Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 15 April 2015

Confidence

Mainly for economists

Francesco Saraceno reminds us about the days in which very important people believed in the confidence fairy (aka expansionary fiscal austerity), which are not so very far away. He also points to some recent ECB research which shows that confidence - as measured by surveys - clearly falls following fiscal austerity. The confidence fairy, rather than waving her wand to make everything alright again, may be making austerity worse. 

However, looking at the research in detail revealed some results I found at first surprising. In particular, revenue cuts have a bigger effect on consumer confidence than spending cuts. In terms of GDP impacts, theory - and most but not all empirical evidence - suggests that temporary spending cuts will have a larger impact on overall activity than temporary tax increases, if there is no monetary offset and incentive effects are not very large. Do these empirical results contradiction this?

To answer that you need to ask two further questions. First, what does consumer confidence actually measure? Second, and perhaps more interesting, what information do fiscal announcements actually reveal.

The answer to the first question seems to be a mixture of things, some of which relate to the individual household’s income, and some related to the general economic situation. To the extent that the consumer is thinking about the former, then it would make sense that a tax increase might have a larger impact on confidence than a spending cut. This would tell you very little about the economic impact of the two types of measure.

The obvious answer to the second question is that the information conveyed by an announcement of a spending cut or tax increase is just itself. If we stick to taxes, then if the announcement had not been made, the consumer would have just assumed lower taxes (for a time, or forever?). But this is naive from an intertemporal perspective, and clearly non-Ricardian. In the logic of Ricardian Equivalence, a tax increase today must imply cuts in taxes tomorrow for a given path of spending.

There are three alternative, more ‘rational’, ways of thinking about the announcement of a tax increase. Suppose the current government budget deficit is not sustainable. Taxes either need to rise today, or tomorrow after more borrowing. The announcement then tells us about the timing of the tax increase. If Ricardian Equivalence held it would have no impact on lifetime discounted income, but if for many possible reasons it did not hold, then a tax increase today could depress consumer confidence. However, to the extent that confidence depended on the general economic situation, you would expect ‘bringing forward’ expenditure cuts to have a much greater impact than bringing forward tax increases (with the caveats noted above), because of consumption smoothing. In that case spending cuts should reduce confidence more than tax increases.

A second possibility is that a tax increase could signal something about the future economic situation. Perhaps the consumer had thought the deficit was sustainable because they were optimistic about future growth, but the tax increase told them to be less optimistic. Reduced optimism could lead to reduced confidence. To the extent that the fiscal action conveys information about future pre-tax incomes, the tax increase conveys the same information as a spending cut.

A final possibility, which is generally ignored when discussing the plausibility of Ricardian Equivalence, is that the announcement of a tax increase tells consumers about the composition of any consolidation. Suppose again that the deficit is unsustainable. Either taxes have to rise or spending fall, but the consumer does not know which of these will happen. If spending is then cut, this tells the consumer that taxes will not rise, which in terms of the consumer’s own income would represent a plus. So in that case a spending cut could increase consumer confidence.

Trying to evaluate the impact of past fiscal actions is complicated, in large part because it is difficult to know what the counterfactual was, or what people thought the counterfactual was. Were changes thought to temporary or permanent? (Governments hardly ever say, and even if they did would they be trusted?) To what extent do people internalise the government’s budget constraint? If they do, are fiscal changes telling us about the timing of taxes or spending, or their mix, or something else? It seems to me that these difficulties arise whether we are trying to assess the impact of fiscal changes on confidence, or on activity itself. 


15 comments:

  1. Rhetorical question: is this why the Conservative 2015 manifesto uses the word 'plan' 121 times?

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    1. "If you repeat a lie often enough, people will believe it, and you will even come to believe it yourself."

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  2. "Perhaps the consumer had thought the deficit was sustainable"

    As a non-economist I always find statements like this puzzling. I sort of understand the importance of expectations in this sort of discussion but surely it can be taken too far? The average consumer doesn't even know what 'deficit' means, so the idea that confidence is affected by individual logical assessments of what tax rises/spending cuts mean for the future path of government deficits just seems unfeasible. Aren't more visceral reactions to spending (profligacy, waste, living beyond your means) and cutting (saving, thrift, prudence) more likely?

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    1. JD,

      I quite agree. Problem is that too many economists are just not interested in reality: complicated but unrealistic hypotheses are more fun.

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    2. I'm sorry, but, Simon, I think that the fact that you have to defend yourself against people wielding Ricardian equivalence arguments shows how messed up some of the economics profession has become.

      If people are so omniscient and rational why don't they even save for their own pensions?

      Show me one example of Ricardian equivalence holding up in reality.

      Ricardian equivalence just should not be a thing. If the people who thought it up had spent as much time studying empirical data as they did creating an extremely 'rational' framework of nonsense, maybe our economy would be in a much better place now.

      Incidentally, I've also heard recently that Art Laffer is back on the scene again, advising the Republicans that the problem with the economy is that the super rich are taxed too much.

      How does this fantasy construct gain so much power that people with sensible suggestions are forced to jump through these ridiculous hoops.

      Rant over!

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    3. good rant! ricardian equivalence is one of those "how many angels on the head of a pin" debates that scholastic economists win nobel prizes for

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    4. I can actually see the point of this sort of thought experiment when it comes to explaining behaviour. Of course individuals don't make decisions about whether or not to spend the proceeds of tax cuts based on their rational assessment of the future path of government expenditure, but at the population level this could happen. The 'consumer' being referred to in this case is not an individual but a shorthand for group behaviour. The behaviour over time of individuals reacting to complex individual circumstances might aggregate to something approaching this rational expectation: the wisdom of crowds and all that. I don't know if this is true, but I'm prepared to believe that it might be, and I assume people spend time trying to work out if it is.

      My point (not very well made) was that whatever usefulness this approach has must break down when it comes to assessing confidence. People answering survey questions about the general economy are not reacting over time to complex individual circumstances: they're just saying what they think at that moment. We know that responses in these sort of circumstances are very heavily influenced by things like the order the questions are put in, or how they're put. Respondents will also be influenced by their current view of their own situation, by what they read in the paper that morning, by their instinctive reaction to concepts like 'thrift' and so on. I would confidently expect these effects to swamp their assessment of the future path of government spending based on recent announcements, if only because that assessment will in almost all cases be non-existent.

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  3. Among other things, Ricardian Equivalence requires intergenerational altruism. Otherwise there's no reason to care about possible tax increases after death.

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  4. Tax rises are easily understood by those who pay them as their personal effect can be clearly calculated.

    Spending cuts tend to have far more diffuse effects, far more difficult to assess the personal consequences of a reduction in defence spending.

    So I'm puzzled as to why anyone would presume that spending cuts would depress confidence more than tax rises other than in those groups where a spending cut is equivalent to a tax increase. For example a cut in the jobseekers allowance for a jobseeker looks a lot like an increase in income tax to an employee.

    And the man in the street whose views the survey captures will, with good reason, be skeptical of a politician's claim that the tax rise is temporary.

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    1. Most of this post is about the effect of tax rises/spending cuts on consumer confidence as it relates specifically to the general economic situation, rather than personal effects.

      However it seems likely that when answering questions about the general situation, respondents will be coloured by the impact on their personal situation. This appears to apply to bankers when contemplating the impact of high income tax rates, so why not the man in the street?

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    2. Actually, just thinking about it...

      Another possibility you didn't mention, which may or may not be Ricardo equivalent (I admit I am not an expert):

      Lower taxes now -> expectation that the government will resort to creating inflation to get out of its debt -> you may as well spend your money now while you still can.

      Equally logical and implausible as the other versions I think.

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  5. I'm not sure why you are surprised. I see no contradiction between the claim that spending cuts cause a larger reduction of aggregate demand and GDP than tax increases and the claim that tax increases would cause a larger reduction in consumption for given GDP. The reason is that G is part of aggregate demand (so simple I am embarrassed to type it).

    The claim that cutting G causes lower GDP doesn't rely on the claim that it causes lower consumer confidence at all. In the USA and Italy it is certainly widely believed that much of government spending is wasted and that lower spending would be better (see countless polls). Given this belief, it is not at all surprising that consumers aren't alarmed by spending cuts.

    As I said, I don't understand why you are surprised. I think there is an inclination to assume rational expectations. You are quite sure that a cut in spending causes a greater decline in GDP in an economy with slack demand in a liquidity trap (I agree). Therefore, you guess that consumers will believe this too. I think you are mildly inclined to guess that consumers' expectations will be consistent with your model, because your model is consistent with the evidence.

    But I remain mystified as to why anyone would make such a strange guess.

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    1. Absolutely agree, if you interpret consumer confidence as confidence about consumption, rather than the economy as a whole. From the nature of the questions it seems unclear which interpretation is correct. But I would just note that the authors of the study seem quite happy to use this evidence to justify spending based fiscal consolidation rather than tax based consolidation!

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  6. I'm not sure why you are surprised. I see no contradiction between the claim that spending cuts cause a larger reduction of aggregate demand and GDP than tax increases and the claim that tax increases would cause a larger reduction in consumption for given GDP. The reason is that G is part of aggregate demand (so simple I am embarrassed to type it).

    The claim that cutting G causes lower GDP doesn't rely on the claim that it causes lower consumer confidence at all. In the USA and Italy it is certainly widely believed that much of government spending is wasted and that lower spending would be better (see countless polls). Given this belief, it is not at all surprising that consumers aren't alarmed by spending cuts.

    As I said, I don't understand why you are surprised. I think there is an inclination to assume rational expectations. You are quite sure that a cut in spending causes a greater decline in GDP in an economy with slack demand in a liquidity trap (I agree). Therefore, you guess that consumers will believe this too. I think you are mildly inclined to guess that consumers' expectations will be consistent with your model, because your model is consistent with the evidence.

    But I remain mystified as to why anyone would make such a strange guess.

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  7. If Ricardian Equivalence and rational expectations are true and we are all knowing can we sack the economics profession as an efficiency measure ;)

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