More on climate change and budget deficits

When I wrote this, I was reminded of a rather different but clearly related argument that I have seen the Oxford philosopher (but also economist) John Broome make,[1] although its fullest exploration is probably by Duncan Foley (pdf)[2]. The Stern report clearly suggests that incurring the costs of mitigating climate change today will raise the utility of future generations by more than it reduces ours.[3] However the current generation appears unwilling to incur these costs.[4] Let us call the ‘status quo’ the situation where nothing much is done to prevent climate change, and so future generations suffer as a result.

Broome and Foley suggest that a Pareto improvement is possible compared to the status quo. (A Pareto improvement is a change where some people are better off, but no one is worse off.) This would involve taking measures today to mitigate climate change, but getting future generations to pay for it. How can this trick be pulled off? Following the logic of the arguments I discussed here and here - that government debt involves a transfer between generations - we could pay for climate change mitigation by issuing government debt, which would be redeemed by future generations. Reducing CO2 emissions would not cost us anything, because the money to pay for it would come from selling government debt to the young. The cost would fall on future generations, who would have to pay the higher taxes to either service the extra debt or pay it off. The Stern report suggests future generations would prefer this outcome to the status quo, because they would be prepared to pay to reduce climate change. It is therefore a Pareto improvement compared to the status quo. Let’s call this the ‘debt solution’.[5]

Now there is one immediate and powerful objection to the debt solution, which is that future generations have to pay for something that this generation is doing. It violates the polluter pays principle. This makes the debt solution unfair or unjust. It would be fairer if the current generation incurs the cost of mitigating climate change, just as it is right for a company that pollutes a river to pay to clear up the pollution. Let us call this the ‘just solution’.

The Stern review recommends that we move from the status quo to the just solution. Unfortunately so far most governments, individually or collectively, seem unwilling to do this. In these circumstances should we instead at least start by implementing the debt solution, and then work on achieving the just solution? Broome suggests “we should not encumber the process of controlling climate change with the quite different matter of transferring resources to future people.” That is a controversial suggestion: many will feel that giving governments that option will reduce the chances of achieving the just solution. But perhaps this is an example of where the best is the enemy of the good.

     

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[1] Broome’s paper is mainly about how we value the hopefully small chance of total catastrophe, but the argument discussed in this post is made early on in that paper.

[2] Foley, D. 2007. The Economic Fundamentals of Global Warming. Working paper 07-12-044. Santa Fe, New Mexico: Santa Fe Institute.

[3] Stern argued that it was ethically wrong to value the utility of future generations less than our own. He values their consumption less, because they will be better off and so require more consumption to achieve a certain level of utility. Stern’s report was controversial among many economists because they prefer to follow the supposed ‘revealed preference’ of the current generation to discount the utility of future generations.

[4] The qualifier ‘appears’ is important here. My own, relatively uninformed, view of the politics is that policy in this area is guided by particular vested interests, rather than the collective view of the current generation. If it was the case that the current generation was simply unwilling to make a present sacrifice for future benefit, why is so much money spent on trying to discredit the evidence about climate change?

[5] Government debt probably crowds out productive capital to some extent, but this could be offset if the money spent today involves increasing capital, in the form of renewable energy generation for example.

The UK and Austerity: some facts

There has been some recent debate about whether UK austerity is responsible for the poor performance of the UK economy (which remains poor, despite the Q3 growth numbers). The debate could be summarised thus:

Austerity Critics (e.g. Paul Krugman): “The UK has gone for strong austerity, and since it did so GDP has stagnated – told you so.”

Austerity Apologists (e.g. Tyler Cowen): “But if you ignore tax increases, and public investment, actually there has not been much austerity. The weakness of the UK economy reflects other factors.”

So, for those who are confused, here are some facts.[1]

Austerity can involve tax increases, cuts in transfers and spending cuts, so it is natural to look at the overall deficit. As I have suggested before, the best figure for the direction and impact of policy is the cyclically adjusted primary deficit. Both IMF and OECD estimates show substantial austerity.

UK Cyclically adjusted primary deficit

	2010	2011	2012	2013
IMF[2]	-6.1	-3.9	-2.8	-1.5
OECD[3]	-5.8	-4.1	-3.0	-1.9

However any deficit figure may not be a good guide to the aggregate demand impact of policy, because many tax and transfer changes will have smaller multipliers than changes in spending on goods and services. As I noted here, the IMF suggest that UK austerity over the full 2009-2013 period is relatively focused on government spending rather than taxes. However what about 2011 and 2012 in particular? The table below looks at the government spending on consumption and investment numbers that go into the national accounts.

Growth Rates in UK Government Spending on Goods and Services, and Employment

Government consumption		2011	2012	2013
	OBR March	0.3	0.5	-1.1
	OECD June	0.1	-0.7	-1.8
Government investment
	OBR March	-13.0	-5.0	-3.6
Government employment
	OBR March[4]	-4.0	-2.0	-1.9

The OBR’s forecast is quite old, but the new one will not come out until 5^th December. I’ve included the OECD’s June numbers because their 2012 figure is a clear outlier compared to other forecasts, and because many people (myself included) use these forecasts. If they are right it will make a significant difference, but for the rest of this post I’ll assume they are not, and use the OBR numbers.

Government investment makes up only about a tenth of government spending on goods and services (G for short), so putting the two together the OBR numbers suggest a fall in G of 1% in 2011, about flat in 2012 and a fall of almost 1.5% in 2013. So, the ‘contribution to growth’ of G to GDP is to reduce it by a bit more than a quarter of one percent in 2011 and 2013, with no impact in 2012. (OBR forecast (pdf), Table 3.4.)

However this ‘contribution to growth’ number in effect compares what actually happens to a counterfactual in which there was no growth in G. A better counterfactual is if G had increased by, say, 2% a year in each year, which would be a kind of neutral, average sort of figure.[6] On that basis cuts in G directly reduce total GDP by about three quarters of a percent in 2011 and 2013, and by half of a percent in 2012. If the multiplier was only one, these are still big numbers, but if it was two they become really large. It would mean that the UK economy might have grown by over 2% in 2011 rather than by less than 1%, without allowing anything for the impact of higher VAT.

So whichever way you look at it, it seems that austerity has had a major impact on UK growth. Of course other things have been important too, but I’m not sure anyone has actually claimed that austerity is the only thing holding back the UK economy.

But in one important sense this is all beside the point. Those who criticise austerity only require three things to be true:

(1) Austerity is real, rather than something imaginary. The figures above make that clear.

(2) Multipliers at the Zero Lower Bound are significant.

(3) If we had not had austerity, monetary policy would not have offset stronger growth.[5]

This is why the multiplier debate is so important. There is a lovely non-sequitur in Chris Giles FT piece on this recently, which Jonathan and Richard Portes have already commented on. Chris correctly notes that theory suggests that multipliers are larger if interest rates are stuck at zero, and then says “so theory tells us very little about the likely effect of fiscal policy on economic growth”. As I have argued many times, theory is pretty clear that multipliers on G will be greater than one in current circumstances, and could be a lot greater than one. And as Paul Krugman quite rightly keeps reminding us, it is theory that has stood up pretty well since the crisis.  

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[1] My thanks to Jonathan Portes for some discussion on this issue, but I alone am responsible for what appears here.

[2] Source: IMF Fiscal Monitor October 2012 Statistical Table 2.

[3] Source: OECD Economic Outlook June 2012.

[4] Final quarter of financial year, so 2011 figure is actually 2012Q1/2011Q1.

[5] Unfortunately we cannot be certain that (3) is true, as I have discussed before. However we cannot be certain the other way either, which is sufficient in my view to continue to criticise UK austerity. 
[6] Postscript. We are interested in why the UK economy did not grow by, at the very least, 2% pa. So the natural counterfactual is where G grew in line with GDP at 2%. It is nonsense to say that G did not contribute to zero growth because it also did not grow. 

A political economy argument for economic policy delegation

In a previous post I talked about an example of the pernicious impact that politics can have on academic economists, and promised to write something on how this might be avoided. (For a more recent example, see here.) Now one response to this is to shrug ones shoulders and say it is inevitable given the nature of the discipline. It would certainly be naive to imagine economics could ever be free of ideological influence.  However I do not think it is unreasonable to try and discourage situations where evidence is distorted, and in particular to try and avoid occasions where minority views are turned into policy because they happen to fit certain political prejudices.

As I have argued before, you cannot rely on the media to do this. Much of the media actually encourages this problem, by giving minority views equal airtime. One of the really depressing developments over the last decade has been how, when the issue of climate change is in the news, the media often tries to ‘balance’ the views of some climate change scientist with someone from the climate change denial community.

In the case of climate change, one way that scientists have tried to overcome this problem is by ‘learned societies’ issuing reports. In the US we have the National Academies, and in the UK the Royal Society. Now it is interesting to wonder whether economics could ever do something similar, but you also have to ask how much that would achieve. As I have noted before, no amount of expert opinion stopped certain newspapers in the UK hyping the imagined link between the MMR vaccination and autism, and many politicians worry more about what is in newspapers than what academic opinion says. Some may even encourage erroneous fears for political ends.

The problem in essence is this: on some issue with a significant technical content (i.e. requiring expertise), there is a clear majority amongst academia on what the answers are, but also some minority opinion suggesting something different. Answers are correlated with political preferences, so politicians pick the answers (and the advisors) that suit those preferences, whether they are in a majority or minority. They face no comeback from the media, who instead encourage the view that there are two, evenly populated, sides. Now of course occasionally the minority view will turn out to be the correct view, but most of the time it will not be. So how do we give more weight to the majority view?

One answer is institutional delegation. The government sets up a permanent body (or enhances an existing body) with the remit to focus on the contentious issue. By establishing the institution itself, it gives it political authority. The institution is designed as far as possible to be politically neutral: indeed its survival to some extent depends on this, because it wants to outlive any particular government. It is designed to be transparent, which should help it to be resistant to lobbying interests (including lobbying by the government). It may contain the expertise on the issue, or it may find that expertise within places like the academic community. Because it is non-partisan it can sort expertise from opinion, and distinguish between majority and minority views.

The obvious example we have in macroeconomics is monetary policy and central banks. In some ways this delegation was quite easy, because the institution already existed, and it had operational control. However in other respects it was more difficult to achieve, because delegation involved giving complete power to the institution to determine policy. Governments just set some general parameters, and sometimes a specific target. Independent central banks are far from perfect, but if you think returning monetary policy to governments would be a step forward, have a look at some of the strange ideas gaining political currency in the US.[1]

By delegation I do not just mean politicians giving up control. Instead the institution can be charged with providing expertise and advice. The macroeconomic example here is the fiscal council. The advice they provide may be quite specific and limited (as is the case with the UK’s OBR with macro forecasts) or more general and wide ranging (as with the CPB in the Netherlands). There is no obligation for the government to follow that advice, but it may bear a significant political cost if it does not do so because the fiscal council has been established by government to provide authoritative advice.

Sometimes a private institution can emerge to fulfil a similar role, such as the Institute for Fiscal Studies in the UK. However, this role can easily be contested, by think tanks that have a clear political agenda. Here competition is a problem. We already have plenty of competition over ideas: the failure is in getting the better ideas adopted as policy. Whether delegation of advice can be effective will depend on the political system in place. In countries where large sections of the media can be bought, there is less cost to ignoring such institutions, as the experience of the CBO in the US shows (although the effectiveness of the CBO could be improved, as I suggested here). However in other countries with a more politically independent media, there is a greater political cost in overriding advice from independent institutions set up by government.

Macroeconomists have a standard argument for delegation in the case of monetary policy, and various reasons why fiscal policy may be subject to a deficit bias which delegation might avoid. What I am suggesting here is a more general argument for delegation (which goes beyond economics) in cases which mix technical expertise with political controversy.

A particular example where such delegation could be useful is fiscal policy and demand stabilisation. This involves not just the austerity versus stimulus debate, but the macroeconomics of how best to achieve debt reduction with as little damage to growth as possible. One argument against delegating decisions or advice in this area is that the academic community is too evenly divided. I would make two observations. First, I find much less division about fiscal stabilisation policy among those that work in this area than among macroeconomists more generally. Second, would there be so many arguing for austerity today if it was not for the politics of the moment? (Recall that the previous US President used countercyclical policy arguments as part of the case for tax cuts.)

I used to think that fiscal stabilisation issues could be delegated to the central bank, because they know all about demand stabilisation. [2] However the obsession in many central banks with budget deficits probably makes this a bad idea (see the Netherlands). It could be a supranational body like the IMF. But at a national level the obvious alternative is a fiscal council. A fiscal council’s main focus is long term debt control, which is an important issue in its own right (which is why I wrote this) and is sufficient justification to set up such a body. But although the focus of their work should be on the long term, in practice they find they have to spend some proportion of their time (often a very large proportion) on shorter term issues. As a result, the possibility of short term fiscal demand stabilisation could fall within their remit. They can be the apolitical institutional filter that can sort out majority from minority opinion within academia.

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[1] In some ways the current debate over fiscal policy reminds me about how monetary policy used to be debated thirty years ago. To which many would say that with monetary policy we know better now, but I think one reason why our understanding has improved is the role central banks play in fostering this knowledge.

[2] The way the proposal would work is that central banks would be allowed to change a select number of fiscal instruments on a temporary basis. The time spans involved, and any limits on the size of changes, would be established by government. When I once argued for this before a committee of UK MPs, to say the idea was not popular among those MPs would be a definite understatement. I did wonder at one stage whether they might ask for the Serjeant-at-Arms to take me to the Tower for undermining Parliament.  

A short answer to Tyler Cowen’s question

The question, following the observation that UK real wages have fallen substantially, is “In the traditional Keynesian story, stimulus lowers real wages through nominal reflation.  Is that the Keynesian view here?  If so, why do Keynesians believe that British real wages need to fall more than 8.5%?”

Actually I think this question has nothing especially to do with the UK, and a great deal with Keynesian theory, or at least how Keynesian theory is often taught. The problem in the UK and nearly everywhere else right now is lack of aggregate demand, not the level of real wages. Why, asks Tyler, are not more workers being hired if real wages are so low? Well low real wages are having some effect – it is one factor behind the ‘productivity puzzle’ that is widely discussed in the UK. But when the problem is aggregate demand, low and declining real wages will not ensure ‘full employment’. Firms may employ more labour, but there is no reason to expect the labour market to clear.

I think what lies behind this question is the idea that aggregate demand matters because sticky wages are preventing the labour market clearing. So, to rephrase Tyler’s question, falling UK real wages do not look very sticky, so where is the problem? When I was studying macro, there were these debates about whether it was sticky wages, or sticky prices, which underpinned Keynesian theory.

The answer I would give, at least at the zero lower bound under inflation targeting, is neither. To get technical, imagine a toy model with imperfectly competitive firms who set a constant mark-up on labour costs, and a linear technology. Nominal wages could fall forever, but firms would cut prices to match, so the real wage would not change. So the question is then whether falling prices will raise aggregate demand. But why should they, particularly if nominal interest rates are stuck at zero, and the central bank puts a lid on expected inflation.

The price that is ‘wrong’ when aggregate demand is deficient is the real interest rate. This is one area where New Keynesian theory has helped sort out old Keynesian confusions. If falling wages and prices do nothing to change real interest rates, then aggregate demand need not rise. And if aggregate demand does not rise, unemployment can persist. But at the zero lower bound, with a central bank mandated to target inflation (and a government showing no signs of changing that mandate), the real interest rate cannot be reduced. So expansionary fiscal policy is needed to raise demand, not lower real wages. Or, in the case of the UK at the moment, contractionary fiscal policy is currently reducing demand and therefore output.

Austerity, debt burdens and hypocrisy

After the weekend march against UK austerity, I saw a government minister on the TV justifying their fiscal plans. One of the arguments he used was that it was necessary for the sake of our children. In these circumstances I can quite understand the urge to dismiss such arguments as invalid. Part of this urge comes from knowing that, in many cases, the argument about debt being a burden on future generations represents simple hypocrisy.

How do I know this? Because often exactly the same people championing austerity also argue that we cannot take action to reduce future climate change because the current costs will be too great. The UK government’s spin was that it would be the greenest government ever, but its policy is quite the opposite. The Republican Party in the US also resists any action to reduce climate change because of the current costs of doing so (at least when they are not denying climate change exists). The connection? Both issues involve trading off costs to the current generation (austerity, measures to reduce climate change) with costs to future generations (higher taxes, climate change itself). If you really believe that we must reduce debt right now (rather than after the economy has recovered) because of the impact debt will have on future generations, then you should also be doing everything you can right now to reduce carbon emissions.

But just because some of those who use the ‘we are doing it for our children’ argument to justify today’s austerity are doing so hypocritically does not mean the argument is wrong. I will not go over why it is not wrong again, except to stress a point I do not think I have made forcefully enough before. Arguments which look at the distributional implications of permanently higher government debt (debt incurred but never repaid), and then ponder whether real interest rates will or will not be higher than the growth rate, are analytically convenient but practically irrelevant. There are many strong reasons, which have nothing to do with intergenerational equity, why it would be foolish to not try and reduce the high levels of government debt we currently have when the economy recovers, and so additional debt issued today will need to be repaid (and not just financed) at some point in the not too distant future.

However, although concerns about intergenerational equity are valid, they are unlikely to be critical to the austerity debate. Probably most major economic issues involve some element of redistribution, and in practice the device of compensating the losers is not an option. Take monetary policy, for example. We currently have low real interest rates, which benefits some but harms others. Do we let the fact that savers are worse off as a result of this policy hinder the central bank from keeping interest rates low? Of course not.

In the case of reducing debt today through austerity, there are other factors which have distributional consequences going in the other direction. To the extent that we have austerity through lower investment in infrastructure or education, it is the young more than the old that will be hurt by this policy. As important, high unemployment among the young today can have lasting effects (pdf, HT TC) on their welfare, and their children's welfare, as this study (pdf) shows. More generally, if DeLong and Summers are right that the hysteresis effects of austerity today are significant, then an entire future generation may be worse off as a result.

So it is not that ‘burden of debt’ arguments are wrong, but that they are just not that important in the context of the current austerity debate. The welfare loss to future generations of delaying debt reduction by ten years is small relative to the massive loss of resources and welfare caused by austerity today. If we are worried about future generations, a far cheaper way of helping them is to take action to mitigate the impact of climate change. 

Different approaches to austerity

This is a really interesting chart from the IMF’s October 2012 Fiscal Monitor (HT Antonio Fatás). The red dots are the cyclically adjusted primary balance, the blue bars changes in government expenditure and the yellow bars changes in tax revenue.

It shows the extent of austerity (the red dots). Look how ludicrous is the idea that Greece is not trying hard enough – their current and planned fiscal contraction is literally off the scale! (Here are similar numbers from the OECD.) But what I want to focus on, which this chart clearly shows, is the tax and spend composition of austerity.

In many countries (Ireland, Spain and the UK) austerity is concentrated on the expenditure side. In some (e.g. US) it is more evenly balanced, while in a few (France in particular) it mainly takes the form of rising taxes rather than lower spending. Now how you regard this depends crucially on whether these measures are permanent or temporary (where by temporary, I mean lasting around ten years or less).

If they are permanent, then this is largely a political issue about the size of the state. Raising taxes protects the existing size of the state (taking on board any distortionary costs that permanently higher taxes may bring), while cutting spending aims to reduce the size of the state. In terms of short run demand impact - which is obviously important given the current state of demand deficiency in most countries - permanent tax and spending changes will have similar effects.[1]

On the other hand, if these measures are temporary, then in macroeconomic terms their impact will be rather different, because multipliers are different. A very broad generalisation is that theory suggests multipliers for spending cuts will be significantly higher than those for tax increases. The simple idea is that consumers will smooth the impact of income changes due to tax increases, whereas cuts in spending go straight into reducing demand. In addition, incentive effects on labour supply will be much less important if they are temporary and output is demand constrained.

We need to be careful, however, because this is a generalisation that applies to government spending on goods and services with a high domestically produced content. If the decline in government spending involves a temporary reduction in civil servants’ salaries, rather than building fewer hospitals or roads, then it is much more like a tax cut. As analysis later in the IMF’s report shows, cuts in wages make up a significant proportion of spending cuts in Portugal, but not much in the UK, where cuts in government investment are more important.

So are these austerity measures temporary or permanent? Normally governments do not say. An exception is a much remarked upon feature of the French austerity plans, which is the introduction for two years of a new top tax rate of 75% on incomes over €1m. We can be pretty sure that this is one group where the income effects of tax increases on consumption will be largely smoothed away (which is good), but where the incentive effects are the subject of debate which seems more ideological than evidence based. Of course whether such temporary tax measures will in fact be temporary is a moot point, as the Bush tax cuts in the US illustrate.

In the absence of reliable information from governments, people have to make their own assessments.  In the initial stages of a crisis, if either there is an unforeseen shock to government finances, or to the long run level of output, then it may make sense to regard any austerity as permanent. However as austerity proceeds, the goal is to get debt down from a high but sustainable level to a lower sustainable level. In these circumstances a rise in taxes (say) will be temporary, and will eventually be reversed as lower debt reduces debt interest payments and therefore taxes.

So it seems likely that a good part of current austerity plans involve temporary fiscal changes designed to reduce debt levels, and so the differences between the multipliers of tax and spending changes will apply. For countries like the UK, that have focused on spending cuts, the knock on effects on output will be relatively large, whereas for countries like France the impact of austerity may be more moderate (although still unwelcome).

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[1] Spending cuts may still have a larger impact on domestic demand because government spending tends to have a lower import content than private spending.

Heterogeneity at the IMF

Right now, the IMF appears to some to be on the side of the angels. Their self criticism about the impact of austerity is both unusual and commendable in equal measure. They also appear to recognise that pushing Greece further than it can or should go is stupidity of the highest order. They are producing some of the best policy orientated empirical macro research at the moment (e.g. here and pdf). Yet this is the same IMF that in May co-hosted a conference on Latvia that looked very much like a PR job for the benefits of short sharp shock austerity. (For some links, see here and here.) The IMF’s attitude to austerity remains nuanced and country specific (as noted here, for example).

I’m not going to try and see if those apparently different views can be reconciled. Instead I will offer a more institutional explanation for any apparent confusion. The first point to make is that the IMF is a very large organisation: there are around 150 economists in the European department alone, and that department is one of many: some geographical, some functional (e.g. fiscal affairs, research). These are highly trained, very bright and often very experienced macroeconomists: the shear intellectual fire power can seem overwhelming.

The second point is that, for the moment, there seems to be no strong rigid party line imposed from the top. The country teams that conduct and write the annual Article IV reports appear to have a degree of independence, and so they do not have to completely subordinate their analysis to the political sensitivities of the Board or Managing Director (as was evident for the UK, for example).  There is far from complete independence of course: there are mechanisms to try and ensure some consistency of approach, but these mechanisms are not strong enough to achieve total homogeneity.

With so many talented individual macroeconomists, with such a diverse knowledge of particular economies, and in the absence of a strong command and control structure, differences of opinion are not surprising. Indeed, we might expect to see the range of opinion outside the organisation (among academics and policymakers) reflected to some extent within. It would also not be human if country teams were not just a little bit influenced by the dominant macroeconomic perspectives within those countries. After all, the influence of the IMF in most cases is marginal at best, so being attuned to those perspectives is essential.

Having said all this, it might still seem puzzling to find within one organisation such diversity over time as we have seen in the last few years. In 2008/9 the IMF was calling for expansionary fiscal policy to support the world economy, but by 2010 it was arguing for fiscal consolidation. Now the pendulum is swinging back again. One explanation, to possibly misquote a British Prime Minister, is “events, dear boy, events”. In 2009 the panic was the prospect of another Great Depression. In 2010 that possibly had receded, but then the panic was Greece.

A deeper explanation is the argument that the default mode within the IMF has in the past involved imposing austerity on governments that have overspent. So the 2010 switch to advocating austerity was a return to familiar ground. From this perspective it was the championing of stimulus during the worst of the recession that was the more interesting development for the organisation. To quote from the excellent account by Farrell and Quiggin[1]

“The Keynesian resurgence was not entirely a product of the crisis. A Keynesian analysis and associated prescriptions had already begun to emerge in expert debate in January 2008, before the crisis proper hit. Dominique Strauss-Kahn, the Managing Director of the IMF, had announced at Davos that “a new fiscal policy is probably today an accurate way to answer the crisis", prompting Larry Summers to note that “This is the first time in 25 years that the IMF managing director has called for an increase in fiscal deficits" [Giles and Tett, 2008]. Both Strauss-Kahn and the IMF's chief economist, Olivier Blanchard, were pragmatic Keynesians, with a theoretical bent that differed markedly from the previous consensus position at an institution notoriously fond of advocating fiscal retrenchment for countries in difficulty.”

This change in position in 2008/9 probably reflects a pragmatic yet informed response to the unique (after the 1930s) position that the global economy found itself in, with interest rates at the Zero Lower Bound. What is interesting is that the IMF was able to make this change, despite its reputation for promoting fiscal discipline, while other institutions such as the ECB or European Commission (and sections of academia) were less adaptable. Perhaps in comparison the IMF was relatively free of political influence, so basic Keynesian logic was able to win the day, but that would just be speculation on my part. Anyhow, it is good to see this view reasserting itself after the disastrous shift to austerity in 2010. 

   

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[1] Farrell, H and Quiggin, J (2012) Consensus, Dissensus and Economic Ideas: The Rise and Fall of Keynesianism During the Economic Crisis. 

Misusing cyclically adjusted budget deficits

Chris Dillow alerts us to new claims that the UK government’s finances were in a terrible state before the financial crisis. Latest estimates from the IMF and OECD put the UK’s cyclically adjusted budget deficit in 2007 at around 5% of GDP, and the usual suspects have used these numbers to justify the theme that the Labour government was grossly irresponsible in fiscal terms before the recession. Chris explains why this might be quite acceptable to offset surpluses being run in the private sector. However as these figures appear to contradict what I argued about the Labour government’s fiscal record in this post, I want to explore a little bit where this number comes from.

The actual budget deficit in 2007 was just under 3% of GDP. As I argued in that earlier post, somewhat larger than the deficit required to keep debt to GDP constant, and therefore larger than it should have been, but not outlandishly so. The debt to GDP ratio in 2007 was much the same as when Labour took office ten years earlier. So to get a cyclically adjusted deficit of around 5% from an actual deficit of below 3%, the IMF and OECD must be assuming that 2007 was a boom year for the UK economy. That is exactly right – the OECD now estimates that UK output was 4.4% above trend in 2007.

Funny how it didn’t seem like that at the time. Indeed, the OECD in 2007 thought that the output gap that year was about zero, which was pretty much the consensus estimate. In which case the cyclically adjusted deficit would be much the same as the actual deficit. So what is going on? Why have the OECD and IMF changed their minds so radically about the state of the economy in 2007?

The answer, of course, is what happened after 2007. This was not just the recession, but the lack of recovery thereafter, and the absence of firms today saying they have spare capacity. I discussed the case of disappearing UK potential output (the ability or desire to produce output if demand is there) in this post. It is the same issue as our apparently poor productivity performance since the recession, which the longer it continues looks less like a temporary cyclical decline.

Now the capacity to produce output does not evaporate overnight. Capacity depends on three main things: capital, labour and productivity. Earthquakes aside, machines that could produce output yesterday can still do so today. The labour is still around, which is why we have high unemployment. Productivity is about how efficiently we use labour and capital to produce output. Once again, productivity should not fall overnight: we don’t just forget how to produce things efficiently. But the growth rate of productivity can fall to very low levels, if no innovation is taking place.

But even if productivity growth slowed dramatically after 2007, it cannot explain why apparent productive capacity is so low today. So if we believe productivity is really so low today, it must have started slowing down before the recession. In other words, productive capacity in 2007 must have been much lower than we thought at the time. Hence the actual level of output must have been well above productive capacity, leading to current estimates of a 4-5% positive output gap.

Three points follow from this. First, claims based on these figures that UK fiscal policy was grossly irresponsible before the recession are simply silly. None of the major institutions that analyse the macroeconomy thought in 2007 that the UK was in the middle of a major boom. Even if we assume that what the IMF and OECD now estimate about 2007 is correct, the government – like these organisations – did not have a crystal ball. In 2007 they, and pretty much everyone else, thought the economy was close to trend, and the government based their policy on that judgement. If the government at the time had tried to argue that the economy was in the middle of a major boom, they would have been ridiculed. 

Second, 2007 did not feel like a boom, so maybe it was not. In an overheating economy we normally see shortages pushing up wages and prices, but that was not happening in 2007. To argue that, despite this, 2007 really was a boom, you have to find reasons why it did not show up in inflation. Maybe in time we will, but nothing obvious springs to mind. This is why the UK productivity puzzle is so puzzling – it really does look as if we either have to rewrite history, or productivity just disappeared in the recession. Alternatively, of course, perhaps productive capacity today is really much more (and the output gap much larger) than people currently think, as some have suggested (most recently here).

Third, does this mean looking at cyclically adjusted budget deficits is a bad idea, if the adjustment itself is so uncertain? The answer is clearly no. It makes sense to run surpluses in a boom and deficits in a recession. We do the best we can to estimate when we are in a boom and when we are in a recession. Much of the time it is pretty obvious. It was obvious from inflation data, for example, that periphery Eurozone countries were experiencing boom conditions before the recession, and that therefore they should have been running bigger budget surpluses. Sometimes, particularly in extraordinary times like these, we may get things wrong, but that does not imply that we should give up trying.