Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 16 June 2015

No basis in economics

That was the claim about George Osborne’s plan to outlaw government deficits in normal times made in the letter signed by 79 economists. It is a strong claim. To see why it is a tenable claim, it is important not just to think about the short term situation and the usual controversies that go with it.

Before I do that, I have a confession. I had until recently assumed that the surplus target would be inserted into the kind of rule he set up when he became Chancellor, which allowed considerable flexibility in how quickly that target was achieved. However while writing this post I realised I may be wrong: he could be planning to replace that kind of flexible rule with legislation that simply outlaws deficits in normal times. That is important, because it would mean one of two things. The first is that the government would attempt to hit some target for a small surplus (say 0.5% of GDP) each and every year. That means that in response to quite normal shocks and forecast errors that hit the public finances, taxes or government spending would be pushed up or down to compensate. [1] The second is that the government would have to aim for surpluses somewhere around 2% of GDP, to provide a sufficient buffer to absorb those shocks and forecasting errors.

The most basic of macroeconomic theories when it comes to thinking about fiscal policy is due to Robert Barro, who is hardly an active supporter of Keynesian stimulus spending. It is called tax smoothing, but it can easily be applied to government spending as well. (It forms the basis of much of what economists call the dynamic optimal taxation literature.) This says it is taxes and spending that matter, not debt or deficits, and it is best to plan such that the path of taxes and spending is smooth. Another way of putting the theory is that the deficit should be a shock absorber, and planned reductions in debt should be slow. (This was the theory behind the recent IMF paper I discussed here.)

So how does the plan to outlaw deficits look in the light of this literature. If the plan involves targeting a small deficit each and every year, that is the complete opposite of tax smoothing. Taxes and spending would become volatile so the deficit could be smooth. That is crazy, because it is taxes and spending that impact on people and not the deficit.

If the plan involves going for a larger surplus on average, that would allow smoother taxes and spending in the short term. However average surpluses of 2% would imply an incredibly rapid reduction in government debt. Coupled with 4% nominal GDP growth they would cut the ratio of debt to GDP from the current 80% to Gordon Brown’s 40% target within a decade. Within two decades government debt will have largely disappeared, which allows taxes to fall or spending to rise. [2] But that will also violate tax smoothing, this time at a frequency involving generations rather than years. You could put this in terms of intergenerational equity: the current young, who suffered most from the Great Recession, will bear the full burden of reducing debt. Future generations will get the benefits of existing public capital while contributing nothing towards it. 

So both versions of outlawing deficits in normal times violate the tax smoothing idea. But it gets worse. If real interest rates and wages vary over time, it is best to invest when borrowing and labour are cheap: that is not just basic economics but common sense. Both borrowing and labour are currently cheap. Yet to meet the surplus target, the government plans to keep public investment on infrastructure lower than at any time over the last twelve years.

So even if you put all the short term Keynesian concerns to one side (which of course I would not), outlawing deficits makes no economic sense. Yet Philip Booth of the IEA takes exception to this claim. But the only theory he can come up with to support the plan is the idea that sometimes it is better for the government to tie its own hands. He says “the 79 seem unaware of these basic ideas”. Of course the 79 are aware of the pros and cons of commitment (for a full discussion applied to fiscal rules see Portes and Wren-Lewis), but what you should never do is commit to rules that make no sense. Following daft rules will always be daft. Outlawing deficits is a daft rule.


[1] The rule then is virtually identical to a policy of always running a balanced budget. Students learn the problems with that rule in their first year studying economics.

[2] The only way you could make sense of this policy is if the surpluses continued even when debt had disappeared, and the government built up a large sovereign wealth fund. Although I have explored this possibility in an academic paper with colleagues, the current government has never mentioned this goal, so I think we can discount it here.  

32 comments:

  1. Worryingly, there is a way to make Osborne's plan consistent with intergenerational equity: privatise all currently public capital. Then future generations will have both no public capital and no debt liability to go with it.

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  2. Whilst you have provided another excellent analysis and clear explanations highlighting the idiocy of Osborne's economic proposed policies/laws, there is a seemingly irreconcilable difference in your approach to this debate and Osborne's, giving rise to an asymmetrical argument : Your arguments are based in economics and a considered analysis of the merits/demerits of the proposals; Osborne's arguments and proposals are based in pure ideology, with no reference or consideration to theoretical or practical economics, or evidence of course. It is impossible to engage in a meaningful, coherent debate with someone who will not engage in theory and evidence based analysis.
    Rather like pointing out to someone on a beautiful summer's day that the sky is blue, only for them to vehemently disagree and do so whilst refusing to look upwards - which bizarrely means for them that the sky is not blue and you are wrong.

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    1. I agree with the gist of your argument, but would argue that whilst SWL basis his arguments on an attempt at rationally choosing optimal economic policies, Osborne is rationally choosing optimal policies to get himself re-elected.
      Osborne is aiming his message (which btw, I believe is nonsense) at his target audience. There is that sector of the UK electorate that want to hear that sort of stuff – they will never get beyond seeing the economy as a whole in terms of a household budget and see borrowing as bad – saving good – end of. SWL can put forward all the arguments he wants – they aren't listening and never will – Osborne knows it and so doesn't have to argue back.
      It is about creating a general sense of Conservative branding that is an attempt to reinforce the impression that they are prudent etc….
      Osborne's ideology is to get re-elected.

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    2. I agree with what you say, just to add that the icing on the cake of getting re-elected is that of the ideological goal of a smaller state.

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    3. Yes you're probably right. I suppose I see all policy rhetoric as a means of getting re-elected rather than an end in itself. But then, when thinking of politicians, I do use Jim Hacker as my yardstick.

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  3. A sensible compromise would be to aim at 0 deficit over a long period and allow for some small deficits and small surpluses. Coming from a family that looked upon mortgages with concern, I think that a slow decrease in the debt would be good for the economy in the long run.

    Of course, it would be possible to legislate adequate controls on banks were implemented to prevent future crises, but I also believe in fairies.

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    1. You can't apply household analogies to government. It just does not work - at all.

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    2. Random16 June 2015 at 09:31

      "You can't apply household analogies to government. It just does not work - at all."

      That's what you believe.

      You probably also believe thatinflation is the cure, not the disease.

      Dream on.

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    3. You reduce inflation by reforming areas of the economy that have price or cost pressure.
      Not by jiggling around with govt policy!

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  4. You provide a link to the Philip Booth article which makes a number of arguments which you then don't challenge for example the effect of an ageing population on both revenue and expenditure, that the original letter appeared to ignore the holding of UK govt debt by institutions outside the UK and so forth

    Would be good to hear the reasons why these are not effective points (or acknowledgement that they are)

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    1. The arguments would need developing more to make sense of them. For example, the obvious solution to people living longer is to increase the retirement age. A real issue is that as people on average get richer they want to spend more on their health, but it is not clear why that should not be met by higher taxes nearer the time.

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    2. Yes, Simon, I would also like to see you respond to Booth's other arguments, particularly about the foreign sector. There's also an article by Ryan Bourne here:

      http://www.cityam.com/217985/hysterical-keynesians-need-ditch-hyperbole-if-they-don-t-want-be-ignored

      I'm not saying these articles are great throughout, but think some of the points are worth responding to.

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    3. Looked like much the same to me: "Perhaps those academics were just ignorant of developments in their field." That kind of thing is just pathetic - the monetarist policy he is referring to failed dismally and was abandoned with a few years. Perhaps I could ask you to pick out the points you think need responding to - I just find this kind of political polemic too annoying!

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    4. The foreign sector is really quite a red herring here. While it is true that the government deficit was approximately equal to the current account deficit this year, there is no direct causation running from government deficit to current account deficit.

      There is a certain proportion of government money that will be spent on imports but it is considerably less than 100%. Demand for imports would go down a little but so would demand for domestic goods and therefore GDP.

      In order to get the current account deficit to zero, the UK would have to follow the same demand destroying, savings enhancing, policies as the surplus countries. This race to the bottom would be bad for everyone.

      Maybe the Bank of England could print new GBP in the amount of the current account deficit and sell them for foreign exchange. This would reduce the value of the pound, acting as a tax on uk citizens, reducing demand for imports.

      But to talk about the foreign sector as if it has a serious impact on the budget deficit question is ridiculous. They are two separate issues.

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    5. Simon, I am referring to this passage:

      "This might be true under one very strict assumption – that the foreign sector is irrelevant to this process. Given that the foreign sector holds 33 per cent of UK government debt, this is a really rather implausible assumption. A government surplus could – indeed, probably would - lead directly to reduced capital inflows which are necessary to finance borrowing, in turn this would precipitate a fall in the exchange rate and possibly a consequent improvement in the balance of payments.
      This might not happen, all sorts of other things could happen too, but, even if we assume away the 6,940m people who do not live in the UK, the chain of events that the 79 propose is highly unlikely to happen. What might be the result of a budget surplus in the absence of any foreign capital flows? The most likely scenario is that the government would begin to redeem its bonds or issue fewer bonds to fund redemptions. Around 60 per cent of government bonds not held by overseas lenders are owned by UK life and pension funds. Most of the rest are held by non-bank financial institutions. So, the government will redeem bonds and UK life and pension funds, for example, will invest in other financial instruments.
      This may lead to various consequences, such as increases borrowing and equity issuance by corporations. This may represent an increase in net investment or a reduction in net saving by the UK non-government sector as the 79 suggest but the intellectual somersaults you need to jump through to turn this into a banking crisis are extraordinary. If this group of economists believe that the next banking crisis will be caused by the government running a small surplus, then they can no longer see the wood for the trees."

      Ari you have partially addressed the issue but I don't feel you have addressed Booth's arguments head on.

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    6. There is an old literature on the 'twin deficits' - to what extent do budget deficits go hand in hand with current account deficits. This is the same question in reverse. And what that literature comes down to is that you cannot say anything precise until you know how the budget deficit is changing.

      For example, if the surplus is achieved by cutting child benefits for the well off, the impact on consumption could be quite small, and so the surplus would largely be met by a larger personal sector deficit. Other means of achieving a surplus could involve a real depreciation, and therefore a move to current account surplus.

      So the argument that a budget surplus will lead to an increase in the consumer deficit is not obviously silly. This in turn may increase the likelihood of personal debt problems. It is not in my view the most important reason why going for surpluses makes no sense, but it is not a stupid concern either. I seem to remember a number of people noting the personal sector deficit projections the OBR has been making with concern.

      I personally would place more emphasis on short term ZLB issues and medium term inflexibility, which the letter also mentions.

      But I would make an additional, very important point. What the letter has succeeded in doing is getting across the message that there is no obvious economic rationale in favour of Osborne's policy. The IEA does not seem to be defending the policy itself: they are more interested in picking apart the details of a letter that no doubt was drafted by a committee. That in itself is a ploy. We should be talking about the policy, and the fact that - for the moment at least - no economist seems to want to defend it.

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  5. I can't understand why a government would want to restrict its freedom of action in such a way. But then, the government has obviously been captured as a whole. You say that people are not affected by deficits but by changing taxation. That's correct, but then this government doesn't make policy for the people, but instead for those who ARE affected by debt, i.e. those who fear that deficits will have to be inflated away, i.e. rich people and financial institutions.

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  6. I see that Skidelsky's has penned three responses to Niall Ferguson, a man Skidelsky describes as a 'skilful controversialist', the second of which cites your £4,000 figure (Project Syndicate, MAY 28, 2015 'Niall Ferguson’s Wishful Thinking').

    I wonder if Booth and Ferguson are better dealt with simply by being ignored, while all time is spent focusing on the uneconomics are our current government?

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    1. My original post commenting on Ferguson's FT article has now risen to number one in my most read posts of all time chart. He has a big audience, and so cannot be ignored. I hardly ever comment on IEA posts.

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    2. Ignore Skidelsky.

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  7. In the U.S., the states have to balance their budgets and so we see how this harms their economies during recessions when tax revenues dry up and they have more social spending. Growth slows and unemployment goes up, etc. They lay off public employees.

    During recessions, the Federal government would include financial aid to the states as part of their countercyclical stimulus packages. In the past these worked quite well.

    With the Obama stimulus after the financial crisis, the aid was meager because Republican Senators didn't want to let state governments off the hook and Democratic Senators didn't want to help Republican governors who might run for the Senate. In the end, the Obama stimulus's economic effects was canceled out or negated by the "50 little Hoovers" balancing their budgets and so the recovery was long and slow and the central bank had to work harder to meager effect.

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    1. The QE programs from the central bank did not benefit the recovery.

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  8. "...the government plans to keep public investment on infrastructure lower than at any time over the last twelve years." Does this contradict the Conservatives' manifesto pledge page 14: "Public investment will be higher on average over this decade as a percentage of GDP than under the whole period of the last Labour government"? I suspect both statements are truthful but it would be interesting to see a reconciliation of the numbers.

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    1. Not quite true for net investment, but just true for gross investment. My statement is true for both. Reason both statements are true is that investment in the first few of the Brown years was very low. In terms of gross investment, plans average 3.5% of GDP. Average from 1948-1996 was 7.2%. Suggests massive under investment in public capital.

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  9. What Osborne is saying then is "We won't mend the roof when prices are low, we'll wait until they cost a lot."

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  10. forgive me for being off topics but your link to the niesr blog doesn't work.
    The blogs you regularly read are outstanding

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  11. So whenever there's a demand fluctuation and a small temporary deficit arises we'll have a permanent cut in benefits because it's the "only way we can stick to our fiscal rules". Great plan for gradually shrinking the state.

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    1. And if multipliers are near 1 then the cuts will have to be quite a lot bigger than the deficit. Sounds like a recipe for making recessions worse.. and for the government to only be allowed to invest in boom times.

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  12. You are a joke. For years you've been arguing for increased borrowing during the bad times and running surpluses and balanced budgets in the good times. Now, you are arguing that running surpluses in the good times is a bad thing. It's obvious what's going on. You're just adjusting your economic opinions to bash the Torys based on your left wing views.

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    1. Good times? Interest rates at 0.5% almost by definition imply these are not good times. I have set out what a reasonable path for deficits might look like in average times here:

      http://mainlymacro.blogspot.co.uk/2014/06/uk-fiscal-policy-from-2015.html

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    2. Yes, and the bill doesn't say anything about this year. It just talks about good times in general. Presumably a few years down the line.

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  13. George Osborne, the Manchurian candidate

    If indeed “the government would have to aim for surpluses somewhere around 2% of GDP, to provide a sufficient buffer to absorb those shocks and forecasting errors” and if abnormal times are sufficiently unusual, the State will have no debt left within several decades and will own the country’s capital stock within several generations.

    And for all we know, because of the more violent business cycle – no automatic stabilisers left – and accompanying immiserisation, the Manchurian candidate may even reach his goals within his own life time.

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