How to judge fiscal policy in the time of Truss

 

As expected, Truss has announced a freeze in energy prices. That means that inflation will not be as high as some recent forecasts, the cut in living standards will not be as great as in the most recent Bank of England forecast, and so therefore the Bank’s prediction of a prolonged recession with plummeting inflation is less likely to come to pass. All good news, but what about the government’s deficit, particularly if she keeps her promise to cut various taxes?

This is the question that many journalists, and I suspect opposition politicians, are currently asking. Despite furlough, much of the media continues with the ‘government as household’,’how will you pay for it’ version of macroeconomics. Partly for this reason, the Labour oppositions since 2010 have felt obliged to ‘be responsible’ by ensuring key spending announcements are accompanied by equal revenue raising plans. Does this all now need to change?

I have always argued that it should change. (On why debt targets are a bad idea, see here and here.) The emphasis given to the government deficit in the media is totally inappropriate, and can at times be extremely dangerous (as we saw after the Global Financial Crisis). However it is also true that the media takes very little notice of academic economics, and much more notice of what a government (particularly a Conservative government) is doing, so the media’s obsession with ‘the deficit’ would only have a chance of changing if the government changed its emphasis. It now has.

I suspect and hope we will see an end to two particularly silly aspects of deficit fetishism in the media. The first was monthly commentary on public borrowing, with associated ‘tax will go up/down’ headlines. That kind of commentary only makes sense when Chancellors have short term deficit targets, and I will be surprised if Kwarteng doesn’t ditch this aspect of Sunak’s policy. The second was around budget time, when annual movements in the deficit attracted far more attention than they deserved.

However those hoping that both the government and the media will completely ignore what happens to the government’s deficit will I suspect be disappointed. If I am right, at some point Conservatives will resume using an unsustainable government deficit to argue for spending cuts and a smaller state. The argument between Truss and Sunak was essentially political. Truss believed that, with two and a half years before the next election, playing the deficit responsibility card would reap few political dividends and might prevent the government from doing more popular things, like cutting taxes. Deficit obsession was never a fundamental part of neoliberalism, but just a useful tactic at certain times to achieve a smaller state.

So I would not be surprised to see Truss and Kwarteng still stressing the importance of fiscal ‘responsibility’. How will they square this with the fiscal largess implied by an expensive energy price cap and tax cuts (compared to previous plans)? It is actually easier than you might think.

The huge cost of the energy support package can be justified in the same way as furlough was: an exceptional response to exceptional events. After all, the main event that has had the biggest positive impact historically on government debt was a war, and the government could with some justification argue that the need for a large scale fiscal support package is the war in Ukraine.

The government is on trickier ground with any tax cuts, but even here they have an excuse within the spirit of some of the rules they themselves have set. A UK recession is still a strong possibility, and Conservative Chancellors since 2010 have generally recognised that fiscal rules can be set aside in recessions (or even milder economic downturns). So the new Prime Minister and Chancellor might try to justify any tax cuts as measures to prevent a recession, and still argue that they were being ‘responsible with the deficit’ in the medium term.

In macroeconomic terms this doesn’t wash for three reasons. First, if you were looking for a fiscal stimulus to prevent a recession, you would not choose cutting national insurance or corporation tax as effective measures to do that. The most effective and quick way of stopping a recession is to increase universal credit, because you can be reasonably sure most of that will be spent. In contrast, it’s not clear whether cutting corporation tax will have more than a tiny positive impact on aggregate demand during an economic downturn. The main influence on business investment is what is happening to output, not the corporate tax rate.

Second, and more importantly, effective fiscal stimulus during a recession is inevitably temporary. It is designed to either prevent a recession, or lift the economy out of one, and once that goal has been achieved you no longer need any stimulus. Truss, however, intends her tax cuts to be permanent, so the prospect of a recession is no answer to the ‘where is the money coming from’ question.

Third, outwith the lower bound for interest rates, it is monetary policy that should be worrying about inflation and recessions. In this light cutting taxes to avoid/moderate a recession looks very odd when the Bank of England is raising rates. Does the government think the Monetary Policy Committee of the Bank could be making a mistake? 

However all three points are unlikely to be made by most of those who will interview government ministers, so in political rather than economic terms the excuse of a possible recession is tenable. [1] What this means, I suspect, is that Truss and Kwarteng are not going to start saying the deficit doesn’t matter, implying everything Osborne and Sunak said about it was wrong. What it will mean is that the government can no longer use fears about the deficit under a Labour government as a political weapon. Instead they will just say that a Labour government will mean higher taxes.

Where I think the government is more vulnerable, and where I think the media will rightly continue to talk about the deficit, is following OBR or other reputable medium term forecasts. Absent unexpected good fortune, the OBR is likely to be forecasting in five years time government deficits which will imply either government debt or net wealth are unsustainable. This five year time horizon is important not because it is likely to happen, but because it’s a good assessment of the underlying level of taxes and spending, abstracting from short term shocks and the business cycle.

This will not imply any immediate crisis, and any impact on the exchange rate will have probably already happened. But it is important nevertheless, and it is why we should not ignore government deficits altogether. Persistent and large excess deficits (where excess means government debt is persistently rising or net wealth is persistently falling) generally indicate spending cuts or tax rises in the future as I suggested earlier. But if left unchecked, they can predict one of two things. The first is a persistent fiscal stimulus, which in absence of monetary policy would imply rising inflation. Of course with an independent central bank with a medium term inflation target persistent fiscal stimulus will imply higher interest rates to prevent higher inflation. While that upward pressure on interest rates was welcome when rates were stuck at the zero lower bound, that is not true today.

However persistent deficits need not imply that much inflationary pressure, if they take the form of tax cuts for businesses or the better off. The second possibility is that they signal a redistribution towards the most wealthy. If tax cuts directly benefit businesses or disproportionately those on high incomes, they will not add that much to effective demand in the economy because most of the tax cut will be saved. Instead they indicate a redistribution of income to the already rich.

In all cases projected persistent excess deficits are not a problem in themselves, but because of what they indicate could happen as a result of current fiscal plans: spending cuts or tax rises, or future higher interest rates, or future redistribution towards the wealthy.

In political terms this will be a problem for both the government and Labour. The government will claim that the OBR are underestimating the boost to growth that tax cuts will give, and higher growth will lead to higher taxes etc. Labour, along with the non-partisan media, should rightly describe this as wishful thinking not backed up with evidence. If it was backed up by the evidence the OBR would incorporate that in its forecast.

However Labour cannot say the same, so while they can blame the government for being fiscally irresponsible they will also be asked how they would deal with the problem if they win power. As Labour are likely to be repeatedly asked how they intend to close any funding gap, that should influence their stance when these tax cuts come into place. I suspect they will vote for tax cuts for ‘working people’ but against tax cuts for ‘big business’?.

So my answer to the question posed by this post’s title is to ignore any residual media interest in monthly borrowing numbers or the dynamic path of deficits in any budget, and instead focus on the medium term deficit implied by OBR (or other reputable) forecasts, where the inappropriateness of tax cuts will become clear. The increase in government debt implied by the short term energy price cap is not a problem and can be easily justified. Otherwise we should see a welcome change to an economic debate about what really matters: whether it is more important to cut taxes or instead provide sustained support to our underfunded public services and the less well off.

[1] Even if a journalist did make the points above, the government’s response would be that tax cuts lead to more growth and more revenue.