Bringing economics back into fiscal policymaking

Today around the world the dominant framework for making fiscal policy decisions is personal finance for the overextended household. The state is like an individual who has borrowed too much, and so it must cut back on its borrowing. It is as if the basic insights of macroeconomics (let alone the more sophisticated analysis of the last 20 years) never took place. To take just one example: John Quiggin describes the success story of how Australia dealt with the Great Recession, which included a large fiscal stimulus, yet the politicians that helped achieve that success are now on the defensive because the budget is not in surplus.

As I argued in a recent post, what we have here is a combination of two things. First a strong political force that wants deficit reduction to be the focus of policy because it sees this as a useful way of reducing the size of the state. Second, public perceptions that try and understand events in terms of what they know: their own borrowing and spending decisions. So the need for immediate austerity becomes the dominant policy almost everywhere. I get frustrated sometimes that some colleagues, naturally concerned about the details of academic debate, cannot see the bigger picture here. The bigger picture is the marginalisation of our discipline - used when it suits a particular political purpose, but ignored otherwise. If policymakers and the pundits just pick up economic ideas when its suits them, and when the analysis or facts do not suit them just make stuff up (examples from US and UK), economic analysis just becomes fodder for speech writers. That reduces the discipline to an academic game, and soon those same people will ask: why are we paying people just to play games?

So how do we get macroeconomics back into fiscal policy making? First, we need to sort between politicians and political parties that are quite happy with the current state of affairs, and those who are not. Those who are not need to fight fire with fire, replacing one bit of homespun thinking with another which gets us closer to how policy should be made. One way of doing that is to replace the ‘state as an overextended household’ idea with the ‘state as an innovative firm’.

In terms of the sorting, in many cases that is pretty easy. Let’s take the example of the coalition partners in the current UK government: the Liberal Democrats. Now some might simply use guilt by association, but I prefer to be charitable. Perhaps they were bounced into supporting austerity by events in 2010 and advice they received from certain quarters. As the 2015 election comes nearer, the LibDems are trying to differentiate themselves from the Conservatives on many issues, and they do have a reputation for progressive thinking.

So have a look (pdf, page 37) at the key motion on the economy to be discussed at their September conference. It has Nick Clegg’s name on it, so we can assume it reflects the leadership’s thinking. It starts thus:

“Conference welcomes recent improvements in the UK economy, specifically that: 

I. Faced with the highest budget deficit in post-war history in 2010 as a consequence of the banking crisis and Labour’s mismanagement, the Government has managed to reduce the structural deficit by a third since it came to power.”

Point number two then talks about recent GDP growth figures. So the best thing that has happened to the UK economy recently has been that the deficit has come down. The message seems clear: reduction of the budget deficit is the number one priority and all else has to be subsumed to that.

Now you might in Clegg’s defense say that he has to put it this way, as he has been part of a government which has made deficit reduction the overriding priority. I think that is simply wrong. He could say instead that the focus on deficit reduction was appropriate given all the uncertainty as the Eurozone crisis broke. However now it is clear that this was a crisis specific to the Eurozone, and with interest rates on UK borrowing really low and likely to stay there, the UK can make reducing unemployment the priority, while still of course operating a prudent fiscal policy in the longer term. In other words, he could begin to de-prioritise deficit reduction. The fact that he chooses to do the complete opposite suggests he is content to see fiscal policy as an extension of household financial management. We will see in September whether the Party as a whole is happy to follow its leader in ignoring 80 years of macroeconomic analysis.

So how do politicians that do want to bring macroeconomics back into fiscal policymaking start to change the public debate? Knowing that the intellectual case for austerity is crumbling is reassuring, but it is not enough to make these politicians feel confident in challenging the dominant narrative. They need an alternative narrative, and a good one is the idea of investing when borrowing is cheap. In the UK the argument that there are plenty of useful infrastructure projects for the public sector to undertake has already been conceded by the government, and as Uwe Reinhardt points out here, it is also an easy argument to make in the US. So all that is needed is to see the state like a firm that decides to undertake these investments by borrowing when borrowing is cheap and there is plenty of spare labour to complete them.

As Martin Wolf wrote over a year ago: “Not only the economy, but the government itself is virtually certain to be better off if it undertook such investments and if it were to do its accounting in a rational way. No sane institution analyses its decisions on the basis of cash flows, annual borrowings and its debt stock. Yet government is the longest-lived agent in the economy. This does not even deserve the label primitive. It is simply ridiculous.” I think ‘borrowing to invest when borrowing is cheap’ is a message that can resonate with the public, which is why I suspect David Cameron described those pushing the idea as ‘dangerous voices’.