Fiscal Policy and a Dollar’s Real Claim

In a recent post, I considered the Austrian critique of fiscal policy. One issue that arose concerned the Austrian claim that fiscal measures cause a reduction in the real claim of a unit of money (e.g. a dollar). Austrians tend to view the market as the only valid arbiter of “value”, with deviations from a pure market outcome thought to reduce the value produced, and hence the real claim of a dollar.

As was pointed out in the earlier post, this Austrian position is not supported by logical analysis. Orthodox general equilibrium theory indicates in its first fundamental theorem of welfare economics that markets only ensure allocative efficiency (pareto efficiency) under stringent conditions that, if satisfied, would enable alternative allocative mechanisms (e.g. mixed economies, planned economies) to achieve the same level of efficiency.

More importantly in the present context, once there are at least some distortions – and there must always be some due to the presence of what the orthodoxy terms externalities, public goods, market failures, etc. – the orthodox theory of the second best demonstrates that eliminating some but not all distortions will not, in general, improve allocative efficiency. Conversely, adding more distortions (e.g. the introduction of fiscal policy) will not, in general, reduce allocative efficiency, and may well increase it.

In other words, the Austrian identification of deviations from pure market outcomes with increased inefficiency is an intuition that has been shown not to hold on logical grounds. Austrians are not entitled to persist with the claim until they can demonstrate it.

There is also a distributive consideration. Even if a market outcome were preferred, there is not just one market outcome. There is a different market outcome for every possible initial distribution of income and wealth. Even in a ‘first-best’ world, non-distortionary lump-sum taxes and transfers could be used to redistribute income and wealth, after which the market could be left to generate its outcome. By the orthodoxy’s second fundamental theorem of welfare economics, the outcome would be allocatively efficient, irrespective of the initial distribution.

In a second-best world, there is not even a presumption in favor of lump-sum taxes and transfers, since the addition of distortions through tax-and-transfer measures will not necessarily be less efficient than alternatives.

In this post, I want to illustrate some of these points with a simple numerical example. But before doing this, it is worth taking a little time to consider what is meant by the term “value” in the present context.

The Austrian Conception of Value

The Austrian notion that markets are the only legitimate arbiter of value is an arbitrary one. It reflects a view of the market mechanism as a natural process, one that is more natural than other methods of organizing economic behavior.

This is not the only interpretation of value, which takes on a variety of other meanings in economics. For example, the Classical economists and Marx distinguish exchange value from use value. Exchange value is determined by a commodity’s ’embodied labor’ in Ricardo’s approach or the amount of labor time required to produce it in Marx’s theory. Use value, in contrast, relates to the utility or usefulness of the commodity. As another example, neoclassical economists distinguish private value from social value to account for the effects of externalities.

There is also a distinction between the positive question of how markets value goods and services and the normative question of how they should be valued. For instance, Marx’s theory of value is concerned with how commodities are valued under capitalist conditions of production and exchange. But Marx was not trying to suggest that this is the way goods and services should be valued. Whereas processes of production and exchange are treated by the Austrians as if they were natural, Marx’s analysis brings out the social character of capitalist production and exchange.

Ultimately, it is society that answers the normative question. In answering this question, it has a variety of mechanisms at its disposal. The market is only one such mechanism. In a range of circumstances, society may deem the market to be an appropriate method. Of the other mechanisms, the most important is the democratic process. In principle, democracy expresses society’s preferences on the basis of ‘one person, one vote’, in contrast to the market’s ‘one dollar, one vote’.

The Austrians tend to stress the susceptibility of the democratic process to corruption, and no doubt there is this problem. But much of the vulnerability of democracy comes from imbalances of economic and political power that are based on extreme inequalities of income and wealth. Markets are also susceptible to this imbalance of power. At one level, the pattern of demand reflects the distribution of income and wealth, and therefore distribution impacts heavily on what is produced and how resources are put to use. At another level, the centralization of capital creates rents and monopolistic pricing power that give some producers and owners of resources a dominant say over the direction in which an economy is developed.

Political processes are not perfect, but neither are markets. Without government intervention, developed economies would not have provided universal education or universal health care, and would have severely underprovided public infrastructure, basic scientific research, etc., simply because these things are not profitable for individual capitalists to supply.

Chances are, if the market were left as the sole arbiter of value, developed economies would never have become “developed” in the first place. To this day, education and health care might only be preserved for a privileged minority, science might be far behind the level to which it has progressed, and so on.

It might be asked, who are we to say that these things should have occurred, in opposition to the market? The answer is, we are society. What we say goes. If we say these things have value, and express our answer sufficiently coherently through democratic and political means – as we have in the past – then these accomplishments are deemed to have value. The determination of value is social, and can never be otherwise.

Fiscal Policy and the Real Claim of $1

In opposition to the MMT (and Keynesian) view that fiscal policy can be used in a non-inflationary manner to alter the distribution of income, or, in the presence of unemployment and excess capacity, to boost output and employment, Austrians tend to argue that the benefits of such policies are illusory, merely causing a reduction in the real claim of a dollar.

This alleged reduction in value per dollar is argued to occur in at least two ways. First, a balanced budget, while not adding to demand overall, will alter the pattern of demand through its redistributive effects, and so alter sectoral levels of production from those that would obtain under purely private-market conditions. This is taken as evidence of inefficiency. Second, budget deficits add to demand overall, and so may induce production that would not have occurred under purely private-market conditions. For this reason, the additional output is considered to represent less value (perhaps no value), reducing the real claim of a dollar.

In my previous post on the Austrians, I argued that their position really reduces to a complaint over distribution. In the remainder of this post, I want to illustrate this with a simple numerical example.

Balanced Budgets, Distribution and Demand

Imagine a pure-market closed economy, initially operating at full employment. We can suppose there is a government, but that it is currently not taxing or spending.

The society can be divided into two groups of equal size on the basis of income – high and low. Final goods can also be divided into two categories, customary and luxury items. Examples of customary consumption items might include basic food and shelter, transport, popular entertainment, basic education and health care. Examples of luxury consumption items include any that are not currently widely accessible, such as the most expensive cuisine, elite schooling, yachts, private jets, and so on.

     Category    YD    Customary  Luxury  Saving  Investment
       High    90,000    30,000   30,000  30,000    30,000
       Low     10,000    10,000      0       0         0

The average disposable income in the high-income group is assumed to be $90,000. The average for the low-income group is $10,000. By assumption, the high-income group initially spends, on average, one-third of its income on each category of consumption and saves the other third. The low-income group spends all its income on customary consumption items.

As a matter of accounting, investment must equal saving, since the government’s budget is in balance (zero taxing and spending) and there is no external sector. Since half the population are categorized as “high income”, the saving of $30,000 per high-income person represents saving of $15,000 per capita. (That is, Per Capita Saving = 0.5 x $30,000 + 0.5 x $0.) Likewise, investment can be regarded as $15,000 per capita.

Now, suppose it is determined through political processes that the minimal acceptable standard of living requires an income of $30,000. In view of this, the government decides to impose an average lump-sum tax of $20,000 on members of the high-income group and provide an average transfer to low-income individuals of the same amount. Since transfers are categorized as negative taxes, government spending remains at zero, as does tax revenue (taxes minus transfers equal zero). Apart from this redistribution of income, the government decides to let the market determine the outcome for the period.

This redistribution of income will alter consumption patterns and induce output responses from producers in the two consumption sectors and investment sector. The final outcome for the period might look something like this:

     Category    YD    Customary  Luxury  Saving  Investment
       High    70,000    30,000   20,000  20,000    20,000
       Low     30,000    30,000      0       0         0

                                             G         T
                                             0         0

The fiscal measures have not only altered the distribution of income, but also induced a change in production and employment levels in the various sectors. The production of luxury consumption items has been reduced while the production of customary consumption items has increased. Production and employment in the investment sector has decreased, and within the sector there may also have been a shift towards producing investment goods for producers of customary consumption items.

Although the distribution of income and demand patterns have changed, aggregate output has remained the same. Both before and after the introduction of the fiscal measures, per capita GDP is $50,000. Before the redistribution:

     Per Capita GDP = C + I + G
                    = 0.5(40,000 + 30,000) + 0.5(30,000) + 0
                    = $50,000

After the redistribution:

     Per Capita GDP = C + I + G
                    = 0.5(60,000 + 20,000) + 0.5(20,000) + 0
                    = $50,000

In connection to this scenario, the Austrians would wish to argue that the per capita GDP of $50,000 after the redistribution represents less value than the per capita GDP of $50,000 prior to the redistribution. But both outcomes were generated by the market. The only difference was the initial distribution of income.

Prior to the redistribution, members of the high-income group had a bigger say in the valuation of goods and services than they did after it, since collectively they possessed 90 percent of the “dollar votes” rather than only 70 percent. This greater voice in the marketplace induced production more in keeping with the preferences of the high-income group. By the same token, this pattern of production was less in keeping with the preferences of the low-income group. Once the low-income group had a louder voice in the marketplace, it exerted a bigger influence on what production took place.

This makes it clear that the Austrian objection to fiscal policy amounts to nothing more than a dislike of redistribution. However, unless there is something sacrosanct about the status quo distribution of income, it is not clear why the more unequal distribution should be preferred to the more equal one. In particular, it is not clear why the preferences of the low-income group should be considered less indicative of “value” than the preferences of the high-income group. This is especially so if society indicates, through democratic and political means, a preference for a more equal distribution of income.

Budget Deficits and Value

Let’s reconsider the hypothetical economy as it existed prior to the introduction of fiscal policy except now suppose that unemployment and excess capacity emerge. The unemployment could arise because of weak investment demand (let’s say $5,000 per capita) that falls well short of the non-government’s desired level of saving ($15,000 per capita). This will cause a build up in unsold inventories in the investment sector and a subsequent reduction in aggregate income and employment as firms cut back production in response to weaker demand conditions. The negative income adjustments will persist, in accordance with the expenditure multipliers, until saving has settled at $5,000 per capita, equal to investment.

Since it is only high-income individuals who save on average, the entire impact on saving of the negative income adjustment will fall on the high-income group.

     Category    YD    Customary  Luxury  Saving  Investment
       High    70,000    30,000   30,000  10,000    10,000
       Low     10,000    10,000      0       0         0

The negative income adjustments mean that GDP has decreased from $50,000 per capita down to $40,000 per capita.

Suppose the government decides to step in to restore full-employment output of $50,000 per capita. It decides to provide subsidies of $20,000 on average to low-income earners. One effect of this policy will be to increase aggregate demand through the effect of the subsidy on the spending power of low-income individuals. Another effect will be to enable non-government net saving intentions. The reason for this is that the extra consumption expenditure of the low-income group will end up in the hands of capitalists and owners of businesses, who can be assumed to be members of the high-income group. This is an example of Kalecki’s aphorism, “Workers spend what they get and capitalists get what they spend.” (Thinking in a Macro Way discusses the implications of Kalecki’s insight in more depth.) In this way, saving is sustained above the level of private investment by the amount of the budget deficit.

Here is one possible outcome:

     Category    YD    Customary  Luxury  Saving  Investment
       High    90,000    30,000   30,000  30,000    10,000
       Low     30,000    30,000      0       0         0

                                             G         T
                                             0     -20,000

As a matter of accounting, (G – T) = (S – I). By running a budget deficit, the government has enabled a higher level of non-government saving ($15,000 per capita rather than $5,000 per capita), an increase in consumption expenditure in the low-income group, and an increase in output to the full-employment level of $50,000 per capita. Before the government ran the deficit:

     Per Capita GDP = C + I + G
                    = 0.5(40,000 + 30,000) + 0.5(10,000) + 0
                    = $40,000

As a result of the deficit:

     Per Capita GDP = C + I + G
                    = 0.5(60,000 + 30,000) + 0.5(10,000) + 0
                    = $50,000

Again, if the Austrians wish to argue that there has been a reduction in the real claim of a dollar, they need to explain why the spending decisions of the low-income group are lesser indicators of value than the spending decisions of the high-income group.

It should be clear that the Austrian dislike of fiscal policy is motivated by a desire for a particular type of distributive outcome rather than a legitimate argument based on “value” considerations.


4 thoughts on “Fiscal Policy and a Dollar’s Real Claim

  1. a few comments

    they don’t note the difference between what ‘a’ dollar buys and what all the dollars buy (total ‘real’ gdp)

    the currency is a public monopoly. hence the nominal value of a dollar is necessarily a function of prices paid by the issuer/govt. at the point of expenditure (and/or collateral demand when lending).

    relative value is a function of supply and demand, which is a function of institutional structure more so than ‘natural personal preference’ per se, to the extent there is such a thing.

    Govt. spending does at a minimum prevent deflation, which can be called inflation. For example, if, at inception, spending isn’t even enough to cover the tax, prices fall continuously until the situation is remedied. So it can be said in that sense govt. spending, and, in fact, all spending, is what supports prices, which some call an inflationary bias.

    More here:

    Hope this helps!

  2. Very helpful comments. Thanks! I am about to study the link once I’ve submitted this reply and made myself a cup of coffee. It’s late evening down here in China’s coal mine. 🙂

    The important insight that the value of a dollar is a function of the prices paid by government is something I never comprehended prior to exposure to MMT, and still something I need to understand more fully.

    I think it is time I revisit all the mandatory readings and pick up implications I missed the first time around, when MMT was very new to me (still is pretty new to me, of course).

  3. if you take the spectrum from monopoly to pure competition, monopoly is the easiest to analyze and understand, with pure competition the most difficult.

    fortunately the currency is a very simple public monopoly, which makes it inherently very easy to understand!

  4. Re-reading “A general analytical framework” has cleared things up for me a lot. The first time I encountered it, I missed a lot of the insights and implications.

    The analogies with the corn farmer and the water monopolist are really effective illustrations for someone like me who always found money rather mysterious and difficult to fathom before learning about MMT.

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