Showing posts with label OBR. Show all posts
Showing posts with label OBR. Show all posts

Friday, 19 September 2014

Wishful thinking and economics

Economics is often called the dismal science, and the Scottish referendum showed why this description has stuck. The Yes side appeared full of hope and optimism about what could happen once the constraints of Westminster rule had been cast off, while the No campaign kept on going on about one problem or other, which usually involved economics.

The general meme is that this negativity was a tactical mistake by the No side, but it was a quite understandable mistake, because the economic problems were large and self evident. It is no surprise that the vast majority of economists thought Scotland would be worse off under independence (see here, or here, or here). They had looked at the numbers and issues, or looked at institutions they respected that had done so, and thought this does not look good. Even for some of those economists who are in favour of independence, like Joe Stiglitz for example, it is clear that the attraction is despite, rather than because, of the basic macro and fiscal numbers. (See also Adam Posen’s response.)

This is of course not new. Politicians on the right like to believe that tax cuts will pay for themselves, and it is boring economists who (mostly) point out this is not true. Politicians of all shades thought that austerity would not have much impact on output and growth, while the vast majority of economists knew better. One of the reasons for deficit bias is that politicians believe that their policies will galvanize the economy and raise the tax base, and most of the time the macroeconomy stubbornly refuses to be impressed.

Now it is tempting to say, given this evidence, that politicians will believe anything that suits them. But what the independence referendum showed us is that voters have similar problems. As the campaign progressed the stronger the Yes vote became, and there is some evidence that this reflected additional information they received. As I suggested here, the problem is that this information was superficially credible sounding stuff from either side, but often with no indication from those who might have known better of the quality of the analysis.

For me this has always been the major argument for establishing fiscal councils - independent institutions who are charged with, at a minimum, scrutinising fiscal projections. Although the OBR (the UK’s fiscal council) has a remit that is quite narrow, we also have the highly respected IFS. In Sweden the fiscal council itself has a much wider economic remit.

Whenever I make this point, someone puts forward the argument that this is anti-democratic, or that I want economists to dictate decisions. This is wrong on at least two levels. First, my general argument is not specific to economics, but involves any area that involves technical expertise. Indeed, the case I make here is partly to avoid politicians using the views of a small minority of economists as cover. Second, the problem with democratic accountability as normally defined is that it is very weak: voters make one decision every five years that involves a whole basket of issues. I would suggest that charging an institution with a small set of tasks, where there is effective democratic oversight over the performance of that institution, can make that institution more accountable to the electorate than any politician doing the same.

In the case of Scottish independence, although we did not have a direct assessment of fiscal prospects from the OBR, that organisation’s oil revenue forecasts were used by the equally respected and independent IFS to point out the problematic outlook that an independent Scotland would face. Although the Yes side attempted to suggest that the OBR was part of the very Westminster elite that it wanted a divorce from, I suspect many voters saw this as independent analysis and were concerned by it. In a world where politicians can always find some experts to back their view, I suspect it is only through singular institutions like the OBR and IFS that the views of the majority of economists get to have some influence, and the economics of wishful thinking gets exposed.

Sunday, 14 September 2014

Shrinking the State

More on George Osborne’s plans, courtesy of the OBR’s latest publication. (Campaigning for a UK Fiscal Council was one of my better calls - just imagine if you had to rely on today’s government for this kind of information.)

Consider three points in time: 2001/2 (when the UK budget was last in balance, and still largely reflecting the actions of the previous Conservative government), 2007/8 (pre-recession, under Labour), and 2018/9, when George Osborne also intends us to be back in balance. The first chart actually comes from the OBR’s historical database, which only covers the broad aggregates. (It would be fantastic if this database could include more disaggregated information.)

This shows total government receipts (taxes) and expenditure (spending) as a percent of GDP. The two lines meet at the start and end. In 2007/8 we had a budget deficit of 2.6% of GDP. At the time that seemed a bit on the high side: something between 1.5% and 2% would have kept the debt to GDP ratio constant. (Budget balance implies a falling debt to GDP ratio.) For this post the point to note was that the Labour government chose to use this fiscal loosening to increase spending rather than cut taxes.

The Conservative government plans to do the reverse. So does that mean that it is just trying to undo the increase that occurred under Labour? The answer is no, and this is where the OBR’s latest report comes into its own.

Their chart shows how we get from the deficit of 2007/8 to the small surplus of 2018/9. (There is, as I note here, no good macroeconomic reason to aim for a surplus.) The cuts in spending are not just the size of the 2007/8 deficit - they are much larger for two main reasons: higher debt interest and higher ‘welfare’ spending. The reason for the higher debt interest is straightforward: debt is much higher because of the recession (and to a small extent the fiscal stimulus in 2009). Although academics often assume that higher debt interest is paid for by raising taxes, a more ‘neutral’ approach would be to raise taxes and cut government spending. Osborne plans to just cut spending.

The increase in welfare payments is probably not what you might think it is. The report’s Table 5.7 shows it is not higher unemployment benefits or income support: by 2018/9 unemployment benefit is the same as in 2007/8, and income support is 0.5% lower as a share of GDP (which is the main reason why poverty will increase over the next five years). Housing benefit is 0.3% higher as a share of GDP (partly reflecting depressed real earnings), but the main reason is the state pension, which is almost 1% higher as a share of GDP. This represents both an increased ‘caseload’ (more pensioners) and a more generous value of pensions themselves. Although the numbers suggest that here too Osborne plans to pay for this additional spending by cutting the size of government, he has indicated that he hopes to reduce this increase in welfare payments by some, as yet undeclared, means.

So this is why the reduction in the size of the state planned for 2018/9 is much more than reversing Labour’s increase: in fact, if welfare cannot be cut further, to decrease its size to “probably to the lowest share of GDP since 1938” (p128). In this particular respect, therefore, this government plans to go well beyond anything Margaret Thatcher ever attempted. I suspect when some people write that this Conservative party is more right wing than any since the war, many reading think this is hyperbole. On this metric at least, it is simply fact.  

Friday, 1 August 2014

How to muddy the waters on impact of austerity

Jamie Murray of Bloomberg writes “U.K. Austerity Critics Must Explain Productivity Link”. To which my immediate reaction is ??!? When have those who criticise UK austerity ever claimed it is responsible for the UK productivity puzzle? Certainly not me, and I’m the only critic quoted in the piece.

The problem is in the framing, set out in the first paragraph. There is apparently a debate between those who blame poor UK growth since 2010 on austerity, and those who blame it on other factors like the Eurozone crisis and a risk averse banking sector. No, there is no such debate. The reason there is no such debate is given in the first line of the next paragraph: “Both are likely to be true to some degree ….” Exactly right! But then the sentence goes on “and the extreme polarization of views reflects badly on economists and commentators, some of whom may be motivated by political ideology rather than reason.” You talkin’ to me?

This is classic “plague on both houses” stuff - both sides are too extreme (probably because they are ideologically motivated), so let’s take a more reasonable middle view. The only problem in this case is that to do this you have to misrepresent one side. There is very little disagreement among serious economists that UK austerity in 2010 and 2011 reduced UK GDP. The OBR, using rather conservative multipliers, thinks that GDP in 2010 was about 1% lower, and in 2011 about 1.5% lower as a result of fiscal policy, with significant knock on effects into later years. The estimates by Jorda and Taylor involve similar magnitudes, but perhaps if you added in large expectations effects you could double the OBR’s numbers, although whether you could then also assume no offset from monetary policy becomes an important issue. Whatever you do, there is no way you are going to get close to the fact that GDP is currently around 15% below its pre-recession trend. Put simply, the productivity puzzle matters more. But that does not mean austerity is unimportant: just 1% of GDP completely wasted is a big deal.

Now it could be that the productivity puzzle is not completely independent of austerity, and Murray’s article actually makes some suggestions about possible links. But the bottom line is that, among serious economists, austerity is highly unlikely to explain all or indeed most of poor UK growth. So this side of the 'debate' does not really exist. But the other side does exist, if only in the shape of the UK government. They want to avoid as far as possible any discussion of exactly how much austerity reduced GDP, and instead they want to claim that austerity produced the recovery! It is that side of the debate that has some explaining to do. Given the links between austerity and productivity the article discusses, a much fairer headline would have been 'impact of UK austerity may be even worse than critics suggest'.

While I’m in complaining mode, two other things that I get annoyed at. Murray says a good place to start is the OBR’s analysis of how its forecast changed between 2010 and 2014. He is not the only one to focus on the OBR’s forecast errors when addressing this ‘debate’. But this makes no sense, because the 2010 OBR forecast already had their estimates of austerity (see above) embodied within it! The government loves to play this trick, but good journalists should not follow their lead.

The second point is that critics of UK austerity would never argue that external factors were not important, if only because a key external factor was the impact of austerity in the Eurozone. As this Commission analysis shows, backed up by similar analysis at NIESR, austerity was a key factor behind the second Eurozone recession, and most of that austerity came from core rather than periphery countries. The argument that this was all a necessary response to the debt crisis just does not wash after the obvious impact of OMT. 

What is really going on here is this. The intellectual debate over austerity is largely over, and the right side won. Good commentators who do not have an axe to grind know this. But they also know that the political debate went the other way. Writing about this paradox would appear politically one-sided. Much better to portray critics of this political outcome as much more extreme than they actually are, and get to something like the truth by being more ‘balanced’. It is not a game I like, and I like even less being misrepresented.

Monday, 21 July 2014

Fiscal deceit

Vince Cable, the LibDem minister whose remit includes UK student finance, is apparently having cold feet about the plan to privatise the student loan book. Which is good news, because if ever there was an example of a policy designed to lose money for the public sector (or, as they say in the media, cost the taxpayer more), it was this.

As I explained in this post, if a public asset that generates income is privatised, the public gains the sale value, but loses a stream of future income. The ‘debt burden’ need not be reduced, because although future taxes will fall because there is less debt to pay interest on, they will rise because the government has also lost a future income stream.

With assets like the Royal Mail, we can debate endlessly whether the asset will become more or less efficient under private ownership. If it is more efficient, and therefore profitable, under private ownership, the private sector might be prepared to pay more for it, and so the public sector (and society) is better off selling it – unless of course the government sells it at below its market price! However in the case of the student loan book, it is pretty clear that privatisation is a bad deal for the public sector for two reasons.

First, as Martin Wolf has pointed out, the revenues from student loan repayments are very long term, and pretty uncertain. Any private sector firm that might buy this book is likely to discount these revenues quite highly, and so will not be prepared to pay the government enough to compensate the government for the lost revenue. Second, as Alasdair Smith points out, the main efficiency issue is collecting the loan repayments. Here the government has clear advantages over the private sector, because loan repayments are linked to income, and the government has all the information on people’s income, and an existing system for collecting money based on income.

So selling the student loan book is an almost certain way of increasing the ‘debt burden’ on current and future generations. As Alasdair Smith reports, George Osborne justified the sale by saying that it helped the government with a ‘cash flow issue’. As Alasdair rightly says, the government does not have cash flow issues. This kind of ludicrous policy either comes from ideological fundamentalism (the government shouldn’t own assets) or the need to meet ridiculously tough deficit targets. Whichever it is, every UK citizen loses money as a result.

George Osborne is hardly the first finance minister to play tricks like this, so how do we stop future governments from doing the same? I’m glad to see more journalists, like Chris Cook, making the points I make here. However it would be better still if an independent body, set up by the government to calculate its future fiscal position, was charged with a statutory duty to make these points. At present the OBR does not have that duty, and it feels naturally reluctant to go beyond its remit and pick fights with the government. However, if it became more of a public watchdog, with a remit to flag government proposals that appeared to lose money for the public sector in the long term, that might just stop future governments doing this kind of thing.

Thursday, 26 June 2014

UK fiscal policy from 2015

In a previous post I talked about why it made sense to keep the form of the current government’s fiscal mandate, although the five year rolling target should involve the deficit rather than the cyclically adjusted current balance. But what about actual numbers?

I start the analysis in financial year 2015/16, with the OBR’s forecast for headline public sector net borrowing (hereafter the deficit) of 3.8% of GDP. Let us also assume that the debt to GDP ratio at the beginning of that financial year is a nice round 80% (the OBR’s forecast is slightly less). That is the deficit and debt that any new government will inherit. Let us also assume that by that time interest rates are above the Zero Lower Bound (ZLB) and are more likely to rise than fall back to the ZLB. That is by no means certain, and in my view it is critical. If interest rates are still stuck near zero, fiscal policy should be aiming to speed the recovery, not reduce the deficit.

A deficit of 3.8% is too high to start bringing public debt down, and the analysis outlined here or here suggests it makes sense to bring debt down. So the key question is simply - how fast should the deficit and debt fall?

Long run D/Y %
 Alternative paths for the deficit to GDP ratio

Economic theory only really tells us one thing on this question: deficit reduction should be fairly slow, if there is no danger of default. So in the table above I look at four possible paths. In the ‘slow’ path, the target for the deficit 5 years ahead made in 2015 would be 3% of GDP. If we make the assumption that long run growth in nominal GDP is 4% a year, then maintaining a 3% deficit would stabilise the debt to GDP ratio at 75% of GDP. I think that is still too high, and for various reasons it is good to plan for a steady fall in the debt to GDP ratio over the next few decades. So the slow adjustment path involves a steady but slow reduction in deficits to 1% of GDP by 2040, which if maintained would eventually stabilise the debt to GDP ratio at 25%. The path of debt, assuming 4% nominal growth each year, is shown below.

Alternative paths for the debt to GDP ratio, assuming 4% nominal GDP growth

This ‘slow’ path is much slower than anyone is currently talking about, but I’ve included it just to make the point that it should be an option that is on the table and seriously considered. It gets debt down to a smaller share of GDP than at any time in the UK over the last two hundred years. It may do so too slowly, but it is important to discuss why it is thought to be too slow.

The path labelled medium is more ambitious in two respects. First, the five year target made in 2015 is a deficit of 2.4% of GDP rather than 3%, so the pace of deficit reduction from 2015 is more ambitious. Second, the target is an eventual debt to GDP ratio of 12.5% of GDP. So the deficit is steadily reduced to 0.5% of GDP. However both of these paths fail to noticeably reduce debt by 2020 compared to 2015. (With 4% nominal growth, and starting with debt to GDP at 80%, the deficit needs to be below 3.2% for debt to start falling).

The ‘quick’ path involves a deficit target of only 1.5% by 2020, and further reductions so that the deficit reaches its steady state level by 2025. However I assume for this path that the desired long run debt level is the same 12.5% of GDP as on the medium path. If public investment stays at around the 1.5% of GDP mark projected by the OBR, then the 2020 figure for the deficit would correspond to achieving current balance by that date.

The final path, labelled Osborne, involves the OBR’s forecasts for the deficit under current plans for 2016 and 2017, and a zero deficit thereafter. This brings debt down much more rapidly, and with a zero deficit the debt to GDP ratio steadily tends towards zero. I cannot see any logic to such rapid deficit and debt reduction, so it seems to be a political ruse to either label more reasonable adjustment paths as somehow spendthrift, or to continue to squeeze the welfare state. What it already seems to have done is shift the opposition's position towards the fast adjustment path.

Labour’s current commitment is to achieve a current balance surplus as soon as possible, and certainly by 2020. If public investment stays at around 1.5% of GDP, that would correspond to the fast path above or even faster. It is less clear what the LibDem plans would be, either in terms of numbers or rules, although Giles Wilkes suggests here that they are broadly similar to Labour's plans.

There is nothing complicated in all this - anyone can produce similar numbers on a spreadsheet. Yet they really matter. As Giles Wilkes and also Steven Toft note, achieving deficits of the kind shown on the fast path will be very painful unless growth is very strong. So where is public debate about which path is more desirable? I guess it went the same way as the public debate over austerity. As Aditya Chakrabortty aptly observes, the fiscal policy debate at Westminster is in danger of becoming like Monty Python's Four Yorkshiremen sketch.

Saturday, 21 June 2014

Fiscal rules: politics and economics

Jonathan Portes and I have an article in Prospect, which is a short summary of our discussion paper on fiscal rules (see here or here). In this post I want to use that paper to make two observations on the interaction of politics and economics.

Jonathan and I are frequently accused of being against fiscal austerity for political or quasi-political reasons: either we dislike governments that impose austerity, or we want to increase public spending and think that by advocating temporary increases in government investment at the zero lower bound we can achieve this goal. In which case we would obviously reject any fiscal rule formulated by this government, and more generally we would be against any kind of discipline on public debt or deficits.

If that is what you think, the Prospect article or the discussion paper will have you scratching your head. After a thorough analysis of the principles behind fiscal rules (on which more below), we conclude that the form of the coalitions current fiscal mandate is about right. It makes sense to have an operational target for the deficit rather than debt, and it makes sense to target that deficit always looking five years ahead.

There is one huge caveat, which is that this form of rule is appropriate as long as interest rates are not at, or expected to be at, their zero lower bound. In this recent post I outline what we recommend in our paper should happen in those circumstances, and of course current governments have (since 2010) failed to follow this advice. So our endorsement of the form of the current fiscal mandate only applies to when monetary policy can operate in a normal fashion.

Our paper also endorses another innovation of the current UK government: the formation of the OBR. In fact we suggest that it should have additional duties. So these two structural changes brought in by the coalition, the fiscal mandate and the OBR, were positive innovations. The tragedy is that the former was applied in the one circumstance in which it should have been (temporarily) abandoned.

Of course the form of the fiscal mandate is different from the actual numbers targeted for the deficit in five years time, and I will talk about those in a subsequent post. We also have some minor suggestions to improve the rule: for example if you are targeting a deficit in five years time when monetary policy is working normally, the target does not need to be cyclically adjusted, and we would target the deficit (actual or primary) rather than the current balance, and have a separate target for the share of public investment in GDP.

There is a second sense in which our paper directly addresses the interaction between economics and politics. The way I began thinking about fiscal rules was a standard way macroeconomists think about rules: how close are they to the optimal policy that would be chosen by a benevolent policy maker? This is a perfectly sensible question to ask, but for fiscal policy it is on its own hopelessly incomplete, because we also know that politicians are often not benevolent, in the sense that they act in their own interests rather than in the interests of society as a whole. As a result, we get deficit bias, although this bias may occur for other reasons. The role of fiscal rules is to a large extent to discourage this non-benevolent behaviour.

Take the current UK fiscal mandate, for example. An obvious criticism is that, by always targeting the deficit five years ahead, it allows a government to keep putting off making the adjustments required to achieve the target. Don’t worry that the deficit is above target, a government might say, in five years time it will be on target. And it could carry on saying that year after year. In the paper we say that this rule lacks an ‘implementation incentive’.

So why not make the target for some fixed date in the future, so adjustments cannot be continually delayed. The problem with a rule of that kind is that it can produce very sub-optimal behaviour as we approach the fixed date. Our macroeconomic theory says that the deficit should be a shock absorber, so having to achieve a target at a fixed date whatever shocks hit the economy could be harmful when unexpected shocks occur near that date. Imagine how much worse austerity would have been if the government had tried to achieve current balance by 2015.

Fiscal rules therefore involve a trade-off between optimality and effectiveness in preventing non-benevolent behaviour and deficit bias. The latter depends on a political judgement about policymakers. For the UK, both past evidence and current behaviour suggests that deficit bias is not a huge problem, which is why the rolling five year deficit target can work, but in other countries it might not. This is where a fiscal council like an enhanced OBR can be very useful.

Even the more responsible governments are tempted by devices that allow spending today but which shifts costs into the future (PFI in the UK for example). It is very difficult to devise fiscal rules that involve ‘operational targets’ (i.e. targets that a government can try to meet during its term of office) but also prevent such tricks. This is an important reason to do long term fiscal forecasts, undertaken or assessed by independent institutions, which is where the costs of such schemes become evident. However that alone is not enough. A fiscal council like the OBR should also have a duty to clearly alert the public when such tricks are being played. In addition, when targets are flexible so that the implementation incentive is weak (as in the case of a rolling five year target like the UK fiscal mandate), fiscal councils should also judge on behalf of the public whether meeting the target is being delayed for justifiable reasons or not.

So the choice of a fiscal rule and the mandate of a fiscal council inevitably involve political as well economic issues. However the politics is more about the transparency and accountability of government, rather than left versus right and associated ideologies.

Thursday, 5 June 2014

Privatisation and government debt

Possibly the worst argument for privatising part of the public sector is a supposed ‘need’ to reduce public sector debt. I think the problem with this argument is obvious to most economists, but as it is repeatedly ignored by politicians, it is worth spelling it out.

As I argued in a previous post, decisions to privatise or contract out should be based on considering the microeconomic pros and cons, which will vary from case to case. This analysis should include political economy considerations, like the extent of public sector corruption, or the ability of firms to extract rents from the public sector.

Suppose that such an analysis left the decision to privatise evenly balanced. Should macroeconomic factors, like the need to reduce public sector debt, ever be used to sway the decision in favour of privatisation? In our recent paper, Jonathan Portes and I argue (here or here) that a government should have some view about what the long run desirable level of public debt relative to GDP should be. Two arguments that could be used to argue for lower long term debt are that paying interest on debt requires raising taxes, which are ‘distortionary’ (they tend to reduce GDP and welfare), or that public debt may crowd out private capital and investment (assuming those are thought to be too low).

If we start out with public debt above its long run target, why not use privatisation to help get us towards that target? To see why that is nonsense, consider the two reasons for reducing debt given above. The first was to reduce the need to raise taxes to pay interest on that debt. While privatisation might reduce debt, it will also reduce future revenues or increase future public sector payments. Privatisation will either mean that the public sector loses the revenue that the privatised activity produced, or the private sector will have to be paid to undertake the outsourced activity. So the net impact on taxes will be zero.

What about the point that public debt may crowd out private investment? Once again privatisation does nothing to encourage additional private sector investment. All that happens is that existing capital and any investment that goes with it are relabelled private rather than public. No additional savings are released to encourage new private sector activity.

Consider an extreme example: Greece. The country is desperate to show that debt can be at least be brought to some sustainable level. So what is wrong with selling off some state asset, like part ownership of a water company for example, to help reduce this debt? Now there may or may not be good microeconomic reasons for doing this, but is there a good macro reason? Selling the asset would allow the Greek government to reduce its debt, but it would also have to raise future taxes, or cut future spending, to make up for the revenue lost from no longer owning that company. If microeconomic efficiency is unchanged, this sale would make no difference to the balance between taxes and spending required to make debt sustainable. Debt interest payments would fall, but so would receipts.

To make the same point another way, if we valued public sector assets and calculated the public sector’s net asset position, privatisation would have no effect on that net number. So why should anyone think that the position of the Greek government had been improved by this asset sale?

Obvious though this point may be, it illustrates a problem with most fiscal policy rules. Most rules need to involve what Jonathan and I call realisable operational targets: goals that politicians can aim for (and be judged by) within the lifetime of administrations and parliaments. Privatisation is one of a number of devices that flatter the short term public finances with no impact (or worse) on the long term position. (Considerably worse if the asset is sold far too cheaply, as in the most recent UK case for example.) Because fiscal rules inevitably focus on the next few years, politicians will always be tempted to use these devices to in effect cheat those rules. This is why it is vital to have effective fiscal councils to work alongside any rules. These independent institutions need to be able to shout when they believe only the letter and not the spirit of these rules is being met. The UK’s fiscal council, the OBR, does not have this kind of mandate, and can therefore only note when policies have this kind of effect (see here, paras 1.8-9).  

Wednesday, 11 December 2013

The UK’s macroeconomic battleground to come

The Institute for Fiscal Studies’ (IFS) analysis of the specific measures in the Autumn Statement shows a certain degree of frustration. From their (economists) perspective, there seems no unifying theme or direction. For example transferable allowances for married couples adds a complication to the income tax system, without providing a major incentive. Free school meals for all children in the first 3 years of primary school benefits better off parents, as those on low incomes can already claim.

And then there is the continuing squeeze on the size of the state. The government has already reduced the share of government consumption in GDP, but that is nothing compared to its plans for the next five years, as I note here. It is pretty clear that both the IFS and the OBR regard this plan as incredible - it just will not happen. So what is the point in putting forward a plan for an unrealistically massive cut in the size of the state?

I am sure both organisations know why, but cannot say. It is, as ever with this Chancellor, all about the politics. For example, when it comes to the specific measures, the married couples allowance is an attempt to neutralise the impact on some conservative supporters of the Prime Minister’s support of gay marriage! Other popular tax giveaways are funded by ‘cracking down’ on tax avoidance - a win-win combination in political terms, even if the numbers might be unrealistic. In terms of the big picture, the Chancellor wants to ensure that Labour cannot pledge to match his spending, tax and deficit plans. As a result, he will be able to go into the next election accusing the opposition of either being dangerously imprudent, or planning tax increases.

Is this not a dangerous hostage to fortune? If the Conservatives win the next election, will this mean that they will have to admit their previous plans were hopelessly unrealistic? Perhaps, but I suspect the OBR’s assumptions about the output gap will be too pessimistic, and so economic growth will bring larger than expected falls in the debt to GDP ratio. So even if the Chancellor does not achieve cuts in government spending on the scale planned, deficit targets might still be met.

In a rational world (i.e. one where the economics made sense) the opposition could argue that the government’s plans aimed to cut debt too fast. But the ‘too far, too fast’ argument has already been judged to have failed by the political class, which has swallowed the myth that Labour’s fiscal policy played a large part in creating our present problems. So Osborne hopes that his unrealistic plans will paint Labour into a difficult corner, and the LibDems for that matter.

Yet it is far from obvious that this trick will work this time. Labour can take these numbers at face value, and say that they can only be achieved by cutting funding to the NHS, or education (see Declan Gaffney here - HT Alex Marsh). While government austerity may (perversely) be accepted in bad times, when the economy is growing it may be more difficult to argue that we cannot afford to maintain existing levels of public spending.

The government’s attempts to gain political advantage where none should lie also tie its hands. Labour’s major theme at the next election will be the decline in living standards for most income groups. This in turn is largely down to the UK productivity puzzle. It is not obvious that this decline in productivity growth is the result of government actions. Yet, as I note in this Free Exchange piece on the Autumn Statement, the government’s attempts to claim credit for growth in employment means that they cannot publicly address the subject of the productivity puzzle, still less argue that it is none of their doing. Here is a slightly amended graphic from my Free Exchange commentary that might look good on a Labour Party election billboard.

Conservative Lessons in Lost Output

So the battleground for the next election is set out. Labour will argue that living standards have shown an unprecedented decline (true), and the fault for this can be laid at the government’s door (half true at best). The Conservatives will argue that austerity has enabled the economy to grow again (false), and that continuing growth requires yet more austerity (completely false). Which will win out will be fascinating if you are interested in political spin, but it will all be pretty excruciating for any macroeconomist.

Thursday, 10 October 2013

Why I am obsessed by austerity

Chris Giles of the FT says about the austerity debate:
“What is important is that all this gnashing of teeth is beside the point. The numbers are small. For example, let us have faith in Profs Jordà and Taylor’s estimate for a moment. Output is 18 per cent below the 1997-2008 trend, so the effect found by these academics represents a sixth of the total. Is 3 per cent still not large? No.” 

This is right in one sense, but wrong in four. If the aim is to explain why UK output is so far below trend, then looking at fiscal policy is not going to get us very far. We need to look elsewhere: maybe at why consumers are saving so much more than they used to, or why UK productivity has fallen so far. Yet, although I have written posts about these things, I have written much more about fiscal policy. Why?

The first reason Chris Giles is wrong is that 3% of GDP, or whatever it is, is an awful lot of money and resources. In my post on the Jorda and Taylor estimates I put the total cost of austerity from 2011-13 (roughly 1% of GDP in 2011, 2% in 2012 and 3% in 2013) at £3,500 per household.  I would not call that unimportant. Think of all the hospitals and schools that could be built with 6% of annual GDP (nearly £100 billion).

Or instead, let’s take the more conservative estimates recently provided by the OBR in the nice chart below. Jonathan Portes has already discussed the paper from which this comes, so let me just explain the colours and dig out the numbers. This looks at the impact of discretionary fiscal policy (changes the Chancellor actually makes) in successive years. The blue bar in 2009/10 shows the expansionary impact of the Labour government’s attempts to moderate the recession, which had a continuing positive impact (according to the OBR’s calculations) in subsequent years. But in 2010/11 this was outweighed by fiscal tightening in that year (light brown), some of which was already planned by Labour, but which the coalition added to. And so on. So if you add the light brown, green, red and yellow areas, you get the total impact of fiscal tightening on output from 2010-13, which is a bit above 5% of GDP. Not as high as 6%, but still an awful lot of money. And the cost goes on, as the chart shows. Now is not the time to get into detail about how these numbers are estimated. In particular, they are ‘expectations naive’, in that they assume policy has no impact when it is announced, but only when it happens. But however you estimate the numbers, any reasonable evidence based estimate is going to have the same order of magnitude – it is always going to be a huge economic cost. And that is not counting additional costs, in terms of the distribution of income, or the lasting damage of long term unemployment, or health.

The second point is that this was something where the government had a choice. Most of the time GDP changes for reasons that governments have very little control over, except perhaps in the longer term. If GDP is low because banks, firms and consumers are adjusting their balance sheets, there is very little the government can do to stop them. (Monetary policy can try to discourage them making this adjustment too quickly, but as we know, interest rates cannot go below zero.) But discretionary fiscal policy is, by definition, directly under the government’s control.

Which brings me to the third reason why Chris Giles is wrong. The baseline here should not be ‘doing nothing’. There is nothing that says the best the government could have done was to be fiscally neutral in terms of GDP impact. As we can see, in 2009/10 we had fiscal stimulus, and this could have continued. Now of course there is a debate about how far fiscal stimulus could have gone: would the impact on inflation have been too great, or would the financial markets have panicked in a way that would have been harmful to the economy. But 6%, or 5%, is just the positive harm that government policy has done – it might have instead done some positive good.

The fourth reason why I, and maybe others, might be a little obsessed about austerity is that governments, and regretfully a few economists, have tried to deny that austerity has had any impact at all. The public debate has often been about the sign of these effects rather than their size. When governments appear to ignore or contradict the bread and butter macro that academic economists teach their students, then I believe these academics have every right (and indeed a duty) to get a little hot under the collar.

This is the other reason that I wanted to display this chart. In the past, both the Prime Minister and the Chancellor have been the first to quote the numbers crunched by the OBR when it suited them. So let them be consistent and honest. Why not say that the OBR estimate that their fiscal actions have kept GDP well over 1% lower than it might have been each year since 2011, and that this will continue, but that this is worth it because it prevented a debt crisis (or whatever). And if they will not do that, why cannot journalists quote these OBR numbers when discussing the merits or otherwise of austerity. Then let the people decide whether these numbers really are as small as Chris Giles suggests.   

Tuesday, 24 September 2013

Labour’s OBR Proposal

It is not the stuff of headlines, but Ed Balls conference speech contained an interesting idea for extending the remit of the Office for Budget Responsibility (OBR). Although this could in theory have major implications for the 2015 debate on UK fiscal policy, I suspect in practice it will not. But first some background.

Labours failure to contest the profligacy myth

In the year after the 2010 election, the new government relentlessly plugged the line that Labour’s past fiscal profligacy was central to the need for current austerity. It was a smart line to push, so it didn’t worry those making it that it was not true. I’ve documented the facts in a peer reviewed article, in various blog posts, in a debate with Jeremy Warner (follow links back from here), and elsewhere. I have no political interest in pursuing this point, beyond a perhaps naive belief that evidence should not be distorted for political ends.

Preoccupied with electing a new leader, Labour did little to counteract the myth at the time. Whether they could have done anything in the face of a largely right wing press I do not know, but the result had two key negative consequences. First, there was no effective political opposition to austerity. Second, Labour or its supporters fell over themselves any time they were asked whether their proposals might lead to additional borrowing. It is also clear that the government will return to this line of attack in the next election, meeting any policy proposal that involves spending money with the accusation that this signifies a return to Labour’s profligate ways.

The OBRs remit

The OBR is a ‘fiscal council’ or ‘independent fiscal institution’ established by the current government, of which there are now many international examples. (Calmfors and Wren-Lewis analyse in detail eleven that existed in 2011.) The two most longstanding are the CBO in the US and the CPB in the Netherlands. Both these institutions can cost opposition as well as government fiscal plans, if they are requested to do so, although the CPB approach appears less open to political game playing than the CBOs. The OBR has a much more restricted remit: it can only cost the governments announced fiscal plans.

Labours new proposal

Ed Balls will ask the OBR to cost the fiscal proposals it puts to the electorate in the 2015 election. If the OBR did this, this would either expose Labour’s dodgy fiscal arithmetic, or deflate claims their proposals were not properly costed. As Labour would do its utmost to prevent the former, this looks like a smart move politically. I also think it would improve the level of the macroeconomic debate, which is why I have often suggested the OBR might be given this role.

The only problem is that the OBR cannot say yes under its current remit, and it would also need additional resources to undertake this. In theory the remit of the OBR could be extended before the next election, but the government will block this, because it does not want to lose a valuable political weapon. (The block will probably come in the form of some delaying tactic, perhaps linked to a formal review of the OBR’s performance after 5 years.)

So Labour will not be able to say that its plans have been costed by the OBR, but only that it is happy for the OBR to do this. As it knows this offer will not be taken up, its political force appears weak. I cannot help but remark that this shows how foolish Labour was in government to reject the idea of a fiscal council. If they had created a fiscal council with wider powers than the current OBR, they would be in a much stronger position now.  

In practice, therefore, anyone seeking the facts on the fiscal plans of the opposition during the election will have to turn to the expertise at the widely respected Institute of Fiscal Studies (IFS). So for 2015, not much will change. But in the longer term the momentum for extending the OBR’s remit is building, which I regard as a very positive development.

Tuesday, 18 June 2013

Bold macroeconomic policy changes for a new government

One of the features of the incoming 1997 Labour government was that it undertook significant and progressive changes in macroeconomic policy. Not only was it right to give independence to the Bank of England [1], but the institutional framework they created for this was innovative and effective. As I have written recently, the fiscal framework established a year later was also clear and progressive compared to past practice and what was being done elsewhere.

So could the government that gets elected in 2015 be equally bold? I think it could be. Furthermore, the suggestions I make below apply to many advanced economies. Yet why look two years ahead now, when recovery from recession is either far from complete, or for many countries has not begun? One reason is that the lags in policy making can be quite long. A new government will not have spent the year before an election working out its policies - it will have been too busy campaigning. Policies get decided much earlier. To have a chance in that decision making process, ideas need to be bounced around earlier still.

On monetary policy, the new government needs to acknowledge that the recession has indicated clear problems with the inflation targeting regime. Three things need to change. First, the medium term inflation objective should be accompanied by an objective of minimising the output gap - in other words the UK should have a dual mandate like the US. Second, nominal GDP should be adopted as an intermediate target, to guide the MPC as to how best achieve these two objectives. Third, the inflation target of 2% is too low, because it increases the risk that we will soon suffer another Zero Lower Bound (ZLB) recession. In the UK the government fixes this target (which is one reason why the 1997 decision was progressive), and it should raise it. All of these changes will assist the process of recovery as well as help in the longer term.

On fiscal policy, we have to distinguish between policies pre and post recovery. If the government inherits an economy where the interest rate set by the Monetary Policy Committee is still at 0.5%, then its priority should be fiscal policies that promote recovery. I agree 100% with Paul Krugman that governments around the world have needlessly confused long term issues involving debt with this short run priority: here is one of many posts I have written arguing this. Yet the incoming government should also have a fiscal strategy post recovery.

This should involve both rules and institutions. Whatever fiscal rule is adopted, it should make three things clear. First, it does not apply at the ZLB. [2] Second, it should focus on a long term objective of reducing the debt to GDP ratio. Third, deficits have to be flexible in response to shocks in the short term. Now how you square these three things is tricky, and I still have an open mind on this, but for the moment you should read this very interesting proposal from Tony Dolphin at the IPPR as to how it might be done. That proposal utilises an enhanced UK fiscal council (OBR), which is the institutional leg of the reform.

Before discussing that, however, I want to say a bit more about why the policy goal should be to gradually reduce debt to GDP. I would give four main reasons. First, it allows room for fiscal policy to support monetary policy if it again hits the ZLB, without worrying about the bond markets. Second, it reduces real interest rates, which should encourage private investment (although the more open the economy the smaller this effect will be). Third, it reduces future distortionary taxation. Finally, future generations will need all the resources we can give them to help cope with their inheritance of hugely disruptive climate change.[3]

In the context of similar proposals from Hopi Sen [4], Chris Dillow recently raised some doubts. Some of these relate to the short term position: yes, investment probably responds more to expected future growth than the cost of capital, but with an active monetary policy, reducing debt to GDP should not inhibit growth. A more serious concern is that reducing real interest rates might increase the risk of hitting the ZLB, which is one reason why I propose raising the inflation target. [5]

The current government should be credited with setting up the OBR, but it did so with a very restricted remit. The OBR is not allowed to crunch the numbers on alternative policies, so it cannot even produce the raw material on which others can propose advice. Perhaps this made sense to avoid throwing a new institution into the middle of a fierce political debate in 2010, but it does not make sense in the longer term. At the very least the OBR should be given the freedom to look at alternative fiscal policies, but its role could go further still, as the IPPR proposal suggests.

[1] I should confess that before 1997 I was very dubious about central bank independence. In retrospect that was because I did not have the imagination to see how that the institutional set-up could be crucial. Despite my recent criticisms, I think the MPC has done much better than elected governments would have done. However my fears were that we would get something more like the ECB, so they were not groundless. I also worried that an independent central bank might be too conservative in the Rogoff sense, and that concern has also been realised

[2] Or equivalently, there should be a rule that directs policy in very different ways at the ZLB.

[3] In an ideal world, we would be dealing with climate change now, and perhaps - as I discussed here - using higher government debt to help pay for it. However we are not, and it does not look like this is going to change any time soon.
Postscript 24/6/13: As well as leaving capacity for fiscal stimulus after a large negative demand shock, Obstfeld argues that we need low debt to leave capacity for a (partial) bail out of the financial sector.

[4] I obviously disagree with Hopi on how the Labour party should respond to the myth that their fiscal mismanagement was responsible for the UK’s current plight. If you want to get into the apology idea, then it seems reasonable that governments should only apologise for major errors rather than every particular thing they could have done better. As I have argued before, there is no comparison between Labour’s fiscal errors and the current government’s mistakes. Governments that commit errors that go against expert opinion at the time bear a particular responsibility. Few (myself included) raised objections to the constant 40% debt to GDP ratio when it was adopted in 1998.

[5] In the UK I suspect that the main short term impact of a tighter fiscal regime will be a depreciation in the exchange rate rather than lower interest rates. In the context of the last Labour government, I think that would have been helpful.