Market Macro Myths

Source:

Market Macro Myths: Debts, Deficits, and Delusions

Hyperinflations, Hysteria, and False Memories

The Idolatry of Interest Rates Part I: Chasing Will-o’-the-Wisp

 

I always think that the ratio of deficit/GDP may not be as danger as people believe. We might see 200% or 300% deficit/GDP as insane just like a thousand years ago people would feel government deficit was unforgivable sin. James Montier holds a similar view and verify it from some simple macroeconomic perspectives.

 

“Sound finance”

Governments should seek to balance their budgets. Or simply not having deficits of more than X% of GDP.

“Functional finance”

government deficits should be judged only by the degree to which they help us reach the goals of macroeconomic policy (generally held to be full employment and price stability)

“The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science… The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance.” by Abba Lerner1943 

Why people holds sound finance?

Myth 1: Governments are like households

Over-accumulation of private sector debt is a problem. But this may not apply to governments and their deficits. 

For either nations with monetary sovereign status or nations without, public debt is different from private debt.  [1]

expenditure model of GDP:

Y = C + I + G + (X – M)

income model of GDP:

Y = C + S +T

-> (S – I) = (G – T) + (X – M)

-> if the private sector wishes to save in excess of its investment, then there must be a government deficit and/or a current account surplus.

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1.The private sector generally runs surpluses with the counterpart coming from the government’s fiscal deficits.

2. wherein the private sector has run significant deficits with neither experience ending well.
1st was the TMT bubble, when firms drove the private sector into deficit.
2nd was the housing bubble with households driving the private sector into deficit.

-> The dangers of debt seem accumulated by the private sector rather than the government sector

–> mind-bogglingly large national debt won’t be repaid, given the counterpart nature of the government deficit, the national debt could easily be relabled as national saving.

Myth 2: Printing money to finance budget deficits is inflationary

 

MV = PY

If one is willing to make rather unrealistic assumptions such as velocity and output being fixed, changes in money must cause changes in prices.

PY = C + I + G + (X – M).

-> It is certainly possible that running government deficits can create inflation (if doing so pushes the economy beyond its limits), but so could any other element of GDP (e.g., consumption or investment).

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In neither case of US or Japan, there is any evidence of a strong link between fiscal deficits and inflation. [2]

Myth 3: Budget deficits/high debt lead to high interest rates

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The biggest issue is that the model assumes that savings must precede investment.

“This is a reasonable assumption if you are living in a onecommodity, corn-based economy. If you want to invest in more corn, you must save some corn first. However, when we move to monetary-based economies this ordering is no longer true. Investment can (and does) precede savings in such a system. When you want to invest, you go to the bank and ask for a loan. The bank decides whether or not to grant such a loan, but it isn’t constrained by deposits or reserves. It will make the loan, and then worry about how to ensure regulatory compliance with reserve requirements, etc., afterward.”

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The real world model acknowledges that when a government runs a fiscal deficit, it creates excess reserves at the bank. [3]
-> No bank willingly sits on excess reserves, and so money is lent out in the interbank market.
–> This has the effect of lowering the interest rates towards zero (or to the level that the central bank pays on reserves).

—-> So the prediction from the real world model is that interest rates get driven down by budget deficits, not up as per the loanable funds framework.

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Budget deficits and high debt levels don’t seem to be associated with higher interest rates at all. 
<- weak economic growth is likely to cause both high deficits and low interest rates

Myth 4: Budget deficits are unsustainable

In essence this comes down to whether the real interest rate (r) is higher or lower than the real growth rate (g).

∆d=-s+d*[(r-g)/(1+g)]

s is the primary surplus (the budget position before interest payments), d is the initial level of debt to GDP

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The biggest problem: Is it reasonable to assume that real rates and real growth will be the same for the next 750 years?

And,
because the central bank sets the interest rate, they should pretty much always be able to ensure that the real interest rate is below the real growth rate.

<- The obvious issue for Greece (in the chart above) is that it isn’t monetarily sovereign, and also not fiscally sovereign

Myth 5: Debt is a burden on future generations

“There may well be distributional issues if all of those bonds are owned by, say, the grandchildren of Bill Gates, but these will be intragenerational issues, not intergenerational ones.”

How this matters

1. Given monetary policy is largely impotent with regard to the real economy,  fiscal policy offers a real alternative, if we understand the nature of government debts and deficits.

2. A greater reliance upon fiscal policy rather than monetary policy could also be good news for value investors. 

Reliance on monetary policy as an effective stabilising device would involve…a high degree of instability …in the capital market…The capital market would become far more speculative… longer run considerations of … profitability would play a subordinate role. As Keynes said, when the capital investment of a country “becomes the by-product of the activities of a casino, the job is likely to be ill-done.” — Kaldor, 1958

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Why “business” doesn’t like the idea of fiscal policy?

“The reasons for the opposition of the “industrial leaders” to full employment achieved by government spending may be subdivided into three categories: (i) dislike of government interference in the problem of employment as such; (ii) dislike of the direction of government spending (public investment and subsidizing consumption); (iii) dislike of the social and political changes resulting from the maintenance of full employment.” by Kalecki 1943 [4]

 

 

[1]

Monetarily sovereign are those that issue their own currencies, have floating exchange rates, and issue debt in their own currency, such as the United States, the United Kingdom, and Japan. While the Eurozone is a prime example of those that lack such sovereign status.

Those nations that enjoy monetary sovereign status can, in effect, borrow from themselves. They have the ability to create money and spend it – essentially ex nihilo. Thus they can’t ever be forced into insolvency.

[2]

The only evidence of any linkage that I could find in the U.S. data was around the time of World War II, when the U.S. was running major deficits due to the war, and then seeing inflation as a result of the shutdown in trade and eventually the return to a peacetime economy with the unleashing of pent-up demand.

[3]

When a government spends it simply tells the central bank to credit the government’s account with funds (created by keystrokes).5 Similarly, when a government taxes, these funds eventually end up as a credit to the government in their account at the central bank.

[4]

Kalecki notes that in a system without significant active fiscal policy, business is in the driver’s seat, and their animal spirits may determine the state of the economy.

On the “dislike of the direction of government spending,” Kalecki notes that industrial leaders hold a “moral principle of the highest importance” to be at stake.

“Under a regime of permanent full employment, the ‘sack’ would cease to play its role as a ‘disciplinary’ measure… ‘discipline in the factories’ and ‘political stability’ are more appreciated than profits by business leaders. ”