One indirect comment I have received on the numbers set out in
this post is that they ignore the possibility of
major negative shocks hitting the economy. That is not really fair, because a
major reason for aiming for such historically low levels of debt to GDP in the
long term was to allow for such shocks. However it seems reasonable to ask what
sort of shocks these plans might accommodate, so here is an illustration.
A key idea in my paper with Jonathan Portes is that if interest
rates are expected to hit the Zero Lower Bound (ZLB), the central bank and
fiscal council should cooperate to produce a fiscal stimulus package designed
to allow interest rates to rise above that bound. So the key questions become
how often such ZLB episodes might occur, and what size of stimulus packages
might be required.
The chart below assumes that the next ZLB episode will occur in
2040. Thereafter they occur every 40 years. This is all complete guesswork of course.
Each ZLB episode requires a fiscal stimulus package which increases the budget
deficit by 10% of GDP in the first year, 10% of GDP in the second, and 5% in the third. For
comparison, the Obama stimulus package was worth a little over 5% of GDP. So
this is much bigger, but that package was clearly too small, and I’ve also
allowed something extra for the automatic stabilisers.
These shocks are superimposed on the ‘medium’ adjustment path
that I gave in the previous post. This involves much less austerity than George
Osborne’s plans. Whether it is less draconian than the other political parties’
plans is less clear. For example with Labour, there is a commitment to achieve
current balance by 2020. To get the total deficit we need to add public
investment. Current plans have public investment at around 1.5% of GDP, but if
investment was raised to 2.5% of GDP, this would be consistent with the path shown here.
 |
| Medium debt reduction path with shocks |
So the 2040 crisis starts with debt to GDP at just under 50%,
and sends it back up to levels close to but below current levels. In the next
crisis the debt to GDP ratio peaks at 50% of GDP. At the turn of the century we
settle down to an average of around 30% of GDP, with the ratio never rising
above 45%.
With a chart that ends in 2200, many will feel that this is all
rather unreal. So perhaps we can compartmentalise discussion into two
questions: is this long run average of 30% about right, and are we prepared for
the next crisis? Although the 30% figure seems quite prudent by historical
standards, our paper does give some reasons why you might want a lower long run
average. However this debate really is for the future - it should have no
impact on what happens before 2020.
Are we prepared for the next crisis? For the size and timing of the crisis I have
chosen my answer would be a clear yes. In this recession UK debt to GDP has
risen to higher levels, and there has been no market panic. Political leaders
became obsessed with debt for two reasons: misunderstanding the Eurozone crisis
(where OMT has clearly demonstrated the nature of the misunderstanding), and
because austerity suited other agendas. I am a sufficient optimist to think
that another 25 years is long enough to allow most people to figure that out.
“A key idea in my paper with Jonathan Portes is that if interest rates are expected to hit the Zero Lower Bound (ZLB), the central bank and fiscal council should cooperate to produce a fiscal stimulus package designed to allow interest rates to rise above that bound.”
ReplyDeleteSo essentially the authorities print and spend not just enough to return us to full employment, but they spend ADDITIONAL amounts with the result that the private sector has MORE base money than it wants, thus it has to be bribed into not spending that money by being offered interest, i.e. by being induced by buy government bonds. Thus taxes have to be collected off the less well off so as to fund interest payments to the better off. That doesn’t make sense to me.
Why not just print and spend enough to return us to full employment, and leave it at that?
Good post Simon. I think a full answer to this criticism would need to address the fact that the deficit can depart from its planned path for reasons other than discretionary stimulus in the face of the ZLB. A 'mild' and unexpected (by central bank) shock will see a negative output gap for some period of time but may not result in the economy hitting the ZLB. In this case, government revenues will fall. But because government sets much of departmental spending for years in advance and has limited control over spending which is demand driven and statutory (at least in the short term), spending may not adjust to keep the deficit on track. And presumably, you might argue that the deficit should be allowed to increase in this sort of situation anyway - to support demand while monetary policy changes are still feeding through to demand.
ReplyDeleteThese sorts of episodes - where the deficit departs from its planned long term level and the debt stock increases - are surely more frequent than ZLB episodes and the sort of thing that you would want to model too.
The only way that I can imagine that this sort of situation wouldn't arise would be if monetary policy could always immediately offset any shock, even if it is unexpected. But I doubt you would agree with this, would you? If not, I think you need to address the impact of mild downturns as well as ZLB episodes on the path of debt reduction.
I would not want to include these because they should be matched by equivalent mild booms. The only reason for modelling these large negative shocks is either because there are no equivalent large positive booms (maybe because monetary policy is effective), and/or because fiscal action is required at the ZLB.
DeleteThanks. That makes sense. It would be interesting to know whether mild booms and mild recessions have matched each other in the past. Seems like a reasonable assumption though.
DeleteThen some desperate politician buys people's votes with tax cuts so they can stay in power long enough to fully adopt their ideological plans... and the plan falls through. Isn't that why Keynesianism always fails too?
ReplyDeleteDavid Hume will be applauding you from his grave. He pointed out 200 years ago that the REAL REASON governments are tempted to cut taxes and borrow instead is that it enables politicians to ingratiate themselves with voters. All other reasons for government borrowing are bunk, in my view. I.e. there ARE NO good reasons for government borrowing. However, I don't agree that "Keynsianism always fails". Keynes made it clear that an alternative to "borrow and spend" is "print and spend" as Simon W-L, and Portes advocate (in limited circumstances). I.e. even if government borrowing is never justified, that does not destroy Keynsianism.
Delete"Isn't that why Keynesianism always fails too?" On what facts is this statement based?
DeleteIt is still amazing to look at the ten year government bond rates, which none of the invisible bond vigilantes crowd predicted their historic lows nor that countries with different sized states would have similar figures.
ReplyDeleteToday, UK at 2.55%, US at 2.47%, France at 1.51%, Germany at 1.12%.
You'll note that when Plan A of the Coalition went wrong (2010-12) before the switch to Plan B (2012-present), Osborne said that his plan was good because his borrowing rate was lower than that of France.
I don't think we're prepared for the next crisis. Not because of the conditions, but because the politicians have not learned a thing from this episode. I dare say even that what they have learned is a net negative. E.g., many have learned that austerity is good in such situations.
ReplyDeleteHi Simon - enjoyed reading the post.
ReplyDeleteHow do these shocks compare against the Rogoff Reinhart "stylised facts" on public debt increases following a financial crisis? (http://www.theigc.org/sites/default/files/sessions/The%20Aftermath%20of%20Financial%20Crises.pdf)
I don't think it is unreasonable, given historical experience, to assume that ZLB episodes occur in the wake of severe financial shocks (indeed that is my reading of your view in this post). I was under the impression that RR suggest that gross public debt rises by on average 86% following a financial crisis. In this case, your initial jump from 0.5 would go to about 0.93 (assuming the asset side is held constant). You then reduce by 0.45 (as in your chart) to get to 0.48, which when scaled up by 86% for the next ZLB episode gives you a second peak of 0.89. This is very crude back of a postage stamp numbers, but it feels like the margin for error under these conditions is thinner than in your chart - it might not take very much in addition to derail the long term plan (no political pun intended!).
As for the long term average question - I recall a piece of work from the IMF (http://www.imf.org/external/pubs/ft/wp/2010/wp10245.pdf) collating gross debt to GDP numbers for various countries (including the UK since 1800). I seem to recall that the UK historical average is 110%. So for net debt, call it 100% :)
Best regards,
Rupert
Rupert - Two things. First, with all due respect to R&R, I'm not sure how meaningful % increases in debt are. Does that mean a country with zero debt before a crisis sees no increase in debt? Second, I like to think we at least run monetary/banking policy a bit better during a crisis than we did in the past.
DeleteHi Simon - thanks very much for the reply. You make two very interesting points, although I'd like to follow up on just the first one.
DeleteOn the question at the end of the first para - "what sort of shocks these plans might accomodate". It might be useful to view it as a reverse stress test where one asks - what is the minimum size of shocks, given the ZLB episode timings you have that would lead to the successive peaks in your debt path increasing? And then how plausible might these shocks be?
RR's % increases in gross debt (plus some assumptions around NGDP growth and asset growth) seem like a reasonable rough starting point to assess the plausibility question. You are of course correct that it is absurd to expect a country with zero debt to see no increase following a financial crisis by construction. But only Libya has zero debt according to the IMF. So I'm not sure that the legitimate point you raise is an issue in a practical sense for advanced economies (although I am open to being convinced otherwise). Incidentally, from 2007-2010, the UK followed the RR increases pretty well, although given nominal growth, debt/GDP went up by 80%, less than the 87% increase in gross debt. I appreciate this is a fluke, but as a rough initial guide on plausibility, such historical comparison might still be useful for your exercise?
Best regards,
Rupert