February 24, 2007

Deficit Financing

When deficits are unnecessary

Friday, February 23, 2007

ECONOMICS Nobel Laureate James Buchanan published a book in 1979 that surprised economists. The book was called: Democracies in DeficitThe Legacy of John Maynard Keynes.

Keynes came up with a cure for the depression of the 1930s that started with The Wall Street Crash of 1929 in the United States, spread to the rest of the industrial world, and lasted for a decade until the beginning of the Second World War in 1939.

His was a very simple solution for lifting the industrial economies out of depression let the workers dig ditches and re-fill them! The underlying economics of the solution was contained in Keynes path-breaking economics treatise he wrote in 1936 named: The General Theory of Unemployment, Interest and Money, or The General Theory, for short.

Reportedly, when the US President Roosevelt was told of Keynes new insight on fighting economic depression digging ditches and all that he told his advisors: This (way of fighting depression) looked too simple. By saying this Roosevelt implied that if the cure for depression were so straightforward and painless, no country in the world would have suffered from it and for so long.

And the economic hardships caused by depression was for everyone to see in the US and elsewhere in the industrialised world: close to a third of labour force unemployed whereas full employment had been the norm; factories and banks closed; long lines at soup kitchens all across US to feed unemployed workers; and spreading gloom if the depression would ever end.

Keynes logic for fighting depression was simple but in no way simplistic. He understood but not in the manner others in the economics profession envisioned at that time what had caused depression and why this had been so persistent.

Industrial economies had built a massive amount of productive capacity since the industrial revolution began in the latter part of eighteenth century. As long as growth in production capacity was matched by growth in incomes and demand in about equal proportions goods produced in factories can be sold in the market place at their full cost of production that included normal return to producers for their efforts and labour, commonly known as profit.

This cyclical process supply creating its own demand and in an equivalent amount, according to the famous Says Law, named after nineteenth century famous British economist, John Say worked without a hitch for over a century, with only infrequent and minor interruptions in the smooth functioning of the capitalistic economy, which most people did not even notice.

But, nonetheless, some thinkers of the time, most famously Karl Marx in the 1860s, questioned whether the capitalistic system (which was another name for this cyclical process supply generating its own demand) was stable and fair for the workers who produced the wealth that yielded profits for the capitalists.

Marxs view was that capitalists took too much out of the national income stream in the way of abnormal profit and paid too little to workers for them to be able to afford buying all the goods they had helped produce and being sold at their full cost of production.

If the factories could not sell all the goods that had been produced at their given prices which Marx thought was inevitable, given the fact that capitalists saved (i.e., not spent) all the profits they took there would be unsold goods in the market, their prices would decline, factories would not get new orders, would operate only part-time or close down, and so workers would be thrown out of work.

If this downward spiral in economic activities persisted for a long time, the capitalistic system would collapse because of deficient demand for all that can be produced. Marxs view was pooh-poohed at the time he came up with the doom and gloom about the capitalistic system but he was vindicated when depression struck the capitalistic (i.e., industrial) world in the 1930s. There were many converts to Marxs theory about the unworkability of capitalism but Keynes fought back with his new theory of how to cure depression and, implicitly, how to prevent it from occurring again.

Here then comes the Government with its budget deficit Keynes invention of the panacea that can cure depression and also help the capitalistic system to make it depression-proof. It worked this way.

Government needs to open up its purse and spend freely. If it runs out of money, it should borrow and, because only the central bank of the country has the power to create money just by printing it at no cost it can open its spigot for the Government supply it with almost unlimited amount of liquidity, which the Government can use (spend) to end depression (offset the deficiency of demand).

The reasoning worked something like this. Depression happens because of lack of demand from people (consumers and investors) for the purchase of goods and services already produced and brought in the market place. In order to purchase (demand) something, people must have an income, which meant having a job. If government spending helped create jobs and added to the income stream, demand in the economy would increase, hereto-unsold merchandise could be sold, factories would receive new orders, they would begin hiring the laid-off workers and, eventually, everyone would get employed.

Keynes was careful to note that, since a lot of unused production capacity already existed (hence the depression), workers need not be employed for creating things of value (i.e., addition to existing supply capacity). It would be beneficial for the economy if, in fact, they created nothing.

Hence the advice: employ the unemployed workers to dig ditches and make them fill again! Not ridiculous advice after all given the circumstances!

Fijis case is different

The interim government has resolved to keep this years budget deficit at no more than 2 per cent of GDP (roughly $100million or same as proposed by the previous Government in November 2006), in the face of an expected shortfall of about $200million in revenue collections from the level estimated earlier.

This has invited opposition from some economists on whether this is the right move for fighting the depression that the Fiji economy is feared to be sliding into.

Some social groups and religious organisations also have opposed the Governments deficit control intentions. They fear this would require suspending programs and slicing expenditures, including allocations for social programs. Some of these are already funded poorly and any cuts would mean more miseries. I sympathise fully with these concerns. Any cuts in aid to the poor must come as the last, not the first, item in the Governments deficit control campaign. On the contrary, it would be wise giving the poor some extra help, since they are the ones who suffer most when times get hard.

However, I am opposed to the view that the Government not target a lower deficit than is likely with the expected decline in revenue because doing so, according to the critics, will induce or intensify depression. On the contrary, I would say that keeping a lid on deficit can be beneficial for the economy and the Government should go one step further and balance the budget not over the medium-or long-term but now and immediately.

The reason is simple, if one is able to think through with an open mind.

Fijis economy is passing through a difficult period low or non-existent growth, high job losses, declining foreign reserves, pessimistic outlook for the future. But this can hardly be said to be caused by low or deficient aggregate demand that is, too much supply chasing too little demand.

In fact, the opposite can be said of the current situation. There is an excess of demand in the economy (most of it courtesy of Governments deficit spending binge over the years), which is not being met by available supply amount of goods and services produced inside Fiji.

As a result, unmet demand in the economy is leaking out into imports and, with export stagnant because of the shortage of supply of most items available for export, the trade and balance of payments deficits have ballooned, which must be paid for by the drawdown of foreign reserves held at Reserve Bank and/or by borrowing overseas. And, in fact, both of this is happening. The RBF has been losing reserves for some time now, and, lately, it has borrowed funds from overseas to maintain reserves at a comfortable level.

Therefore, in the given situation of limited capacity to expand production, any addition to demand will mean the worsening of trade position and loss of reserve.

Because of the reason that this is already happening and probably for some years the logical thing for the Government to do will be to reduce aggregate demand, not add to it by maintaining or increasing its budget deficit. Any measure of control of budget spending to help rein in the historically fattened budget deficit will protect exchange reserves and reduce the threat, for example, of a devaluation. The cure for Fijis economic malaise short-term and long-term is not for the Government to resort to pump-priming which is what fighting recession with budget deficit is known as but working to soften the supply constraints, focusing on items that could be exported.

For numerous reasons, output in all major sectors of the economy been stagnant or declining, and there is no reason to believe that we have seen the worst of it.

And the same difficulties plaguing recovery in traditional sectors of the economy have discouraged new initiatives for growth in other sectors, making it harder for anyone to believe that recovery is just around the corner. Until a solution to Fijis supply problems is found which, in my view, is rooted more in social and political choices the country has made and less related to its economic fundamentals aggregate demand needs to be kept in check, not expanded, which, as the preceding analysis shows, can be a dangerous thing to push for. A balanced-budget stance is the minimum this Government needs to adhere to for keeping the economy in reasonably good health.

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