The Project Syndicate is held out as an independent, quality source of Op Ed discussion. When you scan through the economists that contribute you see quite a pattern and it is the anathema of ‘independent’. There is really no commentary that is independent, if you consider the term relates to schools of thought that an economist might work within. We are all bound by the ideologies and language of those millieu. So I assess the input from an institution (like Project Syndicate) in terms of the heterodoxy of its offerings. A stream of economic contributions that are effectively drawn from the same side of macroeconomics is not what I call ‘independent’. And you see that in the recurring arguments that get published. In this blog post, I discuss Jeffrey Frankel’s latest UK Guardian article (August 29, 2018) – US will lack fiscal space to respond when next recession comes – which was syndicated from Project Syndicate. Frankel thinks that the US is about to experience a major recession and that its government has run out of fiscal space because it is not running surpluses. We could summarise my conclusion in one word – nonsense. But a more civilised response follows.



In 1987, American economists John Y. Campbell and Robert Schiller introduced the – Cyclically adjusted price-to-earnings ratio (CAPE) as a guide to assessing whether the US equities market is overpriced or not (the long-term average of 16 is considered the threshold).

Their research found that “the lower the CAPE, the higher the investors’ likely return from equities over the following 20 years.”

Schiller refined the measure and it became known Schiller P/E (aka CAPE).

By construction, the CAPE allows a comparison between the current market price and itsinflation-adjusted, average performance over a ten-year period.

Schiller’s rule of thumb is that when the ratio exceeds 25, a “major market drop” follows – Schiller’s 2000 book Irrational exuberance was a reflection of this observation.

The provenance of the CAPE goes back to the work of Benjamin Graham and David Dodd published in their 1934 book – Security Analysis.

As an aside, I drew on the work of Benjamin Graham in my early development of the buffer stock employment idea (now called the Job Guarantee).

His 1937 book Storage and Stability: A Modern Ever-normal Granary, New York: McGraw Hill provided some great insights into buffer stocks schemes and price stability – in his case, for agricultural products.

The CAPE is considered a flawed measure though because of the way it defines earnings (for example, accounting changes to definitions, the exclusion of retained earnings), which tends to inflate the ratio.

But the technicalities of that debate are not what this blog post is about.

The following graph shows the CAPE ratio calculated by Robert Schiller from January 1880 to August 2018. The long-term average (17.48) is the red line and the gray bars are the NBER recession periods (peak to trough).

As you can see the P/E ratio, which in August 2018 was 32.29, is now well above its long-term average and has been since August 2009.

It hasn’t reached the December 1999 peak (of 44.20) – the ‘Dot.com bubble’ – but it is certainly well above the pre-GFC levels.

What does this mean?

Well according the Harvard economist Jeffrey Frankel in his latest UK Guardian article (August 29, 2018) – US will lack fiscal space to respond when next recession comes – the level of the CAPE is “one possible trigger for a downturn in the coming years is a negative shock that could send securities tumbling”.

Which means? Share prices will fall.

Is the relatively high CAPE ratio a sign of ‘irrational exuberance’ which Alan Greenspan considered marked the Dot.com boom and bust? That looks doubtful to me.

There is no frenzied share buying going on. If you were an investor in that market then you realise the shares are over-priced, which is a relative term, and just means for anyone who knows what they are doing that their expected returns will be lower than if the CAPE ratio was lower.

But that is relative too – the returns on other financial assets (government bonds, etc) are equally low.

So the combination of the technical flaws in the CAPE ratio (overstating the true P/E ratio) and the overall state of the investment markets indicates to me that there is no major collapse coming from that quarter.

The graph tells us that the CAPE ratio falls during recession, which is unsurprising but there is no consistent eveidence that it leads a recession (that is, could cause it).

It is possible that investors are heavily leveraged and if the PE falls they cannot pay up and the banks enter crisis. But I think the GFC taught us that treasury departments and central banks have all the capacity they need to prevent that sort of financial kerfuffle spreading more broadly.

Which brings me to the next and substantive point.

Jeffrey Frankel believes that one source of shock or another (share market collapse, trade war, Turkey spreading, Italy, China, etc) will trigger a new crisis in the US economy.

He concluded:

Whatever the immediate trigger, the consequences for the US are likely to be severe, for a simple reason: the US government continues to pursue procyclical fiscal, macroprudential, and even monetary policies. While it is hard to get countercyclical timing exactly right, that is no excuse for procyclical policy; an approach that puts the US in a weak position to manage the next inevitable shock.

There are several recurring themes in that paragraph:

1. What is a pro-cyclical policy? Does counter-cyclical policy require fiscal deficits/low interest rate in a downturn and fiscal surpluses/high interest rates in an upturn?

2. How can the US policy institutions – Treasury Department and Federal Reserve Bank – be in a “weak position to manage the next inevitable shock”? Is there any meaning to the term “weak”? If so, what is a ‘strong’ position?

The title of Frankel’s article should tell you where he stands.

He is one of those mainstream macroeoconomists (supervised by Rudiger Dornsbusch) that believes there is a time for fiscal stimulus, when monetary policy hits the zero-bound (yes, that!) but that essentially at other times, monetary policy should be firmly in charge of counter-stabilisation duties.

In that context, he defended President Obama’s fiscal stimulus in 2009 but now thinks that the fiscal party has gone on for too long and that Trump is setting the US economy up to fail.

He has been an advisor the Clinton Administration, which also should tell you something.

He has long claimed that policy makers pursuing ‘Keynesian’ fiscal positions fell into disrepute because (Source):

… politicians often failed to time countercyclical fiscal policy – “fine tuning” – properly. Sometimes fiscal stimulus would kick in after the recession was already over. But that is no reason to follow a destabilizing pro-cyclical fiscal policy, which piles spending increases and tax cuts on top of booms, and cuts spending and raises taxes in response to downturns. Pro-cyclical fiscal policy worsens the dangers of overheating, inflation, and asset bubbles during booms, and exacerbates output and employment losses during recessions, thereby magnifying the swings of the business cycle.

He also wrote in a 2013 Symposium published in the Spring issue of The International Economy – his response to the question “Does Debt Matter?” – is HERE.

He wrote on public debt in the context of the Rogoff-Reinhart 90 per cent threshold that was prominent during the crisis, until their Excel incompetence (at least) was exposed, that:

Yes, debt matters. I don’t think I know of anyone who believes that a high level of debt is without adverse consequences for a country. There is no magic threshold in the ratio of debt to GDP, 90% or otherwise, above which the economy falls off a cliff. But if the debt/GDP ratio is high, and especially if the country’s interest rate is also high relative to its expected future growth rate, then the economy is at risk. One risk is that if interest rates rise or growth falls, the economy will slip onto an explosive debt path, where the debt/GDP ratio rises without limit. In the event of such a debt trap, the government may have no choice but to undertake a painful fiscal contraction, even though that will worsen the recession. (The resulting fall in output can even cause a further jump in the debt/output ratio, as it has in the periphery members of the eurozone over the last few years.)

So before I consider those two themes above, you can see the problem he has.

The previous paragraph comes down to this:

1. Debt matters.

2. Why? Because in a recession debt will rise as governments (under current arrangements match their deficit spending with debt-issuance).

3. Why is that a problem?

4. Debt matters.

Of course, the Modern Monetary Theory (MMT) response (the purist one) is that currency-issuing governments such as the USA do not have to issue any debt when they are running fiscal deficits.

But that ignores the institutional realities.

Taking reality into account, however, doesn’t alter the conclusion.

Central banks can effectively buy whatever volume of public debt they choose and keep interest rates around zero for as long as they like no matter the quantity of public debt (in absolute or relative terms (to GDP)).

The private bond markets have no traction in those cases.

I last considered that sort of situation in this blog post – The bond vigilantes saddle up their Shetland ponies – apparently (February 12, 2018).

I concluded:

1. The private bond markets have no power to stop a currency-issuing government spending.

2. The private bond markets have no power to stop a currency-issuing government running deficits.

3. The private bond markets have no power to set interest rates (yields) if the central bank chooses otherwise.

4. AAA credit ratings are meaningless for a sovereign government – they can never run out of money and can set whatever terms they want if they choose to issue bonds.

5. Sovereign governments always rule over bond markets – full stop.

I also updated my analysis of central bank holdings of US governemtn debt in this blog post – Central banks still funding government deficits and the sky remains firmly above (August 23, 2017).

Here is the latest update.

First, cast your mind back to March-quarter 2011.

The following pie-chart shows the proportions of total US Public Debt held by various categories as at the March-quarter 2011.

The government sector held about 42 per cent of its own debt. These holdings were either in the intergovernmental agencies or the US Federal Reserve Bank.

The US Federal Reserve held 8.9 per cent of total US public debt. Its total holdings were around $US 1,274.3 billion.

The three largest foreign US debt holders at the March-quarter 2011 were China (8 per cent), Japan (6.4 per cent) and Britain (2.3 per cent). The total foreign held share was equal to 31.4 per cent.

Now, to the most recent data – March-quarter 2018 – some 7 years later. Some of the data, by the way, is available for the June-quarter 2018, but only the complete set required for this analysis is available for the March-quarter.

As at the end of March 2018, there were $US21,089.9 billion Federal Securities outstanding.

These were broken down into:

1. Privately held – $US12,360.60 billion (60.3 per cent of total).

2. Federal Reserve and Intragovernmental holdings (SOMA and Intragovernmental Holdings) – $US8,132.10 billion (39.7 per cent of total).

3. Foreign and international – $US6216.60 billion (29.5 per cent of total) – of which $US4049.1 billion held by Foreign Official institutions (central banks etc).

A comparison of movements over the last 7 or so years in the composition of US Treasury debt holdings is provided by the two pie charts

1. The government sector overall held about 39.6 per cent of its own debt in the March-quarter 2018. This is slightly down on the proportions held in the March-quarter 2011 (40.3 per cent).

2. These holdings were either in the intergovernmental agencies (27.8 per cent) or the US Federal Reserve Bank (11.8 per cent). The central bank has increased its holdings over the period in question (though proportionally now holds less).

3. The Chinese holdings were around 5.8 per cent of the total and hardly consistent with the rhetoric that China was bailing the US government out of bankruptcy. These holdings have fallen in recent years.

4. The three largest foreign US debt holders at the March-quarter 2018, were China (5.8 per cent); Japan (5.2 per cent) and Ireland (5.1 per cent).

The recent history provides a very important lesson. The US central bank can initiate very dramatic shifts in the mix of debt holders whenever it chooses.

This means that the central bank can always purchase any debt that the private sector chooses not to purchase via the primary auctions.

There is never a reason for US government bond yields to rise above a level that the government considers to be accpetable.

Lets move on.

In this blog post – The full employment fiscal deficit condition (April 13, 2011) – which I consider to be core MMT, I showed the conditions that determine the fiscal deficit, once the government assumes its responsibility to achieve and sustain full employment.

The lessons, in summary are:

1. A macroeconomy is in a steady-state (that is, at rest or in equilibrium) when the sum of the injections equals the sum of the leakages. The point is that whenever this relationship is disturbed (by a change in the level of injections, however sourced), national income adjusts and brings the income-sensitive spending drains into line with the new level of injections. At that point the system is at rest.

2. The injections come from export spending, investment spending (capital formation) and government spending.

3. The leakages are household saving, taxation and import spending.

4. An economy at rest is not necessarily one that coincides with full employment.

5. When an economy is ‘at rest’ and there is high unemployment, there must be a spending gap given that mass unemployment is the result of deficient demand (in relation to the spending required to provide enough jobs overall).

6. If there is no dynamic which would lead to an increase in private (or non-government) spending then the only way the economy will increase its level of activity is if there is increased net government spending – this means that the injection via increasing government spending (G) has to more than offset the increased drain (leakage) coming from taxation revenue (T).

So in sectoral balance parlance, the following rule hold.

To sustain full employment the condition for stable national income defines what I named the Full-employment fiscal deficit condition:

(G – T) = S(Yf) + M(Yf) – I(Yf) – X

The sum of the terms S(Yf) and M(Yf) represent drains on aggregate demand when the economy is at full employment and the sum of the terms I(Yf) and X represents spending injections at full employment.

If the drains outweigh the injections then for national income to remain stable, there has to be a fiscal deficit (G – T) sufficient to offset that gap in aggregate demand.

If the fiscal deficit is not sufficient, then national income will fall and full employment will be lost. If the government tries to expand the fiscal deficit beyond the full employment limit (G – T)(Yf) then nominal spending will outstrip the capacity of the economy to respond by increasing real output and while income will rise it will be all due to price effects (that is, inflation would occur).

What that means in relation to the issues I identified above is that there is a difficulty in defining pro-cyclicality in terms of a given fiscal balance.

It is nonsensical to say a fiscal surplus is always pro-cyclical and a deficit is always counter-cyclical. It all depends on the spending and saving patterns of the non-government sector.

We can only really appraise the impact of the fiscal balance in terms of changes at specific points in the cycle.

So if an economy was at full employment and the fiscal deficit was, say 2 per cent of GDP and that satisfied the condition specified above.

That is not a pro-cyclical position even if the economy is growing – it is maintaining a steady-state growth path.

Should the government, with no other changes evident, increase its net spending to say 3 per cent of GDP, under those circumstances, we might consider that a pro-cyclical policy change because it is pushing the cycle beyond its full employment steady-state growth path.

So the fact there is a fiscal deficit coinciding with strong GDP growth should not be taken as a case of irresponsible and dangerous policy.

What about running surpluses when recovery is apparent?

The same logic holds. It might be that the non-government spending and saving decisions drive overall spending so fast that total spending then starts to outstrip capacity.

Then, to restore the full employment steady-state (and this also requires stable inflation), the fiscal stance has to contractionary – which might require a fiscal surplus.

For example, nations such as Norway will typically solve the Full-employment fiscal deficit condition with a fiscal surplus given how strong their external sector is (energy resources).

The second issue relates to Jeffrey Frankel’s notion of ‘fiscal space’.

I considered that issue in these blog posts:

1. Fiscal sustainability 101 – Part 1 (June 15, 2009).

2. Fiscal sustainability 101 – Part 2 (June 16, 2009).

3. Fiscal sustainability 101 – Part 3 (June 17, 2009).

Frankel claims that the:

The US deficit is being blown up on both the revenue and expenditure sides … As a result, when the next recession comes, the US will lack fiscal space to respond.

The next recession, when it comes, will coincide with millions of workers in need of jobs, capital equipment lying idle, and other productive resources looking for a buyer (user).

That is what fiscal space relates to in a modern monetary economy.

It has nothing to do with what the current fiscal balance is or has been and what the current public debt ratio is or has been.

A sovereign government can purchase any idle resources that are for sale in its own currency, including all idle labour.

That is the fiscal space the US will have.

And, it can never run out of funds to do that.

So a past deficit poses no particular constraints on what the US government can do in the future, except to say that if the deficit has been properly calibrated to satisfy the Full-employment fiscal deficit condition then there will be less to do should the private sector contract.

The rest of Frankel’s article is irrelevant to this discussion.

The questions that the US policy makers have to answer are:

1. How close the economy is to being at full capacity – labour, capital and other productive resources.

2. If, it is, is the current net public spending position driving total spending beyond the Full-employment fiscal deficit condition.

My assessment of Question 1 is that there is still some idle capacity in the US economy. Just look at wages growth and the broader indicators like participation rates.

There is a massive public infrastructure shortfall – in terms of quality and scope.

Inflation is benign as is wages growth.

Conclusion

Frankel’s argument is like a cracked record. It just keeps being recycled by mainstream economists as if it is common sense.

The facts are:

1. We can never conclude that the coexistence of a fiscal deficit and strong growth requires the government push back into surplus. Sometimes yes, usually no.

2. Fiscal space has nothing to do with what the current fiscal balance is or has been and what the current public debt ratio is or has been.

That is enough for today!

(c) Copyright 2018 William Mitchell. All Rights Reserved.