Things can go wrong when policymakers do not ask the right questions, or worse still ask the wrong questions. Take my analysis of alternative debt reduction paths for the UK following the 2015 elections. There I assumed that the economic recovery would continue as planned, with gradually rising interest rates, achieving 4% growth in nominal GDP each year. I set out a slow, medium and fast path for getting the debt to GDP ratio down, and George Osborne’s plan. On the latter I wrote: “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.”
Ah, said some, that is all very well, but you are ignoring what might happen if we have another financial crisis. That will send debt back up again. The implication was that the Osborne plan might make sense if you allowed for this kind of occasional but severe shock. In a subsequent post I showed that this was not the case. However this also illustrates a clear example of asking the wrong question. Rather than setting policy today on the basis of something that might happen in 30+ years time, we should be worrying about much more immediate risks.
The question that should have been asked is what happens if we have a rather more modest negative economic shock in the next five years. The list of possibilities is endless: deflation in the Eurozone, the crisis in Iraq and Syria gets worse, Ukraine blows up, things go wrong in China etc. We can hope that they do not happen, but good macroeconomic policy needs to allow for the fact that they might.
That is the question that was not asked in 2010. The forecast attached to the June 2010 budget didn’t look too bad. GDP growth was between 2% and 3% each year from 2011 to 2015 - not great given the depth of the recession, but nothing too awful. But suppose something unexpected and bad happened, and economic growth faltered. The question that should have been asked is what do we do then. The normal answer would be that monetary policy would come to the rescue, but monetary policy was severely compromised because interest rates were at 0.5%. So 2010 was a gamble - there was no insurance policy if things went wrong. And of course that is exactly what came to pass.
As I have always said, there was an excuse for this mistake. In 2010 there was another risk that appeared to many to be equally serious, and that was that the bond vigilantes would move on from the Eurozone periphery to the UK. This was a misreading of events, but an understandable confusion. By 2011, as interest rates on government debt outside the Eurozone continued to fall, it was clear it was a mistake. Policy should have changed at that point, but it did not - instead we had to wait another year, and then we just got a pause in deficit reduction rather than stimulus.
Today, there is no excuse. There are no bond vigilantes anywhere to be seen. No one, just no one, thinks the UK government will default. This means we are free to choose how quickly we stabilise government debt. However what is very similar to 2010 is monetary conditions. Interest rates may have begun to rise by 2015, but any increase is expected to be slow and modest. So there will again be little scope in the first few years for monetary policy to come to the rescue if things go wrong. A negative demand shock, like another Eurozone recession, will quickly send interest rates to their zero lower bound again, and we will have little defense against this deflationary shock. The tighter is fiscal policy after 2015, the greater the chance that will happen. In that sense, it is just like 2010.
So the right question to ask potential UK fiscal policymakers in 2015 is how will you avoid 2010 happening again? If their answer is to do exactly as we did in 2010 and keep our fingers crossed, you can draw your own conclusions.