BEE Partner, South Africa Economy Watch

William Vickrey (1996: 10) argued, ‘The “deficit” is not an economic sin but an economic necessity. Its most important function is to be the means whereby purchasing power not spent on consumption, nor recycled into income by the private creation of net capital, is recycled into purchasing power by government borrowing and spending. Purchasing power not so recycled becomes non-purchase, non-sales, non-production and unemployment.’ In an endogenous money world, there can be no crowding out unless the monetary authority stops lending.

The recent Asian financial troubles and IMF intervention have once again given credence to the view that increasing levels of debt will eventually lead to lenders refusing to take up further public borrowing. Usually this is cast in terms of countries with low levels of capital that have major private debt denominated in a foreign currency used to finance imports. Crises occur when the export revenue, which services the debt, falls for one reason or another. But none of these countries would have any trouble issuing debt in its own currency.

To fine-tune this point, government spending would still have occurred if there were no bond issues. The excess reserves would be held somewhere in the banking system earning zero return. If the Treasury offers too few or too many bonds relative to the holders of reserve balances at the Central Bank, the Central Bank ‘offsets’ those operations to balance the system. In any case, the `money’ is in one account or another at the central bank. We then ask the question — ‘Why should government care if the holders of the excess balances choose the one that does not pay interest as opposed to the ones that do (buying bonds)?’ — the answer is simple: ‘They would be indifferent.’

The Job Guarantee policy also requires that the government have the ability to implement a largely independent monetary and fiscal policy. In this section, we examine the effects of budget deficits on interest rates and current account performance and also seek to establish causality within the term structure of interest rates. As noted above, Glyn (1997: 226-27), an advocate of fiscal activism, believes that taxation should be used to ‘finance’ necessary spending. He accepts the notion that international financial markets will react to higher budget deficits and ‘exact a higher real-interest rate’ (Glyn, 1997: 224).

Mitchell (2000a) structured this contention into a set of empirically testable hypotheses:

1. Is there evidence of a relationship between budget deficits and short-term and long-term interest rates? If there is no discernible statistical relationship found, it is difficult to argue against fiscal activism based on financial crowding out arguments.
2. Is there evidence of a relationship between long-term interest rates across countries in globalized financial markets? If there is no relationship detected, then the view that financial traders in the large markets like Japan and the United States can render domestic monetary policy ineffective is problematic.
3. Is there any evidence that the relationship between domestic long- and short-term interest rates is unstable? Stability implies that the cash rate, which is set as a policy instrument, and the longer-term interest rates, which are influenced by market considerations, move together in a proportional manner over the long run.
4. Is there any evidence to support the twin-deficits hypothesis that imposes causality from the fiscal deficit changes to changes in the current account deficit? A lack of such a direct relationship also provides further support for the use of budget deficits under the Job Guarantee policy.

Using a range of econometric testing methodologies, Mitchell (2000a) found no evidence to support any of these contentions. First, it appears that the longterm interest rates in the large markets do not ’cause’ enduring movements in the long-term rates in Australia. The evidence appears to support the idea that, after the move to freely determined exchange rates, globalization has led to more independence of long-term rates between Australia and the rest of the world. Second, the yield gap appears to be stationary over a range of time periods. In other words, the difference between domestic long-term and short-term interest rates is stable over time. This is contrary to the view, often alleged by antagonists of the use of activist deficit-based government policy, that Australian monetary authorities are at the behest of global funds managers and are thus unable to pursue their policy objectives. Third, the paired relationships between the cash rate and the medium- and long-term rates in Australia are cointegrated, indicating that, over a long period, there are no systematic departures over a long period between the rates of interest. Fourth, the tests fail to support any notion of causality between changes in the Current Account deficit and changes in the Budget Deficit. Neither direction of causality was detected. Finally, no relationship between changes in the deficit/GDP ratio and changes in the real interest rates could be detected at short or long lags. The evolution of real interest rates appears to be independent of changes in the relative size of the deficit. These results are consistent with those found in the literature for other economies (see Kasman and Rodrigues, 1991; Christiansen and Pigott, 1997).

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