Australia’s addiction to private debt

Macrobusiness.com have just posted a crackerjack article on the misreading of the Australian government budget emergency  and the errant path they have elected to follow.

 

"A perennial and divisive issue in politics and economics today is the matter of public debt. It is commonly asserted that rising public debt threatens the economy and needs to be reined in. Governments are often portrayed as ‘irrational’ actors when they incur a fiscal deficit, causing unnecessary inflation and interest rates to rise by borrowing to meet the shortfall.

Private sector lending is supposedly ‘crowded out’ by lifting the cost of money and limiting access to a finite lending pool by government actors. A large stock of public debt and chronic deficits are considered economically harmful, due to increasing the interest payment burden on taxpayers. A centrepiece of the Abbott government’s economic policy platform is its strident warnings about growing public debt: Australia’s ‘budget emergency’.

This specious claim remains unchallenged, for commentators are generally unfamiliar with the long-term trends in debt and its composition. This analysis fills that void by examining the long-term trends in public, private and external debt. Unsurprisingly, the conclusions arrived at are diametrically opposed and differ sharply to those stemming from the established political and economic narrative."

A detailed long term analysis of public, private and external debt plus an overview follows. Read the full article by Philip Soos and Paul D Egan on Macrobusiness. The article concludes by pointing out the errors of the orthodox approach and the fallacy of the debt reduction mantra.

The Heterodox Perspective

There is a reason why mainstream economists ignore private debt while focusing intently upon public debt. Neoclassical economic models assume markets operate in a static state of equilibrium, but these models are based on a slew of preposterous assumptions which are never met in the real world. The banking and financial system is modelled by assuming that money, debt and banks do not exist! The element of time is also removed, making it difficult for economists to understand the inter-temporal allocations of debt.

This is like an astronomer or astrophysicist building a model of our solar system absent the sun, moon and gravity – an inadequate framework that will inevitably produce glaring mistakes. By using a circular form of logic, private domestic and external debts are assumed to be the outcome of rationally-derived contracts, so the level of debt is deemed to be efficient by definition. In contrast, public debts are considered to be managed by ‘irrational’ government planners, who cannot make optimising decisions; a clear fallacy based on stereotypes of the competency of financial actors within the economy.

In the post-1970s era, neoliberal economic policy has dominated mainstream perspectives. A major goal of government has led to an unyielding mantra that public debts must be reduced by running surpluses where possible. The obsession with public debt and deficits has blindsided policymakers to the rapid accumulation of private debts. For instance, the severe mid-1970s recession was caused largely by the collapse of the dual commercial and residential real estate bubbles, inflated by sharply accelerating private debts, but the economics profession failed to take notice.

Unfortunately, this made no difference, with the 1981 Campbell Report advocating further deregulation of the banking and financial sector. By the time of the 1997 Wallis Report, neoclassical economists had the benefit of hindsight when examining the mid-1970s dual commercial and housing bubbles, the 1981 Sydney housing bubble, the 1987 stock market bubble and crash, the late 1980s dual commercial and housing bubbles, and the lead-up to the largest stock market bubble in Australian economic history, the Dot-Com era.

With Australia’s economic history littered with asset bubbles, irrational exuberance, recessions and depressions, what were the recommendations of the Wallis Report? More financial deregulation! Mainstream economists in Australia (and elsewhere) are wilfully blind to countervailing evidence which demonstrates the harms caused by financial deregulation.

The reason that financial deregulation is advocated becomes obvious: booming private debts enhance the power, profit and authority of the horde of private monopolists, usurers, speculators, rent seekers, free riders, financial robber barons, control frauds, inheritors and indolent rich.

Another widespread economic fallacy is that government should manage debt as if it were a household or firm. This is a false analogy as the latter cannot print money and/or increase income at will. Governments that issue their own currency with a central bank do not need to operate as if they are constrained like a household or firm. Under this arrangement, a government can almost indefinitely fund deficits without fear of bankruptcy – though whether it should is another matter.

Interestingly, this analogy raises a contradiction. If government were to manage its debt like Australia’s households and businesses, then the immense private debt to GDP ratio suggests the government should embark on a mission of out-of-control spending and pork-barrelling to raise the public debt ratio considering how high the ‘rational’ private ratio is. Clearly, this is not what supporters of the analogy are advocating, even though it is a logical consequence of their logic.

More realistic and dynamic models of the banking and financial system suggest that a government dedicated to persistent surpluses will eventually cause a breakdown in the economy. The reason for this is as follows. There are three ways for income or demand to increase in a capitalist economy: a current account surplus, a budget deficit and/or increased private sector indebtedness. If government runs persistent surpluses in the face of CADs, then the only way for an economy to grow is via increased private sector indebtedness.

The dynamics of rapid and toxic private debt accumulation caused the GFC, precisely as the exponential rate of growth ended around 2008. The Howard government provides an obvious example of this trend. From 1996 to 2007, ten out of twelve annual budgets produced a surplus, while the current account remained in persistent deficit. The result: private debts ballooned, particularly in the household and non-banking financial sectors, though more slowly in the non-financial business sector.

While Howard and Costello bestowed themselves with the gratuitous titles of ‘good economic managers’, their management of debt was in fact appalling given the exponentially-growing private debt juggernaut they presided over. This runaway debt train continued under Swan and Hockey, indicating they are no better than each other regarding the issue of debt. Both sides of Australian politics have really been managing a bubble, not an economy.

A more sensible approach is for government to engage in moderate and persistent deficits of around 3 per cent of GDP. Over time, the level of public debt remains relatively constant to GDP as the economy becomes progressively larger. This helps reduce reliance on increased private sector indebtedness to grow the economy and wards off the threat that accelerating private debt could cause further asset bubbles.

Research indicates there is no evidence for a specific public debt to GDP threshold that undermines economic growth. The revelations coming out of the ‘Excelgate’ scandal have confirmed this. Unfortunately, the prevailing belief is the opposite: in an attempt to curb rising public debt and address falling tax revenues, politicians often implement austerity measures – raising taxes and slashing expenditure – which worsens any economic downturn as government and private sector demand falls in unison.

Economists advocating austerity misguidedly use equilibrium models to assert rising government debt will burden future generations and ‘crowd out’ private sector borrowing, following an alleged rise in interest rates. This view should be disregarded, as the endogenous creation of credit and the flow of causation from loans to reserves demonstrates the private sector is not limited by the scope of government borrowings (the falsified money multiplier model and commodity view of money).

If bank lending is not constrained (‘credit is created from thin air’), then it follows the standard balance sheet model asserting a dollar lent to the government is one less dollar available to the private sector is false. Further, significant lending to the public sector may ‘crowd-in’ private sector investment because the assessment of loan portfolio safety rises when it is composed of a greater proportion of government assets, typically in the form of government bonds.

If any crowding-out does occur, then it is the banks themselves that are to blame. They have chosen to lend immense sums to households instead of the more productive non-financial business sector, boosting profits from interest income and fees off a thinly-capitalised base. The result is less credit is made available to the non-financial business sector. Government is not forcing the banks to take this course of action; they have done so of their own free volition.

Reducing the Deficit

If the government was serious about reducing the deficit, it could be achieved in a far more efficient and equitable manner than is currently being pursued via cuts to social welfare and associated expenditures. Australia already has very low social welfare spending relative to GDP, relying the most upon income-testing and directing the greatest proportion of support to the poor, resulting in the most efficient outcome in terms of inequality reduction per dollar of expenditure anywhere in the OECD.

Theoretically, the deficit could be easily plugged in an efficient and equitable manner. Government should focus on reducing the scope of economic rents that are privatised,  estimated at a total of $340 billion or 23.6 per cent of GDP in 2012, and slashing tax expenditures, estimated at over 8 per cent or around $110 billion in 2010, much of it directed at superannuation, mining and housing. The $8.8 billion boost to the RBA could be reversed, which didn’t ask for or require it.

$9.1 billion was lost to the repeal of the carbon tax, and another $4.9 billion from cutting the corporate tax rate to 28.5 per cent. The refusal to reform taxation onto efficient bases combined with funding of the paid parental leave policy, roads, border security, education and the latest round of foreign adventurism in the Middle East, are set to cost taxpayers tens of billions of dollars more.

As Treasurer Hockey openly admitted while in New Zealand, there is no ‘budget emergency’. The government has simply fabricated panic over the budget to ram through unpopular measures, further skewing distributional effects to advantage the wealthy. The hysteria surrounding public debt is provoked, amplified and echoed by the FIRE (finance, insurance and real estate) sector, including its economists and political allies, for several reasons:

1. It distracts the public from the threat of the massive private sector debt boom. The diversion is understandable, for the FIRE sector has fuelled an immensely profitable land market bubble enriching many.
2. To fabricate deceptive ‘economic Armageddon’ scenarios, advocating further privatisation of public assets and services as a ‘solution’ to reduce public debt. The end result is the expansion of rent-seeking private monopolies, duopolies and oligopolies to maximise economic rent extraction and above-normal profits.
3. To prevent government from funding infrastructure and other social concerns in a more efficient manner, given its borrowing costs and fees are significantly lower than that of the private sector. The difference is economic rent, eagerly appropriated by bankers, notably via noxious public-private partnerships.
4. It provides a pretext for austerity policies that deliberately disadvantage middle and lower income earners: increasing individual tax rates, reducing employees’ bargaining power and widening income disparities.
5. It ensures government has room to accumulate significant debts to fund a future FIRE sector bailout. Wikileaks cables reveal that the IMF was advising the Australian government in 2009 to limit its borrowing in case it needed to bailout one or more of the Big Four banks due to their inability to rollover short-term debts.

Conclusion

The wastes and inefficiencies of government are well-known, expected and predictable. In contrast, the wastes and inefficiencies of the private sector, especially the FIRE sector, are not properly understood, are unpredictable and can quickly cascade out of control. Policymakers and economists have provided a free pass to the toxic and rapid growth of private sector debts, an outcome which overwhelmingly benefits the wealthy.

There is no intrinsic problem with public, private or external debt. All forms need to be carefully managed to ensure efficient allocations into productive, rather than wasteful and speculative, activity. As history and recent international events plainly illustrate, the most dangerous form of debt is private, followed by external, with public a distant last.

The frenzied focus on public debt is an unfortunate distraction; an increase in public debt and larger deficits would be welcome, given the weakness in the economy outside of the FIRE and mining sectors, and the social returns to public investment. Concern over historically low public debt is misplaced, despite the claims of government, the FIRE sector and many economists.

At present, the public debt burden is certainly sustainable, even if interest rates were to increase. The fashionable but unsubstantiated assertion is that rising public debt and deficits pose a risk to the economy. Compared to the pre-WW2 era, governments of today are a picture of fiscal responsibility and prudence, regardless of their political persuasion.

Australia’s history provides a test of whether a relatively high level of public debt is damaging to the economy. Coming out of WW2, the economy experienced three decades of sustained and equitable growth during the social democratic period. Australia’s experience suggests high levels of public debt are not necessarily detrimental, and the much smaller levels today are benign.

The case against public debt and deficits are based upon pseudo-scientific economic theory which has not progressed since the 19th century, political point-scoring and rank opportunism. Australia certainly does not have a ‘budget emergency’, is not ‘running out of money’, and is not headed towards ‘peak debt’ or ‘bankruptcy’. In conclusion, “Australia does have, however, a surplus of government hypocrisy and a deficit in truthfulness and competence.”