator that we shouldn’t be worried at present is inflation – in theory such a stimulus should create inflationary pressure – the 1970’s yes but today this is less likely when you look at the velocity of circulation.

Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:

M x V = P x T

M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output

For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250. Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change in the money supply causes an equal percentage change in the price level.

However when the velocity of money is falling, monetary policy which would otherwise cause inflation doesn’t seem to do so. The velocity graph (USA) above shows that you need to go back to 1949 to find a time when it was lower than today, and it was actually rising rapidly after the postwar lows. Remember that this graph was before the Covid-19 lock down. Velocity needs to increase at rapid rate to cause any inflation.

We have no idea of how the future is going to unfold because we have never seen anything like this before – to quote Rogoff and Reinhart – This time it is definitely different.

Source: Thoughts from the from line by John Mauldin

Post coronavirus policy with new normals: low interest rates and liquidity trap

I blogged yesterday regarding the shape of recovery after the coronavirus pandemic and have been reading Paul Krugman who suggests that conventional monetary policy can’t offset an economic shock like coronavirus.. Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap (see graph below) for 8 of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.

Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors

  • First, when the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
  • Second, if the investment is productive, it will expand the economy’s productive capacity in the long run. This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost.
  • Thirdly, there’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015). Again, by avoiding these effects a sustained fiscal stimulus would partially pay for itself. Put these things together and they probably outweigh any fiscal effect due to stimulus raising interest rates.

Can the Japanese experience tell us anything?

The policies proposed are similar to those by Japan in the 1990’s but the environment there was unique from what most other developed economies are experiencing. Krugman makes two points:

  1. Japan allowed itself to slide into deflation, and has yet to convincingly exit.
  2. Japan’s potential growth is low due to extraordinarily unfavourable demography, with the working-age population rapidly declining.

As a result, Japan’s nominal GDP has barely increased over time, with an annual growth rate of only 0.4% since 1995. Meanwhile, interest rates have been constrained on the downside by the zero lower bound. Even with this Japan still faces no hint of debt crisis.
Therefore according to Krugman, with negative shocks to economies becoming more prevalent it maybe better to implement a productive stimulus plan instead of trying to come up with some short-term measures every time there are shocks to our economy.

Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro