The New Keynesian fiscal rules that mislead British Labour – Bill Mitchell.

The British Labour Party is currently leading the Tories in the latest YouGov opinion polls (February 19-20, Tories 40 per cent (and declining), Labour 42 per cent (and rising). They should be further in front, given the disarray of the Conservatives as they try to negotiate within their own party something remotely acceptable about Brexit.

When there is this degree of political capital available, in this case for the Labour Party, a party should use it to redefine policy agendas that have gone awry. To build a narrative that will advance their cause for the future decades.

British Labour has a chance to break out of its recent Blairite neoliberal past and present a truly progressive manifesto to the British people that will force the Tories to move closer to the centre and squeeze the extreme right-wing elements.

In part, under Jeremy Corbyn and John McDonnell, Labour is making progressive noises on a number of fronts. But ultimately, where it really matters, the macroeconomic narrative, they are remaining firmly neoliberal and this will blight their chances of pursuing a truly progressive agenda.

One of the glaring mistakes the Labour Party has made is to accept advice from neoliberal economists (so-called New Keynesians) who have instilled in them a need for fiscal rules. This is an analysis of the sort of advice that Jeremy Corbyn and John McDonnell are getting and why they should ignore it.

l have written about fiscal rules in the past. There is only one fiscal rule that a progressive government should adhere to and I outlined that in this blog post The full employment fiscal deficit condition (April 13, 2011).

See also the suite of blog posts Fiscal sustainability 101 Part 1 Fiscal sustainability 101 Part 2 Fiscal sustainability 101 Part 3 to learn how Modern Monetary Theory (MMT) constructs the concept of fiscal sustainability.

The discussion in those blog posts rejects fiscal rules that are defined exclusively in terms of financial ratios, the type that the neoliberals use to reduce the scope of government and bias policy towards austerity and elevated levels of labour underutilisation.

I wrote about the madness in the British Labour Party signing up to neoliberal ’fiscal rules’ in this blog post, British Labour Party is mad to sign up to the ’Charter of Budget Responsibility’ (September 28, 2015).

One discussion paper that seems to have influenced the Shadow Chancellor in entering these type of neoliberal agreements was published on May 20, 2014 as Discussion Paper No. 429 from the National Institute of Economic and Social Research.

The NIESR paper Issues in the Design of Fiscal Policy Rules was written by Jonathan Portes (who is the Director of the NIESR) and an Oxford academic, Simon Wren-Lewis.

l have noticed that SWL seems to get involved with vituperative exchanges with Twitter participants who challenge him on matters relating to Modern Monetary Theory (MMT). He seems to think it is smart to label people, who refuse to accept his New Keynesian blather on Twitter, as being plain dumb.

SWL was a member of Labour’s economic advisory committee that John McDonnell formed after becoming the Shadow Chancellor. He later fell out with Corbyn it seems and urged the Party to dump Corbyn as leader and install Owen Smith instead.

On July 26, 2016, he wrote that “What seems totally clear to me is that given recent events a Corbyn-led party cannot win in 2020, or even come close.”

Well that prediction might still be relevant in 2020, but the last national election outcome, where Corbyn went close (even with many of the Blairites in his own party whiteanting him) suggested that SWL hasn’t much grip on reality.

Anyway, we digress.

In their discussion of issues that arise in the design of fiscal rules, Portes and SWL fail to mention the concept of full employment in the NIESR article. Their discussion is pitched entirely in terms of ‘financial ratios’.

It is hard to see that the general public will be enamoured with a government that delivers a target fiscal deficit (for example) but at the expense of elevated levels of unemployment and poverty. Fiscal policy has to relate to things that matter.

The belief (assertion) that by running fiscal surpluses or getting a public debt below some threshold will automatically deliver prosperity (jobs for all, growing real wages, first-class public services, etc) is one of the greatest con jobs that mainstream economists have foisted upon us. Fiscal policy has to relate to targets that matter like jobs, wages growth, and the like.

Depending on what the external and the private domestic sectors are doing (with respect to spending and saving), a fiscal deficit of 10 per cent of GDP might be appropriate just as a fiscal deficit of 2 per cent, or even a fiscal surplus of 4 per cent. Context matters not some particular ratio.

As an aside, the NIESR was a foremost Keynesian research group after being founded in 1938, as the academy was embracing the rejection of neoclassical thinking (which has morphed into the modern day neoliberalism) and recognising the positive role that government fiscal policy could play.

lts capacity to engage in quantitative research to support policy was valuable.

In more recent times, it has declined and is part of the neoliberal misinformation machine. The Keynesian roots has become New Keynesian, which eliminates all the meaningful insights of the original.

I have been asked by a lot of people to comment on the NIESR paper (cited above) and I have been reluctant to do so, given how flawed it is.

But given it has been so influential in framing the way in which the British Labour Party hierarchy thinks about macroeconomics, l have decided to consider it. It is hard to discuss the paper though in non-technical terms accessible to my broad readership, given the way it is framed. So at times, this essay will disappear into jargon. Not much though. I am trying to bring the message as fairly and simply as I can, so as to demonstrate the stupidity of the analysis but not be unfair (misrepresent) the authors.

Generally, the NIESR paper falls into the realm of what I call fake knowledge.

The simple response is that it spends several pages outlining the theory of optimal debt and fiscal policy then admits such a thesis “undeveloped”.

Not to be discouraged by the inability of the ‘optimal theory’ to say anything definitive about the real world, the authors, then proceed to draw conclusions from the theory anyway, which just amount to standard assertions.

Wren-Lewis just should stick to Twitter. He seems to like that. It would save us the time reading the other stuff. in effect, the substantive conclusions from the paper have no basis in theory and could have been tweets.

Let me explain why.

The motivation of the authors is to discuss what might be a “simple rule to guide fiscal policymakers”.

They point out that central bankers have used the “Taylor rule for monetary policy”, which is a simplification in itself. But I won’t get bogged down in discussing whether decision-making in central banks has or had become so mechanistic. It has not been but that is another story.

Mainstream monetary economists certainly teach students that central banks operate in the mechanistic way described by the Taylor rule, which is just a formula the textbooks claim is used to set interest rates.

But then these characters also teach students that central banks can control the money supply, that the money multiplier is responsible for determining how the monetary base scales up into the broad money supply, that expanding bank reserves will allow banks to make loans more easily, that expanding bank reserves is inflationary and al st of the litany of lies.

None of the central propostions that are taught to macroeconomics students in this regard are valid. They are fake knowledge, a stylised world of how these neoliberal economists want to imagine the real world works because they can then derive their desired policy regimes from it.

In the real world central banks and commercial banks do not function in this way.

Some of these monetary myths spill over into the analysis presented by Portes and SWL, which I will indicate presently.

Their motivation is to “search for such a rule” that might apply to fiscal policy, although they conclude at the outset that “one single simple rule to guide fiscal policy may never be found”.

They surmise that this is because:

1. “basic theory suggests that fiscal policy actions should be very different when monetary policy is constrained in a fundamental way. They cite the case of the so-called zero lower bound” as constraining fiscal policy options. In fact, no such constraint exists. Whether interest rates are zero or something else, the currency-issuing government has the same capacities and options.

There is no evidence that monetary policy suddenly becomes effective as a counter-stabilising tool at some positive target policy rate and should be preferred over fiscal policy.

The authors also suggest that the exchange rate regime will constrain fiscal policy. This is correct, which is why Modern Monetary Theory (MMT) theorists argue against pegged arrangements, they reduce the sovereignty of the government.

If a nation pegs its exchange rate then it strictly loses its sovereignty because the central bank has to conduct monetary policy with a view of stabilising the external value of the currency, which then limits the flexibility of domestic policy.

That is why the Bretton Woods fixed exchange rate system collapsed in August 1971. It biased nations running external deficits towards elevated levels of unemployment and crippling interest rates, which proved to be politically unsustainable.

2. Portes and SWL then say: “The second reason why a fiscal equivalent of a Taylor rule may be elusive also reflects national differences, but in this case differences in political structure.”

Here we get the bizarre notion introduced that theory describes an “optimal policy” but that ”there may be a trade-off between rules that mimic optimal policy, and rules that are effective in countering deficit bias” because politicians cannot be trusted to exhibit the ‘correct’ degree of austerity and instead become drunk on net spending (their concept of a “deficit bias”).

These ‘deficit drunk’ governments are labelled “non benevolent” because they allegedly trash the future of our children. Heard that one before? Sure you have, along with ‘governments running out of money’, ‘tipping points’, etc. To solve the problem of these ‘deficit drunk’ governments, Portes and SWL think technocratic constraints are needed to prevent governments responding to the desires of the population as represented by their mandate.

Of course, imposing technocratic constraints against a democratically elected government has become a major characteristic of the neoliberal era. Portes and SWL fit right in with that trend.

All this is part of the ‘depoliticisation’ trend that has seen elected governments shed political responsibility for key decisions that have damaged the well-being of the vast majority of people in their nations by appealing to ‘external’ authorities.

The ‘we had to do it, we had no choice’ ruse, the ‘Dennis Healey, we had to borrow from the IMF because we were running out of money‘ ruse, the ‘we need to outsource fiscal policy to economic experts because politicians just want votes’ ruse.

These external authorities might be so-called independent central banks (even though they are not independent see later), the IMF, and fiscal boards (such as the Office of Budget Responsibility in the UK).

We examine that trend in our new book Reclaiming the State: A Progressive Vision of Sovereignty for a Post-Neoliberal World (Pluto Books, September 2017)

Further, the term ‘deficit bias’ is loaded. Portes and SWI would claim that continuous fiscal deficits illustrate this bias. However, in most nations, such continuity is necessary to support the saving desires of the non-government sector, while sustaining full employment.

There would be no ‘bias’ there. Just responsible fiscal practice. I will discuss that in more detail presently. Refer back to the blog post The full employment fiscal deficit condition.

Further, the so-called New Keynesian ‘optimum‘ is unlikely to have any relevance for the well-being of the population, and, in particular, the most disadvantaged citizens in society.

The standard New Keynesian ‘model’ didn’t even have unemployment in it.

If you understand the dominant New Keynesian framework, which has become the basis for a new consensus emerging among orthodox macroeconomists like Portes and SWL, then you will know the following.

1. The basic New Keynesian approach has three equations which in themselves are problematic. They claim authority based on the microfoundations that are alleged to represent rigourous optimising behaviour by all agents (people, firms, etc) captured by the model structure.

2. Because the ‘optimal’ theory, specified in the basic structure (Calvo pricing, rational expectations, intertemporal utility maximising behaviour by consumers, who face a trade-off between consumption and leisure, etc) cannot say anything much about real world data, the empirical models are modified (adjustment lags are added, etc). As a result ad hocery enters the applied domain where substantive results that are meant to apply to policy are generated.

3. But it is virtually impossible to builds these ‘modifications’ into their theoretical models from the first principles (intertermporal optimisation, etc) that they start with.

4. Which means that like most of the mainstream body of theory the claim to micro-founded ‘rigour’ is unsustainable once they respond to real world anomalies (of their theory) with ad hoc (non rigourous) tack ons.

5. The results they end up producing in empirical papers are not ‘derivable’ from first-order, microfounded principles at all. Their claim to theoretical rigour fails, At the end of the process there is no rigour at all. It becomes a false authority that they hide behind to justify their assertions.

The Portes-SWL paper is no exception.

Further, the ’Great Moderation’ was considered a move closer to the New Keynesian utopia (‘the business cycle’ was declared ‘dead’, for example).

Yet all we witnessed during this period in the 1990s and up to the onset of the GFC, was the redistribution of national income capital as real wages failed to keep pace with productivity growth, increased inequality and private debt, elevated levels of unemployment, the emergence of underemployment, and the dynamics being put in place which manifested as the GFC.

And, the burden of the GFC was not borne by the banksters or the top-end-of-town. Their criminality largely escaped unscathed while millions of workers lost their jobs and many became impoverished.

The belief that one can derive ‘optimal’ rules from a New Keynesian model that have any relevance to people or the world we live in is another characteristic of the neoliberal era. My profession basically went from bad to worse over this period.

However, none of that reality discourages Portes and SWL, who begin their analytical section by outlining this so-called New Keynesian “Optimal debt policy”.

Two propositions enter immediately:

1. taxes impose costs in terms of social welfare because they “are distortionary”. This means that they prevent people from making ‘optimal’ decisions.

The microeconomic theory these authors rely on claims that tax distortions include workers not working hard enough because the imposition of taxes create incentives for them to take more leisure.

This is a body of theory that also says unemployment is a choice workers make when the real wage (after tax) is so high that they prefer to take leisure instead of working. No problem, the workers are ‘optimising real income’ by being unemployed leisure is part of this ‘real’ income measure in these models.

If you thought that sounded like nonsense then you are right. Quits do not behave countercyclically, which would be required if unemployment was a choice made by workers.

Further, the research evidence suggests that the imposition of taxes does not alter the desire of workers to offer hours off work in any significant way.

For a start, most workers do not have continuous (hours) choices available to them. They work 40 hours (or whatever) or not at all.

But this is a digression.

Further what about carbon taxes and other similar taxes, which, even in the mainstream theory, correct market failure and enhance efficiency?

2. Then we read the “government would like to minimise these costs [from the taxes] but they need taxes to pay for government spending and any interest on debt.

Which is an absolute lie in terms of the intrinsic nature of a monetary system where the national government issues its own currency.

It is a convenient lie because they rely on it to derive the results in their paper. They also need this ‘optimality’ smokescreen to persuade politicians to take the results seriously as if their ‘assumptions’ are, in reality, natural constraints on governments.

The lie also implicitly biases the reader to accepting the ‘lower’ taxes are better than higher taxes, a proposition that depends on other assumptions they choose not to disclose because they are smart enough to know that that would push the discussion into the ideological domain and these characters want us to pretend that economics is ‘value free’ and everything they are writing is derivable from ‘optimal’ theory.

One of the first lectures an economics student is forced to endure contains assertions that there is a divide between what mainstream economists call ‘positive’ economics (value free) and ‘normative’ statements (value laden).

Mainstream theory holds itself out as being ‘positive’ and then blames dysfunctional outcomes on the ‘normative’ interventions of policy makers, who choose to depart from the ‘optimal’ world of positive economics.

If you thought this was an elaborate joke played on the students then you would be correct.

And in terms of the above, the correct statement would be that governments impose voluntary constraints on themselves, engineered by conservative ideologues. They have created accounting processes that ‘account‘ for tax receipts into, say Account A, which they then ‘account’ for their spending from. A sort of administrative fiction to give the impression that the tax receipts provide the wherewithal for government spending.

But anyone knows that these institutional practices can be altered by the government whenever they choose (unless they are embedded in constitutions and then it takes more time).

The reality is that unlike the assertion on of Portes and SWL (which drive their overall results):

Governments do not need taxes to pay for government spending. That is an ideological constraint designed to limit spending. Intrinsically, a sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

Modern Monetary Theory (MMT) tells us that taxation serves to create real resource space (idle non-government productive resources), which governments can then bring into productive use to fulfill its elected socio-economic mandate. That taxation reduces the inflation risk of such spending but does not ‘fund’ it.

The fact is that a currency-issuing government can purchase anything that is for sale in its own currency including all idle labour.

MMT also recognises other roles for taxation such as taxes on bads designed to divert consumers or producers away from these goods and services. But that is another story.

Further, a government never needs to issue debt to ‘fund’ deficits.

That is another institutional practice that carries over from the fixed-exchange rate, gold standard days. It is no longer necessary and an understanding of MMT leads one to realise it is largely an exercise in the provision of corporate welfare that should be abandoned.

The point is that if you build ‘economic models’ based on these voluntary constraints, as if they are intrinsic constraints, then the results turn out radically different to the outcomes of an analytical exercise where you assume, correctly, that the government does not need taxes to ‘fund’ spending or to issue debt to fund deficits. Then the mainstream results largely collapse.

I suspect the authors in question implicitly know this. If they don’t then you can draw your own conclusions.


The paper I am using to represent the New Keynesian approach has, by all indications, been somewhat influential in the formation of the macroeconomic approach currently being espoused by the British Labour Party. In that sense, the critique aims to disabuse the Labour politicians and their apparatchiks of building policy options based on fake economic knowledge, and, instead, embrace the principles of Modern Monetary Theory (MMT), which provides an accurate depiction of how the monetary system actually operates and the policy options for a currency-issuing government such as in Britain, and the likely consequences of deploying these options.

The one major lesson that comes out is that the New Keynesian approach is an elaborate fraud. It plays around with so-called ‘optimising’ models asserting human behaviour that no other social scientist believes remotely captures the essence of human decision-making, and then derives conclusions from these models that are claimed to apply to the world we live in. Prior to the GFC, these ‘models’ didn’t even consider the financial sector.

The fact is that nothing of value in terms of specifying what a government should do can be gleaned from a New Keynesian approach. It is barren.

Above, we noted that one discussion paper that seems to have influenced the Shadow British Chancellor was published on May 20, 2014 as Discussion Paper No. 429 from the National Institute of Economic and Social Research.

The NIESR paper Issues in the Design of Fiscal Policy Rules was written by Jonathan Portes (who at the time of writing was the Director of the NIESR before he was ‘let go’) and an Oxford academic, Simon Wren-Lewis.

Here I begin by examining the way that the authors try to use the New Keynesian theory as an authority for specific policy conclusions, which they essentially admit (not in those words) cannot, in fact, be derived from the ‘optimal’ theory.

To specify what they call the ‘optimal’ state, Portes and SWL write out some simple mathematical expressions and note: that the government must satisfy its budget constraint (there is no default), and we ignore financing through printing money.

It is interesting that in defending the New Keynesian position against say Modern Monetary Theory (MMT), proponents make a claim for superiority based on their mathematical reasoning and the apparent absence of such optimising mathematics in MMT.

When useful, MMT uses formal language (mathematics) sparingly. Mostly, propositions can be established without resort to mathematics, which avoids creating a wall of comprehension that most people cannot break down.

Further, there is nothing sophisticated about the mathematics that New Keynesians use. It is just simple calculus really, the sort that I learned as an undergraduate studying mathematics. Hardcore mathematicians laugh at the way economists deploy these tools and parade them as if they are generating something deep and meaningful.

We move on.

Note that while the imposition of taxes is deemed a “cost” by Portes and SWL (discussed in earlier), their ‘model’ doesn’t allow the interest payments on the debt to be a ‘beneflt’. They are silent on that. Conveniently so.

Anyway, the equation they write out which captures the constrained optimisation process is claimed to be an ex ante financial constraint, akin to the financial constraints facing a household that must earn income, borrow, reduce savings or sell assets in order to spend.

As we know, the ‘household budget analogy’ applied to a currency-issuing government is wrong at the most elemental level.

Nothing relating to the experience of a household (the currency user) is relevant to assessing the capacities of or the choices available to such a government (currency issuer).

Further, why do they ignore “financing through printing money”? Not that “printing money” is a term that could be associated with the real world practice of government spending anyway.

They ignore it because it would not allow them to generate the results they desire.

The reality is that these so-called ‘budget constraints’ do not depict real ex ante financial constraints. They are, at best, ex post accounting statements, meaning they have to add up. There is nothing much more about them than that.

They may also reflect current institutional practice which is a political rather than an intrinsic financial artifact.

But, if the authors were to be stock-flow (accounting) consistent (which most mainstream models are not meaning they deliberately leave things out and that flows do not accumulate properly into the corresponding stocks), then they would have to include the change in bank reserves arising from central bank monetary operations associated with fiscal policy (for example, crediting banks accounts on behalf of the government).

But those operations are absent in their approach, which means their analysis is incomplete in an accounting sense. Conveniently so.

Of course, one of the glaring omissions of the New Keynesian models that people learned about after the GFC was that they didn’t even have a financial sector embedded in their basic structure. But that is also another story again.

The upshot of Portes and SWL’s mathematical gymnastics, simple though they are, is that the ‘optimal’ fiscal policy requires “tax smoothing”, so that:

if for a period government spending has to be unusually high (classically a war, but also perhaps because of a recession or natural disaster), it would be wrong to try and match this higher spending with higher tax rates. Instead taxes should only be raised by a small amount, with debt increasing instead, but taxes should stay high after government spending has come back down, to at least pay the interest on the extra debt and perhaps also to bring debt back down again.

So, they are saying:

1. Taxes are necessary to fund government spending but temporary deficits (to cope with wars or deep recessions) should be funded by debt.

2. When economic activity improves, there should be a primary fiscal surplus (”taxes at least pay the interest on the extra debt”) and spending should be cut to allow that outcome.

3. Public debt should be a target policy variable (the lower the better) but in the short-term is a “shock absorber to avoid sharp movements in taxes or government spending”.

4. This is a ‘deficit dove’ construction. We will have austerity but it will be delayed.

The questions one needs to ask is under what conditions would a primary surplus be a responsible state for a government to achieve? Portes and SWL want the primary surpluses to be a target goal for government. But such a target is unlikely to be a desirable state.

Remember, a primary fiscal balance is the difference between government spending and taxation flows less payments on outstanding public debt.

One could imagine a situation where a government would sensibly run a primary surplus or even an overall fiscal surplus (inclusive of interest payments on public debt) if it was accompanied by a robust external surplus, which was pumping net spending in the economy and financing the desire of the private domestic sector to save overall.

Then a fiscal surplus would be required to prevent inflationary pressures from emerging. But it would also be consistent with full employment, the provision of first-class public services, and the fulfillment of the overall saving desires by the private domestic sector. Think Norway.

That is not remotely descriptive of where the UK (or most nearly all nations) are at or have been at in recent decades.

The absurdity of the reasoning that arises from the sort of economic framework that Portes and SWL deploy is illustrated when they start tinkering with the parameters of the ‘model’ to see what transpires.

The exercise is trivial. The model has some equations with parameters that link the variables that describe the equation structures. The parameters are conceptual but to get certain results one has to make assumptions about their values (at the most basic level whether they are positive or negative or above or below unity, etc).

Then one muses about what specific assumptions imply for the results.

One such tinkering by Portes and SWL generates an interpretation that taxes:

gradually fall to zero. How can this happen, given that the government has spending to finance? The answer is that debt gradually declines to zero, and then the government starts to build up assets. Eventually it has enough assets that it can finance all its spending from the interest on those assets, and so taxes can be completely eliminated.

Which then raises the question of how the government gets access to any of the real resources that are available for productive use in the society.

If taxes are zero, why would people offer their labour (and other resources) for the public use? And, how will government make non-inflationary real resource space in order for them to spend (command real resources from the non-government sector)?

But discussing those issues will take us away from the main focus.

In essence, none of their mathematical ‘cases’ (the scenarios they defined with differing parameter values) can be established in reality. This is a common problem of this sort of economic reasoning.

What happens next? They ditch the ‘optimal’ results derived from the calculus and start making stuff up asserting their ‘priors’.

So as not to spoil their story, the authors just assert that “there are two reasons for believing that policy should aim to steadily reduce debt in normal times” even if the ‘optimal’ condition indicates the opposite.

First, they introduce the standard argument that “shocks may be asymmetric” with “large negative shock”(s) not being offset in the other direction.

This is a sort of ‘war chest’ argument. That a government will not be able to respond fully in a major downturn if it starts with high levels of public debt.

Why? It will not be attractive to bond investors, it will run out of money, etc.

Tell that to Japan! Fake knowledge.

Second, they write that:

large negative shocks like a financial crisis might mean that we enter a liquidity trap, so that fiscal expansion is required to assist monetary policy, while large positive shocks could be dealt with by monetary rather than fiscal contraction. There is no equivalent upper bound for interest rates, so prudent policy would reduce debt in normal times to make room for the liquidity trap possibility.

This is the standard mainstream claim that monetary policy is the more effective counter-stabilising (and preferred) policy, except in a deep recession when interest rates are cut to zero and have no further room to fall.

So to counter that ineffectiveness when rates are zero, fiscal policy has to be used. But, in general, monetary policy should be prioritised.

But then the same assertion follows. So that fiscal policy can be on standby for those times when interest rates are zero, the government should have low levels of outstanding debt.

Why? The same argument. It will not be able to fund a new fiscal stimulus if it hasn’t eliminated the impacts from a previous stimulus exercise.

That is a plain lie.

The authors just assert that the capacity of a government to net spend is inversely related to the current stock of outstanding debt.

Why? No reason can be derived from their ‘optimal’ models to justify that assertion.

And, again, tell that to Japan!

The post-GFC period has demonstrated that ’monetary policy’ is not a very effective counter-stabilising tool. Governments that used fiscal policy aggressively in the GFC resumed growth much more quickly than those that didn’t. The stimulatory effects of monetary policy are, at best, ambiguous.

Further, the truth is that the capacity of the government to spend is in no way constrained by its past fiscal stance whether it be surplus, balance or deficit.

A surplus today does not mean that the government is better placed to run a deficit tomorrow. It can always run a deficit if the non-government spending and saving decisions push it that way.

The same goes for outstanding debt, which under current institutional arrangements, will be influenced by the shifts in the flows that make up fiscal policy.

But the level of debt doesn’t constrain or alter the government’s ability to net spend.

The authors might claim that bond markets will rebel and stop funding the deficits. Even if the recipients of this corporate welfare decided to cut off their noses to spite their faces and stopped buying the debt that would not alter the government’s capacity to spend.

First, if it persisted in the unnecessary practice of issuing debt, it could instruct the central bank to set the yield and buy all the debt that the private bond markets didn’t want at that (low to zero) yield. Including all of it!

In other words, the government can always play the private bond markets out of the game if it chooses. Even in the Eurozone, where the Member States are not sovereign, the ECB has demonstrated it can set yields at whatever level it chooses. It can drive yields on long-term public debt into the negative! Who would have thought? No New Keynesian that is for sure. They think deficits ‘crowd out’ private investment spending via higher rates (see below).

Second, the government can also alter a rule or two or change legislation that embodies these voluntary accounting constraints that I noted earlier. That is the right of the legislature and beyond the power of bond markets!

In another one of their musings about parameter values, Portes and SWL tell us that:

there is an additional reason why it might be desirable to eliminate government debt completely, and that is because it crowds out productive capital. In simple overlapping generation models, agents save to fund their retirement, and this determines the size of the capital stock. If agents have an alternative means of saving, which is to invest in government debt, then this debt displaces productive capital.

Really now!

Again, the authors are just rehearsing the standard and deeply flawed mainstream macroeconomic theory, which has the loanable funds model of financial markets embedded.

According to this specious approach, savings are finite and investment competes for the scarce resources. The ‘interest rate’ on loans then brings the two into balance.

The logic then says if there is a shift in the investment demand outwards (capturing in this instance the entry of the government bond to compete with corporate bonds), then the interest rate has to rise to ration off the higher demand for loans, given the finite supply (savings). Wrong at the most elemental level.

First, savings are not finite. They rise with income and if net public spending increases (rising deficit) then national income will rise and so will saving.

Second, and more importantly, real world banks do not remotely operate in a loanable funds way. They will generally extend loans to creditworthy borrowers. This lending is not reserve constrained. Banks do no wait around for depositors to drop their cash off, which they can then on lend.

Loans create deposits (liquidity). Not the other way around, as is assumed by the ‘crowding out’ argument which these authors introduce to their analysis.

So even if the government is selling debt to the non-government sector, the banks still have the capacity (under our current system) to increase private investment.

Further, there is the standard ideological assertion that public spending is ‘less efficient’ (unproductive) compared to “productive capital” (private investment).

The research evidence doesn’t support that assertion. it is just a made up claim to justify privatisation and cuts to government activities.

It has been used to justify the handing out of millions of dollars of public funds to investment bankers, lawyers, accountants etc to sell off public assets at well below market prices to grasping private investors.

We have a long record now of how disastrous most of these selloffs have been from the perspective of the quality, scope and affordability of services that were previously provided by the state.

The next furphy that Portes and SWL introduce is the intergenerational equity argument aka government debt imposes burdens on our grand kids claim.

They claim that lower debt will mean that “Future generations will enjoy a world with lower distortionary taxes, while the current generation will bear the cost of achieving that goal.”

Again, this conclusion follows their assumption that taxes pay back the debt so deficits today force future generations to incur higher costs.

Refer to the previous discussion of the actual role of taxes in a flat monetary system.

The reality is that each generation chooses its own tax and public spending profile via the political process. The way in which intergenerational inequities occur is via real resource utilisation.

We can kill the planet and the kids will then miss out. Alternativelv. we can ensure the kids get access to first-class public infrastructure (education, health, recreation, etc) and have jobs to go to when they develop their skills and knowledge.

Then the kids benefit from today’s fiscal deficits.

But after all of their tinkering with mathematical coefficients (which I have only skimmed here), the authors admit that the “analysis of the optimum long run target for government debt is undeveloped” but:

the case for aiming for a gradual reduction in debt levels seems to be reasonably strong in practice, particularly given the currently high levels of debt in most countries

In other words, the mathematical reasoning leads to nothing definitive so we will just assert things anyway.

It helps economists like this gain promotion as academics and other status that they might enjoy such as picking up ’Inside Job’ type commissions and misrepresenting ideological reports as independent research.

Remember Mishkin in Iceland?

Please read my blog Universities should operate in an ethical and socially responsible manner for more discussion on this point.

I make that comment generally rather than specifically about the authors (Portes and SWL) in question. I don’t know what they do on the side.

So, after all that, what have Portes and SWL to fall back on? Not much. Assertion based on false assumptions.

That doesn’t stop them though.

In Section 3, they still claim ‘authority’ from the discussion on optimal fiscal rules to make the following assertion:

It follows from the previous section that a welfaremaximising government would in general be expected to follow fiscal policies which broadly satisfied the following conditions: a gently declining path of debt over the medium term, but with blips in response to shocks broadly stable tax rates and recurrent government consumption.

Noting it doesn’t follow at all from any results about “welfaremaximising” behaviour that they present. The simple optimising model presented, by the authors’ own admission, is “undeveloped” and incapable of any definitive result.

The results that they claim were derived from the “previous section” are assertions.

But their point is clear. They claim that OECD governments (in general) have not followed these rules and instead the public debt ratios have “steadily increased since the 1970s”, which is evidence of what they call “deficit bias”.

Their claim then is that for various reasons, governments have been acting contrary to “welfare-maximising” behaviour meaning they are acting badly.

Simple isn’t it. Make up a benchmark using flawed assumptions that you know does not apply in the real world. Then label any departures from that fantasy world ‘bad’ and QED, you can then claim in the ‘real world’ that the government is behaving badly.

However, one can contest the benchmark.

If public debt is such an issue, why is the 10-year bond yield for Japanese government bonds at 0.058 per cent (at the time of writing) and why did ‘investors’ pay the Japanese government for the privilege of buying that debt (negative yields) at certain times last year?

Moreover, why are ‘investors’ agreeing to negative yields on all government bond maturities from 1-Year to 8-Years at present.

Further, back in the 1990s, the financial commentators and mainstream macroeconomists were claiming the outstanding Japanese government debt was the mother of all ticking time bombs and they have used this scare tactic long and hard for decades across all nations.

I recall reading some commentator claiming long ago Japan was facing the “mother of all debt-bunnies”, whatever that meant. I guess the ‘bunnies’ hopped away somewhere.

I have gone back through the records I keep and found regular references over the last 27 years to the impending insolvency of Japan because it is violating the economists’ notion of welfare maximising’ debt behaviour.

Across the Pacific, the US was apparently “near to insolvency” on Thursday, September 26, 1940.

Here is an Associated Press story from The Portsmouth Times (Ohio), which was headlines in the New York Times on the same day.

The story quotes one Robert M. Hanes, who at the time was the President of the American Bankers’ Association:

“The evangelists of the new social order are undermining the confidence of the American people in political and economic freedom.

It is a matter of grave concern that we have come to accept deficit financing as a permanent fiscal policy. We not only proceed from year to year on an unbalanced federal budget, but we have permitted the compounding of the federal debt to a huge total which threatens the entire country.

Unless we put an end to deficit financing, to profligate spending, and to indifference to the nature and extent of government borrowing, we shall surely take the road to dictatorship.

By subtle propaganda, special pleading and similar devious device The American people are being persuaded to surrender more and more of their independence to the direction and control of government. This is an evil that feeds on itself.

Deficits and borrowings call for continually larger taxation, which must be met by private enterprise.”

We can find similar remarks throughout history. And, yet, nothing happens. I guess you can cut the Americans some slack such is their penchant for OTT way of doing things.

The point is these economic models that claim public debt should be minimised to prevent costly tax burdens are pie-in-the-neoliberaI-sky sort of stuff.

Further, higher public debt to GDP ratios means that the nongovernment sector has more risk free debt as a proportion of GDP than previously and corresponding income flows.

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