Exploring pro-cyclical budget positions

Sometimes one agrees with a conclusion but realises the logic that was used to derive the conclusion was false. Which means that the person will get things wrong when applying the logic to other situations. This is almost always the case when we encounter the reasoning offered by so-called deficit doves. These are economists who do not out-rightly reject the use of deficits but typically believe them to be cyclical phenomenon only and should thus be offset at other points in the economic cycle by surpluses – the so-called balanced budget over the cycle rule. While many progressives think that is a sensible strategy – the reality is that it is an unsustainable fiscal rule to try to follow. The same economists talk about the dangers of pro-cyclical fiscal positions but fail to appreciate that such positions are desirable in certain cases and there is a fundamental asymmetry that applies to evaluation the desirability of a “cyclical” position. Fiscal austerity (pursuing surpluses when the economy is contracting) is never appropriate whereas expanding the deficit when the economy is growing might be. It all depends. This blog aims to clear up some of these misconceptions.

One such article (August 7, 2012) was written by Harvard economist – Jeffrey Frankel – The Procyclicalists: Fiscal austerity vs. stimulus.

This article demonstrates some of the classic mistakes that economists make when considering the relationship between the government and the non-government sector.

Dr Frankel wrote:

The world is seized by a debate between fiscal austerity and fiscal stimulus. Opponents of austerity worry about contractionary effects on the economy. Opponents of stimulus worry about indebtedness and moral hazard …

Is austerity good or bad? It is as foolish to debate this proposition as it would be to debate whether it is better for a driver to turn left or right. It depends where the car is on the road. Sometimes left is appropriate, sometimes right. When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit.

Which is not only a poor (inapplicable) analogy but also a rule that should never be specified in such terms.

First, the analogy. There is no inherent accounting rule of traffic that says that if x per cent turn left, -x per cent will turn right. So attempting to apply that to a sectoral balance – such as the government budget outcome – which depends and influences the spending and saving decisions of the private domestic and the external sectors is clearly inappropriate.

In the case of sectoral balances, the national accounting methodology and the national income adjustments that underpin it, ensures that if the sum of these three balances (government, private domestic and external) add to zero.

Second, which leads to the further observation. The statement of the fiscal rule that booms require surpluses and recessions require budget deficits is deeply unsound and does not equate to appropriate or responsible fiscal policy.

Why is that?

Modern Monetary Theory (MMT) is built, in part, from the insights provided within what is known as functional finance (as per Abba Lerner). Please read my blog – Functional finance and modern monetary theory – for more discussion.

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 (G – T) will equal the excess of saving (S) over investment (I), which drains domestic demand, minus the excess of exports (X) over imports (M), which adds to domestic 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.

It could also occur if both balances on the right-hand side are in deficit.

However, that simple observation doesn’t mean that the discretionary fiscal policy associated with this position is desirable. Note, that we have to think of this in terms of dynamic flows (which combine to render the balances).

I used the term – “level of national income can remain stable” – at the point where these balances sum to zero. That condition will be satisfied by national income adjustments. So if, for example, we had all balances equal to zero and private consumers became pessimistic and consumption fell (so saving rose) then the right-hand side would go into surplus, immediately.

But it wouldn’t stay that way because the resulting downturn in economic activity and fall in national income would impact on the other two balances. Imports would fall pushing the external balance into surplus and taxation revenue would fall as welfare oriented public spending rises. That would push the budget balance into deficit. The national income adjustments would stop when the balances were summing to zero – but now we would have a budget deficit.

The important point though is that the “level” of national income where these adjustments ceased – that is, the macro-equilibrium or steady-state – may not be very desirable and there could be mass unemployment.

Which leads to the second insight from functional finance.

2. Most importantly, the prior discussion focused on the level of income remaining stable but as we have seen that may bear no relation to what we would consider to be full employment. In other words, the fiscal rule doesn’t necessarily define a full employment condition.

We can define a full employment level of national income as being achieved 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, given the current population, technology etc.

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 national 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.

Please read my blog – The full employment budget deficit condition – for more discussion on this point.

You should thus be able to critique the fiscal rule espoused by Dr Frankel – that “(w)hen an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit”.

He was right in one respect, notwithstanding the poor analogy he used about turning right and left. What the appropriate fiscal position of the government should be – does depend “where the car is on the road” – which in more correct terms means – does all depend on the state of non-government spending relative to the full employment level of aggregate demand and the desired mix of public versus private command of real resources.

Note that last qualification. Economists cannot dictate what the appropriate mix of public and private spending in an economy is. They try to tell is that small government is better but that just reflects their ideology. There is nothing in economic theory that can determine that an economy where 90 per cent of the national income is due to government net spending is worse (or better) than an economy where this ratio is, say 10 per cent.

These are essentially political choices. Every time you hear an economist say small government is better you can conclude that they are making an ideological statement which has no more merit than the religious incantation from a priest. They might pretend they are backed by the authority of economics but that is a smokescreen to expres their religious preferences.

Dr Frankel then makes another fundamental error, which is common of this deficit dove style of reasoning.

Deficit doves think deficits are fine as long as you wind them back over the cycle (and offset them with surpluses to average out to zero) and keep the debt ratio in line with the ratio of the real interest rate to output growth.

Deficit doves are within the same species as the “deficit hawks” in that they believe that the long-term deficits pose serious risks. They differentiate themselves from the “hawks” by their willingness to accept that short-term deficits might be necessary during a recession. A standard aspiration for a deficit dove is thus to propose the government runs a “balanced budget” over the business cycle which is clearly dim-witted as a stand-alone goal and un-progressive in philosophy.

Please read my blog – When you’ve got friends like this … Part 6 – for more discussion on this point.

A deep understanding of national accounting, that I briefly outlined above, tells us that if a government was successful in achieving this fiscal goal (balance over the cycle), then the private domestic sector balance (the difference between its spending and income) would be equal, on average over the business cycle, to the external balance (the difference between income flows in and out of of the nation).

The import of this is that if a nation was running a continuous external deficit, then the private domestic sector will also, on average, be in deficit. Which means it would be continuously accumulating debt – an unsustainable dynamic.

Dr Frankel says that timing issues relating to fiscal policy (there are lags in making decisions etc) give us:

… no reason to follow a pro-cyclical fiscal policy. A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes in response to downturns. Budgetary profligacy during expansion; austerity in recessions. Procyclical fiscal policy is destabilising, because it worsens the dangers of overheating, inflation, and asset bubbles during the booms and exacerbates the losses in output and employment during the recessions. In other words, a procyclical fiscal policy magnifies the severity of the business cycle.

Yet many politicians in the US, the UK, and the Eurozone seem to live by procyclicality. They argue against fiscal discipline when the economy is strong, only to become deficit hawks when the economy is weak. Exactly backwards.

This is a common source of confusion. Regular readers will know I rail against pro-cyclical fiscal policy under certain conditions but make the distinction between a steady-state flow of net public spending and discretionary changes in net spending designed to alter the budget balance.

This distinction is crucial to understanding why the term “pro-cyclical” can be mis-interpreted.

Following on the earlier discussion about the full employment budget deficit condition, it becomes obvious that if the non-government sector is in surplus at full employment then the budget balance has to be in deficit to sustain full employment. That might be interpreted as a pro-cyclical budget position given that the economy would be booming (growing at full capacity utilisation) and the budget would be in deficit.

But of-course it would be an appropriate fiscal stance. Budget deficits that support growth up to full employment are appropriate.

Think about an economy that is returning from a recession and growing strongly. Budget deficits could still be expanding in this situation, which would make them obviously pro-cyclical, but we would still conclude the fiscal strategy was sound because the growth in net public spending was driving growth and the economy towards full employment.

Even when non-government spending growth is positive, budget deficits are appropriate if they are supporting the move towards full employment.

However, once the economy reached full employment, it would be inappropriate for the government to push nominal aggregate demand more by expanding discretionary spending, as it would risk inflation.

Further, there is an asymmetry to this discussion. Pro-cyclical fiscal strategies when the economy is contracting are never appropriate. That is, trying to reduce a budget deficit, when the non-government sector is trying to increase its net position (saving overall) is pro-cyclical – but always a flawed and damaging strategy.

There is also the nuance that the two components of the final budget outcome – the discretionary fiscal policy choices (spending and tax structure) and the automatic stabilisers (the cyclical part) – can move in opposite directions. The automatic stabilisers are always counter-cyclical by definition.


While Dr Frankel supports the use of fiscal deficits and is critical of the widespread use of fiscal austerity, that conclusion is derived from a theoretical framework which is inapplicable to the

So he gets the right answer – in this case – for the wrong reasons. That means that in other cases, the fiscal position he advocates will not be appropriate. That is a common problem when we consider the class of so-called progressives who are deficit doves.

They wrongly assume that there are financial constraints on currency-issuing governments and that these constraints mean that budget deficits will normally drive up interest rates and damage private spending. Neither the assumption or the predictions are valid.

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.

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    15 Responses to Exploring pro-cyclical budget positions

    1. apj says:

      1st paragraph Bill: Fiscal austerity (pursuing deficits when the economy is contracting) is never appropriate

      Should that be pursuing “surpluses” or, at least, “balance”?

    2. bill says:

      Dear apj (at 2013/01/29 at 19:02)

      Thanks for the correction of the typo.

      best wishes

    3. larry says:

      Another typo Bill,

      typically below them

      Shouldn’t ‘below’ be ‘believe’?

      I mention it because it brought me up short asking myself what you could have meant.

    4. Jan says:

      Mario Draghi: “There is no possibility of sustained growth based on permanent debt accumulation; and by the way, there is no social fairness based on permanent debt accumulation.”

    5. bill says:

      Thanks Larry

      Typos are a hazard when you type like the TGV to get it all done. I always appreciate editorial scrutiny.

      best wishes

    6. Ikonoclast says:

      Some issues and questions Bill. Hope you can respond! :)

      Issue 1.

      I asked the question below of a broadly leftish but also deficit dove-ish economist who advocated “balanced budgets over the cycle”.

      “If the economy is growing, wouldn’t running balanced budgets over the cycle equate to a contraction in money supply? In other words, the same amount of money would be circulating in a larger economy. Would this not be contractionary?”

      His reply was essentially, “balanced over the cycle” means “balanced whilst allowing for growth in the money supply proportionate to growth in the economy”.

      I am prepared to give the benefit of the doubt to this economist who is most assuredly not a neoclassical and overall is very enlightened IMHO. He meant his reply literally and honestly but my follow up question was “well why talk in code then?”. I am not sure I got a complete answer on that one.

      I think a lot of “talking in code” goes on but at the public debate level this just serves to confuse the public. It can also mean economists operating with different assumptions can “mis-communicate”. Also, how much deliberate obfuscation is going on from the neoclassicals in this area. Any thoughts on this issue?

      Issue 2.

      What is money? It’s a very good question and one seldom addressed these days. In fact, IMO some of the most fundamental questions of political economy are;

      What is money? What forms can it take and in what ways does it originate?
      What is value? What forms can it take and in what ways does it originate?
      In what ways can money and value be related?

      Returning to money. I think a fundamental question is this. “Is money real?” I think the answer in a nutshell is that money is notionally real but not empirically real in the material sense. Money is not empirically real in the material sense notwithstanding the fact that it can be and must be presented by material or energy tokens (pieces of metal, pieces of paper, inked marks, bits of potential energy in a computer).

      The trouble is that the average unreflective, unphilosophical person thinks money is real just like goods and services are real. Sure money is “real” notionally and socially though not materially/energetically (in the transaction sense) but how does one educate Joe Public in the nuances of this? There are powerful forces arrayed (oligarchic capital etc.) that benefit from the “fetishisation” of money and capital and benefit from the crude belief that it is real in all senses. Ideological positions that benefit from crude belief and require more complex understanding to dispel the fetishisation and mystification processes which are going on… well these ideological positions are dashed hard to fight. Everyone needs to be de-propaganised and properly educated in these matters. How is that ever going to happen? Any thoughts?

    7. Ikonoclast says:

      If I may be forgiven for pasting a long quote from John Ralston Saul’s book “The Doubters Companion”.

      “National debts are treated today as if they were unforgiving gods with the power to control, alter and if necessary destroy a country. This financial trap is usually presented as if it were peculiar to our time, as well as being a profound comment on the profligate habits of the population. The reality may be less disturbing.

      1. The building up of unsustainable debt loads is a commonplace in history. There are several standard means of resolving the problem: execute the lenders, exile them, default outright or simply renegotiate to achieve partial default and low interest rates.

      2. There is no example of a nation become rich by paying its debts.

      3. There are dozens of examples of nations becoming rich by defaulting or renegotiating. This begins formally in the sixth century BC with Solon taking power in debt-crippled Athens. His organization of general default – “the shaking off of the burdens” – set the city-state on its road to democracy and prosperity. The Athens which is still remembered as the central inspiration of WESTERN CIVILIZATION was the direct product of a national default. One way or another, most Western countries, including the United States, have done the same thing at some point. Most national defaults lead to sustained periods of prosperity.

      4. The non-payment of debts carried no moral weight. The only moral standards recognized in Western society as being relevant to lending are those which identify profit made from loans as a sin. Loans themselves are mere contracts and therefore cannot carry moral value.

      5. As all businessmen know, contracts are to be respected whenever possible. When not possible, regulations exist to aid default or renegotiation. Businessmen regularly do both and happily walk away.

      The collapse of the Reichmann financial empire – larger than most countries – is a recent example. The family was able to turn around, walk away and almost immediately begin a new life, promoting the biggest property development in the history of Mexico.

      6. There are no general regulations dealing with the financial problems of nations simply because they are themselves the regulatory authority. There is however well-established historical precedent. Mexico effectively defaulted in 1982-83, thus regenerating its economy. The reaction of Western lenders has been to treat these crises as special cases. The sort of thing that only happens to Third World countries. That’s nonsense.

      7. The one major difference between private and public debt is that the public sore cannot be based upon real collateral. This makes default a more natural solution to unviable situations.

      The question of national collateral was fully addressed in the eighteenth century when it became clear that an indebted people could not owe their national rights (their land and property) to a lender. The citizen’s natural and concrete rights took precedence over the lender’s abstract rights.

      One of the most peculiar and insidious aspects of twentieth-century CORPORATISM has been an attempt to reverse this precedence. The managerial imperative suggests that national debts can be indirectly collateralized in several ways. Governments can be forced to sell national property to pay debts (PRIVATIZATION). They can also be pressed to transfer ownership of national property to lenders, as has been done in the Third World.

      There is also the threat that defaulting nations will be treated as international pariahs. This is a strange argument since it doesn’t apply in the private sector (see 5). It is also an idle threat, as Mexico has demonstrated (see 6).

      8. Debts – both public and private – become unsustainable when the borrower’s cash flow no longer handily carries the interest payments. Once a national economy has lost that rate of cash flow, it is unlikely to get it back. The weight of the debt on the economy makes it impossible.

      9. A nation cannot make debts sustainable by cutting costs. Cuts may produce marginal savings, but savings are not cash flow. This is another example of the alchemist’s temptation.

      Mrs. Thatcher spent a decade trying to slash the British national debt. She had the advantage of being able to use North Sea oil income for this purpose. The result was a damaged industrial sector, economic stagnation and endemic unemployment.

      The payment of debts is a negative process which can only be a drain on investment and growth. The more successful major repayment programs are, the more the economy will be damaged.

      10. Strong nations weaken their own economies by forcing weaker ones to maintain unsustainable debt-levels. For example, in spite of enormous efforts on all sides, the Third World debt has continued to grow. In 1993 it was $1.6 trillion. This costs them far more in interest payments sent to the West than the West sends in aid. The practical effect is to make economic growth impossible. The Third World thus constitutes a dead weight in our ongoing DEPRESSION; a barrier to renewed cash flow

      11. Civilizations which become obsessed by sustaining unsustainable debt-loads have forgotten the basic nature of money. Money is not real. It is a conscious agreement on measuring abstract value. Unhealthy societies often become mesmerized by money and treat it as if it were something concrete. The effect is to destroy the currency’s practical value.

      12. An obsession with such false realities and with debt repayment indicates a liner, narrow managerial approach to economics. The management of an economy is the profession of finance-department technocrats, economists and bankers. Their approach is quite naturally one of continuity. This is a means of denying failure.

      To treat money or debt as a contractual matter – therefore open to non-payment or to renegotiation – would mean treating the managerial profession as of secondary importance and unrelated to fundamental truths. What sensible people might see as originality or practicality, financial experts see as a threat to their professional self-pride.

      13. Does all of this mean that governments should default on their national debt? Not exactly.

      What it does mean is that we are imprisoned in a linear and managerial approach which denies reality, to say nothing of experience. Money is first a matter of imagination and second of fixed agreements on the willing suspension of disbelief.

      In other words, it is possible to approach the debt problem in quite different ways.

      14. There have been changes which limit our actions in comparison to those of Solon or Henry IV, who negotiated his way out of an impossible debt situation in the early seventeenth century and re-established prosperity. First we have to recognize and protect the investment made by citizens directly (government bonds) and indirectly (bank deposits) in the financing of national debts. Second, there is the new and unregulated complexity of the international MONEY MARKETS, which now constitutes an important corporatist element.

      15. Our central problem is one of approach. For two decades governments have been instructing economists and finance officials to come up with ways in which the debt can be paid down and interest payments maintained.

      No one has instructed them to propose methods for not paying the debt and not maintaining interest payments. No one has asked them to use their creativity in place of a priori logic.

      16. Were the members of the Group of Seven (G7) each to pool their economists and give them a month to come up with modern versions of default, we might be surprised by the ease with which practical proposals would appear.

      17. There are two simple guiding points:

      A. The appearance of continuity is easily achieved in default scenarios through paper mechanisms which can be categorized as “debt retirement.”

      B. What is difficult for a single country in contemporary circumstances is easy for a group, particularly if that group speak for the developed world.”

    8. CharlesJ says:

      Your economoist friend said the following:

      The only way that I can see of this being possible, is for him to mean something very neoclassical indeed – to have a balanced fiscal budget, with unsustainable net bank lending providing the increased liquidity and spending. That kind of thinking is what got us (to some extent) into this balance sheet recession in the first place.

      Kind Regards

    9. Ikonoclast says:

      CharlewJ, I know what you are driving at. He didn’t explicitly mean that, tempting as it sounds as a criticism. He meant allowing (or rather making) the fiat money supply to expand to match growth and calling that a “neutral” fiscal setting. This approach could be different from MMT. MMT proposes leading with budget deficits when necessary, the deficit dove neutral fiscal approach means (I assume) using trailing budget deficits. Growth happens (probably by debt money creation, then when a deleveraging credit crisis and money supply crisis occurs you hit the fiat money creation button.) The problem with this is really the same as the one you point out. Without adequate financial regulation, bank lending kicks-in in an unsustainable way as a “natural” alternative. This is the result of squeezing one compartment of a hydrodynamic like closed system which consists of elastic compartments connected by pipes. Squeeze one compartment (fiat money) and another compartment where you have relaxed pressure expands. (This analogy isn’t really right but I hope you get the picture. We are squeezing creation not current stock when we squeeze fiat creation.)

    10. Alan Dunn says:

      The money supply tracks economic activity. In other words it is endogenous.

      Some of the above wreaks of money multipliers and the notion of a government / Central Bank being able to control the money supply.

      That’s Neo_liberal in my book.

    11. Ikonoclast says:

      Alan Dunn, I find your reply somewhat cryptic and puzzling. What do you mean exactly?

      If a government that controls a currency (fiat currency) does not control money supply then who does? Where exactly does this money come from in your opinion?

    12. Alan Dunn says:

      It would appear Ikonoclast does not know the difference between the Money Stock and the Money Supply.

      The Government / Central Bank for the most part control the Money Stock – they cannot control the money supply.

      Add securitisation and derivatives to the mix and any notion that the government controls the money supply is laughable.

    13. Ikonoclast says:

      Well as I clearly don’t know the difference between Money Stock and the Money Supply please enlighten me. What are the definitions of each and how are they measured? Please feel free to answer these questions from both the orthodox and heterodox perspectives.

    14. Tony says:

      I have a lot of sympathy with people who get confused about what is meant by different kinds of money supply. Whenever I try to finally understand it, I come across many and various definitions which are confusing and confused and I am always finally defeated by jargon.

      As far as I do understand it, the money supply in its broadest sense includes endogenous money that is created by bank loans and this is not controlled by the central bank. “Base money” (is that the same as money stock?) I take to be something like the net financial assets in the private sector but excluding things like government bonds. Changes in net financial assets are related to governments deficits, but even these deficits are not fully controlled by the government.

      If there is someone who really understands the definitions, and that’s a big if, please enlighten us.

    15. Alan Dunn says:

      The monetary aggregates such as M0, M1, and so on are in order of liquidity with M0 being the most liquid.
      Money Base / Money stock / M0 being the most liquid.
      Base Money is notes and coins held by private sector + bank deposits held by / with the Central Bank.

      M1 is notes and coins plus current or demand deposits of the non bank public with licensed banks.

      M3 is M1 + all other bank deposits

      M4 is M3 + building society deposits

      M5 is M4 + finance company deposits

      M6 is M5 + merchant bank deposits

      Broad Money is M3 plus borrowings from Non-Bank public / deposits of Non-Bank financial institutions.

      There are two versions of the money supply process.

      The fools version known as the money multiplier approach and the more correct version which takes into account that the Central bank maintains an interest rate target which focuses on the transmission mechanism (not a money supply target).

      Source: Juttner and Hawtrey (1997) Financial Markets Money and Risk, Longman, Chapter 5

      The fact that the money supply is endogenously determined is nowhere better proven by monetarist regimes and their epic failures attempting to target the money supply rather than the cash rate.

      Bill’s blogs on the money multiplier myth contain all you need to know.

      Note: These are my words not Bills – so don’t hold him responsible for any errors on my part.

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