Winner of the New Statesman SPERI Prize in Political Economy 2016

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.


  1. "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"

    Really? Who says this?

    "In which case .... we would be against any kind of discipline on public debt or deficits"

    An obviously crackpot position to take. Who do you think has accused you of this crazy position?

    There are some economists who obviously are politicised in the way you describe Blanchflower is the obvious UK example. His tweeting every decent poll Labour ever receives whilst ignoring the bad ones has become delightfully comic. Using the prestige of the academy in this way is pretty bad.

    I would be surprised if even your fiercest critics took the same view of you and Portes. Portes' tireless and brilliant defence of free movement of people hardly marks him out as a Labour stooge.

    I would have thought that a more plausible criticism is that your intellectually commitment to a certain Keynesian view causes you to over egg the criticism (eg the suggestion that not cutting investment spending for a couple of years would have made a difference to the damage caused by unprecedented floods), ignore political constraints on government (eg the electoral cycle), ignore or downplay exogenous factors (eg commodity price rises) and fail to spot, until after its impact had long since become apparent that 'austerity' in the UK ended more than two years ago.

  2. " a standard way macroeconomists think about rules: how close are they to the optimal policy that would be chosen by a benevolent policy maker? "

    Perhaps this was simply badly expressed, but of course there is no assurance there *is* one optimal policy which a benevolent policy maker would choose. The first question to ask is always the ontological.

  3. “It makes sense to have an operational target for the deficit rather than debt…”. Really?

    Suppose there’s a fall in consumer and business confidence i.e. fall in Alan Greenspan’s “exuberance" (rational or irrational). Aggregate demand then falls. Do we take it government should stick to its “operational deficit target” and thus let unemployment rise and GDP contract?

    I suggest not. I suggest government should abandon any “target” of the above sort (as MMTers have pointed out time and again).

  4. Thanks for the good example of 'endogenising ideology and politics in economics', as I phrased it 2 months ago in response to your student rebellion blogpost!
    Essential steps on that path are distinguishing between more and less benevolent economic actors and explicitising one's own ideology that measures 'benevolence'.

    "a standard way macroeconomists think about rules: how close are they to the optimal policy that would be chosen by a benevolent policy maker?"
    (Contrary to "a"'s position) I DO think that there *is* one optimal policy which a benevolent policy maker (or the benevolent economist that comments on policies) would choose, IF THE IDEOLOGY MEASURING BENEVOLENCE IS CONSIDERED GIVEN.
    The optimum depends on perspective: Optimal for whom? Balancing benefits and costs for different interest groups and for unrepresented interests/ideals (like ecological sustainability) how?

    1. You need an ideology which is in some way complete, which forces the benevolent being to choose in every circumstance. Completeness is unlikely to exist for benevolence (just consider the trolley problems), although of course you can pretend and force one.

      The more I think of the quote the more I am convinced it is a fundamental error, which has bad consequences. If you don't think you need to justify the existence, then you can use reasoning otherwise not available. For instance, suppose you can assert A v B, and you can argue that B is obviously not optimal for a benevolent being. Then, by assuming existence, you can assert A. But if you don't, you can't. Now take A = Keynesian economics and B = austerity.

  5. «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 very good statement of something very wrong with the politics of "macroeconomists": it begs the question "benevolent to *whose interests*"?

    Because it seems wholly ridiculous to me that today there are still people who think they can portray "macroeconomists" as splendidly fair philosopher-kings who can be benevolent to everybody who deserves it.

    And if the answer is "but the markets will decide whose interests deserve the most benevolence" the the best comment to that is a tired laugh. Because we know very well whose interests are dear to the propagandists that spin that the markets reward the most deserving.

    The coalition's fiscal, monetary, credit and regulatory decisions for example have been those of "benevolent policy maker", one benevolent to "highly productive" rentiers in the City and "highly productive" rentiers in property in the South East, and quite benevolent to employers, helping them finding lots of desperate poor people in low cost countries eager to beg for jobs in the UK.

    Just considering welfare and tax policy, hundreds of billions of welfare handouts have gone to benevolently protect the jobs and incomes of "highly productive" financiers mostly in the South, while the government has also benevolently incented the "nasty scroungers" unemployed or disabled mostly in the North to shake off their paralyzing dependency by cutting the few billions of social insurance wasted on them; and taxes on "wealth creating" rentiers and high income managers have been cut, while those on "lazy employees" have been maintained and increased.

  6. Simon,

    It's not possible to access Prospect articles without paying. That severely cuts down on your audience. After all, there is so much FREE STUFF out there that it's impossible to keep up with it all. So who's going to pay? Certainly not me.

    1. Just noticed that there IS SOME relevant stuff available for free - linked to by the words "here and here" at the start of the above post. But "here and here" weren't highlighted in blue, which was why I missed them.

  7. The Tuesday, June 24, 2014, trade lower in the European Financials, EUFN, and the trade lower in Ireland, EIRL, and its Bank, IRE, and Greece, GREK, and its Bank, NBG, marked an inflection point in economic history, as the world pivoted from the age of currencies and credit, and into the age of diktat and debt servitude.

    The age of investment choice is over and the age of debt servitude has commenced.

    There is no amount of reform that can be done to reinvent Ireland, Greece, France, Italy, or any of the Eurozone nations.

    Periphery Europe, that is Portugal, Italy, Greece, and Spain, as well as France, are socialist nations characterized by truly staggering amounts of sovereign and municipal debt; and their banks loaded to the gills with such debt, as well as real estate debt.

    For all practical purposes these are insolvent sovereigns and insolvent financial institutions, whose seigniorage, that is whose moneyness, comes courtesy of the Liquidity Announcements of the ECB Chairman, Mario Draghi.

    It is disinvestment out of debt traded and currency carry traded Ireland, and Greece, that is leading world stocks lower. This comes as Gigaom posts Apple’s Irish Tax Avoidance Schemes Come Under Formal European Investigation.

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