Conjuncted: Balance of Payments in a Dirty Float System, or Why Central Banks Find It Ineligible to Conduct Independent Monetary Policies? Thought of the Day

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If the rate of interest is partly a monetary phenomenon, money will have real effects working through variations in investment expenditure and the capital stock. Secondly, if there are unemployed resources, the impact of increases in the money supply will first be on output, and not on prices. It was, indeed, Keynes’s view expressed in his General Theory that throughout history the propensity to save has been greater than the propensity to invest, and that pervasive uncertainty and the desire for liquidity has in general kept the rate of interest too high. Given the prevailing economic conditions of the 1930s when Keynes was writing, it was no accident that he should have devoted part of the General Theory to a defence of mercantilism as containing important germs of truth:

What I want is to do justice to schools of thought which the classicals have treated as imbeciles for the last hundred years and, above all, to show that I am not really being so great an innovator, except as against the classical school, but have important predecessors, and am returning to an age-long tradition of common sense.

The mercantilists recognised, like Keynes, that the rate of interest is determined by monetary conditions, and that it could be too high to secure full employment, and in relation to the needs of growth. As Keynes put it in the General Theory:

mercantilist thought never supposed as later economists did [for example, Ricardo, and even Alfred Marshall] that there was a self-adjusting tendency by which the rate of interest would be established at the appropriate level [for full employment].

It was David Ricardo, in his The Principles of Political Economy and Taxation, who accepted and developed Say’s law of markets that supply creates its own demand, and who for the first time expounded the theory of comparative advantage, which laid the early foundations for orthodox trade and growth theory that has prevailed ever since. Ricardian trade theory, however, is real theory relating to the reallocation of real resources through trade which ignores the monetary aspects of trade; that is, the balance between exports and imports as trade takes place. In other words, it ignores the balance of payments effects of trade that arises as a result of trade specialization, and the feedback effects that the balance of payments can have on the real economy. Moreover, continuous full employment is assumed because supply creates its own demand through variations in the real rate of interest. These aspects question the prevalence of Ricardian theory in orthodox trade and growth theory to a large extent in today’s scenario. But in relation to trade, as Keynes put it:

free trade assumes that if you throw men out of work in one direction you re-employ them in another. As soon as that link in the chain is broken the whole of the free trade argument breaks down.

In other words, the real income gains from specialization may be offset by the real income losses from unemployment. Now, suppose that payments deficits arise in the process of international specialization and the freeing of trade, and the rate of interest has to be raised to attract foreign capital inflows to finance them. Or suppose deficits cannot be financed and income has to be deflated to reduce imports. The balance of payments consequences of trade may offset the real income gains from trade.

This raises the question of why the orthodoxy ignores the balance of payments? There are several reasons, both old and new, that all relate to the balance of payments as a self-adjusting process, or simply as a mirror image of autonomous capital flows, with no income adjustment implied. Until the First World War, the mechanism was the gold standard. The balance of payments was supposed to be self-equilibrating because countries in surplus, accumulating gold, would lose competitiveness through rising prices (Hume’s quantity theory of money), and countries in deficit losing gold would gain competitiveness through falling prices. The balance of payments was assumed effectively to look after itself through relative price adjustments without any change in income or output. After the external gold standard collapsed in 1931, the theory of flexible exchange rates was developed, and it was shown that if the real exchange rate is flexible, and the so-called Marshall–Lerner condition is satisfied (i.e. the sum of the price elasticities of demand for exports and imports is greater than unity), the balance of payments will equilibrate; again, without income adjustment.

In modern theory, balance of payments deficits are assumed to be inherently temporary as the outcome of inter-temporal decisions by private agents concerning consumption. Deficits are the outcome of rational decisions to consume now and pay later. Deficits are merely a form of consumption smoothing, and present no difficulty for countries. And then there is the Panglossian view that the current account of the balance of payments is of no consequence at all because it simply reflects the desire of foreigners to invest in a country. Current account deficits should be seen as a sign of economic success, not as a weakness.

It is not difficult to question how balance of payments looks after itself, or does not have consequences for long-run growth. As far as the old gold standard mechanism is concerned, instead of the price levels of deficit and surplus countries moving in opposite directions, there was a tendency in the nineteenth century for the price levels of countries to move together in the same direction. In practice, it was not movements in relative prices that equilibrated the balance of payments but expenditure and output changes associated with interest rate differentials. Interest rates rose in deficit countries which deflated demand and output, and fell in surplus countries stimulating demand.

On the question of flexible exchange rates as an equilibrating device, a distinction first needs to be made between the nominal exchange rate and the real exchange rate. It is easy for countries to adjust the nominal rate, but not so easy to adjust the real rate because competitors may “price to market” or retaliate, and domestic prices may rise with a nominal devaluation. Secondly, the Marshall–Lerner condition then has to be satisfied for the balance of payments to equilibrate. This may not be the case in the short run, or because of the nature of goods exported and imported by a particular country. The international evidence over the past almost half a century years since the breakdown of the Bretton Woods fixed exchange rate system suggests that exchange rate changes are not an efficient balance of payments adjustment weapon. Currencies appreciate and depreciate and still massive global imbalances of payments remain.

On the inter-temporal substitution effect, it is wrong to give the impression that inter-temporal shifts in consumption behaviour do not have real effects, particularly if interest rates have to rise to finance deficits caused by more consumption in the present if countries do not want their exchange rate to depreciate. On the view that deficits are a sign of success, an important distinction needs to be made between types of capital inflows. If the capital flows are autonomous, such as foreign direct investment, the argument is plausible, but if they are “accommodating” in the form of loans from the banking system or the sale of securities to foreign governments and international organizations, the probable need to raise interest rates will again have real effects by reducing investment and output domestically.

Velocity of Money

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The most basic difference between the demand theory of money and exchange theory of money lies in the understanding of quantity equation

M . v = P . Y —– (1)

Here M is money supply, P is price and Y is real output; in addition, v is constant velocity of money. The demand theory understands that (1) reflects the needs of the economic individual for money, not only the meaning of exchange. Under the assumption of liquidity preference, the demand theory introduces nominal interest rate into demand function of money, thus exhibiting more economic pictures than traditional quantity theory does. Let us, however concentrate on the economic movement through linearization of exchange theory emphasizing exchange medium function of money.

Let us assume that the central bank provides a very small supply M of money, which implies that the value PY of products manufactured by the producer will be unable to be realized only through one transaction. The producer has to suspend the transaction until the purchasers possess money at hand again, which will elevate the transaction costs and even result in the bankruptcy of the producer. Then, will the producer do nothing and wait for the bankruptcy?

In reality, producers would rather adjust sales value through raising or lowering the price or amount of product to attempt the realization of a maximal sales value M than reserve the stock of products to subject the sale to the limit of velocity of money. In other words, producer would adjust price or real output to control the velocity of money, since the velocity of money can influence the realization of the product value.

Every time money changes hands, a transaction is completed; thus numerous turnovers of money for an individual during a given period of time constitute a macroeconomic exchange ∑ipiYi if the prices pi can be replaced by an average price P, then we can rewrite the value of exchange as ∑ipiYi = P . Y. In a real economy, the producer will manage to make P . Y close the money supply M as much as possible through adjusting the real output or its price.

For example, when a retailer comes to a strange community to sell her commodities, she always prefers to make a price through trial and error. If she finds that higher price can still promote the sales amount, then she will choose to continue raising the price until the sales amount less changes; on the other hand, if she confirms that lower price can create the more sales amount, then she will decrease the price of the commodity. Her strategy of pricing depends on price elasticity of demand for the commodity. However, the maximal value of the sales amount is determined by how much money the community can supply, thus the pricing of the retailer will make her sales close this maximal sale value, namely money for consumption of the community. This explains why the same commodity can always be sold at a higher price in the rich area.

Equation (1) is not an identical equation but an equilibrium state of exchange process in an economic system. Evidently, the difference M –  P . Y  between the supply of money and present sales value provides a vacancy for elevating sales value, in other words, the supply of money acts as the role of a carrying capacity for sales value. We assume that the vacancy is in direct proportion to velocity of increase of the sales value, and then derive a dynamical quantity equation

M(t) - P(t) . Y(t)  =  k . d[P(t) . Y(t)]/d(t) —– (2)

Here k is a positive constant and expresses a characteristic time with which the vacancy is filled. This is a speculated basic dynamical quantity equation of exchange by money. In reality, the money supply M(t) can usually be given; (2) is actually an evolution equation of sales value P(t)Y(t) , which can uniquely determine an evolving path of the price.

The role of money in (2) can be seen that money is only a medium of commodity exchange, just like the chopsticks for eating and the soap for washing. All needs for money are or will be order to carry out the commodity exchange. The behavior of holding money of the economic individuals implies a potential exchange in the future, whether for speculation or for the preservation of wealth, but it cannot directly determine the present price because every realistic price always comes from the commodity exchange, and no exchange and no price. In other words, what we are concerned with is not the reason of money generation, but form of money generation, namely we are concerned about money generation as a function of time rather than it as a function of income or interest rate. The potential needs for money which you can use various reasons to explain cannot contribute to price as long as the money does not participate in the exchange, thus the money supply not used to exchange will not occur in (2).

On the other hand, the change in money supply would result in a temporary vacancy of sales value, although sales value will also be achieved through exchanging with the new money supply at the next moment, since the price or sales volume may change. For example, a group of residents spend M(t) to buy houses of P(t)Y(t) through the loan at time t, evidently M(t) = P(t)Y(t). At time t+1, another group of residents spend M(t+1) to buy houses of P(t+1)Y(t+1) through the loan, and M(t+1) = P(t+1)Y(t+1). Thus, we can consider M(t+1) – M(t) as increase in money supply, and this increase can cause a temporary vacancy of sales value M(t+1) – P(t)Y(t). It is this vacancy that encourages sellers to try to maximize sales through adjusting the price by trial and error and also real estate developers to increase or decrease their housing production. Ultimately, new prices and production are produced and the exchange is completed at the level of M(t+1) = P(t+1)Y(t+1). In reality, the gap between M(t+1) and M(t) is often much smaller than the vacancy M(t+1) – P(t)Y(t), therefore we can approximately consider M(t+1) as M(t) if the money supply function M(t) is continuous and smooth.

However, it is necessary to emphasize that (2) is not a generation equation of demand function P(Y), which means (2) is a unique equation of determination of price (path), since, from the perspective of monetary exchange theory, the evolution of price depends only on money supply and production and arises from commodity exchange rather than relationship between supply and demand of products in the traditional economics where the meaning of the exchange is not obvious. In addition, velocity of money is not contained in this dynamical quantity equation, but its significance PY/M will be endogenously exhibited by the system.

Surplus. What All Could Social Activists Do, But Debate?

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The social surplus is a basic concept of classical political economy which has been revived in the post-war period by Paul Baran and Paul Sweezy. They defined it as

.. the difference between what a society produces and the costs of producing it. The size of a surplus is an index of productivity and wealth, and of how much freedom a society has to accomplish whatever goals it may set for itself. The composition of the surplus shows how it uses that freedom: how much it invests in expanding its productive capacity, how much it consumes in various forms, how much it wastes and in what ways.

The surplus can be calculated in alternative ways. One is to estimate the necessary costs of producing the national product, and to deduct the costs from the national product. This raises the conceptual problem of calculating the necessary costs of production. Some of the outlays recorded as costs by firms (such as outlays for superficial product differentiation and advertising) may be unnecessary from the social viewpoint. Hence the determination of the necessary costs is crucial for this first method. A second method is to estimate the various expenditures absorbing the surplus (non-essential consumption, investment etc.) and to add them up.

The re-elaboration of the surplus concept in the post-war period is connected to the evolution of certain features of capitalism. In Monopoly Capital Baran and Sweezy argued that capitalism had made a transition from a competitive phase to a monopolistic phase in the twentieth century. In their view, the concentration of capital in giant corporations enables them to fix prices, in contrast to nineteenth century capitalists who worked under more intense competition. These giant corporations set their sales prices by adding mark-ups to production costs. Such price setting gives the corporations control over the partition of the value added with their workers. Corporations also strive to increase their profits by reducing their production costs. On the macroeconomic plane, the general endeavour to reduce production costs (inclusive of labor costs) tends to raise the share of the surplus in GDP. This rising surplus can be sustained only if it is absorbed. The consumption of capitalists, the consumption of employees in non-productive activities (e.g. superficial product differentiation, advertising, litigation etc.), investment and some part of government expenditure (e.g. public investment, military outlays) are the main outlets for absorbing the surplus.

As almost sixty years have elapsed since the above framework was formulated, it is legitimate to ask: has the increasing ratio of trade to global output impaired the diagnosis of Baran and Sweezy with regard to the monopolization of capital, and with respect to the inclination for the surplus in GDP to increase? Has increasing trade and integration of markets raised competitive pressures so as to restrict the pricing latitude of industrial conglomerates?

The immediate effect of global trade expansion obviously must be to increase overall competition, as greater numbers of firms would come to compete in formerly segregated markets. But a countervailing effect would emerge when large firms with greater financial resources and organizational advantages eliminate smaller firms (as happens when large transnationals take on firms of peripheral countries in opened markets). Another countervailing trend to the competition-enhancing effect of trade expansion is mergers and acquisitions, on which there is evidence in the core countries. A powerful trend increase in the extent of firm level concentration of global markets share could be observed in industries as diverse as aerospace and defence, pharmaceuticals, automobiles, trucks, power equipment, farm equipment, oil and petrochemicals, mining, pulp and paper, brewing, banking, insurance, advertising, and mass media. Indications are that the competition-enhancing effect of trade is balanced (perhaps even overwhelmed) by the monopolizing effect of the centralization of capital, which may sustain the ability of large corporations to control the market prices of their products.

On the other hand, if mergers and acquisitions imply an increase in the average size of the workforce of corporations, this could stimulate a counterbalance to corporate power by higher unionization and worker militancy. However, the increasing mobility of capital, goods and services on the one hand, and unemployment on the other is weakening unionization in the core countries, and making workers accept temporary employment, part-time employment, flexibility in hiring and dismissing, flexible working days and weeks, and flexibility in assigning tasks in the workplace. Increasing flexibility in labor relations shifts various risks related to the product markets and the associated costs from firms onto workers. Enhanced flexibility cannot but boost gross profits. Hence the trend towards increased flexibility in labor practices clearly implies increased surplus generation for given output in individual countries.

The neoliberal global reform agenda also includes measures to increase surplus generation through fiscal and institutional reforms, both in developed and underdeveloped countries. Lowering taxes on corporate profits, capital gains and high incomes; increasing taxes on consumption; raising fees on public services and privatization of these services, of utilities and of social security – all these policies aim at disburdening the high income earners and property owners of contributing to financing essential services for the maintenance of the labor force. These reforms also contribute to increasing the share of surplus in total output.

In brief, in the era of neoliberal policies evidence does not seem to suggest that the tendency for the share of surplus in GDP to rise in individual countries may have waned. If so, what is happening to the surplus generated in international production?

Baran and Sweezy argued that the surplus of underdeveloped countries had been and was being drained away to the centers of the world-system. Their description of core firms‘ overseas activities in Monopoly Capital can be read as a description of offshore outsourcing activities today if one replaces subsidiary with suppliers:

What they [giant multinational corporations] want is monopolistic control over foreign sources of supply and foreign markets, enabling them to buy and sell on specially privileged terms, to shift orders from one subsidiary to another, to favour this country or that depending on which has the most advantageous tax, labour and other policies…

The authors’ view was that imperialism had a two-fold function with respect to the surplus: finding cheap foreign sources of supply (which increases the surplus in the home country), and using other countries‘ markets as outlets (which helps absorb the surplus of the home country). A major motive of transnational companies in their current practice of outsourcing parts of production to underdeveloped countries is to cut production costs, hence to increase gross profits. When the corporation of a core country decides to outsource its production to a peripheral country, or when it shifts its sources of supply of intermediate inputs to a peripheral country, this increases global surplus creation. Global output remains the same, the costs of producing it decline. For the firm, the effect of offshore outsourcing is the same as if it were to reduce its own (in-house) costs of production, or were to outsource to a cheap supplier in the home economy. If the workers in the core country dismissed due to the offshore outsourcing find newly created jobs and continue to produce surplus, then global output increases and surplus creation increases a fortiori. If the workers dismissed due to the outsourcing remain unemployed, then their consumption (provided by family, unemployment benefits etc.) absorbs part of the surplus produced by other workers in employment. Should the supplier in the peripheral country expand her production to meet the order under subcontract, there will also be some increase in surplus creation in the peripheral country. In this case the total increase in surplus may accrue to both countries  economies – in indeterminate proportions.

It is worth noting that the effect of offshore outsourcing on productivity in the core economies is ambiguous. The formula

Productivity = (Sales Revenue – Material Input Cost) / Number of Workers

shows that an increase in material input cost (due to the increase in outsourced inputs) and a reduction of the in-house workforce (due to outsourcing) may ultimately affect the outsourcing firm‘s productivity either way. The gains that motivate firms to outsourcing are not gains in labor productivity (which arguably could legitimize outsourcing from a social viewpoint), but gains in gross profits – i.e. in surplus appropriation.

It emerges that the basic tendencies in the production and growth of the social surplus described by Baran and Sweezy have not changed under globalizing capitalism. New economic policies, corporate strategies and international rules of conduct appear to promote increasing surplus transfers from the periphery to the core of the world-system. In order to lift itself out of destitution the periphery is exhorted to remove restrictions on trade and capital flows, and to compete for advantageous positions in global value chains controlled by transnationals by improving quality, reducing costs, innovating etc. The export-led growth economic strategy compels peripheral producers to individually compete for exportation by repressing wages, and conceding much of the surplus produced to their trade partners in the core countries. Part of the surplus accruing to the periphery is consumed by transnational élites imitating the consumption of the well-to-do in the core societies. On the other hand dollarization, capital flight and official reserve accumulation exert downward pressure (a pressure unrelated to trade balances) on the exchange rate of peripheral currencies. The undervaluation of peripheral currencies, reflected in deteriorating terms of trade, translates into a loss of surplus to the core countries, and reduces the capacity of poor countries to import capital goods from the core. The resulting meager per capita fixed capital formation in the underdeveloped countries bodes grim prospects for the welfare of future generations of working people in the periphery. These trends are maintained by the insertion of millions of workers in Asian hinterlands into global production networks, and by the willingness of peripheral states governed by transnational élites to continue free trade and capital transactions policies, and to accumulate foreign exchange reserves. Africa’s poor populations await their turn to be drawn into the world labor market, to eke out a subsistence and produce a surplus, of which a large part will likely flow to the core.

In order to prevent the drift of the victims of globalizing capitalism to irrational reaction (religious or nationalist fanaticism, clash of civilizations etc.) and to focus their attention on the real issues, social scientists and activists should open to debate the social and economic consequences of the export-led growth idea, all the theories and policies that give precedence to global efficiency over national saving and investment, and the social psychology of consumerism. There is pressing need to promote socio-economic programs based on the principle of self-sufficient and self-reliant national development, wherein the people can decide through democratic procedures how they will dispose the social surplus they produce (how they will distribute it, how much they will save, invest, export) under less pressure from world markets dominated by transnational companies, and with less interefence from international institutions and core states. Within the framework of the capitalist world-system, there is little hope for solving the deep social contradictions the system reproduces. The solution, reason shows, lies outside the logic of the system.

The Feedback of Capital and Standard of Living. Some Wayside Didactics.

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It is often said to countries in trouble that their people were living above their standards. That their consumption is higher than their production. This, in fact, is true … for everybody on this planet. In financial terms.

Look at the image of Figure 1. People (Labour Power), together with machines from the capital (MoP) produce goods that only (mostly) humans consume. Left the production, right the consumption.

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Figure 1: Production and consumption of humans and capital

If everything that is produced is consumed (according to Jean Baptiste Say), it is obvious that humans consume more than they produce. This seems contradictory with the ideas of Marx, but it isn’t. Marx said that Labour Power with the help of MoP produces, and that this production is fully attributed to Labour Power and is thus skimmed when it consumes less than this production. We can also equally well say that MoP (‘capital’) is producing with the help of Labour Power. Or just say that both are producing and say that each is the right ‘owner’ of its own production.

In the above figure, the arrows show the flow of production-consumption. The payment for produced products is an arrow in opposite direction. In this example, humans get 95% of consumption while they do only 50% of the production. They thus also only get 50% of payment. The rest of the consumption is paid by ‘borrowing’ money somehow, and they live above their standard. The payment goes 50% to the capital. But, because capital does not consume, this payment is used to increase the capital. Two extreme scenarios:

• The money for payment of production is fully in the form of a loan to the humans. Money starts thus accumulating at the capital.

• The money for payment is fully used to invest in new capital. In that case, the ‘consumption’ of capital is 50%, but after one cycle, a larger part of the production is done by capital. See figure 2 below.

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Figure 2: Production and consumption of humans and capital, if the capital consumes as human, but this consumption is used as new starting capital in a new cycle

In the first step, 50% of the production and consumption is done by capital. In the second cycle it is already 67%. In the third cycle it is 80%, then 89%, etc. In general 2n−1/(2n−1 + 1) at step n; capital doubles at every cycle, where humans stay constant. The final situation is that 100% of production is done by capital. Obviously, sooner or later the system has to switch to the first scenario.

In either scenario, the capital accumulates. The basic ingredient is that capital does not need consumption for its survival; any ‘consumption’ is directly converted into more capital. The system will probably have a mix of the two. After all, capital cannot go on doubling all the time.

So, we see that capital is condensing at the capital. That is because the means of production – other than human labor – do not consume, and, therefore, humans do consume more than they produce, and the means of production (machines) do consume less than they produce, with the total in a zero-sum-game way consuming exactly what they produce. The owners of the means of production get the rights to consumption and these rights are constantly increasing. It is a positive-feedback run-away system.

Let’s put this in an example to explain it better. Imagine I make clothespins and so does my neighbor. However, my neighbor has slightly more costs than me, or is slightly less productive for some reason (work accident, or so). He earns just enough to survive. He makes one ’unit’ and this barely covers the cost of life, which is also minimally 1 unit. I am slightly more productive, or my cost of living is slightly lower. Therefore, I can save a little ‘money’. Let’s assume the former, I am more productive. Now, either I make 1.1 units and the surplus 0.1 units I trade for a clothespin machine, or I work a little less on making clothespins and in this spare time – one hour per day – I make the machine myself. Let’s assume the second scenario, because it is easier reasoning, although they are equivalent. We both make two ‘units’ of pins, sell them and buy things (two units worth) to survive. I however, make as well a machine that makes pins.

After finishing my machine, maybe after ten years, the total production goes up. The demand for our pins stays the same. The markets needs two units of clothespins. It now means that I will get more share of the profit. Imagine my machine makes as much units as a human can, one unit per year. We thus have three units to offer to the market. The price of pins on the market could (and will) drop through the mechanism of supply and demand. In principle down to 67% of the original price. Not lower, because that would imply that the total price of more pins would be lower than before.

To make it simple, imagine exactly that happens. The price is 2/3; one unit of pins gives only 2/3 consumption rights. We sell three units and thus get a total of two units of consumption rights. These are distributed over the production units. My neighbor has one third of the production units and thus gets 1/3 share of the consumption rights, a total of 2/3 units. I and my machine get 2/3 share, 4/3 consumption rights. Note that I confiscate – skim – the production rights of my ‘slave’ machine.

Now my neighbor has a problem. He gets 2/3 units of consumption rights, there where one full unit is needed to survive. He did not start working less, or become less productive, or lazy. He simply lost his percentage share of the means of production. And once this starts, there is no stopping it. It in fact accelerates.

There are two scenarios. Either I keep producing pins myself, as shown above, resulting in immediate misery for my neighbor, or I stop working altogether on making pins manually, and we go back to the situation where we make two units of pins, sell them, and each one gets one unit of consumption rights. However, now I have 100% free time (my machine doing all the work), and I can dedicate it to make a new machine. This takes only one year instead of ten, since I now have 100% free time, instead of only 10%. In the first situation, I could lend 1/3 of my consumption rights to my neighbor. However – nothing is for free in this life – next year I want 10% profit on my loan. His problems will be bigger next year. Next year I will refinance his loan. Etc. The reader will easily understand that my neighbor will wind up being my feudal possession. I will take everything he owns. Instead, I could opt for the second path, producing a new machine in my spare time. In that case, next year we will have 4 production units, my neighbor and I as human labor, and two mechanical units. These mechanical units are mine and will claim the consumption rights; together with my own labor, I will now get 75% of the two consumption rights. 1.5 for me and 0.5 for my neighbor. This path leads to the state where I have 100% of the consumption rights. Or I can again decide to use part or all of my human labor or machine power to make new machinery. Sooner or later, anyway, my neighbor will have to borrow consumption rights from me. This is a feedback system. Any small perturbation results in a saturation in which I will get 100% of the consumption rights and where I will wind up being the feudal lord of my neighbor. One could argue that this reasoning does not work, because the rest of the world is also increasing productivity and the price of the products offered by them (and the cost of living for me and my neighbor) goes down, as fast as the price of our clothespins go down and we will both easily survive. First of all, we consider here only the local effect, independent of the full market. Technological innovation creates immediate misery for some, a deterioration of life while these people are doing nothing worse. Second, when the rest of the market is behaving in the same way, we remain with an overall effect of condensation of wealth. Capital attracts capital. This is a form of the Matthew Effect, named after the apostle from the bible, transferring money from the poor to the rich. Matthew 25:29,

For onto everyone that hath shall be given, and he shall have abundance, but from him that hath not shall be taken away even that which he hath.

Prisoner’s Dilemma. Thought of the Day 64.0

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A system suffering from Prisoner’s Dilemma cannot find the optimal solution because the individual driving forces go against the overall driving force. This is called Prisoner’s Dilemma based on the imaginary situation of two prisoners:

Imagine two criminals, named alphabetically A and B, being caught and put in separate prison cells. The police is trying to get confessions out of them. They know that if none will talk, they will both walk out of there for lack of evidence. So the police makes a proposal to each one: “We’ll make it worth your while. If you confess, and your colleague not, we give you 10 thousand euro and your colleague will get 50 years in prison. If you both confess you will each get 20 years in prison”. The decision table for these prisoners is like this:

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As you can see for yourself, the individual option for A, independent of what B decides to do, is confessing; moving from right column to left column, it is either reducing his sentence from 50 to 20 years, or instead of walking out of there even getting a fat bonus on top. The same applies to B, moving from bottom row to top row of the table. So, they wind up both confessing and getting 20 years in prison. That while it is obvious that the optimal situation is both not talking and walking out of prison scot-free (with the loot!). Because A and B cannot come to an agreement, but both optimize their own personal yield instead, they both get severely punished!

The Prisoner’s Dilemma applies to economy. If people in society cannot come to an agreement, but instead let everybody take decisions to optimize the situation for themselves (as in liberalism), they wind up with a non-optimal situation in which all the wealth is condensed on a single entity. This does not even have to be a person, but the capital itself. Nobody will get anything, beyond the alms granted by the system. In fact, the system will tend to reduce these alms – the minimum wages, or unemployment benefit – and will have all kinds of dogmatic justifications for them, but basically is a strategy of divide-and-conquer, inhibiting people to come to agreements, for instance by breaking the trade unions.

An example of a dogmatic reason is “lowering wages will make that more people get hired for work”. Lowering wages will make the distortion more severe. Nothing more. Moreover, as we have seen, work can be done without human labor. So if it is about competition, men will be cut out of the deal sooner or later. It is not about production. It is about who gets the rights to the consumption of the goods produced. That is also why it is important that people should unite, to come to an agreement where everybody benefits. Up to and including the richest of them all! It is better to have 1% of 1 million than 100% of 1 thousand. Imagine this final situation: All property in the world belongs to the final pan-global bank, with their headquarters in an offshore or fiscal paradise. They do not pay tax. The salaries (even of the bank managers) are minimal. So small that it is indeed not even worth it to call them salary.

Liberalism.

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In a humanistic society, boundary conditions (‘laws’) are set which are designed to make the lives of human beings optimal. The laws are made by government. Yet, the skimming of surplus labor by the capital is only overshadowed by the skimming by politicians. Politicians are often ‘auto-invited’ (by colleagues) in board-of-directors of companies (the capital), further enabling amassing buying power. This shows that, in most countries, the differences between the capital and the political class are flimsy if not non-existent. As an example, all communist countries, in fact, were pure capitalist implementations, with a distinction that a greater share of the skimming was done by politicians compared to more conventional capitalist societies.

One form of a humanistic (!!!!!????) government is socialism, which has set as its goals the welfare of humans. One can argue if socialism is a good form to achieve a humanistic society. Maybe it is not efficient to reach this goal, whatever ‘efficient’ may mean and the difficulty in defining that concept.

Another form of government is liberalism. Before we continue, it is remarkable to observe that in practical ‘liberal’ societies, everything is free and allowed, except the creation of banks and doing banking. By definition, a ‘liberal government’ is a contradiction in terms. A real liberal government would be called ‘anarchy’. ‘Liberal’ is a name given by politicians to make people think they are free, while in fact it is the most binding and oppressing form of government.

Liberalism, by definition, has set no boundary conditions. A liberal society has at its core the absence of goals. Everything is left free; “Let a Darwinistic survival-of-the-fittest mechanism decide which things are ‘best'”. Best are, by definition, those things that survive. That means that it might be the case that humans are a nuisance. Inefficient monsters. Does this idea look far-fetched? May it be so that in a liberal society, humans will disappear and only capital (the money and the means of production) will survive in a Darwinistic way? Mathematically it is possible. Let me show you.

Trade unions are organizations that represent the humans in this cycle and they are the ways to break the cycle and guarantee minimization of the skimming of laborers. If you are human, you should like trade unions. (If you are a bank manager, you can – and should – organize yourself in a bank-managers trade union). If you are capital, you do not like them. (And there are many spokesmen of the capital in the world, paid to propagate this dislike). Capital, however, in itself cannot ‘think’, it is not human, nor has it a brain, or a way to communicate. It is just a ‘concept’, an ‘idea’ of a ‘system’. It does not ‘like’ or ‘dislike’ anything. You are not capital, even if you are paid by it. Even if you are paid handsomely by it. Even if you are paid astronomically by it. (In the latter case you are probably just an asocial asshole!!!!). We can thus morally confiscate as much from the capital we wish, without feeling any remorse whatsoever. As long as it does not destroy the game; destroying the game would put human happiness at risk by undermining the incentives for production and reduce the access to consumption.

On the other hand, the spokesmen of the capital will always talk about labor cost contention, because that will increase the marginal profit M’-M. Remember this, next time somebody talks in the media. Who is paying their salary? To give an idea how much you are being fleeced, compare your salary to that of difficult-to-skim, strike-prone, trade-union-bastion professions, like train drivers. The companies still hire them, implying that they still bring a net profit to the companies, in spite of their astronomical salaries. You deserve the same salary.

Continuing. For the capital, there is no ‘special place’ for human labor power LP. If the Marxist equation can be replaced by

M – C{MoP} – P – C’ – M’

i.e., without LP, capital would do just that, if that is optimizing M’-M. Mathematically, there is no difference whatsoever between MoP and LP. The only thing a liberal system seeks is optimization. It does not care at all, in no way whatsoever, how this is achieved. The more liberal the better. Less restrictions, more possibilities for optimizing marginal profit M’-M. If it means destruction of the human race, who cares? Collateral damage.

To make my point: Would you care if you had to pay (feed) monkeys one-cent peanuts to find you kilo-sized gold nuggets? Do you care if no human LP is involved in your business scheme? I guess you just care about maximizing your skimming of the labor power involved, be they human, animal or mechanic. Who cares?

There is only one problem. Somebody should consume the products made (no monkey cares about your gold nuggets). That is why the French economist Jean-Baptiste Say said “Every product creates its own demand”. If nobody can pay for the products made (because no LP is paid for the work done), the products cannot be sold, and the cycle stops at the step C’-M’, the M’ becoming zero (not sold), the profit M’-M reduced to a loss M and the company goes bankrupt.

However, individual companies can sell products, as long as there are other companies in the world still paying LP somewhere. Companies everywhere in the world thus still have a tendency to robotize their production. Companies exist in the world that are nearly fully robotized. The profit, now effectively skimming of the surplus of MoP-power instead of labor power, fully goes to the capital, since MoP has no way of organizing itself in trade unions and demand more ‘payment’. Or, and be careful with this step here – a step Marx could never have imagined – what if the MoP start consuming as well? Imagine that a factory robot needs parts. New robot arms, electricity, water, cleaning, etc. Factories will start making these products. There is a market for them. Hail the market! Now we come to the conclusion that the ‘system’, when liberalized will optimize the production (it is the only intrinsic goal) Preindustrial (without tools):

M – C{LP} – P – C’ – M’

Marxian: M – C{MoP, LP} – P – C’ – M’

Post-modern: M – C{MoP} – P – C’ – M’

If the latter is most efficient, in a completely liberalized system, it will be implemented.

This means

1) No (human) LP will be used in production

2) No humans will be paid for work of producing

3) No human consumption is possible

4) Humans will die from lack of consumption

In a Darwinistic way humanity will die to be substituted by something else; we are too inefficient to survive. We are not fit for this planet. We will be substituted by the exact things we created. There is nowhere a rule written “liberalism, with the condition that it favors humans”. No, liberalism is liberalism. It favors the fittest.

It went good so far. As long as we had exponential growth, even if the growth rate for MoP was far larger than the growth rate for rewards for LP, also LP was rewarded increasingly. When the exponential growth stops, when the system reaches saturation as it seems to do now, only the strongest survive. That is not necessarily mankind. Mathematically it can be either one or the other, without preference; the Marxian equation is symmetrical. Future will tell. Maybe the MoP (they will also acquire intelligence and reason somewhere probably) will later discuss how they won the race, the same way we, Homo Sapiens, currently talk about “those backward unfit Neanderthals”.

Your ideal dream job would be to manage the peanut bank, monopolizing the peanut supply, while the peanut eaters build for you palaces in the Italian Riviera and feed you grapes while you enjoy the scenery. Even if you were one of the few remaining humans. A world in which humans are extinct is not a far-fetched world. It might be the result of a Darwinian selection of the fittest.

Capital as a Symbolic Representation of Power. Nitzan’s and Bichler’s Capital as Power: A Study of Order and Creorder.

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The secret to understanding accumulation, lies not in the narrow confines of production and consumption, but in the broader processes and institutions of power. Capital, is neither a material object nor a social relationship embedded in material entities. It is not ‘augmented’ by power. It is, in itself, a symbolic representation of power….

Unlike the elusive liberals, Marxists try to deal with power head on – yet they too end up with a fractured picture. Unable to fit power into Marx’s value analysis, they have split their inquiry into three distinct branches: a neo-Marxian economics that substitutes monopoly for labour values; a cultural analysis whose extreme versions reject the existence of ‘economics’ altogether (and eventually also the existence of any ‘objective’ order); and a state theory that oscillates between two opposite positions – one that prioritizes state power by demoting the ‘laws’ of the economy, and another that endorses the ‘laws’ of the economy by annulling the autonomy of the state. Gradually, each of these branches has developed its own orthodoxies, academic bureaucracies and barriers. And as the fractures have deepened, the capitalist totality that Marx was so keen on uncovering has dissipated….

The commodified structure of capitalism, Marx argues, is anchored in the labour process: the accumulation of capital is denominated in prices; prices reflect labour values; and labour values are determined by the productive labour time necessary to make the commodities. This sequence is intuitively appealing and politically motivating, but it runs into logical and empirical impossibilities at every step of the way. First, it is impossible to differentiate productive from unproductive labour. Second, even if we knew what productive labour was, there would still be no way of knowing how much productive labour goes into a given commodity, and therefore no way of knowing the labour value of that commodity and the amount of surplus value it embodies. And finally, even if labour values were known, there would be no consistent way to convert them into prices and surplus value into profit. So, in the end, Marxism cannot explain the prices of commodities – not in detail and not even approximately. And without a theory of prices, there can be no theory of profit and accumulation and therefore no theory of capitalism….

Modern capitalists are removed from production: they are absentee owners. Their ownership, says Veblen, doesn’t contribute to industry; it merely controls it for profitable ends. And since the owners are absent from industry, the only way for them to exact their profit is by ‘sabotaging’ industry. From this viewpoint, the accumulation of capital is the manifestation not of productive contribution but of organized power.

To be sure, the process by which capitalists ‘translate’ qualitatively different power processes into quantitatively unified measures of earnings and capitalization isn’t very ‘objective’. Filtered through the conventional assessments of accountants and the future speculations of investors, the conversion is deeply inter-subjective. But it is also very real, extremely imposing and, as we shall see, surprisingly well-defined.

These insights can be extended into a broader metaphor of a ‘social hologram’: a framework that integrates the resonating productive interactions of industry with the dissonant power limitations of business. These hologramic spectacles allow us to theorize the power underpinnings of accumulation, explore their historical evolution and understand the ways in which various forms of power are imprinted on and instituted in the corporation…..

Business enterprise diverts and limits industry instead of boosting it; that ‘business as usual’ needs and implies strategic limitation; that most firms are not passive price takers but active price makers, and that their autonomy makes ‘pure’ economics indeterminate; that the ‘normal rate of return’, just like the ancient rate of interest, is a manifestation not of productive yield but of organized power; that the corporation emerged not to enhance productivity but to contain it; that equity and debt have little to do with material wealth and everything to do with systemic power; and, finally, that there is little point talking about the deviations and distortions of ‘financial capital’ simply because there is no ‘productive capital’ to deviate from and distort.

Jonathan Nitzan, Shimshon Bichler- Capital as Power:_ A Study of Order and Creorder 

 

Austrian Economics. Ruminations. End Part.

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Mainstream economics originates from Jevons’ and Menger’s marginal utility and Walras’ and Marshall’s equilibrium approach. While their foundations are similar, their presentation looks quite different, according to the two schools which typically represent these two approaches: the Austrian school initiated by Menger and the general equilibrium theory initiated by Walras. An important, albeit only formal, difference is that the former presents economic theory mainly in a literary form using ordinary logic, while the latter prefers mathematical expressions and logic.

Lachmann, who excludes determinism from economics since acts of mind are concerned, connects determinism with the equilibrium approach. However, equilibrium theory is not necessarily deterministic, also because it does not establish relationships of succession, but only relationships of coexistence. In this respect, equilibrium theory is not more deterministic than the theory of the Austrian school. Even though the Austrian school does not comprehensively analyze equilibrium, all its main results strictly depend on the assumption that the economy is in equilibrium (intended as a state everybody prefers not to unilaterally deviate from, not necessarily a competitive equilibrium). Considering both competition and monopoly, Menger examines the market for only two commodities in a barter economy. His analysis is the best to be obtained without using mathematics, but it is too limited for determining all the implications of the theory. For instance, it is unclear how the market for a specific commodity is affected by the conditions of the markets for other commodities. However, interdependence is not excluded by the Austrian school. For instance, Böhm-Bawerk examines at length the interdependence between the markets for labor and capital. Despite the incomplete analysis of equilibrium carried out by the Austrian school, many of its results imply that the economy is in equilibrium, as shown by the following examples.

a) The Gossen-Menger loss principle. This principle states that the price of a good can be determined by analyzing the effect of the loss (or the acquisition) of a small quantity of the same good.

b) Wieser’s theory of imputation. Wieser’s theory of imputation attempts to determine the value of the goods used for production in terms of the value (marginal utility) of the consumption goods produced.

c) Böhm-Bawerk’s theory of capital. Böhm-Bawerk proposed a longitudinal theory of capital, where production consists of a time process. A sequence of inputs of labor is employed in order to obtain, at the final stage, a given consumption good. Capital goods, which are the products obtained in the intermediate stages, are seen as a kind of consumption goods in the process of maturing.

A historically specific theory of capital inspired by the Austrian school focuses on the way profit-oriented enterprises organize the allocation of goods and resources in capitalism. One major issue is the relationship between acquisition and production. How does the homogeneity of money figures that entrepreneurs employ in their acquisitive plans connect to the unquestionable heterogeneity of the capital goods in production that these monetary figures depict? The differentiation between acquisition and production distinguishes this theory from the neoclassical approach to capital. The homogeneity of the money figures on the level of acquisition that is important to such a historically specific theory is not due to the assumption of equilibrium, but simply to the existence of money prices. It is real-life homogeneity, so to speak. It does not imply any homogeneity on the level of production, but rather explains the principle according to which the production process is conducted.

In neoclassical economics, in contrast, production and acquisition, the two different levels of analysis, are not separated but are amalgamated by means of the vague term “value”. In equilibrium, assets are valued according to their marginal productivity, and therefore their “value” signifies both their price and their importance to the production process. Capital understood in this way, i.e., as the value of capital goods, can take on the “double meaning of money or goods”. By concentrating on the value of capital goods, the neoclassical approach assumes homogeneity not only on the level of acquisition with its input and output prices, but also on the level of production. The neoclassical approach to capital assumes that the valuation process has already been accomplished. It does not explain how assets come to be valued originally according to their marginal product. In this, an elaborated historically specific theory of capital would provide the necessary tools. In capitalism, inputs and outputs are interrelated by entrepreneurs who are guided by price signals. In their efforts to maximize their monetary profits, they aim to benefit from the spread between input and output prices. Therefore, money tends to be invested where this spread appears to be wide enough to be worth the risk. In other words, business capital flows to those industries and businesses where it yields the largest profit. Competition among entrepreneurs brings about a tendency for price spreads to diminish. The prices of the factors of production are bid up and the prices of the output are bid down until, in the hypothetical state of equilibrium, the factor prices sum up to the price of the product. A historically specific theory of capital is able to describe and analyze the market process that results – or tends to result – in marginal productivity prices, and can therefore also formulate positions concerning endogenous and exogenous misdirections of this process which lead to disequilibrium prices. Consider Mises,

In balance sheets and in profit-and-loss statements, […] it is necessary to enter the estimated money equivalent of all assets and liabilities other than cash. These items should be appraised according to the prices at which they could probably be sold in the future or, as is especially the case with equipment for production processes, in reference to the prices to be expected in the sale of merchandise manufactured with their aid.

According to this, not the monetary costs of the assets, which can be verified unambiguously, but their values are supposed to be the basis of entrepreneurial calculation. As the words indicate, this procedure involves a tremendous amount of uncertainty and can therefore only lead to fair values if equilibrium conditions are assumed.

Austrian Economics. Some Ruminations. Part 1.

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Keynes argued that by stimulating spending on outputs, consumption, goods and services, one could increase productive investment to meet that spending, thus adding to the capital stock and increasing employment. Hayek, on the other hand furiously accused Keynes of insufficient attention to the nature of capital in production. For Hayek, capital investment does not simply add to production in a general way, but rather is embodied in concrete capital items. Rather than being an amorphous stock of generalized production power, it is an intricate structure of specific interrelated complementary components. Stimulating spending and investment, then, amounts to stimulating specific sections and components of this intricate structure. Before heading out to Austrian School of Economics, here is another important difference between the two that is cardinal, and had more do with monetary system. Keynes viewed the macro system as vulnerable to periodic declines in demand, and regarded micro adjustments such as wage and price declines as ineffective to restore growth and prosperity. Hayek viewed the market as capable of correcting itself by taking advantages of competitions, and regarded government and Central Banks’ policies to restore growth as sources of more instability.

The best known Austrian capital theorist was Eugen von Böhm-Bawerk, though his teacher Carl Menger is the one who got the ball rolling, providing the central idea that Böhm-Bawerk elaborated. For the Austrians, the general belief lay in the fact that production takes time, and more roundabout the process, the more delay production needs to anticipate. Modern economies comprise complex, specialized processes in which the many steps necessary to produce any product are connected in a sequentially specific network – some things have to be done before others. There is a time structure to the capital structure. This intricate time structure is partially organized, partially spontaneous (organic). Every production process is the result of some multiperiod plan. Entrepreneurs envision the possibility of providing (new, improved, cheaper) products to consumers whose expenditure on them will be more than sufficient to cover the cost of producing them. In pursuit of this vision the entrepreneur plans to assemble the necessary capital items in a synergistic combination. These capital combinations are structurally composed modules that are the ingredients of the industry-wide or economy-wide capital structure. The latter is the result then of the dynamic interaction of multiple entrepreneurial plans in the marketplace; it is what constitutes the market process. Some plans will prove more successful than others, some will have to be modified to some degree, some will fail. What emerges is a structure that is not planned by anyone in its totality but is the result of many individual actions in the pursuit of profit. It is an unplanned structure that has a logic, a coherence, to it. It was not designed, and could not have been designed, by any human mind or committee of minds. Thinking that it is possible to design such a structure or even to micromanage it with macroeconomic policy is a fatal conceit. The division of labor reflected by the capital structure is based on a division of knowledge. Within and across firms specialized tasks are accomplished by those who know best how to accomplish them. Such localized, often unconscious, knowledge could not be communicated to or collected by centralized decision-makers. The market process is responsible not only for discovering who should do what and how, but also how to organize it so that those best able to make decisions are motivated to do so. In other words, incentives and knowledge considerations tend to get balanced spontaneously in a way that could not be planned on a grand scale. The boundaries of firms expand and contract, and new forms of organization evolve. This too is part of the capital structure broadly understood.

Hayek emphasizes that,

the static proposition that an increase in the quantity of capital will bring about a fall in its marginal productivity . . . when taken over into economic dynamics and applied to the quantity of capital goods, may become quite definitely erroneous.

Hayek stresses chains of investments and how earlier investments in the chains can increase the return to the later, complementary investments. However, Hayek is primarily concerned with applying those insights to business cycle phenomena. Also, Hayek never took the additional step that endogenous growth theory has in highlighting the effects of complementarities across intangible investments in the production of ideas and/or knowledge. Indeed, Hayek explicitly excludes their consideration:

It should be quite clear that the technical changes involved, when changes in the time structure of production are contemplated, are not changes due to changes in technical knowledge. . . . It excludes any changes in the technique of production which are made possible by new inventions.

…….

 

Fiscal Responsibility and Budget Management (FRBM) Act

The Government appointed a five-member Committee in May 2016, to review the Fiscal Responsibility and Budget Management (FRBM) Act and to examine a changed format including flexible FRBM targets. The Committee formation was announced during the 2016-17 budget by FM Arun Jaitely. The Panel was headed by the former MP and former Revenue and Expenditure Secretary NK Singh and included four other members, CEA Arvind Subramanian, former Finance Secretary Sumit Bose, the then Deputy Governor and present governor of the RBI Urjit Patel and Nathin Roy. There was a difference of opinion about the need for adopting a fixed FRBM target like fiscal deficit, and the divisive opinion lay precisely in not following through such a fixity in times when the government had to spend high to fight recession and support economic growth. The other side of the camp argued it being necessary to inculcate a feeling of fiscal discipline. During Budget speech in 2016, Mr Jaitley expressed this debate:

There is now a school of thought which believes that instead of fixed numbers as fiscal deficit targets, it may be better to have a fiscal deficit range as the target, which would give necessary policy space to the government to deal with dynamic situations. There is also a suggestion that fiscal expansion or contraction should be aligned with credit contraction or expansion, respectively, in the economy.

The need for a flexible FRBM target that allowed higher fiscal deficit during difficult/recessionary years and low targets during comfortable years, gives the government a breathing space to borrow more during tight years. In it report submitted in late January this year, the committee did advocate for a range rather than a fixed fiscal deficit target. Especially, fiscal management becomes all the more important post-demonetisation and the resultant slump in consumption expenditure. The view is that the government could be tempted to increase public spending to boost consumption. but, here is the catch: while ratings agencies do look at the fiscal discipline of a country when considering them for a ratings upgrade, they also look at the context and the growth rate of the economy, so the decision will not be a myopic one based only on the fiscal and revenue deficits.

Fiscal responsibility is an economic concept that has various definitions, depending on the economic theory held by the person or organization offering the definition. Some say being fiscally responsible is just a matter of cutting debt, while others say it’s about completely eliminating debt. Still others might argue that it’s a matter of controlling the level of debt without completely reducing it. Perhaps the most basic definition of fiscal responsibility is the act of creating, optimizing and maintaining a balanced budget.

“Fiscal” refers to money and can include personal finances, though it most often is used in reference to public money or government spending. This can involve income from taxes, revenue, investments or treasuries. In a governmental context, a pledge of fiscal responsibility is a government’s assurance that it will judiciously spend, earn and generate funds without placing undue hardship on its citizens. Fiscal responsibility includes a moral contract to maintain a financially sound government for future generations, because a First World society is difficult to maintain without a financially secure government.

But, what exactly is fiscal responsibility, fiscal management and FRBM. So, here is an attempt to demystify these.

Fiscal responsibility often starts with a balanced budget, which is one with no deficits and no surpluses. The expectations of what might be spent and what is actually spent are equal. Many forms of government have different views and expectations for maintaining a balanced budget, with some preferring to have a budget deficit during certain economic times and a budget surplus during others. Other types of government view a budget deficit as being fiscally irresponsible at any time. Fiscal irresponsibility refers to a lack of effective financial planning by a person, business or government. This can include decreasing taxes in one crucial area while drastically increasing spending in another. This type of situation can cause a budget deficit in which the outgoing expenditures exceed the cash coming in. A government is a business in its own right, and no business — or private citizen — can thrive eternally while operating with a deficit.

When a government is fiscally irresponsible, its ability to function effectively is severely limited. Emergent situations arise unexpectedly, and a government needs to have quick access to reserve funds. A fiscally irresponsible government isn’t able to sustain programs designed to provide fast relief to its citizens.

A government, business or person can take steps to become more fiscally responsible. One useful method for government is to provide some financial transparency, which can reduce waste, expose fraud and highlight areas of financial inefficiency. Not all aspects of government budgets and spending can be brought into full public view because of various risks to security, but offering an inside look at government spending can offer a nation’s citizens a sense of well-being and keep leaders honest. Similarly, a private citizen who is honest with himself about where he is spending his money is better able to determine where he might be able to make cuts that would allow him to live within his means.

Fiscal Responsibility and Budget Management (FRBM) became an Act in 2003. The objective of the Act is to ensure inter-generational equity in fiscal management, long run macroeconomic stability, better coordination between fiscal and monetary policy, and transparency in fiscal operation of the Government.

The Government notified FRBM rules in July 2004 to specify the annual reduction targets for fiscal indicators. The FRBM rule specifies reduction of fiscal deficit to 3% of the GDP by 2008-09 with annual reduction target of 0.3% of GDP per year by the Central government. Similarly, revenue deficit has to be reduced by 0.5% of the GDP per year with complete elimination to be achieved by 2008-09. It is the responsibility of the government to adhere to these targets. The Finance Minister has to explain the reasons and suggest corrective actions to be taken, in case of breach.

FRBM Act provides a legal institutional framework for fiscal consolidation. It is now mandatory for the Central government to take measures to reduce fiscal deficit, to eliminate revenue deficit and to generate revenue surplus in the subsequent years. The Act binds not only the present government but also the future Government to adhere to the path of fiscal consolidation. The Government can move away from the path of fiscal consolidation only in case of natural calamity, national security and other exceptional grounds which Central Government may specify.

Further, the Act prohibits borrowing by the government from the Reserve Bank of India, thereby, making monetary policy independent of fiscal policy. The Act bans the purchase of primary issues of the Central Government securities by the RBI after 2006, preventing monetization of government deficit. The Act also requires the government to lay before the parliament three policy statements in each financial year namely Medium Term Fiscal Policy Statement; Fiscal Policy Strategy Statement and Macroeconomic Framework Policy Statement.

To impart fiscal discipline at the state level, the Twelfth Finance Commission gave incentives to states through conditional debt restructuring and interest rate relief for introducing Fiscal Responsibility Legislations (FRLs). All the states have implemented their own FRLs.

Indian economy faced with the problem of large fiscal deficit and its monetization spilled over to external sector in the late 1980s and early 1990s. The large borrowings of the government led to such a precarious situation that government was unable to pay even for two weeks of imports resulting in economic crisis of 1991. Consequently, Economic reforms were introduced in 1991 and fiscal consolidation emerged as one of the key areas of reforms. After a good start in the early nineties, the fiscal consolidation faltered after 1997-98. The fiscal deficit started rising after 1997-98. The Government introduced FRBM Act, 2003 to check the deteriorating fiscal situation.

The implementation of FRBM Act/FRLs improved the fiscal performance of both centre and states.

The States have achieved the targets much ahead the prescribed timeline. Government of India was on the path of achieving this objective right in time. However, due to the global financial crisis, this was suspended and the fiscal consolidation as mandated in the FRBM Act was put on hold in 2007- 08.The crisis period called for increase in expenditure by the government to boost demand in the economy. As a result of fiscal stimulus, the government has moved away from the path of fiscal consolidation. However, it should be noted that strict adherence to the path of fiscal consolidation during pre crisis period created enough fiscal space for pursuing counter cyclical fiscal policy.the main provisions of the Act are:

  1. The government has to take appropriate measures to reduce the fiscal deficit and revenue deficit so as to eliminate revenue deficit by 2008-09 and thereafter, sizable revenue surplus has to be created.
  2. Setting annual targets for reduction of fiscal deficit and revenue deficit, contingent liabilities and total liabilities.
  3. The government shall end its borrowing from the RBI except for temporary advances.
  4. The RBI not to subscribe to the primary issues of the central government securities after 2006.
  5. The revenue deficit and fiscal deficit may exceed the targets specified in the rules only on grounds of national security, calamity etc.

Though the Act aims to achieve deficit reductions prima facie, an important objective is to achieve inter-generational equity in fiscal management. This is because when there are high borrowings today, it should be repaid by the future generation. But the benefit from high expenditure and debt today goes to the present generation. Achieving FRBM targets thus ensures inter-generation equity by reducing the debt burden of the future generation. Other objectives include: long run macroeconomic stability, better coordination between fiscal and monetary policy, and transparency in fiscal operation of the Government.

The Act had said that the fiscal deficit should be brought down to 3% of the gross domestic product (GDP) and revenue deficit should drop down to nil, both by March 2009. Fiscal deficit is the excess of government’s total expenditure over its total income. The government incurs revenue and capital expenses and receives income on the revenue and capital account. Further, the excess of revenue expenses over revenue income leads to a revenue deficit. The FRBM Act wants the revenue deficit to be nil as the revenue expenditure is day-to-day expenses and does not create a capital asset. Usually, the liabilities should not be carried forward, else the government ends up borrowing to repay its current liabilities.

However, these targets were not achieved because the global credit crisis hit the markets in 2008. The government had to roll out a fiscal stimulus to revive the economy and this increased the deficits.

In the 2011 budget, the finance minister said that the FRBM Act would be modified and new targets would be fixed and flexibility will be built in to have a cushion for unforeseen circumstances. According to the 13th Finance Commission, fiscal deficit will be brought down to 3.5% in 2013-14. Likewise, revenue deficit is expected to be cut to 2.1% in 2013-14.

In the 2012 Budget speech, the finance minister announced an amendment to the FRBM Act. He also announced that instead of the FRBM targeting the revenue deficit, the government will now target the effective revenue deficit. His budget speech defines effective revenue deficit as the difference between revenue deficit and grants for creation of capital assets. In other words, capital expenditure will now be removed from the revenue deficit and whatever remains (effective revenue deficit) will now be the new goalpost of the fiscal consolidation. Here’s what effective revenue deficit means.

Every year the government incurs expenditure and simultaneously earns income. Some expenses are planned (that it includes in its five-year plans) and other are non-planned. However, both planned and non-planned expenditure consists of capital and revenue expenditure. For instance, if the government sets up a power plant as part of its non-planned expenditure, then costs incurred towards maintaining it will now not be called revenue deficit because it is towards maintaining a “capital asset”. Experts say that revenue deficit could become a little distorted because by reclassifying revenue deficit, it is simplifying its target.

 

access to reserve funds. A fiscally irresponsible government isn’t able to sustain programs designed to provide fast relief to its citizens.