Post by Senexx on Aug 6, 2016 11:08:37 GMT
THE FULL EMPLOYMENT BUDGET DEFICIT CONDITION
aka The full employment federal fiscal balance condition
adapted from this source
In an open economy, if there was no government spending or taxation (so a budget balance of zero) the level of economic activity (output) will be determined by private domestic spending (consumption plus investment) and net external spending (exports minus imports). If one or more of those spending sources declines, then activity will decline.
A spending gap is defined as the spending required to create demand sufficient to elicit output levels which at current productivity levels will provide enough jobs (measured in working hours) for all the workers who desire to work.
A zero spending gap occurs when there is full employment. From a functional finance perspective (outlined in the blog above) the role of government fiscal policy is obvious – to ensure there is no spending gap.
It becomes obvious (and incontestable) that if the private spending sources decline from a given position of full employment, the only way that the spending gap can be filled is via a fiscal intervention – direct government spending and/or a tax cut (to increase private disposable income and stimulate subsequent private spending).
That is a core insight of functional finance which underpins MMT.
Another way of thinking about this is to start simply.
The sources of spending which flow and add to aggregate demand are:
Household consumption (C)
Private Investment (I)
Government spending (G)
Export revenue (X)
The income (payments to resource owners involved in the production of output) that is generated by these spending flows can be used in the following ways:
Taxation payments (T)
Household consumption (C)
Household saving (S)
Import spending (M)
Clearly, the sources of income have to equal the uses (as a convention of the National Accounts). This allows us to write the two sides of income generation like this:
C + I + G + X = C + S + T + M
Given C cancels out we know that:
I + G + X = S + T + M
The left-hand side of this equation always is brought into equality with the right-hand side via income adjustments (that is, variations in the level of aggregate activity brought about by spending variations). That is the essential first-principle involved in understanding how the macroeconomy works.
So if for example, Private Investment increases (G and X constant) this stimulates aggregate demand (spending) and firms react by increasing output to meet the new orders. This requires them to increase employment and the increased income is then used to increase saving (S), pay more tax (T) even if tax rates are unaltered, and increase imports (M).
The economy stops expanding again once the change in Investment is equal to the sum of the changes in S, T and M. This dynamic response and subsequent resolution is what we term an movement to a new equilibrium response.
The left-hand side (I + G + X) are called injections – because they inject new demand into the economy whereas the right-hand side (S + T + M) are leakages – because they drain aggregate demand, where aggregate demand is the total spending in a domestic economy per period (say a quarter or a year).
Implicit here is the fact that the increase in investment stimulated rising consumption (C) and the induced consumption stimulated subsequent increases in income and so on. That is the basis of the spending multiplier. Please read Bill’s blog – Spending multipliers – for more discussion on this point.
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.
Three points should be noted.
First, this position of “rest” does not necessarily have to coincide with full employment. The system will adjust to dramatically lower levels of injections and come to rest even if there are high unemployment levels. This was denied by the mainstream orthodoxy who fought it out with Keynes (and Marx before him). One contribution of Keynes was to convince the Western academics (who didn’t want to be convinced by Kalecki or Marx) that economies could settle at very high levels of unemployment and would stay there unless budged by an intervention (that is, a fiscal policy stimulus).
Second, 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). Please read my blog – What causes mass unemployment? – for more discussion on this point.
Accordingly, 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). That is, a budget deficit is needed because there is a non-government spending gap.
Third, this doesn’t mean that a budget deficit is always required. We need one more condition to establish that case for on-going budget deficits. If the non-government decisions taken together (so consumption and saving decisions by households, investment decisions by production firms and the external sector) indicate a desire to “net save” which might be written as
I + X < S + M
then the only way the level of activity can be maintained on an on-going basis (at any rate of unemployment) is if G > T. That is a budget deficit is required on a continuous basis to sustain a given level of activity.
In this case, a budget deficit “finances” the desire by the non-government sector to save by maintaining sufficient demand to produce a level of income which will generate that level of net saving.
Functional finance is very clear – responsible fiscal policy requires two conditions be fulfilled:
1. The discretionary budget position (deficit or surplus) must fill the gap between the savings minus investment minus the gap between exports minus imports.
In notation this is given as
(G – T) = (S – I) – (X – M)
Which in English says for income to be stable, the budget deficit will equal the excess of saving over investment (which drains domestic demand) minus the excess of exports over imports (which adds to demand).
If the right-hand side of the equation: (S – I) – (X – M) – is in surplus overall – that is, the non-government sector is saving overall then the only way the level of national income can remain stable is if the budget deficit offsets that surplus.
A surplus on the right-hand side can arise from (S – I) > (X – M) (that is, the private domestic sector net saving being more than the net export surplus) or it could be associated with a net exports deficit (draining demand and adding foreign savings) being greater than the private domestic sector deficit (investment greater than saving) which adds to demand.
2. Most importantly, the prior discussion focused on the level of income remaining stable but as we have seen doesn’t necessarily define a full employment condition.
We can define a full employment level of national income as that which is generated when all resources are fully utilised according to the preferences of workers and owners of land and capital etc.
Given that S, T and M are all positively related to the level of national income, there is a unique level of each of these flows that is defined at full employment. Changes in behaviour (for example, an increased desire to save per dollar earned) will change that “unique” level but for given behavioural preferences and parameters we can define levels of each.
So lets call S(Yf), M(Yf) the corresponding flows that are defined at full employment income (Yf). We also consider investment to be sensitive to national income (this is outlined in the so-called accelerator theory) such that higher levels of output require more capital equipment for a given technology. So I(Yf) might be defined as the full employment flow of investment. We consider export spending to be determined by the level of World income.
Accordingly, to sustain full employment the condition for stable national income is written more specifically:
Full-employment budget 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 budget deficit (G – T) sufficient to offset that gap in aggregate demand.
If the budget deficit is not sufficient, then national income will fall and full employment will be lost. If the government tries to expand the budget 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).
In this sense, MMT specifies a strict discipline on fiscal policy. It is not a free-for-all. If the goal is full employment and price stability then the Full-employment budget deficit condition has to be met.
How many times have you read any of this in IMF, OECD or other official documents over the last 30 years – the neo-liberal years? Answer: never!
As Bill examined in the blog – Life in the IMF fantasy world – the IMF constructs the budget condition in an entirely different way – divorced from the rest of the macroeconomy.
They define the goal of fiscal policy is to close the “fiscal gap” which they defined as:
… Over an infinite horizon, it measures the adjustment needed for the government to meet its intertemporal budget constraint, so that the present value of the excess of future expenditure and current liabilities over future receipts is zero. It has been argued that when fiscal pressures are concentrated in the long run, as in the United States, using the infinite horizon definition is preferable because finite horizon measures of the gap can underestimate the necessary adjustment …
That is, G – T = 0 when calculated over the “lifetime” of the government (the “intertemporal budget constraint” to use the jargon). That is, pure unadulterated nonsense.
It tells you nothing about the saving and spending preferences of the private sector. It tells you nothing about the dynamics of the external sector.
It creates a faux framework by assuming that “the present value of the excess of future expenditure and current liabilities over future receipts is zero” (Why?) and then the conclusion follows – budgets should be in balance over the infinite horizon.
This framework erroneously assumes that this is a financing constraint and budget deficits have to be “paid back” by which they mean the debt issued to “finance” the deficits have to be paid back via primary budget surpluses (excess of taxes over government spending).
Clearly, a sovereign government is never revenue constrained because it is the monopoly issuer of the currency. As such, the mainstream (IMF) framework misses the point entirely. The entire mainstream discussion about fiscal consolidation and fiscal sustainability and the limits of fiscal policy is based on false premises. It has no application to modern monetary economies.
From the perspective of Modern Monetary Theory (MMT), the whole question of fiscal sustainability has to be in terms of maintaining full employment and price stability. The Full-employment budget deficit condition provides the focus for policy makers in this regard.
Please read the suite of blogs – Fiscal Sustainability 101 – from bottom to top for more discussion on this point.
So before we question whether the “limits” of prudent fiscal policy have been reached we need to collect information from the labour market rather than the bond markets. The existence of mass unemployment is striking evidence that the budget deficit is too small and needs to be expanded.
One way the mainstream gets around this obvious point is to contest the definition of full employment. Accordingly, they invoke a bastardised concept of full employment which they call the Non-Accelerating-Inflation-Rate-of-Unemployment (NAIRU) which says that the economy is fully employed when inflation is stable (irrespective of how many workers are unemployed or underemployed).
Further, if the government doesn’t like that level of unemployment and/or underemployment (perhaps for political reasons) then the only way they can reduce the NAIRU without causing inflation is to operate at a structural level – less regulation, lower welfare benefits, cutting wages particularly minimum wages).
In other words, fiscal policy initiatives designed to influence aggregate spending are futile at best and highly inflationary at worst.
In terms of the MMT Full-employment budget deficit condition, policy designed using some estimate of the NAIRU (which are always above what a reasonable definition of full employment might be) will cause the economy to settle at levels of national income (and real GDP growth) that are insufficient to generate enough jobs.
The mainstream NAIRU-based policy framework, followed by the IMF, the OECD and central banks etc is biased towards entrenching mass unemployment and pressuring policy makers to introduce pernicious anti-worker and anti-equity policies under the guise of structural reform.
As you would recall the NAIRU is a myth that has been perpetuated by the above institutions.
aka The full employment federal fiscal balance condition
adapted from this source
In an open economy, if there was no government spending or taxation (so a budget balance of zero) the level of economic activity (output) will be determined by private domestic spending (consumption plus investment) and net external spending (exports minus imports). If one or more of those spending sources declines, then activity will decline.
A spending gap is defined as the spending required to create demand sufficient to elicit output levels which at current productivity levels will provide enough jobs (measured in working hours) for all the workers who desire to work.
A zero spending gap occurs when there is full employment. From a functional finance perspective (outlined in the blog above) the role of government fiscal policy is obvious – to ensure there is no spending gap.
It becomes obvious (and incontestable) that if the private spending sources decline from a given position of full employment, the only way that the spending gap can be filled is via a fiscal intervention – direct government spending and/or a tax cut (to increase private disposable income and stimulate subsequent private spending).
That is a core insight of functional finance which underpins MMT.
Another way of thinking about this is to start simply.
The sources of spending which flow and add to aggregate demand are:
Household consumption (C)
Private Investment (I)
Government spending (G)
Export revenue (X)
The income (payments to resource owners involved in the production of output) that is generated by these spending flows can be used in the following ways:
Taxation payments (T)
Household consumption (C)
Household saving (S)
Import spending (M)
Clearly, the sources of income have to equal the uses (as a convention of the National Accounts). This allows us to write the two sides of income generation like this:
C + I + G + X = C + S + T + M
Given C cancels out we know that:
I + G + X = S + T + M
The left-hand side of this equation always is brought into equality with the right-hand side via income adjustments (that is, variations in the level of aggregate activity brought about by spending variations). That is the essential first-principle involved in understanding how the macroeconomy works.
So if for example, Private Investment increases (G and X constant) this stimulates aggregate demand (spending) and firms react by increasing output to meet the new orders. This requires them to increase employment and the increased income is then used to increase saving (S), pay more tax (T) even if tax rates are unaltered, and increase imports (M).
The economy stops expanding again once the change in Investment is equal to the sum of the changes in S, T and M. This dynamic response and subsequent resolution is what we term an movement to a new equilibrium response.
The left-hand side (I + G + X) are called injections – because they inject new demand into the economy whereas the right-hand side (S + T + M) are leakages – because they drain aggregate demand, where aggregate demand is the total spending in a domestic economy per period (say a quarter or a year).
Implicit here is the fact that the increase in investment stimulated rising consumption (C) and the induced consumption stimulated subsequent increases in income and so on. That is the basis of the spending multiplier. Please read Bill’s blog – Spending multipliers – for more discussion on this point.
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.
Three points should be noted.
First, this position of “rest” does not necessarily have to coincide with full employment. The system will adjust to dramatically lower levels of injections and come to rest even if there are high unemployment levels. This was denied by the mainstream orthodoxy who fought it out with Keynes (and Marx before him). One contribution of Keynes was to convince the Western academics (who didn’t want to be convinced by Kalecki or Marx) that economies could settle at very high levels of unemployment and would stay there unless budged by an intervention (that is, a fiscal policy stimulus).
Second, 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). Please read my blog – What causes mass unemployment? – for more discussion on this point.
Accordingly, 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). That is, a budget deficit is needed because there is a non-government spending gap.
Third, this doesn’t mean that a budget deficit is always required. We need one more condition to establish that case for on-going budget deficits. If the non-government decisions taken together (so consumption and saving decisions by households, investment decisions by production firms and the external sector) indicate a desire to “net save” which might be written as
I + X < S + M
then the only way the level of activity can be maintained on an on-going basis (at any rate of unemployment) is if G > T. That is a budget deficit is required on a continuous basis to sustain a given level of activity.
In this case, a budget deficit “finances” the desire by the non-government sector to save by maintaining sufficient demand to produce a level of income which will generate that level of net saving.
Functional finance is very clear – responsible fiscal policy requires two conditions be fulfilled:
1. The discretionary budget position (deficit or surplus) must fill the gap between the savings minus investment minus the gap between exports minus imports.
In notation this is given as
(G – T) = (S – I) – (X – M)
Which in English says for income to be stable, the budget deficit will equal the excess of saving over investment (which drains domestic demand) minus the excess of exports over imports (which adds to demand).
If the right-hand side of the equation: (S – I) – (X – M) – is in surplus overall – that is, the non-government sector is saving overall then the only way the level of national income can remain stable is if the budget deficit offsets that surplus.
A surplus on the right-hand side can arise from (S – I) > (X – M) (that is, the private domestic sector net saving being more than the net export surplus) or it could be associated with a net exports deficit (draining demand and adding foreign savings) being greater than the private domestic sector deficit (investment greater than saving) which adds to demand.
2. Most importantly, the prior discussion focused on the level of income remaining stable but as we have seen doesn’t necessarily define a full employment condition.
We can define a full employment level of national income as that which is generated when all resources are fully utilised according to the preferences of workers and owners of land and capital etc.
Given that S, T and M are all positively related to the level of national income, there is a unique level of each of these flows that is defined at full employment. Changes in behaviour (for example, an increased desire to save per dollar earned) will change that “unique” level but for given behavioural preferences and parameters we can define levels of each.
So lets call S(Yf), M(Yf) the corresponding flows that are defined at full employment income (Yf). We also consider investment to be sensitive to national income (this is outlined in the so-called accelerator theory) such that higher levels of output require more capital equipment for a given technology. So I(Yf) might be defined as the full employment flow of investment. We consider export spending to be determined by the level of World income.
Accordingly, to sustain full employment the condition for stable national income is written more specifically:
Full-employment budget 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 budget deficit (G – T) sufficient to offset that gap in aggregate demand.
If the budget deficit is not sufficient, then national income will fall and full employment will be lost. If the government tries to expand the budget 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).
In this sense, MMT specifies a strict discipline on fiscal policy. It is not a free-for-all. If the goal is full employment and price stability then the Full-employment budget deficit condition has to be met.
How many times have you read any of this in IMF, OECD or other official documents over the last 30 years – the neo-liberal years? Answer: never!
As Bill examined in the blog – Life in the IMF fantasy world – the IMF constructs the budget condition in an entirely different way – divorced from the rest of the macroeconomy.
They define the goal of fiscal policy is to close the “fiscal gap” which they defined as:
… Over an infinite horizon, it measures the adjustment needed for the government to meet its intertemporal budget constraint, so that the present value of the excess of future expenditure and current liabilities over future receipts is zero. It has been argued that when fiscal pressures are concentrated in the long run, as in the United States, using the infinite horizon definition is preferable because finite horizon measures of the gap can underestimate the necessary adjustment …
That is, G – T = 0 when calculated over the “lifetime” of the government (the “intertemporal budget constraint” to use the jargon). That is, pure unadulterated nonsense.
It tells you nothing about the saving and spending preferences of the private sector. It tells you nothing about the dynamics of the external sector.
It creates a faux framework by assuming that “the present value of the excess of future expenditure and current liabilities over future receipts is zero” (Why?) and then the conclusion follows – budgets should be in balance over the infinite horizon.
This framework erroneously assumes that this is a financing constraint and budget deficits have to be “paid back” by which they mean the debt issued to “finance” the deficits have to be paid back via primary budget surpluses (excess of taxes over government spending).
Clearly, a sovereign government is never revenue constrained because it is the monopoly issuer of the currency. As such, the mainstream (IMF) framework misses the point entirely. The entire mainstream discussion about fiscal consolidation and fiscal sustainability and the limits of fiscal policy is based on false premises. It has no application to modern monetary economies.
From the perspective of Modern Monetary Theory (MMT), the whole question of fiscal sustainability has to be in terms of maintaining full employment and price stability. The Full-employment budget deficit condition provides the focus for policy makers in this regard.
Please read the suite of blogs – Fiscal Sustainability 101 – from bottom to top for more discussion on this point.
So before we question whether the “limits” of prudent fiscal policy have been reached we need to collect information from the labour market rather than the bond markets. The existence of mass unemployment is striking evidence that the budget deficit is too small and needs to be expanded.
One way the mainstream gets around this obvious point is to contest the definition of full employment. Accordingly, they invoke a bastardised concept of full employment which they call the Non-Accelerating-Inflation-Rate-of-Unemployment (NAIRU) which says that the economy is fully employed when inflation is stable (irrespective of how many workers are unemployed or underemployed).
Further, if the government doesn’t like that level of unemployment and/or underemployment (perhaps for political reasons) then the only way they can reduce the NAIRU without causing inflation is to operate at a structural level – less regulation, lower welfare benefits, cutting wages particularly minimum wages).
In other words, fiscal policy initiatives designed to influence aggregate spending are futile at best and highly inflationary at worst.
In terms of the MMT Full-employment budget deficit condition, policy designed using some estimate of the NAIRU (which are always above what a reasonable definition of full employment might be) will cause the economy to settle at levels of national income (and real GDP growth) that are insufficient to generate enough jobs.
The mainstream NAIRU-based policy framework, followed by the IMF, the OECD and central banks etc is biased towards entrenching mass unemployment and pressuring policy makers to introduce pernicious anti-worker and anti-equity policies under the guise of structural reform.
As you would recall the NAIRU is a myth that has been perpetuated by the above institutions.
