The Art of War – An Introduction to Austere Governance.

The article below is a very indepth response to a freerange post from last year, written by Beale Stainton on his site The Bealian.   Beale has kindly given us permission to re-post his article here.     To quickly summarise: I wrote an article about  the philosophical/economic difference between the ‘left’ and ‘right’ where the left sees full employment and its consequences as the desirable goal, and the right sees low inflation and its consequences as the desirable goal.   I suggest that the right accepts that a certain amount of unemployment is good for the country, in that it keeps inflation down, but then it becomes nasty when it attacks the unemployed for being lazy, a drain on the country, etc, when in fact they are, in this model, making a sacrifice that we all gain from.    Beale has responded with a very informative description of the economic demands on government and what they are and aren’t able to control, suggesting that employment is largely outside of the scope of the government to control.

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The following analysis is in response to an article published by the good folk over at Project Freerange entitled “The nastiness of the mainstream right politics”, which you can read by clicking on the link here.

http://www.projectfreerange.com/the-nastiness-of-the-mainstream-right-politics/

This article argues that there is a fundamental difference between economic policy of the left and that of the right in New Zealand politics.  A press release of Michael Cullen’s policy back in 2002 aimed at, among other things, the creation of full employment.  The 2008 press release given by Bill English on the other hand does not make a mention to employment at all.  This is a very salient observation that has been made.  The Freerange article goes on to then link the employment negligent economic policy of the right with inflation.  It is argued that right wing policy aims to keep unemployment high for the purposes of controlling inflation.  Now we all know that Government policy is conducted with the purposes of engineering some greater master plan.  The question that this raises is how far would a particular government be willing to go in order to control inflation?  Would they purposefully keep employment rates down?

Now, I have written this article for two reasons.  The first reason is, because I wanted to return a constructive and critical response to Barnaby at Freerange.  The second reason is to show the world what the insides of a governments books look like.  In regard to the first reason I will attempt to build upon Barnaby’s valiant attempt at an economic argument.  It does indeed appear as if employment levels could be engineered in order to control inflation.

The current National Government has been, for the most part, conducting itself in a fashion, which it can be argued, goes completely against the unwritten rules of civilized public relations.  They have, through their overly assertive reforms, taken very few prisoners, if any.  They have, time and again, come up against mass public opposition to their policies.  They have expressed a certain culture of authoritarian disregard so to speak, perhaps an arrogance even.  In the opinion of many in our country they have quite simply been rubbing people up the wrong way.  They perhaps have contributed to further backlash by the mere fact that their leader gained the nick name “Smiling Assassin” while employed as head of foreign exchange dealings at international banking powerhouse Merrill Lynch.  He earned this nick name, because he continued to smile while making some hundreds of redundancies in the wake of the 1998 Russian Financial Crisis.  It is no wonder that there is a certain air of mistrust and disillusionment coming from various parts of New Zealand society.

For this reason I hope I can lay down a few reasons as to why such policy has been implemented.  I would like to start off by saying that, in my opinion, this is not so much a matter of left or right wing.  For example, the former Minister of Finance under the Helen Clark Government, Michael Cullen has a past life and so does Helen Clark herself for that matter.  If you go back in history to the Labour Government of 1984-1990.  You will find an up and coming Cullen in the position of Associate Finance Minister plotting away in the shadow of Roger Douglas, the prophet of the New Right.  So it can be argued that Michael Cullen himself contributed to the genesis of the policies of the New Right in this country.  In my opinion Government policy is, for the most part, reactive rather than proactive.  Muldoon’s National Government was forced into extreme national protectionism and regulation by way of reaction.  Lange’s Labour Government was then forced to go extremely open and in pursuit of the free market by way of reaction.  Helen Clark’s Labour Government, post 2001, was the lucky one, because it got to react to good economic times.  It was lucky, because as a result of the success generated on the international free market it was able to oversee a speculative rise in property, financing and construction, which like Spain and Ireland brought a lot of money and jobs into the economy.  2001 was also the defining year for New Zealand in that China joined the WTO and Fonterra was established.  If you want to get a grip on why things are so in New Zealand at the moment then we only need to take a look at Spain, Ireland and many other parts of the world that too heavily depended on property, finance and construction to fuel their economies.

Anyway let’s move on.

The next point I would like to make is that there is not much a Government can do to keep unemployment low.  It can, to a certain degree, in the case where a Government employs a lot of people.  The Government would only need to lay off a required number of civil servants in order to meet a certain measure for the purpose of meeting a particular target percentage of unemployment.  The National Government has in deed been doing this, however this has been done for other reasons, which I will get to later.  In the private sector, demand for labour is unregulated.  When the private sector needs labour it simply takes it.  This is what happens when an economy is picking up.  When it is slower then the private sector doesn’t so much demand labour and so unemployment increases.  As I’ve stated.  This is an unregulated market Government cannot interfere with.

Another point of criticism I would like to make is in regard to the correlation between employment and inflation.  The man who officially argued the connection was the New Zealand born economist William Phillips.  He has, as a result, left to the world the “Phillips curve”, which states that when unemployment is high then inflation is low and vice versa.  This is evidently so, because as unemployment increases the supply of money decreases and therefore producers will be forced to put their prices down.  However Phillips argument was based only on research done in the United Kingdom between 1861-1957.  It has been apparently disproved by the many economies which have both high inflation and high employment.  However I would only take the rebuttal theories with a grain of salt, simply because they are argued first and foremost by Milton Friedman.  I’ve looked at Friedman’sstagflation theory and to be honest with you all, it stinks.  It stinks of the modern financial system and perspective engineering.

Friedman’s stagnation theory argues that when unemployment lowers this triggers a rise in wages and a rise in wages eventually means that unemployment will return to its previously higher level, so far correct, but then he goes onto say that inflation will remain high.  This is how the Phillips curve was disproved and forced to give way to Friedman’s theory ofstagflation.  Philips argued that inflation would eventually reduce too.  Now in pure theory, I’m going to go with Philips on this one, because in a self-regulating market, producers would bring their prices down to match the reduced supply of money in a high unemployment economy.  However we no longer live in a self-regulating market.  We now live in a market regulated by financial systems and the domination of credit.  If cross border credit didn’t exist then the pure theory of Phillips would prevail, but in a world where cross border credit is the main regulating force behind an economy then it is sadly Friedman’s version of events that will prevail.  What I have just discovered is actually quite brilliant and deserves to be written into a doctorate.  Anyway, I’ll come back to that in my own time.  We need to move on.

So there we have it Barnaby and others.  I have successfully altered the direction I was sending this article.  Friedman, being the worshiped economist that he is, was meant to be right and then I was going to proceed to make my final points.  However I’ve just proven him wrong and as a consequence, my further points wrong.  Or have I?  Perhaps I am still on the right track.

Let me just state that the reason unemployment is high at the moment is not so much due to a political engineering campaign by the National Government to keep inflation steady.  Employment is high, because there is a whole bunch of debt to pay off.  This situation has in effect squeezed the life blood out of the economy.  The situation is complicated, but I will try my best to explain it.

Government is not something that renews itself every three years.  It is an ongoing entity.  All that changes is the party or the leadership voted in to manage and direct it.  Debts and surpluses incurred by one government will be inherited by the next and so on.  In the same way, long term debts incurred now, let’s say in the form of a 10 or 30-year bond issuance, will be paid off by future tax payers in 10 or 30 years time and not the current ones.  The current taxpayers reap the benefits, so to speak, for what their children will be forced to pay off.

Now let’s look closer at Government.  It is such a beautiful monstrosity.  Government has revenues and costs just like any enterprise, whether that be yourself, the corner dairy, Telecom or whatever.  As such, just like most other enterprises, it needs to prepare a number of statements and plans.  Let’s start with the statements.  The first statement is the “Statement of Financial Performance”.  This statement records its revenue against its expenses.  The next statement is the “Statement of Financial Position”.  This one records what it owns against what it owes.  The third is the “Cash Flow Statement”.  Now this one is fairly self evident.  Now the important thing to note is that what appears in these statements, generally becomes the basis for preparing the next very important document.  That next document is the “Budget”.

It is likely that bad news in the 3 above statements over a period of previous years will most likely contribute to the publication of a bad news “Budget” for subsequent years.  The “Budget” then gets translated into policy and policy gets translated into execution, which is the responsibility of the party in power.  So hopefully the chain is now obvious.  Bad news in the statements, will lead to bad news in the budget and subsequent bad news in policy and as a result, in execution.

Now, as a result of the sudden contraction in the global economy, the private sector took one hell of a hit.  Let’s not go into too much detail.  It was a bust.  A bust is a cataclysmic event and everyone gets hurt.  Even Berkshire Hathaway stocks went from $150,000 a pop down to $60,000.  A raging private sector is fueled by a need for two things.  It needs labour and capital, the two main inputs of business.  The banks provide the capital and the people the labour.  As such, capital and debt markets boom and unemployment drops.  As a result Governments will receive more taxes and spend less and Reserve Banks will lift interest rates to keep inflation steady.  Up until 2008 the NZ Reserve Bank had the OCR, the primary interest rate of the economy, set at above 8%.  At the moment it is down at 2.5%.

When the private sector is booming there is money left, right and centre, which means prices will go up causing inflation.  Reserve Banks react by lifting interest rates so that people get enticed by the returns to be made simply by putting their money into Government securities.  This takes money out of the economy and keeps inflation steady. When economies are stagnant like now then Reserve Banks react by lowering interest rates making it cheaper to borrow and thus causing an inflationary effect of sorts.  However this gets countered by the lack of economic activity and therefore money.  What I want to describe to you in the boom picture, which lasted from 2001-2008 is how easy the Labour Government had it for that time period.  There was absolutely no need for austere measures.  Their Reserve Bank needed to do the opposite and reduce the amount of money. They were lucky the private sector was booming, takes the weight off their shoulders.

Since 2008 and the arrival of National, Government experienced a reversal.  Their revenues decreased and their expenses increased.  This was a direct result of the bust, not the arrival of National in and of itself.  Remember this is the same Government as always, just under new management.  Not only did tax revenue fall, but the taxpayer had to bail out the broken economy putting further pressure on spending.  As a result the weight got put on the shoulders of Government.  In the performance statement of 2009 there was a surplus between revenue and expenditure, but an overall decrease from 2008.  In the performance statement of 2010 there was a deficit of 2.1%, by 2011 a deficit of 3.3% and this year a deficit of 8.4%.  The large deficit recorded this year was mostly a result of an increase in the “insurance expense” column between 2010 and 2011 of some $8 billion.  It’s all recorded in the books.

Now what these widening deficits do is they force Governments to draw up budgets and policies which will cause a good deal of pain and frustration when they are executed.  Think about it.  If you record a 2.1% deficit this means that the budget for next year is going to come down to either one or two options.  The first is to adjust income or expenses.  The second is to put down a bond issuance and borrow in order to cover your costs for the next year.  The second move means that you need to borrow now, but as a result, future tax payers will be hit with the bill.  Not only that but your credit rating could be effected, which means that the cost of borrowing money next year will go up.  This means that you will hit the pockets of future tax payers even more.  Borrowing more also means that you are creating more expenses.  These expenses get recorded in the books as “interest expenses”.  The more debt you take on the higher this expense column climbs.  This will likely increase your deficit even more.  As a result it is best to resort to the first option than to resort to the second one.  There is a third option.  You can sell some assets, but we go into that.

So the first option is what governments will resort to.  They can increase revenue by hiking tax rates.  However this move is further bad news for the economy.  What they should do is increase taxes on mega profits, however this move causes big business to kick up a fuss and threaten the government with relocation to another part of the world or some other form of rebellion.  This eventuates into further bad news for the economy.  What the current government is doing is they are looking at other sources of national income such as the taxes and royalties generated by mining operations and other economic operations in the long run.  On the other side there needs to be a reduction in spending.  This is evident by the reduction in staff in the public services, a lowering of the teacher to student ratio and a tightening up of welfare services.  For the record, social security and welfare currently costs the Government $2 billion a month.  Education and Healthcare both come in at $1 billion a month, only half that of welfare, but in times like this the welfare is needed.  These three cost centres out shadow all others.  It’s all there in the books.

So I hope I have explained how increasing deficits and spiraling debt forces reactive governance.  It is usually the Finance Minister, who is also the automatic Treasurer, who holds the purse strings.  It is their responsibility, in their role, to create a long term plan, in this case a three year or five year one, to get the books back into surplus.  In order to do this the Treasurer needs to sit in his office, study the statements and a whole host of other reported information from his departments and as a result draw up, to begin with, a budget. The budget will most likely be produced, in a time of deficit, so as to reduce expenses and suggest increases in revenue sources, without needing to borrow too much.  The budget is then communicated through to ministers.  They will be told that they need to cut spending by such an amount.  The minister will then set about turning the expenditure reductions into policy.  The policy will be communicated to the public and, in a time of forced fiscal austerity, they will not react too kindly to it.  The appropriate ministries will then set about executing policy.

Budgets are limited, but relatively precise in that they only look upon the next financial year.  The next level of planning is what is known as the strategy.  Strategies look over periods of three to five to ten years.  They cannot be as precise in their financial estimations and therefore provide only rough projections of future Government revenues and expenditures over, let’s say, a five or ten year period.  They provide direction more than anything.  For example, the Petroleum Action Strategy of 2009 estimated that the mining of New Zealand’s minerals reserves could turn a $3 billion per annum industry into a $30 billion per annum industry by the year 2025.  As such Government would be set to earn from both taxes and royalties and the economy will be boosted.  Now we know that these figures are such an extreme estimation, but they at least provide guidelines to get the ball rolling, develop policy and debate the costs.

The sale of state assets is also set out in a strategy as opposed to budget.  The financial return on the assets will be estimated from, for the most part, an uncertain future.  The estimated return for example might come to $10 billion over four years.  This $10 billion will then be calculated into an estimated budget and performance scenario of Government four years into the future.  The Treasurer will then make a rough estimation and let’s say he concludes that Government will be back in surplus in four years time provided all policies and strategies have been successfully executed.  He will no doubt in include margins of risk to strengthen the estimations.  If the figures add up then Government will go about putting plans into action and when the chain is a result of bad news inputs, like they are at the moment, then there will be bad news outputs.

So there we go everyone.  This is how austere governance works.  Perhaps, after writing this, I now feel quite austere myself.  My main argument is that austere measurements, just like liberal ones are a result of reaction to a given economic environment.  It does not matter if you have a Labour or National party in power.  The boom of 2001-2008 allowed Labour to be liberal, but the dire economic situation of 1984 forced the then Labour Government to be austere and same with Muldoon.  My other argument is that keeping unemployment low is not so much a tool Governments use to control inflation.  If the private sector needs labour then there is nothing Government can do to stop this.  Labour is controlled by the market.  High unemployment usually means that the private sector is not demanding so much or that Government itself is forced to cut back on spending to reduce its deficits.  On the other hand there is a correlation between unemployment and inflation, which Friedman denied, but as I showed you guys I suspect Friedman’s theory of being subject to a regulating factor and that is cross border credit.  Therefore his theory of stagflation should not qualify as pure economics and the Phillips curve should be given its rightful position at the top again.  My final argument is that austere and unpopular policies and executive consequence are the result of bad finances caused by external economic conditions.  This is evident by the way continuing deficits, as a result of a bust, causes certain reactive policies to bring the books back into the black without having to borrow too much.

That is where I will finish.  Barnaby I certainly enjoyed reading your article and, as has been obviously displayed, it did make me think a great deal in order to give you a response you can seriously consider, warts and all, not the pretty picture anyone wants.  Monetary and fiscal policy, when the going gets tough, is not a place for the faint of heart.  However I will leave with a final thought.  What I have given you is my honest description as a result of my education and research.  Austere governance is austere governance.  There are no two ways about that.  It has its place and its time.  The power and influence of fiat money or credit creation on the other hand is a whole completely different set of bad news.  This system likes to pretend that it acts in the interests of deregulating economies, but the truth of the matter is that it has itself and is fast becoming, the ultimate and central power of regulation.  In this sense it is now the state being regulated.  There has been a fundamental shift in power and dominance.  Think about that for a second and the consequences it spells for the future of economy and government.  They will both be locked into cycles of boom, fueled by credit creation and cycles of bust, fueled by credit crunches, which Governments will be forced into taking the rap for.  It is the simple system of credit, which is what we need to look out for.  This is a game John Key and the rest of us are all pawns in.  It is a system people like Friedman have argued into the academic literature as being the way it is.  This is something I can’t quite grasp without speculating and making up conspiracy theories.  So for the moment it is best we keep silent about it and only think on it.