Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 8 August 2013

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’.


  1. Not only is borrowing cheap, but in many countries there is substantial idle capacity, so other costs are cheap.

    We appear to have reached the point where "aggregate spending equals aggregate income" is a profound insight and where thinking about why national debt is bad doesn't progress beyond the level of mindless grunting.

  2. To me, the strangest thing about the pro-austerity argument based on prudent household fiscal management is that the entire recovery plan is based on households doing exactly the opposite. The government must realise this, as there was a little fuss in 2010 when Cameron suggested everyone pay off their credit card and he had to backtrack.

    If everyone is actually not cutting back in the way the Govt likes to think they should, it’s very weird that they seem to buy into (according to polling data) the idea that they and the govt should be. Maybe some kind of guilt thing?

    As you suggest, Cameron seems to be wary of the low cost of debt argument. I wonder if that’s because making people think they aren’t morally or intellectually deficient in some way could be a good meme for a politician. Or perhaps British people prefer self deprecation after all.

  3. Prof Simon,

    MMTers, me included, have been tearing their hair out on this issue for years. I've tried writing to The Guardian saying that I know of several economics profs who would write them an article explaining that the deficit and debt are a complete and total irrelevance: the only barrier to employment reduction being inflation. But they’re not interested.

    How about you trying to do an article for them?

    As to the Labour Party, they’re just like the Democrats in the US: they’ve completely bought into the “deficit reduction” nonsense. If Labour had any guts and brains and if they really wanted to be “radical” (favourite Labour word), they’d be taking the mick out of deficit reduction big time.

  4. Isn't the Coalition an anti-Keynesian coalition, in that the Liberals can't do sticky prices and wages because they support the Euro, and the Tories have the vulgar Keynesian view that the 1970s stagflation was the failure of Keynesian economics in action?

    Added to this is the legacy of the 'IMF crisis' of 1976, a seminal moment for all the political parties despite its economic unimportance to the UK.

    In many ways the Liberals are as historically radical as the Tories, in that they see little to nothing of political worth to their party taking place 1945-79, and it is this Declinism (enter Barry Supple) that led them into supporting the Euro as Europe grew more in the post-war generation than the UK.

    Sadly, I have always thought that the Coalition makes political sense.

  5. The coalition had many months to blame Labour management of the economy without comeback (pace Ed Balls) whilst the Labour Party navel gazed and looked for a new leader. The narative chosen was the simple one of 'you know it makes sense to live within our means because it's what any family would do'. It didn't need any academic underpinning because it played well with the public and the media. Those in the coalition with some grounding in economics probably realised that some recovery however slight would in any case occur naturally within the lifetime of the Parlmt and this could be adduced as proof that 'the hurt is working and you don't want to spoil it by stopping now'. I fear whatever academic arguments are made they will remain academic because they clash with what has become the 'commom sense view'. So very depressing.

  6. I agree that the overextended househould analogy is awful and innacurate, but I also think that it can be improved within its own terms.

    To take a personal example, my father was made redundant some years ago as a result of a downturn in his industry. Instead of just slashing their outgoings and waiting for gradual accretion to make their debts unmanagable my parents invested in his retraining so that he could get jobs in other sectors. The result of the investment was that our household income rose dramatically over time, at which point the debt problem vanished.

    Similarly (in terms of capital investment), most people will intuitively understand that investing in your property will increase its value relative to the size of your mortage. (And that even if the market is going down it will increase its alue relative to other properties)

    My point is that even if it isn't possible to shift the terms of the public debate away from the flawed overstretched household analogy, it should be possible to improve the quality of the debate within that flawed framework. The overstretched household analogy is generally discussed on the assumption that the family only has control over its outgoings. This isn't true. Even if nothing else changes, more focus on how to improve the family's income, including through investment in both capital value and income would at least move the debate towards to a better place.

  7. Going on your innovative firm argument, consider Apple. Billions in the bank (145), and what did they do? Went out and borrowed billions (17).

    Now that's partly to do with paying dividends without getting cash back to the US and slightly murky tax planning.

    But part of it was : "People want to lend us loads of money for diddly squat interest? $17 billion, you say? Three years at 0.5%? Five years at 5 basis points over LIBOR? Seriously? Quick, let's bite their hands off. "

  8. I have been trying to work on pushing:

    "The state budget is like a household budget, for a family in which everyone works for the family firm, which sells nearly all of its output to family members and borrows mainly from family members".

    but I think Luke's idea is more immediately comprehensible; all someone like Ed Balls needs to say when they push him on "would you borrow more?" is something like "If I can borrow at 1% interest, I am going to keep borrowing until I run out of ideas that can earn a 1.5% return on capital. And I can think of a lot of ideas that can earn a 1.5% return on capital employed".

  9. Dan, having introduced the phrase "diddly squat" into a serious economics blog, it only remains for me to lower the tone still further:

    "Georgie Osborne's magic, he wears a magic hat,
    And when he saw 30 year indexed gilt yields at less than 0% real,
    He said "I'd really rather not have that."

    To be sung to the tune of : Arsene Wenger's magic, he wears a magic hat, and when he saw the double, he said: "I'm having that."

    Prof W-L, I can only apologise. But I think I have a point.

  10. 1. I do not think Austrelia is an example of how things should be done.
    They had room for a stimulus and they did one that is the positive part. However other aspects of their economy have become considerably more unbalanced.
    Basically they have used the high commodity prices (which only recently reversed), but with no plan B. It might have worked if commodity prices would have remained high but they didnot and Austrelia has no Plan B.
    They let wagescosts run completely out of hand as well as RRE prices.
    It is not so much the deficit that I am worried about but the 2 issues above.

    Effectively they did an 'all in' on high commodity prices. While longer term that likely will work out (basically you have a continent with stuff in the ground with a population to divide it between slightly larger than Holland). However short and medium turn there were huge risks that there would be a reversal of commodity prices. Fully (nearly) based upon China having 10% growth, which was simply a big if. An export depended economy in a worldeconomy that simply looks for several years crap.

    2. The state is an overextended household. A lot of resources are spend very ineffectively and managementcapacity is crap (and all over the place). People are simply not able to properly manage several important issues. Healthcare, immigration, the economy. Whatever your political view is they are simply not well managed in anyway. I get the idea that part of that problem is it has become to big and these 3 things all are moving rapidly and they simply cannot keep pace.
    Anyway the state has to become inovative not only use different rethoric.

    3. Infrastructure could work. However things should have been properly prepared in a drawer when required (all licenses and approvals and procedures done). With all the procedures in getting things approved it simply takes too long. Hopefully it will help solving the crisis after the next one but this one it will not. And next to the stimulus the whole of Europe needs to work on that a lot of things are totally outdated. Which will effect competitiveness in the longer run.

  11. One important point on austerity.
    Markets would imho not buy from many countries that they are serious in long term debt reduction.
    This is a big part of the problem. With the UK probably looking relatively good/credible.

    Which gives an opportunity to sell an independent board. Politicians are simply not seen as credible by many. And for good reasons a lot of stimulus is new social programms of which long term affordability is highly doubtful (Germany and US). Take austerity champion Merkel she started new entitlement programms (convenient for elections) while a temporary solidarity tax should not be abolished.
    The whole of Southern Europe is covered with entitlements that politically cannot be reversed but are unaffordable. That is no stimulus which should per definition basically be temporary. Also effectiveness could be improved with better planning.

    In other words stimuli in future should be much better planned beforehand so they are effective and timeable (duration can be influenced and things can be stopped). And markets do often not trust politicians to do that job. Like a CB an independent board doing this properly would likely be 'highly appreciated'.

    And politicians are also bad in hedging risks. You would expect from people who should have a long term focuss to move to longer duration borrowing. Not happening. With considerable risks. Markets are a bit strange in their behaviour at this moment and very volatile because of the crisis (now less than a few year ago bit recently again we had some huge yieldhikes) Longer term reduces this risk.
    Unlikely that longer term yields will remain this low. But basically also here even in normal countries the relatively small advantage of short term borrowing apparently is preferred.

    While it is imho essential in order to keep a platform for a welfare state that excesses are attacked especially in recession times, on should keep in m ind that in oreder to keep that platform it is likely essential that the normal nett contributor keeps even in a crisis entitled for the stuff he/she paid sort of premiums for but never earlier got entitlements. If you are supposed to pay in when you earn but are not or limited entitled when you need it solidarity will be out of the window in no time.

    For a board you probably need legislation that all new expenditures should have a proper cost estimate attached. Otherwise things might tutn 'US' simply approve programms with no responsability for the costs attached to it. basically dumping it somewhere else. This might otherwise make functioning of a board considerably more difficult.

  12. A third one.
    As a field you have to learn how to deal with the ultimate decisionmakers.
    Especially for Macro as it deals with issues that are very political. If you are not able to deal with them it will be chanceless. Macro as a field is dealing only with the macro aspect to keep it overseeable probably. Combine it with a lot of group interests anfd the thing is no longer to oversee by the average politician and voter. And they go for instinct (and instinct says not spend when you have little money).

    And be able to react on changes in there. What I mean is eg that traditional politics have lost a lot of its credibility. The main reason we see the rise of populist parties all over the place.
    And that rise influences in a large part behavious of the traditional parties especially the ones most under electoral pressure.
    You can fight that trend which might be a natural reaction (they are sort of fruitcakes of course) but that is very unlikely a winning strategy. In a discussion over an independent board they could be your friends as they distrust the government as well on this. They are the ones that at this moment next to the banks blame the government. The main stream voter is still buying a lot of the crap politicians come up with to distract from their the failings (the Euro is still a great idea and will work with a few cosmetic changes and loans to Greece never have to be written off). It makes you sometimes wonder who are the real fruitcakes.
    Anyway populism is an important trend.

    Also the fact that politics is no longer only divided economically left and right but also socially/culturally. Now we are moving to a division in 4 parts while it used to be 2. Of course all with stuff in between and exceptions.
    Most Northern European populists will be socially/culturally conservatives but economically not left. They like their entitlements and think by making them not available for Johny Foreigners things can remain the same as always.
    Could lead to a de facto split in Labour one skilled workers party and one entitlement receivers one . UK party structure is very stable but IP could also rise. Europe teaches you need one good charismatic guy and you have a chance.
    But anyway populists distrust the present government, like often the markets. These could be your friends, well better allies. With populists possibly divided in 2 groups with different characteristics.

    Another thing to keep focussed on is the fact that government debt has a lot of legal advantages over normal debt. Mainly that certain investors are more or less forced to invest in them. And as assets they get preferential treatment (accountingrules but also repo).
    Highly dangerous of scourse. Could be the cause of the next crisis. Eg if Spain goes so will its banks becuase they are overexposed on Spanish sov debt. If this happens rules likely will change and cost of government borrowing will rise considerably.


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