This post was partly inspired by this recent seminar, but also by this excellent paper from The Resolution Foundation. Apologies for the length, but there is a lot to cover.
This post is in five parts. The first looks at how our understanding of fiscal policy has evolved over the last decade or so. It is an essential background to how fiscal policy should be employed during the pandemic. The second looks at fiscal policy support during the pandemic. The third looks at what could be quite a short period between when the pandemic is effectively over as a result of mass vaccination, and when the economy has fully recovered. The fourth asks whether, once the economic recovery is complete, we should attempt to gradually reduce the debt to GDP ratio. Finally I look at the Chancellor's recent actions and how they are reported by the media.
Just before the Global Financial Crisis (GFC), I talked of a Consensus Assignment between monetary and fiscal policy. Here is a quote from the introduction.
“The consensus assignment from the title refers to the idea that monetary policy (in a closed economy, or a small open economy with flexible exchange rates)5 should normally focus on business cycle stabilisation and inflation control, while fiscal policy (at the macro level) should focus on the control of government debt or deficits. This conventional assignment leaves open the possibility of using fiscal policy in situations where monetary policy is constrained in some way, either by design (such as a monetary union member subject to asymmetric shocks) or misfortune (where interest rates hit a zero lower bound). It is a consensus only if it applies to situations in which monetary policy is unconstrained in its ability to stabilise the business cycle.”
I did not know it at the time, but that caveat concerning the lower bound for interest rates was going to become the Achilles Heel of the Consensus Assignment.
Having written that paragraph, it was obvious to me that when countries hit the lower bound for interest rates during the GFC, fiscal stimulus would be essential to speed up the recovery from that recession. Unconventional monetary policy, almost by definition (‘unconventional’), was not going to be as reliable as fiscal policy and therefore would be an inferior stabilisation instrument.
In the years following the GFC it became clear to many academic macroeconomists that the GFC was not going to be an exception in driving interest rates to their lower bound. What has been called secular stagnation is the phenomenon that the underlying or equilibrium real interest is now so low that downturns would often trigger rates hitting their lower bound. This in turn means that what I called the consensus assignment has to change.
In my view, and the view of an increasingly large number of academics, we need a new assignment that includes fiscal policy stabilisation at least some of the time. The MMT school suggests switching the old assignment around, and using fiscal policy at all times to stabilise demand. However that seems to ignore our pre-GFC history, where monetary policy was very successful at stopping domestically generated inflation expectations exceeding an inflation target.
The alternative I have recently called the state dependent assignment uses fiscal policy to help stabilise recessions, and monetary policy to help stabilise inflation. When fiscal policy is being used to fight a recession, fiscal policymakers should be completely unconcerned about what is happening to government deficits and debt. The time for fiscal policy makers to focus on deficits and debt is when we have largely recovered from a recession. The obvious way to measure when fiscal policy should switch from stabilising the economy to stabilising debt is when interest rates are no longer at their lower bound. (Lags between fiscal policy decisions and the impact of fiscal policy on demand means that the switch point cannot be that simple in practice, but the key point to remember is that the costs of too much fiscal stimulus are far less than the costs of too little.)
Fiscal policy during this pandemic
The need for fiscal stimulus is acute when economies suffer from large demand shocks. There has been endless debate among macroeconomists about whether the pandemic represents a demand shock or a supply shock. When I began looking over a decade ago with public health experts at the economic effects of flu pandemic (paper here), I started off thinking about the pandemic as a supply shock and ended up realising that a severe pandemic would mainly be a demand shock.
With mild flu pandemics, the main economic effects are supply-side, such as people taking a couple of weeks off work. However with severe pandemics, many people take active steps to try and avoid catching the virus. That means they cut back on, or may even stop completely, forms of social consumption: going to shops, pubs or restaurants, going to public sporting or cultural events and so on. What surprised me when thinking about the extent of the demand fall that produces was that social consumption accounts for around a third of total consumption. A government lockdown may enhance and extend that response.
Does that all imply the need for massive fiscal stimulus? Yes and no. First the yes. What should be clear is that whatever reduces the extent of the virus is good for the economy beyond the short term. The economy just will not recover while the risk of catching the virus is perceived to be significant, because social consumption will remain depressed. The most important way fiscal policy can help in eliminating the virus is by providing support to those workers and firms that suffer from the reduction in social consumption. A possible but imperfect analogy is with the automatic stabilisers that work in a normal recession.
The no relates to whether additional substantial stimulus is required beyond that already supplied by rates at their lower bound. As the previous section made clear, for a normal recession that is essential. But the pandemic is not a normal recession, for two reasons. The first is that the demand shock is sector specific. A standard fiscal stimulus like a tax cut is likely to increase demand in sectors that have not been hit by the virus.
You could get round this with a sector specific stimulus, but then we hit the second problem, which is that to the extent that stimulus is effective it will make the pandemic worse. That was the ultimate fate of the Chancellor’s Eat Out to Help Out scheme. The conclusion has to be that if fiscal support measures are comprehensive, then the case for a large additional fiscal stimulus is weak. (For more formal analysis, see Woodford and references therein.) If support is not comprehensive, or largely absent as in the US, then the case for stimulus to reduce unemployment is much stronger.
When the pandemic is over
The Chancellor has indicated that he is prepared to look at measures to boost the economy once the pandemic is over. This would make sense if consumers are slow to resume social consumption even though it is quite safe to do so. The last proviso is critical, if the Chancellor wants to avoid stimulating the pandemic as well as the economy (in only the short term).
But will consumers in aggregate be over-cautious. In that study I did a decade ago looking at a flu pandemic, I made the assumption that consumers might to a limited extent binge on social consumption once the pandemic was over. After all consumers who have continued working or have benefited from fiscal support will have increased their wealth significantly by not spending on social consumption during the pandemic. In realistic models of consumption consumers will begin to unwind some of that when the pandemic ends.
This suggests that any fiscal stimulus during the recovery phase should focus on the public rather than private sector, and particularly public investment. There is little point in trying to second guess how much permanent scarring the pandemic has left, so as I noted earlier it is always better to assume there is a demand gap, because the costs of being wrong (a short term inflation blip) are much less than the cost of assuming potential output is lower than it actually is.
What is clear is that we have a desperate need for public investment. The government is planning investment worth, in net terms, just under 3% of GDP each year. That is high by recent historical standards, but when you think of all we need to do to reduce the extent of climate change and the risks from climate change, it is probably inadequate. There are many other areas where public investment is needed.
When the economy has recovered
I have not mentioned government deficits or debt until now, for the very good reason that they are irrelevant in a recession. The mistake of UK policy after 2010 should never be repeated. But when short term interest rates rise significantly because of clear inflationary pressure because the recovery is complete, then this the time to switch to monetary stabilisation and allow fiscal policy to focus on government debt.
In my paper with Jonathan Portes, we argued that in normal times a medium term rolling deficit target should be set with the aim of achieving some long term trajectory for the government debt to GDP ratio. However given the need for substantial government investment already mentioned, a better measure might be government net wealth (net worth) to GDP. After the pandemic net wealth will be well below levels seen before the pandemic, and there is a case for setting a deficit to achieve a very gradual increase in that ratio over time. If that requires fiscal consolidation, there is an overwhelming case that this should be achieved using tax increases rather than spending cuts. Indeed in a number of areas there is a strong case for increasing current government spending, and once the recession is over and interest rates are well above their lower bound because domestically generated inflation is likely to permanently exceed its target, these need to be matched by higher taxes.
However even when the economy has recovered from the recession caused by the pandemic, we will not be in normal times. The threat of man made climate change is now both very real and imminent. As I have already argued, public investment aimed to achieve our carbon emission targets, like all public investment, should not be restrained by any fiscal rule. The argument that the polluter pays still holds, which means taxes to discourage carbon production and use are essential.
All of this is perfectly compatible with a gradual increase in the government’s net wealth ratio, and indeed carbon taxes should help here. The political problem that may arise, and anticipated in the Green New Deal in 2008, is that it may be politically impossible to enact the necessary taxes without compensating fiscal rebates of various kinds. We live in an imperfect information world, or more accurately a misinformation world, and as a result it is tempting for some political parties to pretend measures to prevent climate change can be achieved with no costs, or worse still that deny the problem is imminent.
If that turns out to be true, the least important goal is an increase in the net wealth ratio or a reduction in the government’s debt to GDP ratio. If we fail to tackle climate change, and in 50 years time our children or grandchildren are suffering the consequences of significant global warming, they will not forgive us failing to do what needed to be done because we were ‘responsible’ with the public finances.
As I have tried to stress, looking after our public finances is a second order problem compared to the first order problems of supporting people during the pandemic, getting a complete economic recovery and tackling climate change. I think most academic macroeconomists would agree with that, and the IMF also agrees with that.
However, you wouldn’t know that from the discourse of the Chancellor and from much of the media. The notion that the government’s finances are like that of a household should have been well and truly buried after the disaster of 2010 austerity, yet they live on among many of the political journalists you will see on the broadcast media. (There are, unlike 2010, a few notable exceptions.)
When we talk about a possible repeat of austerity, we have to be careful what we mean. The original spending cuts from the 2010-18 period have only been partially unwound. What people therefore mean by a second round of austerity is yet further cut backs in spending or tax increases. The first period of austerity was a disaster for two reasons. The first was that the supply of public spending was cut without any attempt to reduce the demand for public services, so problems with services for health, welfare, prisons, police, the justice system and much more were inevitable. The idea that there were substantial efficiency gains in all this provision proved largely mythical.
The second reason it was a disaster is macroeconomic. In a recession due to demand deficiency, taking more demand out of the economy is bound to make things worse if interest rates are stuck at their lower bound. (If demand was not deficient interest rates would be well above the lower bound, and could therefore fall to boost demand and compensate for the demand impact of fiscal consolidation.) If you continue austerity during a period of deficient demand for a number of years there is a significant danger that output will be permanently lower as a result.
Given all this, why does the Chancellor encourage talk of austerity while we are still coping with the pandemic? The obvious answer is that it provides cover for essentially political decisions, like cutting the aid budget or the real wages of public sector employees, while increasing spending on defence. It provides cover because the media (what I call mediamacro) is still largely using the household analogy when it comes to government debt.
An equally serious problem is that the political cycle in the UK is likely to lead to decisions being taken at the wrong time. If taxes do need to rise, they must only rise after the recovery is complete. That might be in 2023 and 2024. Only then will be know the recovery is complete, because interest rates are significantly higher in an attempt to prevent a rise in inflation becoming permanent. The Chancellor and government might think this timing will jeopardize their re-election chances. This leaves a danger that tax rises (or worse still public spending cuts) happen earlier, which might damage the recovery. The alternative that tax rises are delayed until after the election carries much smaller economic costs.
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