Osborne's RES speech and proposed new fiscal rule

I suppose I should say something about this, even though I find it painful reading his speeches. Not because they are so partisan - what would you expect? Perhaps I can describe it by comparing it to an academic reading a student’s essay. With something like Vince Cable’s speech last year, you can read whole paragraphs quite happily, and then make a comment at the end like ‘yes, but you have ignored this etc’. With Osborne’s speeches, you feel the need to get the red pen out after every sentence. Each sentence seems as if it is crafted to mislead.

Take, for example, the issue about whether high debt inhibits growth. Now I happen to think that there are good theoretical reasons why high debt might reduce growth. However my reading of the empirical evidence - exhaustively examined following the critique of Reinhart and Rogoff - is that while there may be some (rather weak) correlation between high debt and low growth, there is no evidence of causality running from debt to growth, and more evidence that causality goes the other way. This is what Osborne speech says:

“And the conclusion of the academic literature is that high debt is undoubtedly correlated with lower growth. Even the possibility should give us cause for concern given the huge impact that small growth differentials can have over time.”

Does this give a rather different impression? But read it carefully - does he say anything that is clearly wrong? As I say, it is calculated to mislead, and the speech is full of this stuff. You may think that just means he has very good speech writers, but this makes it hard for an academic to read, and maybe an odd thing to do in an academic lecture. If the invitation was given because the RES was hoping to get something more substantial than the usual Osborne fare, I fear they will have been disappointed.

Still, let’s put that aside and talk about fiscal rules. I have argued that the form of Osborne’s original rule - achieve a particular deficit target over a 5 year rolling horizon - is very sensible for normal times. Here he proposes something that seems different - to start operating once the budget has got to a surplus. He distinguishes between good times and bad times. In good times the budget should be in surplus. In bad times, as called by the OBR, the budget can go into deficit.

How to compare new and old? Could we reframe the new rule in terms of the old, by simply replacing the target of current balance with a new target of overall surplus? I’m honestly not sure - the speech is vague. What he may be doing is thinking about bad times not as your typical economic downturn, but something much worse, like the recent recession. In other words, he may be thinking about the kind of exercise I did here. If he was, we can make the following points:

1)    To allow debt to GDP to go up substantially when there are occasional large negative shocks (which are not followed by large positive shocks), it makes sense to have debt to GDP falling in more normal times. I recommended such an approach in 2009.

2)    This can be done without going for a surplus in normal times, just because of GDP growth. The exercise I did showed that. What is optimal obviously depends on the size and frequency of shocks, and the extent that fiscal policy is actively used to offset the shock. In my exercise, I allowed for another Great Recession in 2040, and thereafter every 40 years. I also allowed for much more fiscal stimulus than occurred under Obama. I assume Osborne would not allow any fiscal stimulus. Despite this, I still had debt to GDP trending downwards, with a target in normal times that was always a deficit.

3)    One interesting and clear difference between his new and old rules is the focus on the overall deficit rather than the current balance. This is also something that Jonathan Portes and I recommended in our paper. It has to be combined with a separate target for public investment as a share of GDP, and in his lecture Osborne said that in the next Parliament capital investment will grow at least in line with GDP.

4)    His proposal appears to give rather more influence to the OBR during these negative shocks. Jonathan and I also suggested an enhanced role for the OBR. In our proposal large shocks would be identified by the central bank suggesting interest rates might hit their zero lower bound, but we also said the OBR should be involved in thinking how deficits might evolve after the shock.

So there are some sensible ideas here, although the failure to acknowledge the problem of liquidity traps remains. There also seems to be an unnecessary obsession with surpluses, but I expect that is just a consequence of his short term goal of shrinking the state.

OK, one last piece of Osborne speak from the speech with relevance to my last post:

“Core inflation ... remains relatively stable and indeed rose slightly in yesterday’s data.”

And here is the data.