Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 8 October 2016

Very Serious People and the deficit

I'm glad Paul Krugman liked my General Theory of Austerity paper. But he wonders whether I might be missing something, in not explaining why Very Serious People (VSPs) in the US, or mediamacro in the UK, presume that deficit reduction is always a good thing. The constant call for deficit reduction seems to transcends party politics, and furthermore should be something that the wise always promote.

I do talk about the influence of the City/Wall Street and central banks, but perhaps there is something in addition which I talked about in a recent post: deficit bias. 
Keynes talked about 'practical men' who tended to absorb some of the wisdom of 'academic scribblers' of 'a few years back'. The wisdom in this case was deficit bias: the tendency that many economists discussed before the financial crisis for deficits and debt to tend to rise over time, across cycles.  Perhaps VSPs and mediamacro have absorbed this particular area of academic analysis?

I think you can tell a similar story about academic scribbling of years past when it comes to the roles of monetary and fiscal policy. In the UK George Osborne argued explicitly that the economic consensus was now that monetary policy should deal with stabilising output and inflation, while fiscal policy makers should look after their own deficit. I have called this the consensus assignment. If he, or his advisors, absorbed this piece of conventional wisdom, so may VSPs and mediamacro.

So the headline academic scribbling was governments should control deficits, not the economy, and they are bad at it. Some of the theories put forward to explain deficit bias involve politicians knowingly deceiving voters by pretending tax cuts or spending designed to capture votes were 'affordable', and relying on general lack of understanding of the government finances to not be found out. That gives VSPs and the media more generally a clear role in providing a public service to help counteract the wickedness of politicians. VSPs might even think it was their public duty to constantly advocate deficit reduction to counter deficit bias.

As they say, a little knowledge can be a dangerous thing. Those of us working on the front line of monetary and fiscal interaction, or who had studied economic history or looked at the lost decade in Japan, knew the conventional assignment broke down when interest rates hit their lower bound. We knew that a liquidity trap was absolutely not the time to worry about deficits, and if you did so you would cause tremendous damage. And we were right.

So if you believe this story, the lesson for VSPs and mediamacro is you really need to talk to economists in the front line more often.


  1. Krugman blog July 23, 2010 'Getting Trendy':

    "So what we want to do is compare output with what the economy could be producing. And to estimate that, it’s a good rule of thumb to extrapolate from the last business cycle peak. Why? Because at the peak of the business cycle, the economy is usually operating close to capacity — in part because central banks try to throttle growth back when they think the economy is in danger of running too hot, leading to inflation. It’s standard practice to assess economic trends with peak-to-peak interpolation, because the peaks are a reasonable estimate of the economy’s capacity, while other points on the business cycle don’t convey anything like that information.

    So I measure my trends from the last business cycle peak.

    But, say some readers, what if growth at that peak was inflated by a bubble? OK, that’s confusing supply and demand. Bubbles drive demand — they don’t increase the economy’s capacity (if anything they reduce it). They drive capacity utilization, so that a bubble may drive the economy to a peak; but that peak is still a good indicator of how much the economy can produce, no matter if it’s producing stuff people shouldn’t be buying.

    So I know what I’m doing with these trend lines.

    OK, the caveat: we don’t really think the economy has a fixed upper limit on output; it’s more of a soft limit, with inflation accelerating as you push unemployment below the NAIRU. That’s why the economy can sometimes operate above standard measures of potential output, which are NAIRU-based. But that just means that when I use, say, 2007 as a base, you need to ask whether there were signs of accelerating inflation back then. There weren’t. And bubbles remain irrelevant.

    Why does all this matter? On both sides of the Atlantic, advanced economies have surely seen a significant rise in capacity since 2007 — but they’re still producing significantly less than they did then. That’s the output gap. Now, suppose the gap is 6 percent; I’d say 8, but who’s counting? Suppose also that potential output is growing at 2 percent a year. In that case, how much growth would it take to get back to where we ought to be? If we grow at 3 percent, which many would hail as a success, it would take 6 years. If we grow at 4 percent, it would still take 3 years.

    In short, we’re operating hugely under capacity — and I’m both shocked and depressed at the lack of urgency among policy makers about closing that gap."

  2. "So if you believe this story, the lesson for VSPs and mediamacro is you really need to talk to economists in the front line more often."

    I remember Japan in the late 1990s. The people who understood the situation the best were not academic or Bank of Japan economists. I remember a major book that came out by Mizuho economists (in Japanese) who explained why there was a large appetite for government bonds and how there was a mismatch of savings and investment which had made the interest rate largely dysfunctional. They criticised the IMF and the academic economics establishment for taking an 'emerging market' view of Japan which was not appropriate given that it was largely a closed economy (not reliant on foreign capital flows) and explained why the JGB would continue to be a superior form of asset even with large scale bond issuance. Academic economists (particularly English speaking US educated ones) however talked about credibility and consistency, and even Ricardian Equivalence - reflecting what they were taught at US schools. They pointed to the views of credit agencies which had got it terribly wrong on Japan.

    Since then the debate has moved on and people now realise that large asset purchases by the central bank are not the answer either.

  3. SW-L seems puzzled by the existence of deficit bias. I suggest he’s overlooking the obvious: the word deficit has negative overtones. Plus there’s the fact that a deficit means a rising national debt and the word “debt” has even worse negative overtones.

    It’s that simple: 90% of the population (including numerous economics commentators) are fooled by words. If the national debt was re-named the national giraffe, 90% of the population would get worried about how long the national debt’s neck was...:-)

  4. As an aside, in the US, one of the VSP is Peter Peterson (likely you know all this already) and he is paying for tv ads in this political cycle about how the presidential candidates should be focusing on deficit reduction. It's pretty aggravating.

    (Funny how the ad fails to suggest increasing taxes, eliminating major tax loopholes like for "carried interest," and real estate, etc.)


    Another VSP, Phil Gramm, had an op-ed in the Wall Street Journal about how wasteful it is to spend on infrastructure investment, that it is the equivalent of subprime investment and we're heading for a fall:

    I am not an economist, but the sloshing around of money in the pre-2008 days did lead to many bad decisions on the part of infrastructure investors (but it's hard, at least in the US, despite all the claims to the contrary, to see how the private sector can make tons of money from such investments, unless they are allowed to raise tolls to unheard of numbers).

  5. And economists should at some point attend courses, seminars or else that cover topics like rhetorics, body language, negociation, etc.

    Whatever it is we do, we manifestly aren't getting our point across. Moreover, I believe that besides usual interventions, we should bother systematically reinforce a culture of evaluation, making it clear our job can and should be used to make it harder for public decision makers to behave idiotically. Evaluating policies seriously is how we can hold them accountable.

  6. I think the word that explains it is 'ideology'

  7. Ralph Musgrave is getting there... It is astonishing to me how difficult it is for really sharp economists like Drs. Krugman and Wren-Lewis to fully appreciate non-economists' near-universal belief that deficits and a rising national debt are profoundly "irresponsible" and actually immoral. Economists acknowledge non-economists' failure to understand that the economy of a sovereign country with its own currency is completely different than the economy of a family. But they don't appreciate that this fully explains non-economists' aversion to deficits and public debt. Non-economists understandably assume that deficits represent spending that is irresponsibly being borrowed from future generations--like a family that goes deeper and deeper in debt to maintain an extravagant life-style. The immorality of this seems perfectly obvious to non-economists everywhere, and so they are against deficits and frightened of "huge" national debts, which they innocently assume future generations will struggle to repay.

    In my opinion there is no reason to agonize over why Very Important People oppose deficit spending. Ordinary people assume deficit spending is evil because they naturally assume that what's bad for a family must be bad for a nation.

    Do they also seize this opportunity to reduce government? Sure, why not achieve two good things at once? they think. And do they refuse to countenance raising taxes to reduce deficits? Yes, they fear deficits, but they HATE higher taxes even more. So are they hypocrites? Yes. But that doesn't mean they don't sincerely fear deficits and a rising national debt, for the reasons I suggest. There is not a politician anywhere who understands economics well enough, and is courageous enough, to explain the truth about deficits and public debt to an uncomprehending public. I wish prominent economists understood this more deeply; I think they need to spend more time in bars and pubs.

  8. PS: My assessment of non-economists' views on deficits and public debts makes me a strong believer in helicopter money. I have been futilely trying to explain to educated liberals, and others, for 50 years why national debts are not that big a deal. It's hopeless. Progressive economists should accept this political reality and start regularly advocating money-financed deficits as a reasonable way to deal with secular stagnation and future recessions. It's much easier to explain why money-creation by a central bank need not cause hyperinflation than it is to explain why a $20 trillion national debt will not ruin our children's lives. (It's the difference between difficult and impossible, which is an important distinction.) If all progressive economists would pull together on this oar we might be in a decent position to use helicopter money to prevent the next recession.

  9. Interesting comments, I will go along with what Raplh Musgrave states and will add another reason:

    The wrongful assumption - which is also deliberately used as an 'argument' by VSP as well as politicians - that an economy is like a household. And, as the myth goes, just like having debts is bad for a household, so it is for an economy, ergo a high debt is a bad thing.

    I do not need to state the utterly wrongful basis for this assumption (others have done so much better) nor do I need to mention the political propaganda for austerity built around it (with Germany and Dr. Schauble being the standard bearers in the EU).

    However, it is a fact that this myth persists in the public mind and alas economists are doing little in the public domain to dispel that with simple arguments.

    1. I completely agree, especially with your last comment. Since 2008 economists have had their blogs and Krugman and Martin Wolf their op-eds, but that's not enough to educate even liberals about how Keynesian economics works and how different a national economy is from family finances. There has never been a thoughtful article in the Atlantic or Harpers, etc, explaining all this. I think it's shocking.

    2. It is possible to make a household analogy. See my post from 2012:

  10. Many thanks John, it is indeed and I read your article as well as Mr. Lewis' here comments.

    However, you will agree that the effort VSP and politicians make with the household analogy is not stemming from a genuine desire to educate the public but to propagandize on austerity.

    They make propaganda, you educate and - to repeat - I wish economists would spend more time to appeal to broader public and dispel such myths like the one of the household and austerity.

    Konstantinos Maragakis


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