Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 18 December 2014

Why these updated fiscal rules are a backward step

The coalition government in the UK has just updated the fiscal rules that govern how it decides budgetary policy. I think it is helpful to distinguish between the form of those rules and the particular numbers attached to them. I and many others have already discussed the numbers on various occasions. My bottom line: it is stupid to commit to further significant fiscal contraction (‘austerity’) when interest rates are still at or close to their lower bound. It means we become more vulnerable to adverse shocks to demand. An academic quibble? No, it is what happened in 2010. Unlike 2010, however, no one with any sense thinks we must have austerity to avoid being punished by the markets.

I want to talk in this post about the form of the rules. Here the change compared to 2010 appears minor. The primary mandate now has a 3 rather than 5 year rolling horizon, and the date for the secondary target of a falling debt to GDP ratio has just been shifted ahead to 2016/7.

In my paper with Jonathan Portes (here or here), we argue that fiscal rules can have two goals. They can try to mimic optimal fiscal policy, or they can be effective at restraining a government that is subject to deficit bias (basically spending too much and taxing too little). The main point about optimal fiscal policy is that government debt and deficits should be shock absorbers, and spending and taxes should be adjusted slowly to meet any debt target.

In this context the coalition’s secondary target remains a bit of nonsense. Getting the debt to GDP ratio to fall at some stage is a good idea, but having a target for a specific year is silly. It is not optimal because if some shock hits the economy before 2016/7 which means debt tends to rise relative to GDP, it is crazy to try and counteract that to meet the target in such a short space of time. It is not effective because it can be gamed by the government fiddling the timing of expenditures.

In contrast, Jonathan and I argue that the form of the original primary mandate makes a lot more sense, as long as interest rates are not at their zero lower bound. Having a five year rolling target for the deficit allows fiscal policy plenty of time to adjust to shocks. We saw this in action over the last few years, as the Chancellor was able to reduce the pace of fiscal consolidation from 2012 when the economy failed to recover as quickly as he had hoped. Changing this mandate from five to three years gives any Chancellor less time to adjust, which is why it is a backward step.

In talking about the change, the Treasury says it “reflects the progress that has been achieved in tackling the deficit, which means that the mandate can be safely shortened to create a tighter constraint on future fiscal policy choices.“ This is one of those lovely phrases that sounds plausible until you think about it. The whole point of having a rolling target is that it gives you time to adjust to shocks, when too rapid an adjustment would be costly. Has the expected size of shocks got smaller, so we can safely create “a tighter constraint on future fiscal policy choices“? I don’t think so.

Of course I know, and indeed everyone knows, that the reason for this change has nothing to do with economics and everything to do with politics. Whether it is clever politics or not I will leave to others to debate. In addition on this occasion the numbers in the rule, and the risk he is taking because we are still at the zero lower bound for interest rates, matter more than this change from a 5 to 3 year rolling target. But it is still a shame we are going backwards. I have just finished an article, due to appear in February, on the coalition’s macroeconomic policy, and to set against the obvious mistake I was able to count two successful innovations: the creation of the OBR and the 5 year rolling fiscal mandate. Now we are left with just one.    


  1. “The main point about optimal fiscal policy is that government debt and deficits should be shock absorbers..” OK, suppose a shock reduces demand. I think we all favour a deficit, but why fund it with debt rather than new money? Keynes said recessions can be countered by spending new or borrowed money. I totally fail to see the point of borrowing because that has a deflationary effect: exactly what’s not needed in a recession.

    1. An interesting point but perhaps may not be totally deflationary. Whilst the primary drive may be political, from an economy standpoint, the government sector is just crowding out private sector spending. I agree with your point of increased borrowing, I feel the politics of all the major parties are careful on how to address the implications of a less 'favourable' fiscal policy. Alas, the politics is perhaps just a PR exercise in managing the inevitable.

  2. It's been interesting since the OBR outed the Tories for wanting to take the state back to 1930s levels of GDP.

    Repeatedly from radical right journalists - twice at least Andrew Neil on his BBC and others at the regular places - I have heard that spending will only be back to 2003 levels not to those of the 1930s.

    This is what has come of Nick Clegg saying in 2010 that state spending will be back only to 2004 levels when expansionary austerity has finished, a line supported by Stephanie Flanders on her then BBC blog.

    Sadly after 5 years of Coalition government, the OBR seems something less than half a loaf, but at least in its latest action it may be enough to derail the Tories' manipulative behaviour.

    1. I just want to know what will happen if (a) we do not reduce the deficit. (b) we do not reduce the numerator in the "Debt to GDP Ratio". (c) If we do not achieve (a) or (b), how will that affect 26.4 million households and their ability to earn a living, have a bit of fun and put a bit away for their old age. That is, save a "financial" asset issued by the Treasury; or save by creating a "real" asset (a house, but preferably a factory that makes things and employs people), constructed from a commercial bank loan that was paid back.

      Monetary policy is useless in most circumstances, targeted taxation would be much better at controlling sectoral inflation, rather than the sledgehammer of a economy wide base interest rate. The only thing monetary policy can do is swap an interest paying financial instrument, that carries a promise of future redemption, in anything up to 30 or more years, with one that pays out no interest, in no time at all (cash or "reserves"). A sovereign fiat currency economy has no need to issue interest paying "debt" instruments; it does not have to "borrow" money. Unless, it wants a mechanism to inject free money (fiscal stimulus) into the economy; there are much easier ways for the government to do that, if you want a "risk free" interest paying asset to pay your pension.

      As Warren Mosler says. "Mosler's Law: There is no financial crisis so deep that a sufficiently large tax cut or increase in public spending cannot deal with it."

      The bottom line of my argument is that "financial markets" (apart from genuine capital raising ventures for putting new ideas into production), are merely parasitic secondary activity, that add no socio-economic value whatsoever to 99% of our 26.4 million households. Financial markets are the biggest con trick in the galaxy.

    2. The whole if the debt is above "x%" the markets will crash is a load of rubbish. If you take into account PFI and the bank bailouts, it is a lot worse, and there isn't a problem.

  3. All fair comment about binding youself when the future is so unknowable.

    But what is really "stupid" is continuing to think that the zero lower bound constrains monetary policy. Interest rates don't define policy, they are merely one tool for central banks to get what they want.

    It's what central banks want that is crucial, but these days rather vague. The US has just loosened monetary policy by vaguely promising longer than expected (near) zero rates and the market reaction tells us so. The reaction is the policy, not the statement (that is the tool).

    1. What happened to the S W-L who wrote this?

    2. Cameron was right when he said the "rising cost of debt interest" was a problem. The government does not need to issue gilts to finance spending.
      The whole idea of separate fiscal and monetary policy is silly. The government should print money to spend on flood defenses and capital infrastructure.

    3. Why is it always spending with Keynesians, New Keynesians and the like? Why never tax cuts?

    4. Random,

      I agree that "the whole idea of separate fiscal and monetary policy is silly". That was what I said (at least implicitly) in my first comment above.

      Re infrastructure etc, it may well be that we need to spend more on that in the long term, but I don't believe in upping that sort of spending in a recession because (apart from a few shovel ready projects) that sort of investment normally takes years to plan and get going, by which time the current recession will probably have finished.

  4. In the light of todays announcement by the Swiss National Bank to charge a negative interest rate, does this mean the zero lower bound has been removed/avoided/nullified?

    1. Not really. The problem with a substantially negative rate is that banks could simply ask to have their reserves converted to cash and stick it in the vault. The new Swiss rate is only -0.25%, so it's not worth the handling/storage issues of cash just to save a quarter percent. But if a CB tried to push it much more negative, you'd see major cash hoarding. Ideas have been floated for all-electronic money, uncoupling of the cash-to-reserves exchange rate, etc, but nothing like that has been done (yet).

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  7. According to their paper (referenced above), the thinking of Simon Wren-lewis & Jonathan Portes on matters relating to fiscal targets and budget deficits is based on mathematical results derived from unrealistic assumptions, e.g.:
    1."social welfare declines as taxes rise, because taxes are distortionary"
    2. "we ignore financing through printing money" .

    Weird assumptions ===>> weird results.

    Following Abba Lerner, MMT literature is much more relevant because it is not based on such assumptions.
    "Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, “printing money,” etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability …" - Lerner: Functional finance and the federal debt. Soc. Res. 10:38-51, 1943.


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