Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday 15 February 2012

Can Nothing Be Done?

Or why is no one talking about balanced budget expansion?

                As UK unemployment continues to rise, Jonathan Portes asks why the government seems to accept this as inevitable. The same question could be asked in many other countries. The answer is invariably that nothing can be done by way of fiscal stimulus because debt and deficits are so high. Jonathan argues (rightly in my view) that concerns about debt in the short term are hugely exaggerated. I’ve suggested this is particularly true when we have Quantitative Easing. We seem to be in a strange prisoners dilemma where it is absolutely clear that the world wants more safe assets (the rate of interest on indexed debt is zero if not negative), but every individual government thinks that if it provides them lenders will suddenly panic, and think they are no longer safe.
                I think this fear is irrational, but unfortunately events in the Eurozone feed this fear on a daily basis. (It should not, because governments without their own central banks are in a different position from those that have, but that is a rational argument.) Taking notice of ratings agencies is also irrational (see Jonathan again), but it adds to the fear. So even though I think it is fairly easy to win the intellectual debate on debt, this may not be what is decisive.
                If governments believe that they cannot add to government debt and deficits, does that mean nothing can be done? Absolutely not. A temporary increase in government spending financed by an increase in taxes will still raise demand. First year economics undergraduate students will know about the balanced budget multiplier of one: every £1 spent by the government will lead to £1 extra demand, because what consumers lose with lower taxes they gain through higher income. Readers of Michael Woodford (2011) will know that we get exactly the same multiplier with much more sophisticated consumers, if real interest rates are fixed. (I try and explain why here.) So it does not matter what sort of consumers we have, the tax increase comes out of saving, and so demand and output rises by the full extent of the spending increase. (For those who think lower savings will mean lower investment, see here.)
                The news is better still if interest rates are stuck at the zero lower bound. Higher demand and output will imply some increase in inflation, and any increase in expected inflation will reduce real interest rates, further stimulating activity. The size of the multiplier will be above one.
                So there is something we can do with fiscal policy, without increasing government debt. Why does hardly anyone talk about this? (One exception is Robert Schiller.) I suspect the problem is as follows. Those favouring stimulus think debt is not a constraint, and know that there are many reasons why a fiscal expansion financed by issuing more debt will be even more expansionary that one financed through taxes. So why argue for second best? But why do those who do think debt is a constraint not welcome this alternative possibility of raising demand? The reason is obvious:  a tax financed fiscal expansion requires taxes to rise.
                The problem is not an economic one. The distortionary effects of temporarily higher taxes are likely to be small relative to the resources wasted and permanent damage caused by high unemployment. (See Chris Dillow as well as Jonathan Portes on this.) The problem is political, particularly for countries with right of centre governments. However, just because something may be politically difficult should not stop the argument being made.
                Once we get on to this territory, then there is further ground to explore. As well as tax financed government spending, we could think about tax and transfer switches that would stimulate demand. The marginal propensity to consume out of a benefit increase is likely to be quite high, whereas that out of reducing the tax relief on pension contributions for high earners would be pretty small. (Remember any tax switch need only be temporary.) Redistributing money from the old to the credit constrained young would also be likely to raise demand: raise child benefit by increasing death duties, for example. Some companies are not that short of cash at the moment: how about tax incentives to encourage them to invest today rather than tomorrow.
                The idea that there is no alternative to doing nothing about rising unemployment could not be further from the truth. If governments find objections to all these ideas, one might begin to suspect that there are other motives at work.


  1. “Other motives at work”? I suggest c*ock up theory beats conspiracy theory nine times out of ten: the explanation is plain ignorance – no?

  2. "The news is better still if interest rates are stuck at the zero lower bound. Higher demand and output will imply some increase in inflation, and any increase in expected inflation will reduce real interest rates, further stimulating activity. The size of the multiplier will be above one."

    This seems to imply balanced-budget stimulus would be effective even if we were not at the ZLB. Although that's technically possible, I think it's a bit misleading. Woodford's paper shows that the multiplier would be less than one if you take into account the central bank's response to control inflation. In the case of a strict inflation target, the multiplier is the same as for the flexible-price model. My understanding of that is that it's entirely due to the increase in labour supply due to people feeling poorer as they face higher taxes. That seems to me to have little relevance to the real world, so the implication would be that in normal circumstances the multiplier would be close to zero.

    1. I enjoy reading your well informed comments, but this one is I think a bit wide of the mark. Arguments that say fiscal policy is ineffective because it can be counteracted by monetary policy are rather weak in the current situation. With inflation falling and an additional batch of QE, it seems very unlikely that the Bank would respond to fiscal stimulus by raising nominal interest rates, let alone real interest rates.I read the current UK situation as one where the Bank would like to stimulate the economy more, but is not at all confident that it can do as much as it would like through QE.
      As I have said before, you would not normally be interested in fiscal policy as a stimulus tool in a situation where monetary policy was unconstrained. So in that sense, the size of multipliers when the monetary authority is able to achieve the inflation target (which implies, in these models, output is at its natural rate) are beside the point in the current context.

    2. Yes, I agree with everything you say here.

      My objection was to the paragraph I quoted, in which I thought you were implying balanced-budget stimulus would be generally effective, and moreso in the present circumstances. Obviously I was wrong!

  3. We've proposed a plan along these lines today, involving a £15bn p.a. mix of cuts to transfers for the better-off and tax rises on savings policies for the most wealthy.

    The government needs to implement another £15bn of tightening by 2016 anyway, and delaying the decision raises credibility issues the closer we get to the next election. Why not cut/tax and switch now?

    Very interested to know your thoughts.


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