Why fiscal consolidations (spending cuts or tax increases) don't reduce debt to GDP ratios, and why politicians continue to tighten at the wrong time

 

The claim often made for fiscal consolidations (cuts in public spending or increases in taxes) is that they are required to reduce the ratio of public sector debt to GDP. But while fiscal consolidations are likely to reduce public sector debt, they are also likely to reduce GDP, so the impact on the debt to GDP ratio is unclear. Research just published by the IMF suggests that, based on past evidence, the average effect of fiscal consolidations on the debt to GDP ratio is negligible (i.e. virtually zero).

Looking at the study in more detail, the results are even worse for proponents of austerity. By austerity I don’t mean fiscal consolidation in the form of spending cuts, but any fiscal consolidation undertaken when output is below trend. Here is a figure from the study.

On the left hand axis is the probability that a fiscal consolidation will reduce the debt to GDP ratio, where the average probability is 51%. The first column shows that a positive output gap (GDP is above trend i.e. a boom period) turns that probability into 57%. The second column shows that if the world economy is above trend that ratio goes from 51% to 60%. The final column shows that if private credit is high relative to GDP, the probability that a fiscal consolidation will reduce the debt to GDP ratio falls to 42%.

In 2010, all economies were recovering from recession (so the domestic and world output gaps were negative) and private credit was high relative to GDP (although falling rapidly following the financial crisis). So 2010 austerity was significantly more likely to increase the debt to GDP ratio than to reduce it. As many of us said at the time, 2010 was exactly the wrong time (indeed, probably the worst time) to embark on fiscal consolidation, because not only would austerity lower GDP, but it would raise debt to GDP because lower GDP would more than offset lower debt. Which is exactly what National Institute modelling, among others, said would happen back in 2011.

Some have suggested that while that lesson might have been relevant in an environment of low interest rates (where rates can easily hit their lower bound), that era has recently come to an end. This is where a second piece of IMF research, in the same WEO, becomes very relevant. It looks at historical trends in real interest rates, tries to explain them in terms of key drivers, and then assesses where they might go in the future.

The bottom line is that we have not entered a new era. Instead real interest rates are likely to go back to the same low levels that we saw before the pandemic. One reason for this, demographics, is relatively predictable. Another is the global slowdown in productivity growth. Productivity growth is less predictable, but with no pick up in sight continuing modest productivity growth seems like a good assumption. Unless there is something big that is missing from the analysis, the age of low real interest rates (what economists call secular stagnation) is still with us.

In practical terms this means that the trend level of nominal interest rates in the advanced economies, the level that would neither stimulate or depress activity in the medium term and where inflation is at target, is between 1% and 3%. That means that as inflation falls, so will current interest rates. We have not left the era when an economic downturn could easily put interest rates at their lower bound. As a result, it will remain the case that while monetary policy is the first choice for controlling (excess) inflation, it is fiscal policy that needs to be the

first choice for avoiding recessions and boosting recoveries.

The message of this evidence is familiar to anyone who understood macroeconomic theory well before 2010: leave fiscal consolidation for the good times. Yet this is a lesson politicians, and those that advise them, find it very difficult to learn.

So why are so many politicians, and much of the media, so resistant to accepting that fiscal consolidations - if necessary - should be reserved for good times and never undertaken in bad times. A large part of the answer is that, for most politicians on the right, fiscal consolidations are not primarily about reducing the debt to GDP ratio, but instead an excuse to cut public spending and reduce the size of the state. It is what I have called ‘deficit deceit’. No wonder that in the UK over the last 13 years the government’s fiscal rules seem to change very few years, because they are typically chosen to squeeze public spending rather than enhance macroeconomic management.

However I don’t think that is all. The cyclical nature of the government’s deficit (rising in bad times, falling in good) encourages politicians to do fiscal consolidation at the wrong time and discourage them from doing fiscal consolidation at the right time. [1] They do this because deficit targets treat governments like cash-constrained individuals, who if they are short of money have to spend less and if they are flush with money they have to spend more.

In theory this need not happen if credible governments ditch debt targets, and ensure deficit targets are medium term, like a 5 year rolling deficit target. It shouldn’t happen if credible governments ensure this medium term deficit target excludes public investment, allowing public investment to reflect social returns, government missions and the cost of borrowing. It shouldn’t happen if these medium term deficit targets are chosen intelligently, allowing debt/GDP to rise when it makes sense to do so. And finally it shouldn’t happen if these medium term deficit targets are ignored if fiscal policy is needed to avoid a recession, or to stimulate the recovery from one.

That is how sensible fiscal policy would work. If it did, fiscal consolidation would only occur in good times, and it would be effective in reducing debt/GDP. Fiscal consolidation would not happen in bad times, allowing fiscal stimulus to end bad times, and consolidation would only happen in good times if that made economic sense.

But small state politicians are not the only reason why this doesn’t happen. The other reason is the media. Not just the right wing media, that wants a small state, but also the media that likes to think of itself as non-partisan. As I explained here, in the world of mediamacro meeting deficit targets are indicators of ‘government responsibility’, and rolling targets that never arrive just don’t wash. We have a medium term rolling deficit target today, but the media still gives us monthly (!) commentary on the latest numbers for the deficit, with predictable and endless speculation of tax cuts or spending cuts.

This isn’t because most journalists in the media have the wrong model of how economic policy should work, but rather they have no model at all. As a recent BBC report implied, the main feature of much journalism about economic issues is economic ignorance. That is why, for example, ministers can keep asserting that giving doctors or nurses more money would raise inflation without such statements being challenged. (Higher pay for NHS staff or teachers does not put pressure on prices, so it is not surprising that the evidence shows no link to inflation.) If all journalists think they know is government deficits or debt are ‘a bad thing’, then this creates what I have called mediamacro.

Politicians work in a media environment, so many find it hard to combat mediamacro. If the media wildly inflate the importance of deficit targets, and fail to understand why these targets are much more long term than inflation targets, then politicians will be tempted to act as if the media’s view is correct. For this reason deficit targets encourage politicians to do exactly the wrong thing with fiscal policy, consolidating when the economy is weak and the deficit is rising, and undertaking fiscal expansion when the economy is strong and the deficit is falling (or in surplus). [2]

How do you counteract both deficit deceit from the right and mainstream media ignorance? The obvious answer, as Chris Dillow suggests, is to give knowledge an institutional voice, which in this case means enhancing an independent fiscal council. Our own, the OBR, was set up by George Osborne to play a much more limited role. The Treasury farmed out its fiscal forecasting, but none of its macroeconomic analysis. That split makes little economic sense, and it needs to change.

An OBR that was able to provide fiscal policy analysis alongside its forecasts could enhance public discussion of fiscal policy options, and give space for politicians who want to promote good policy to counter media ignorance. That advice could range from acting as a watchdog to stop the government fiddling the process to more general advice about the form of fiscal policy rules. As long as it took its lead from the academic literature and remained independent, this enhanced OBR would improve public debate about fiscal policy, which in turn should help improve policy itself.

[1] Basing targets on cyclically adjusted deficits does not work, because cyclical adjustment is too uncertain.

[2] The example that always springs to my mind here is Spain after the creation of the Euro. Spain should have been running a more restrictive fiscal policy because its inflation rate was above the Euro average, but because the budget was in surplus and because of the centrality of deficit targets in the EZ, the political/media just couldn’t cope with the idea of even larger surpluses.