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.