Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 26 June 2014

UK fiscal policy from 2015

In a previous post I talked about why it made sense to keep the form of the current government’s fiscal mandate, although the five year rolling target should involve the deficit rather than the cyclically adjusted current balance. But what about actual numbers?

I start the analysis in financial year 2015/16, with the OBR’s forecast for headline public sector net borrowing (hereafter the deficit) of 3.8% of GDP. Let us also assume that the debt to GDP ratio at the beginning of that financial year is a nice round 80% (the OBR’s forecast is slightly less). That is the deficit and debt that any new government will inherit. Let us also assume that by that time interest rates are above the Zero Lower Bound (ZLB) and are more likely to rise than fall back to the ZLB. That is by no means certain, and in my view it is critical. If interest rates are still stuck near zero, fiscal policy should be aiming to speed the recovery, not reduce the deficit.

A deficit of 3.8% is too high to start bringing public debt down, and the analysis outlined here or here suggests it makes sense to bring debt down. So the key question is simply - how fast should the deficit and debt fall?

Year
Slow
Medium
Fast
Osborne
2015/16
0.038
0.038
0.038
0.038
2016/17
0.036
0.034
0.032
0.022
2017/18
0.034
0.03
0.027
0.009
2018/19
0.032
0.028
0.022
0
2019/20
0.031
0.026
0.018
0
2020/21
0.03
0.024
0.015
0
2025/26
0.025
0.015
0.005
0
2030/31
0.02
0.01
0.005
0
2040/41
0.01
0.005
0.005
0
Long run D/Y %
25%
12.5%
12.5%
0%
 Alternative paths for the deficit to GDP ratio

Economic theory only really tells us one thing on this question: deficit reduction should be fairly slow, if there is no danger of default. So in the table above I look at four possible paths. In the ‘slow’ path, the target for the deficit 5 years ahead made in 2015 would be 3% of GDP. If we make the assumption that long run growth in nominal GDP is 4% a year, then maintaining a 3% deficit would stabilise the debt to GDP ratio at 75% of GDP. I think that is still too high, and for various reasons it is good to plan for a steady fall in the debt to GDP ratio over the next few decades. So the slow adjustment path involves a steady but slow reduction in deficits to 1% of GDP by 2040, which if maintained would eventually stabilise the debt to GDP ratio at 25%. The path of debt, assuming 4% nominal growth each year, is shown below.

Alternative paths for the debt to GDP ratio, assuming 4% nominal GDP growth

This ‘slow’ path is much slower than anyone is currently talking about, but I’ve included it just to make the point that it should be an option that is on the table and seriously considered. It gets debt down to a smaller share of GDP than at any time in the UK over the last two hundred years. It may do so too slowly, but it is important to discuss why it is thought to be too slow.

The path labelled medium is more ambitious in two respects. First, the five year target made in 2015 is a deficit of 2.4% of GDP rather than 3%, so the pace of deficit reduction from 2015 is more ambitious. Second, the target is an eventual debt to GDP ratio of 12.5% of GDP. So the deficit is steadily reduced to 0.5% of GDP. However both of these paths fail to noticeably reduce debt by 2020 compared to 2015. (With 4% nominal growth, and starting with debt to GDP at 80%, the deficit needs to be below 3.2% for debt to start falling).

The ‘quick’ path involves a deficit target of only 1.5% by 2020, and further reductions so that the deficit reaches its steady state level by 2025. However I assume for this path that the desired long run debt level is the same 12.5% of GDP as on the medium path. If public investment stays at around the 1.5% of GDP mark projected by the OBR, then the 2020 figure for the deficit would correspond to achieving current balance by that date.

The final path, labelled Osborne, involves the OBR’s forecasts for the deficit under current plans for 2016 and 2017, and a zero deficit thereafter. This brings debt down much more rapidly, and with a zero deficit the debt to GDP ratio steadily tends towards zero. I cannot see any logic to such rapid deficit and debt reduction, so it seems to be a political ruse to either label more reasonable adjustment paths as somehow spendthrift, or to continue to squeeze the welfare state. What it already seems to have done is shift the opposition's position towards the fast adjustment path.

Labour’s current commitment is to achieve a current balance surplus as soon as possible, and certainly by 2020. If public investment stays at around 1.5% of GDP, that would correspond to the fast path above or even faster. It is less clear what the LibDem plans would be, either in terms of numbers or rules, although Giles Wilkes suggests here that they are broadly similar to Labour's plans.

There is nothing complicated in all this - anyone can produce similar numbers on a spreadsheet. Yet they really matter. As Giles Wilkes and also Steven Toft note, achieving deficits of the kind shown on the fast path will be very painful unless growth is very strong. So where is public debate about which path is more desirable? I guess it went the same way as the public debate over austerity. As Aditya Chakrabortty aptly observes, the fiscal policy debate at Westminster is in danger of becoming like Monty Python's Four Yorkshiremen sketch.


13 comments:

  1. Looking at previous UK debt reductions using the graph from ukpublicspending.co.uk which plots BoE public net debt to GDP from BoE inception, there are two 'ages'.

    First I shall call the 'age of the workhouse', coming out of the Napoleonic wars with just over 250% debt that was down to about 35% in 1914.

    WW1 and WW2 saw debt never fall below 150%, and then the second period, which is the post-war golden age, saw debt fall much more rapidly from just under 250% to under 50% in 1970s.

    As Krugman says, hardly anyone in the public cares about the debt and most Americans polled think that Clinton put it up and Reagan and the Bushies took it down.

    Let's get that inflation target raised and the pace of debt reduction slowed up.

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    1. So, if the deficit is going to zero, who is going to pay for the imports? Are Households expected to raise their debt to income ratio and stop saving? Or, by some miracle the UKx (ex Scotland that is), is going to start running a 3 - 4% BoP Trade Account surplus!!! I don't think Neil Wilson has had a red bit below the line on his chart before. http://www.3spoken.co.uk/2014/03/uk-sectoral-balances-and-private-debt.html .

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  2. One thing I have never seen satisfactorily explained, and this is a frank confession of ignorance, is why the unwinding of QE is expected only after rates have gone back up.

    In a sense we have been below the zlb (I know that is nonsense). Extraordinary monetary policy measures have been used, insofar as possible, to mimic cuts in rates. Why shouldn't unwinding of this (ie the Bank selling back to the market) come first? Or if not first, come soon so as to forestall any significant rise of rates above 1-2%?

    Unless QE was just a lie, and the debt has really been in practice cancelled?

    As for Osborne's deficit forecasts, nobody in the real world believes them. The cuts that would have to occur are far, far deeper than anything that has happened so far. The only real purpose of the forecast was to paint Labour into a corner, which they succeeded admiraby in doing. He couldn't stick to the 2010 projection and I see no reason for thinking that the 2015 projection will be any different. Despite the rhetoric from both sides (Osborne talking tough, his critics bewailing austerity) the cuts to public spending have been very modest, partly because they are politically extremely tough to do. We have never managed to tax much more than 40% of GDP out of the UK in peacetime, and so there isn't really much scope for taxes going up either.

    So, expect political reality to give a result much closer to W-L's desire to push significant reduction of the deficit to some point after 2020 (ie effectively never).

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    1. “Unless QE was just a lie, and the debt has really been in practice cancelled?” As I pointed out in a letter in the Financial Times and as others have pointed out, government debt held by a central bank is an essentially meaningless concept. I.e. the debt that the BoE holds as a result of QE might was well be torn up. The real economic consequences of doing so would be zero.

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    2. Well, as a matter of law that isn't quite right, nor is it right as a matter of government accounting practice.

      But, if it is never unwound, then yes it is a fiction.

      I suppose the argument for not unwinding first is that we need to get away from the zlb first in order to have some 'normal' monetary policy room for manoeuver.

      Is that right?

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  3. 4% annual growth in GDP? For the UK? Really? Surely 2% would be far more realistic as an average... I remember in the 1970s Ted Heath, who I met once, saying how much the Government were trying hard to attain a 2% per year figure for growth, and he didn't get there. What makes you think any of the current bunch will achieve double that?

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    1. This comment has been removed by a blog administrator.

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  4. Part of the problem in pinning down the government's plans is the official UK use of the terms "budget deficit" or "budget surplus". S-W-L starts his analysys: " headline public sector net borrowing (hereafter the deficit)". This is the standard economists' usuage of "budget deficit". It is also the way it seems to be used elsewhere e.g. in Eurostat . However in ONS public-finance publications, the phrase is always used to refer to the deficit in the "public sector current budget". This latter apparently excludes that part of public sector spending which is classed as investment. The different usages of "deficit" and "surplus" between most people's use of the terms and UK governments' use may be clear to experts (S-W-L gets it correct when talking of Labour's plans), but is likely to confuse others - including many journalists. At least, it confused me for a long time.

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    1. You should have a read of WGA, https://www.gov.uk/government/publications/whole-of-government-accounts-2012-to-2013 Current Deficit becomes "Net Expenditure", which in reality is exactly what it is. Public Sector Net Debt (PSND) becomes "Net Liabilities".

      WGA is tries to account for a sovereign fiat currency issuing government, as if it were like Tesco or any other big corporate. Would you buy UK plc shares having read these accounts? Your Bank would say the company should have a "working capital ratio of 1.2 to 1.8; Not 0.4.

      "Working capital is a measure of current assets less current liabilities and stood at negative £450.7 billion (2011-12 restated: negative £386.0 billion). The deterioration in working capital is driven primarily by growth in deposits held by the Bank of England as a consequence of quantitative easing."

      Then there is a perfectly innocent sentence at the bottom of the "Consolidated Statement of Financial Position" page 52. "Total liabilities to be funded by future revenues £1,629.6 billion.

      This illustrates the shear beauty of being able to spend (Issue) your own sovereign fiat currency into existence. The MMT guys had got it right all along.

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  5. 4% nominal per year? So 5% nominal in the good years, 0% when you have a mild recession every five years, and no severe recessions? Sounds a tad optimistic, but go for it, I guess.

    On the other hand, I don't see any estimate on the level of interest rates. That surely makes a difference as to how quickly total debt goes down. If the average interest rate on the debt is 8% and growth is 4% (say in 2025), debt isn't going to come down, right? This is because the government is unlikely to run a surplus elsewhere to pay 8% * 60% of GDP interest a year = nearly 5% of GDP. It's more likely to end up running a surplus ex-interest of 2% and run a deficit of 3% of GDP.

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  6. I would go for a flexible system (nobody really has a clue what we will see the next years'.
    Reduce debt as much as possible without stoping the growth engine. Simply for safety reasons. It is simply doubtful if the UK could handle a similar crisis like this one with debtlevels at 80/90% levels. Reducing it as soon as possible gives simply more margin ) when there would be a similar crisis) plus would increase substantially even credibility with markets. As this crisis show the more you run a country like a banana republic the lower the max debt level acceptable for markets get.

    Will be a tough job and doubtful if that is manageable. Nearly all positive prognosis end up as disappointments. Likely a lot of negative margin to deal with as it looks now. UK looks ok now but for how long. The EU looks to have very little potential and basically that will be the link the UK economy will most depend upon for growth and by far.

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  7. Meh. On the grounds that governments are likely to achieve a third of what they set out to do, the point of aiming for the Osborne path is to end up on the slow one.

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