The British Left needs to moderate its obsession with austerity

I’m not reviewing this book, but title reveal the left’s attitude to austerity

As a Liberal Democrat I’m often described as being on the political left. One word shows that this is far from true: “austerity”. To people on the left, especially in Britain, this word brings up a visceral reaction. To them austerity is the quintessence of evil: the crushing of all attempts to promote the public good, perpetrated by a brutal government out to protect the interests of the rich. But to me austerity is a government policy that is often necessary – and is part of a healthy tension that keeps the state efficient. Still, I always like to understand the arguments of people I disagree with, and when I saw a link on my New Statesman email to an article by William Davies entitled Fascism’s liberal admirers, I thought I’d take look. The sub-title was Austerity is a fiction designed to uphold capitalism – and it has a dark history. The pretext (I would not call the article a review) for the was a book by Clara Mattei called The Capital Order – How economists invented austerity and paved the way to Fascism. The subheadings demonstrate what I mean about the left’s attitude.

Which is why I was expecting a lot of nonsense – and by and large that is where the article ended up. But along the way it constructed a narrative that was fr from nonsense. The book is about the rise of Fascism, and how the pre-Fascist government in Italy in the 1920s was being pressured by Britain (as a creditor nation) to adopt austerity policies. The British ruling establishment had taken on the austerity narrative after the First World War, and was delighted when the Fascists in Italy followed through with these policies after they took power. Ms Mattei’s and Mr Davies’s point is that this narrative came about as a reaction to a socialist narrative that the success of war economies showed that there was an alternative to market capitalism, with economies led by, and substantially owned by, the state. Revolution was in the air. The capitalists needed to stamp this thinking out, and they aggressively promoted pro-market policies and a rolling back of state intervention. It was not a narrative based on economic necessity, but one developed to protect vested interests. It is but a short step for Mr Davies to suggest that this is what has been happening in the 21st century, following the financial crash of 2008, and now – with the fall of the Liz Truss government. That, historically, support for austerity led capitalists to embrace Fascism shows how they will turn on democracy to protect their interests, and economics is just camouflage. The fight against austerity is the fight to preserve democracy.

There’s something in this. Pretty much all economic policy, whether capitalist, socialist or anything else, is a conspiracy of vested interests: people try to persuade the public at large that their ideas are for the public good, using any argument that they think might gain traction, spurious or otherwise. That is how large, complex societies get anything done. Truth is incidental. And, though I’m not an expert, I think that the British ruling establishment over-reacted to the prospect of more socialist ways of working in the 1920s, and their arguments in support of the package of policies that Mr Davies calls “austerity” do not stand the test of time (though economies in the 1920s swiftly moved to growth after austerity – and it was not until the depression of the 1930s that the narrative seriously came to be questioned). After all they did something quite different after the next war, and capitalism (and wider society too) has never flourished more. It is a stretch to say that the same applies to 21st century episodes of austerity in Britain and the Eurozone, but there is a case to answer. Many of the justifications put up by the supporters of austerity policies were nonsense. So if you want to believe that austerity is always and everywhere economic nonsense promoted by self-interest, you will always find plenty of evidence. That is the insight I gained by the article. Evidence, but not proof.

The resources required to make an economy work are always limited. The bottom line is that economic policy will always be limited by resources, and that the more efficiently those resources are used, the more successful an economy will be. There are times when it pays a government to spend money to do things that are useless. Keynes wrote of getting people to dig holes and fill them in again; Hitler ramped up spending on armaments. That is when the economy is running slack and needs pump-priming. The people digging holes or making tanks spend their wages buying other things, creating a virtuous circle of job creation. Austerity is a bad idea at such times. But when the economy is running at close to capacity, or overheating (as is the case in most developed economies in 2022) then that logic disappears. If anybody, anywhere is employed doing things that don’t enhance society, it is means that the economy is running less efficiently than it should. If the government is running inefficiently, then austerity policies can be justified to cut waste, and move people from doing useless things in the public sector to being more useful in the private one. That is the basic intellectual case for austerity. And it is why governments of all economic stripes, capitalist and otherwise, will often carry out austerity policies. For example, Cuba’s socialist government after Soviet subsidies were withdrawn in the 1990s.

It goes deeper. All human organisations have a tendency to become complacent, and settle into inefficient ways of working to minimise internal conflict. In private enterprise this tendency is tempered by the need to compete, and by downturns in the business cycle. I well remember this from my work days. Things would seem to be going well, and then there would be a crisis. Savings had to be made, usually, eventually, entailing job losses. Workers were disappointed and often angry; but the overall effect of this stop-start was a more healthy, efficient and focused organisation. Some good things might be lost in the process, but that was outweighed by the reduction in waste and follies curtailed. The public sector is generally insulated from such commercial pressures, and so has an even greater tendency to become inefficient. Bouts of austerity act as a check on this, and force managers to focus on what needs to be done – though they won’t thank you for it.

But the timing is often difficult to decide. It is not always easy to tell if an economy is running slack or close to capacity. There is an argument to be had about that in Britain in the 2010s. But the real problems happen over resources transferred between countries. Economies are often sustained by using resources provided by other countries. But this creates international obligations – as well as the temptation to profligacy. If people in one country supply resources to people in another one, they do so because they expect to be repaid in some shape or form, usually profitably. If it turns out that poor economic management (or any other problem) puts the repayment in jeopardy, then the creditor countries will often insist on austerity. This is not always the right thing to do, but the basic premise that the debtor country is consuming more resources than it is producing, and needs to adjust to something more sustainable. This can be a capitalist conspiracy, but it doesn’t have to be. The politics around it get messy with truth, as usual, a casualty; creditors accuse debtors of profligacy – debtors accuse creditors of gratuitous cruelty. Some governments practice austerity simply to prevent getting into this sort of situation – the socialist president of Mexico, Andrés Manuel López Obrador, is an exemplar of this.

All this is common sense. Austerity – and this is best understood as cuts to government spending, rather than raising taxes – can simply be about the management of finite resources in a changeable environment, and doesn’t have to be ideological. So why do the British left react so violently to the idea? I’m not sure how deep the history goes. The New Labour of Tony Blair and Gordon Brown of the mid-1990s embraced austerity, but they were hardly of the left – but the left seemed happy enough to keep in tow. I think the issue originated from the coalition government of 2010. In the five or so years before this, the state payroll, direct and indirect, had expanded considerably. Many parts of the state had become very inefficient. At the time I could see this in both education (I was a school governor) and health (I was following health affairs closely, as I was looking for a job there). In both areas I could see over-complicated management structures and performance grids, and lightweight policies implemented to placate some lobbyist or other. Capital funding was tied to a bidding process that required the use of consultants on both sides. The bidding process was a matter of verbiage – the trick being to find the right trigger phrases. I read my borough’s bid for primary school expansion (which was successful), and it seemed to carefully saying nothing at all – but it was the work of many senior people, with external advice. In the NHS, funding was driven by something called “World Class Commissioning” – a vastly over-engineered superstructure designed to provide employment to consultants and middle managers. I could go on. The writing was already on the wall before Labour lost the election of 2010, as the crash put government finances under strain, but the government had been slow to apply austerity. Not so the incoming Conservative-Lib Dem coalition. They put in place a vicious programme of spending cuts. Suddenly a whole class of public sector employee found their livelihood at risk – and worse, political leaders were suggesting that their endeavours had all been a waste of time. That triggered an angry backlash. And just as the right tends to be controlled by the interests of capitalists, the left tends to be controlled by the interests of state employees.

By and large the angry people were university graduates trained to look for abstract principles to make sense of events. So instead of just protesting against the concrete adverse effects of particular cuts, they spied an abstract idea to focus their anger on: austerity. Austerity was evil; the cuts were not necessary but ideological. Many economists criticised the cuts as excessive, causing a needless recession and economic wasted resources – and this was seized on as evidence of the evils of austerity. As this line of thinking developed in the usual echo-chambers of social media and friendly journals, it morphed into the idea that austerity is always and everywhere evil. Mr Davies’s article shows how entrenched that thinking remains.

And that is a problem. The left seeks to achieve political power, and to do so democratically they must persuade people that they can be trusted. But most people’s attitude to austerity is pragmatic: sometimes it is required. Most people probably have their own hobby horse of perceived government waste that austerity could be used to sort out – though there will be no general agreement on what these actually are. A class of politicians that cannot let the idea that austerity can ever be justified pass their lips are going to find it very hard to win that trust. And yet it is more than easy to campaign convincingly against specific cuts – at a time when so many public services are wilting under pressure, and the public safety net is obviously inadequate in many places. The politically sensible thing to do is to allow for austerity in theory, but oppose it in the here and now: or to follow the example of Gordon Brown who advocated austerity in the mid 1990s, but once in power and having established public trust, launched the expansion of the British state.

The left are part of the Labour Party, but do not control it. The Labour leadership understand well enough the politics of all this. Polls show that they are maintaining credibility on economic management. The left’s obsession with austerity in the abstract undermines their political influence. Which means the advocacy of any good ideas they have is weakened. In a world when many long-held beliefs are being challenged, the left should challenge this shibboleth.

16 thoughts on “The British Left needs to moderate its obsession with austerity”

  1. I’m not sure exactly what you are saying in this article. The 30s was obviously a time of economic failure. There was no need to accept such high levels of unemployment as existed at the time. There was an obsession towards balancing the books which meant that government spending was cut because taxation revenue had fallen which led to a slower economy which led to even lower taxation revenue. It was a classic death spiral in action.

    “Austerity” or whatever term you want to apply to the economic mismanagement of the time led to the rise of fascism and nazism and in turn to WW2. That was spectacularly expensive. The austerity of the thirties failed even on its own terms.

    We’ve seen similar arguments in the 21st century, in the USA, the EU and elsewhere about the need to balance government spending with taxation receipts. They are largely nonsense. A decline in Government spending leads to a decline in government revenue and does little or nothing to balance the books.

    I think we can define “austerity” to be the misapplication of a counter inflation policy. Governments do have the responsibility to raise taxes and/or decrease spending if their motivation is to cool an overheating economy. This could possibly be described as “austerity” but it isn’t what the left has been rightly opposing in the strongest possible terms. At least this has been the case in the past few years. They, or at least the centre left, were guilty of going along with it in the early years of the 2010 coalition government. They EU centre left was guilty of it for even longer which is why they have done badly in many elections in the past decade. The Greek Pasok and French Socialist Party now barely exist as credible political parties.

    In a nutshell: A government applying a fiscal squeeze to slow down an overheating economy is acting responsibly. A government applying a fiscal squeeze in the mistaken belief, or a knowingly false claim, that it will help balance the books is applying unnecessary austerity.

    The situation at present is less easy to describe because our inflation has been caused by a variety of supply shocks rather than an overheating economy. There is still a valid argument than some measure of fiscal tightening is in order to prevent inflation becoming endemic. If this is the Government’s intention this is what they should say.

    1. I think we largely agree about the interwar austerity, especially the 1930s flavour. The book quoted associated Fascism with the 1920s variety, which was less obviously harmful. But the thinking guiding it was the same as led to disaster in the 1930s. My point is that this does not prove that austerity is always and everywhere bad – which is what many left wing here commentators seem to suggest. My main argument is that the scale of public services and benefits sometimes needs to be curbed in order to reduce the wasteful use of an economy’s resources. This is the point I think the so many leftists struggle to admit, even in theory – though it is doubtless different if they are Cuban or Mexican.

      While I agree with you on the general principles of fiscal management, I think there is a problem when countries are running substantial current account deficits, suggesting that their living standards are dependent on support from other countries. What happens when those other countries want to withdraw that support for their own reasons? It is easy to argue that those countries should not have got themselves into that situation (though profligate lending by German banks, in the case of the Eurozone crisis, for example), but less easy to see how you are meant to exit without austerity. The theory is that Greece, et al, should be able to grow their way out – but what if you don’t have confidence in their political system to achieve this? The UK was a bit different, though the current account deficit was present there too. My belief is that the economy was much closer to its maximum productive capacity than most people fought, because too much of the pre-crash economy was unproductive and dysfunctional (much of the banking industry, and some public services), and keeping it going would simply have hastened a financial crisis. The austerity was never as severe in fiscal terms as many critics have made out anyway, with the government easing on several occasions to receive pressure. I don’t don’t expect you to agree with that assessment, but I think it does highly some points of principle.

      There is something important about smaller nations (which means pretty much everybody except the USA) having to be careful about budget deficits in order to stay in control of their countries – otherwise you effectively cede sovereignty to outsiders. This is what AMLO in Mexico understands but his friend Jeremy Corbyn doesn’t.

      1. You’re widening the scope of the discussion by bringing trade imbalances into it. On a global scale the dominant view is that it is better to run a trade surplus than a trade deficit. Obviously it isn’t arithmetically possible for everyone to do this. The trade tensions of the previous eras were another factor which led to wars. WW1 itself in Europe and the desire of Japan to expand its trading ability, free from high tariff barriers, in the Pacific region prior to WW2.

        What currently happens in practice is that those developed economies which let their currencies freely float tend to be in trade or current account deficit which accommodates the desire of those who don’t to run a trading surplus.

        The application of austerity isn’t going to change this in the deficit countries. We saw it didn’t during the coalition period. What might have worked was going into the euro at a relatively low level which would have made our exports more competitive. Then if there had been a fiscal squeeze the net effect would have been the diversion of more available resources towards the export market. A shift towards exports, though, is incompatible with one of the few neoliberal principles, on the overall benefits of a floating currency, I would agree with.

        Sure, if we are relying on cheap imports from overseas there is a potential longer term risk. It probably doesn’t matter that much if its consumer goods such as laptop computers and mobile phones. We can survive long enough without those to readjust in a timescale of a few years. It is more problematic if we’re relying on cheap food and cheap energy always being on hand and as we are finding out the hard way just now.

        1. I don’t think you can separate trade imbalances from austerity. But you are right that the austerity policies in the UK did pretty much nothing to address those imbalances here, unlike when austerity was applied in the mid-1990s.Although, of course, we don’t know what would have happened in the counterfactual of the UK not going for austerity in in 2010. Interestingly the government splurge on furlough et al during the pandemic didn’t seem to have a negative impact on trade balances – perhaps because people were saving, so delaying the problem. In the eurozone it was different matter – austerity was associated with a reduction of imbalances in Greece, etc.

  2. I would say you can’t separate the trade imbalances from macroeconomic policy, which includes any policy of the flexibility or otherwise of the exchange rate. The UK and Greece aren’t directly comparable because the pound floats solely according to conditions in the UK economy relative to the rest of the world, whereas the euro floats according to conditions of the eurozone as a whole, of which Greece is only a small part.

    The imposition of either a monetary or fiscal squeeze in the UK economy will likely cause the pound to rise which will counteract any intended effects of reducing the trade imbalance.

    Any economy which runs a current account deficit in trade will need to replenish the money lost to pay the net import bill from somewhere. It could come back in via the capital account in the form of land and property purchases. Some of it will come back as the purchase of Govt bonds. This needs to be spent back into the economy to keep it working at or near to full capacity. It is inevitable, therefore, that the Govt will be in deficit or be seen to be ‘borrowing’.

    This isn’t such a problem providing inflation is under control.

    The other possibility is that the private sector does more of the borrowing so that Govt can borrow less. The downside is that interest rates have to be kept ultra low which leads to far too much indebtedness in the private sector, which is very likely to be the cause of our next big economic problem. Now that interest rates have risen we can expect increasing levels of default. The banks could well panic and call in loans which, somewhat ironically, will bring about the crash they are dreading.

    1. Yes Greece is very different, leading to different impacts of trade imbalances. A monetary squeeze should lead to currency appreciation; a fiscal squeeze should have the reverse effect by reducing the demand for currency – at least that’s what they taught me in macroeconomics at UCL. We’ve debated that one hard! Depending on how the private economy responds, a reduction in the budget deficit should reduce the current account deficit.

      I accept that current account deficit can be quite sustainable, depending on how it is balanced out. I suspect that property sales have had a big role to play in the UK – but I have found the ONS data on the capital account very hard to make sense of. A budget deficit likewise. A budget deficit paired with a current account balance or surplus (e.g. Japan) in principle is highly sustainable. But there are always limits to these things, and it isn’t linear. The problem for the UK government is that nobody knows how close the country is to the brink. The Truss/Kwateng fiasco showed that are limits.

      1. @ Matthew,

        Before the Covid pandemic we weren’t that close to our limit. I accept that the situation is different now. It is true that unemployment figures have been relatively low but the underutilisation of resources is more apparent in the relatively recent phenomenon of underemployment. Economists, as you’ll know, have a concept of the NAIRU which is the non accelerating inflation rate of unemployment. It probably should be redefined with an extra U at the end to include underemployment.

        I think we have previously discussed the so called “productivity puzzle” of the previous decade or rather lack-of-productivity. I think this is easily explainable on the basis that employers will largely invest in capital equipment to improve productivity when labour is expensive and in short supply. The conventional view is that higher productivity leads to higher wages. I’d put it the other way around. This indicates that labour hasn’t been in short supply and so it has been cheaper to hire extra workers than increase productivity.

        It is easy to see why a monetary squeeze will increase the value of the currency. Interest rates rise and there is a higher capital inflow. A fiscal squeeze does have the effect of reducing inflation which in turn means that real interest rates will rise for any given level of monetary constraint. So this is one factor to indicate that both squeezes will produce a similar outcome. Another is that if aggregate demand is reduced then imports should first fall. This reduces the demand for foreign currency which pushes the pound higher and leads to imports being more affordable again. So the net position, or the trade deficit, ends up being unaffected.

        Sorry to introduce some algebra but from the sectoral balances we can say:

        (G-T) =(S-I) +(M-X)
        or Government Deficit = Private Surplus + Trade Deficit
        So what does this mean if we want Government spending (G) to be approximately equal to Taxation Revenue (T). Say G-T =0
        If the exchange rate floats and the economy is doing reasonably well there is no reason to think that our overseas trading partners will want to change their wish for them to be in surplus and us to be in deficit. Therefore our imports (M) will be higher than our exports (X). M-X will be +ve.

        This means (S-I), the contribution of the Private Domestic Sector, will have to be equally negative. In other words savings (S) will have to be lower than investment. (I) This is possible if Government persuades the private sector to do the borrowing so that it doesn’t have to. This can’t be permanent. The private sector can’t continue to borrow indefinitely. It’s only what happens, temporarily, in a credit boom.

        Another way of putting it is that if Government wants a lower deficit it needs the private sector to save less and/or be able to afford fewer imports. This does possibly correspond to your suggestion that a fiscal squeeze can reduce the trade deficit but it’s not going to be in a good way if everyone feels poorer.

        I only say ‘possibly’ because there is no way of knowing just how everyone will react to a fiscal squeeze. If real interest rates are higher they might well save more if they are concerned about the future and there are fewer good investment opportunities.

        1. Well, the conventional economic argument runs a bit differently. Fiscal tightening means that G-T increases. That means either net private savings (S-I) comes down, or the trade deficit (M-X) comes down. The way that happens in a floating currency environment is for the exchange rate to depreciate. as imports are reduced; demand for currency is diminished by the overall contraction. This reduces the net flow of imports. In a fixed currency system the central bank is forced to raise interest rates in order to defend the currency, which has to effect of reducing net savings instead. (since you can’t have a free monetary policy with a fixed rate). So the rather neat idea is that for a small free-trading economy, fiscal policy is neutralised for floating rates but amplified for fixed rate – while monetary policy is effective for floating rates but impossible for fixed rate. Of course things don’t quite work that way in practice.
          To try to reconcile that to your idea, I think you have the problem that a country can’t have a floating rate if everybody else’s rate is fixed! and you argue that many countries are letting their currencies float fully because they want to operate a trade surplus. So the rate doesn’t adjust fully.
          Of course playing with the algebra (and especially identities like sectoral balances) doesn’t get you all that far, as human behaviour easily upends things. if private savers respond to austerity with their own version, the currency effect may be more muted, or the currency may even appreciate.

          1. Oh dear. I should have reread that before pushing sent – the first sentence is the wrong: fiscal tightening means G-T reduces. And many countries aren’t letting their currencies float freely. Of course if your currency is fixed only because other countries are, you can get a bit of a free ride – which I think is something you have argued.

  3. Maybe a better title would have been ” The Left (and not just in Britain) needs to better understand what austerity actually is”

    My suggestion is that it is the application of a fiscal and/or a monetary squeeze when there is no counter-inflationary need to do so. We should be thinking about the economy in terms of resources rather than in currency terms.

    Even the BBC get it all wrong. In the link below their “Reality Check Team” are questioning the sum total of £28 bn given by Rishi Sunak for various increases in public sector pay.

    Interestingly, they go part of the way to what some might mistake for an MMT explanation of Public finances by saying “there’s also the question of the tax public sector workers would be paying if they got an inflation-linked pay deal. If it cost the government £18bn, it would be getting some of this back through tax – roughly a third – bringing the bill down further.”

    I’m not sure why they stop there. The extra money that isn’t paid in tax by public sector workers will still be spent, and then respent in subsequent transactions. It will all go back to the government in tax unless someone temporarily prevents it doing so by saving it.

    So it isn’t too difficult to argue that it won’t actually cost anything at all – no matter how large the pay rise might be and no matter how many workers receive a pay rise.

    However, surely if some sectors get more we can ask: “won’t someone else will have to “pay for it”? Yes, they probably will. The mistake we are making is to think in terms of pounds rather than resources. If there is significant slack in the economy the government can engage in some extra spending to use up the slack and so it won’t cost anything at all. However, if there isn’t, the government will be diverting resources from some to give to others, by creating an increase in the rate of inflation.

    This is not to say that low paid public sector workers aren’t deserving of a decent pay rise. This is a political rather than an economic question, and I’m firmly on their side! However, I would have to say that it needs to be financed mainly by extra taxation at the moment.

    1. Yes – a lot of the issue is that many are using austerity as a totem rather than actually trying to understand it.

      It is interesting that the BBC are starting to question some of the government’s economic arguments. I was amazed at lunchtime when Martha Kearney suggested that increasing NHS pay isn’t inflationary because nobody was charging for their services! I’m not sure I follow your argument that any increases all come back in tax anyway. I have a feeling that it isn’t quite true (but you’ve thought about it quite a bit, so that’s unlikely) – or else that some nasty things can happen on the journey. Excessive public sector pay, or excessive budget deficits can be a problem.

      I still don’t think the government’s arguments add up. If the government gives public sector worker payrises similar to the private sector, then surely there won’t be any wage-price spiral. And inflation increases taxes, especially with the fiscal drag effect. Lord Baker was arguing this in the Martha Kearney interview – and he’s a Tory! It’s a shame Labour aren’t challenging the economics properly.

  4. The point about all public sector funded pay increases coming back as taxation revenue follows quite straightforwardly from the MMT concept that a fiat currency is an IOU of, and therefore also a creation of government. Government creates money as it spends and destroys it as it taxes. Unless of course someone else obligingly destroys it for them. The process is slowed down by anyone saving it but ultimately it will all end up back with Government. If a Government increases its spending its revenue will rise. It it cuts its spending its revenue will fall.

    The whole mainstream concept, therefore, of extra spending leading to a higher deficits and debts, and vice versa, is flawed. The Government finances aren’t like a local councils. It is quite possible for a Government to balance its books or have a low deficit at the same time as the economy is overheating. Check out what happened around 1990 and again at the turn of the millenium.

    The MMT concept of the Job Guarantee gives me some problem. The idea is to ensure that everyone has the offer of a job which is paid at a fixed wage. And it is fixed. It actually becomes a sort of currency labour standard based on the pay levels of the lowest paid workers in the community. This seems to also be the thinking of the current government. The Labour Party has also pursued the same line when faced with the same inflationary problems.

    MMT economists, if not many MMT followers, would very much agree with you that increasing the pay of NHS staff would be inflationary if not covered by increases in taxation when there is insufficient slack in the economy to allow for fiscal expansion.

    PS I couldn’t figure out why you said earlier that a fiscal squeeze should have a downwards effect on the currency. This must be the mainstream view if you were taught that. Except, it could be true in the longer term if it leads to lower levels of growth but I can’t see why it would have this short term effect.

    1. Thanks Peter. I’m going to need to do a bit more thinking on this. When the money side of things get confusing, I’m a big believer in go back to the resources side. But the resources are the workers and not the wages – so the impact of a wage rise isn’t so obvious! I think the MMT concept of money has a lot going for it – that it is intimately linked to government. One of the reasons that cryptocurrency is nonsense.
      As for the conventional view of a fiscal squeeze leading to a depreciation of currency, this is based on logic that MMT economists despise (IS/LM models – Mundell-Fleming) though I’ve not fully understood why; I don’t see it as either-or. The government reduces the amount of money it borrows from the markets; interest rates fall as a result (government debt is auctioned, and so there is a supply-demand effect on longer term rates independent of the bank rate); and the currency depreciates. That’s one mechanism, but I’m sure there are others allowing the same basic logical trajectory. But the logic can always break. If the currency depreciation means that equity assets (FDI, Property, etc) become cheap by International standards, that would draw in foreign capital, which would tend to push the other way.

  5. Thanks Matthew.

    I thought it might be something like this. This is also related to what MMT calls the “crowding-out” fallacy , which contends that increasing the level of government borrowing, or a looser fiscal policy, will crowd out the private sector. Therefore a fiscal consolidation will release resources enabling the private sector to expand.

    The MMT view is that tighter fiscal policy will, on its own, act the other way. The government is putting less money into the economy than it otherwise would which means there is less money available to be borrowed and so the pressure on interest rates is upwards. This assumes that Govt and the central bank wants an upwards movement. The Monetary committee of the central bank of course decides on the level of short term interest rates on the basis of a vote. Longer term rates are set by the actions of the central bank as a net buyer or seller of government bonds.

    So, in a way it doesn’t really matter who’s right. The central bank controls the level of interest rates both in the short and longer term.

    1. I’m not sure if the idea of crowding out in this context is part of conventional economics, rather than put about by some conventional economists with a political agenda; I can’t remember it being part of my BSc course. I have seen it suggested in the context of borrowing – on the basis that there is only a limited amount of funds to lend, which doesn’t sound convincing at all. Crowding out must surely be an issue when it comes to resources though. If the government recruits more nurses, soldiers, or whatever, then surely there are less resources for the private sector to use? That logic doesn’t apply to taxes or benefits, of course.
      I really can’t get my around “which means there is less money available to be borrowed”. I don’t understand money like that at all. There is clearly a contractionary fiscal effect (which is part of the mainstream ISLM model), but what has money got to do with it? I thought it was a fallacy to suggest that banks only lend money that people deposit. This sounds like a variant of that type of fallacy. I think I’m beginning to understand why conventional economists dislike MMT so much! My view is that there are a lot of moving parts which mean that assertions that tighter fiscal policy will lead to currency depreciation or the opposite reflect the limitations of the models used. Both models can be right in different contexts. I’m trying to understand what those contexts are…

    2. I’ve been trying to get my head round this. Both Mundell and Fleming were much cleverer than me, and thought about this deeply – and they were iconoclasts of their time, challenging the assumption that fixed exchange rates were the only sensible way to manage international finance. I’m loth to rubbish their work on the say-so of some MMTers. The ISLM model was not their work: it is a more modern idea used to explain their ideas, and others, to undergraduates. I think there is something missing from my understanding/explanation of their model. I think it must be the implications to an economy of being open to international trade. It is based on a small, open economy. I have heard MMT being criticised as being developed mainly by Americans, based on the US economy. And the US economy is not small, and not so influenced by International trade and finance – besides the fact that the USD is the de facto currency of the bulk of international trade. The UK is much closer to be a small, open economy. From our exchanges I have always thought than an understanding of international finance and trade was a bit if a weak spot for MMT – they are trying to bend the logic into their world view (which we all do of course…).
      I think the critical insight of M-F is that in a small open economy the effects of fiscal policy are diluted by a floating currency. The MMT prediction of fiscal contraction leading to higher interest rates is what they predict for a fixed rate, and (though I haven’t worked the logic through) for a closed economy. MF predicts that reduced domestic demand will be replaced by increased exports by a depreciating currency, unless the central bank moves in to defend the currency. The mechanism is as I suggested – reduced domestic demand for currency reduces its international price.

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