Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 21 March 2023

What can be done about the Chancellor gaming his fiscal rules


As Chris Giles explains here, Chancellor Hunt is gaming his fiscal rules. He is not the first Conservative Chancellor to do so. In particular, it is now routine for Conservative Chancellors to announce that they are freezing fuel duty, but they then tell the OBR that they will raise them with inflation in every forthcoming Budget. They have repeated this fiction for the last dozen years. The fiction that the duty will be raised in the future, just not now, flatters future revenue projections and makes it easier for the Chancellor to meet his fiscal rules.

This particular problem arises because the OBR is legally obliged to produce a forecast on the basis of what the government claims is its policy. However there is the letter of the law, and there is politics. Suppose the head of the OBR decided next year that it would ignore the government and instead use past data to assume that fuel duty would not be uprated in future, what exactly would the Chancellor do? Fire him? It just wouldn’t happen.

I know the previous head of the OBR thought about doing this. The current head, Richard Hughes, would have his hand strengthened considerably if the Treasury Select Committee stated that in future it expects the OBR to do this. This committee has to approve senior appointments to the OBR. Whether the Committee has the political courage to do this is another matter. In the longer run the legislation governing the OBR should be changed so as to allow it to base its projections on what it believes the government will do in the future. [1]

Much the most difficult and serious element of gaming, that I mentioned myself after the budget, involves the projections for public spending. As was clear from the last Autumn Statement, the Chancellor’s plans involve two things that almost certainly will not happen. The first is that we have a renewed round of public spending cuts, in a public sector that is already cut to the bone. The second is that the relative pay of public sector workers continues to be reduced relative to other workers, in a situation where public sector vacancies are at critical levels and public sector workers are either striking or have won awards that exceed the government’s assumptions. This bit of gaming is more difficult to fix, yet it risks making a mockery of the whole Budget forecast.

Some might say that fiscal rules are a fiction anyway, so who cares about this. I don’t like the particular fiscal rules the Chancellor has chosen [2], but I do think fiscal rules are there for a good reason. I partially disagree with Stephen Bush on why they are important. They are not there to keep the markets happy, and nor are they required to keep departmental spending in place. The purpose of fiscal rules is to stop the Chancellor fooling voters, by for example cutting taxes just before an election and pretending that these cuts are sustainable. Voters deserve to know whether pre-election tax cuts or other bits of fiscal largesse are bribes that will disappear once the government is elected or something that is more permanent. That is why gaming the fiscal rules matters.

If we go into why the rules are currently being gamed, it helps to understand why it’s difficult to stop. Paragraph 4.46 of the OBR report explains why assumed pay growth for the public sector is about 1% lower than that for the private sector, thereby continuing the relative fall in the pay of public sector workers that we have seen since 2010/11. There are two points to make. The first involves implausibility, given the increase in vacancies, quit rates and strikes we are currently seeing in the public sector. But just because something is implausible doesn’t mean it is impossible. The second is visibility - you have to dig deep in the OBR’s report to find this analysis.

On public spending, the numbers the government have pencilled in are broad aggregates, so you have to make some assumptions to see what this means for individual departments. Luckily the IFS post-budget analysis has a go in the chart below.

NHS spending increases are at the past long term average, which is the minimum conceivable in that it does nothing to relieve current pressures. Spending on schools declines as a share of GDP, while it is announced policy that defence spending does the opposite. That leaves an annual real term fall in spending of 3.2% in everything else. We have the same two problems. The government’s assumptions are opaque, so they can always say they don’t ‘recognise these numbers’, and they are highly implausible but it is hard to say they are totally impossible.

So the OBR under its current remit cannot say that these projections cannot happen, but because the detail is hidden (pay) or not spelled out (departmental totals) the Chancellor bears little cost in putting these implausible numbers forward.

One way around this problem is to make fiscal rules apply to the short term rather than medium term, but there are excellent reasons why this cure would be worse than the disease. A much better option is to strengthen the watchdog role of the OBR, to make it more in line with some other fiscal councils. This would require two changes to the legislation that set up the OBR.

First, the OBR needs to be able to do policy variants: simulations/forecasts where policy variables are different from the government’s announced plans. That goes well beyond the minor tweak suggested for fuel duty, because no evidence would be required that this would be what the government might actually do. The Treasury were insistent that the OBR would not be able to do this when it was set up, partly I suspect because it didn’t want to see alternatives to austerity.

Second, the OBR would be mandated to comment on the feasibility of aggregate public spending plans, and if the government’s projected plans were unlikely to be feasible, to prepare an alternative forecast based on plans that were feasible. Very quickly this alternative, more plausible forecast would be the one that everyone quotes.

Of course neither of these things will happen under the current government, so what is to be done next year if, as some have suggested, the government not only cuts taxes but pencils in even more tax cuts, and combines these with even more unlikely paths for public spending than are already there. The IFS and Resolution Foundation will no doubt call the government out on this, and the text in the OBR forecast will provide plenty of hints, but both are likely to pass most voters by.

Ironically the government will see these tax cuts as a ‘trap for Labour’. If Labour say they will not implement these tax cuts if they win the election then they give a real ‘higher taxes under Labour’ weapon to the Conservatives. If they say they will cut taxes then journalists, with some justice, will ask Labour about the clear implications for public spending. A compromise for Labour would be to accept the immediate cuts, but not future cuts, saying the Conservatives couldn’t afford these either. There are no easy answers here, but these dilemmas stem from the government’s ability to game the system. The government’s ability to game the system in turn stems from the weakness of the OBR as a watchdog.

[1] Another example of possible gaming that Giles and others have mentioned is investment allowances for firms. In the OBR projections this is a three year policy, but Hunt announced that he would like to make it permanent if and when resources allow. There is the expectation that the Chancellor probably will make it permanent at some point, but this is based on politics rather than experience. In this case the OBR would have little past evidence on which to warrant overruling what the Chancellor says his current plans are. For that reason I don’t think this is an example of gaming the rules. Chancellors should be able to announce aspirations, but if the fiscal rules don’t allow those aspirations to happen I can see no reason why the OBR should do otherwise than take the Chancellor at his word. I think this is an example of the rules working.

[2] I have always argued that falling debt to GDP is a silly rule, and I’m glad the consensus seems to be shifting that way even if Labour policy is not. In addition, targeting the total deficit rather than the current deficit that excludes private investment is wrong both in principle and in practice.


Tuesday, 14 March 2023

Will this week's Budget be pre-election giveaways, or show signs of strategic thinking?


See also postscript below written shortly after the Budget

To say that much of the media treats Budgets as if the government was a household is not really accurate. Much Budget analysis treats the government as a cash constrained household, such that any change in expected tax revenue is regarded as money the Chancellor has to spend or give away. Most households don’t work like that, because they have the capacity to save and borrow. The government of course finds it much easier to borrow than households.

Unfortunately some governments encourage the media’s attitude to Budgets. On this occasion, however, the government’s fiscal rules are medium term, with targets always five years into the future. So there is nothing in these fiscal rules to suggest that temporary improvements to the government’s fiscal position need to be spent or given away. The reason they are likely to be spent or given away in the forthcoming budget is because we are close to an election. But because many in the media treat the government like a cash constrained household, what in reality is fiscal electioneering will be portrayed as normal practice.

The forthcoming election is likely to influence Chancellor Hunt’s first Budget in two ways. First, he will want to produce fiscal giveaways that will make newspaper front page headlines the next day, and perhaps sway some voters to vote Conservative. Second, he will want to try and get the economy growing again as quickly as possible. The reason why can be seen from this chart.

Whereas the US economy at the end of last year had GDP per head around 4% above its level at the end of 2019, the UK economy had GDP per head around 2% lower. This number may be flattering to the US because at the end of last year at least it was probably running a little hot, but the same is true of the UK yet GDP per head is still significantly lower than before the pandemic. The UK’s relative performance over the last three years has been even worse than its performance in the decade since 2010. The Chancellor will be desperate to see some positive economic news before the election, and hope that enough voters are myopic enough to forget how bad things have been since 2010.

One of the reasons why the US has performed so much better than the UK since 2019 is that Biden had a clear long term plan of how he was going to support growth, while the UK did not. That plan involved first ensuring a strong vaccine enabled recovery from the pandemic using a fiscal stimulus focused on poorer citizens. Then came large instructure projects, followed last year with incentives for greening the economy. In contrast the strategy of the Conservative government since 2010 has involved shrinking government, tax cuts for firms and Brexit. The aim was to let an ‘unburdened’ private sector do all the work, and it has been a complete failure.

A conventional pre-election fiscal stimulus runs the risk of encouraging the Bank of England to raise interest rates yet further. That suggests he will look at measures that increase aggregate supply as well as aggregate demand, and so might be regarded by the Bank as inflation neutral. Trying to increase aggregate supply is laudable of course, but unfortunately he is likely to shun the two most obvious choices: more public investment and better health.

In his Autumn Statement he had already cut back on public investment, and it will be interesting if he goes further. Delaying the completion of HS2 is an example of what John Elledge had earlier called ‘Treasury brain’. Such delays in investment rarely save money in the longer term, and obviously they delay getting the benefit of the investment. It’s not as if the UK is ‘world beating’ with high speed rail - it’s actually way behind much of Europe. What is important here is not the rhetoric, which is always positive in Budget speeches, but the actual numbers for aggregate public investment, which I will report on in the postscript after the Budget. With so many good reasons to increase public investment in so many areas, it is so short sighted to be cutting it back. If public net investment over the next few years remains below 3% of GDP this will be a consequence of the stupidity of including public investment in the fiscal rule targets.

The Chancellor will probably do something to tackle the large number of inactive people of working age that is one of the two key factors behind the UK’s current labour shortage (the other is Brexit). However, as this report argues, the main reason why this problem has been so uniquely persistent in the UK since the pandemic is the large number of people not working because they are sick, which in turn reflects the chronic state of the NHS after thirteen years of Conservative government.. Providing more money to the NHS (the report dubs this “check-ups to pay cheques”) is the best way to achieve this. Yet other reports suggest that the Treasury is trying to stop plans for more NHS nurses and doctors, which in turn suggests the Chancellor is unlikely to provide assistance where it can be most effective.

One area where he may well act to increase demand and supply is incentives for investment by firms. While these incentives generally sound like a good idea, there is a danger that all they do is bring forward investment to years where the incentive applies from years when it doesn’t. If that is all that happens then little has been achieved from a long term point of view, yet with the cost of government payouts to the firms doing the intertemporal switching. However if the Chancellor wants to boost investment in an election year, at the expense of lower investment under what may well be a Labour government, this may not be his major concern!

Low public investment, ignoring the long term sick, and politically motivated subsidies to firms are all examples of where poor political decisions mean that fiscal policy fails to improve the economy in the longer term. If the headline grabbing giveaways include not raising petrol duty yet again, then we can add that to the list. The media will report this as ‘popular with motorists’, as if motorists are united in welcoming climate change.

As I noted in this post, the United States has for the first time a clear plan to encourage the kind of green industries which will play such an important part in all major economies over the next few decades. As their plan is also protectionist, it has encouraged the EU to increase subsidies for these industries. The UK needs its own response. As Torsten Bell points out, it cannot just be an attempt to duplicate what the US and EU are doing, because the UK is a smaller, more open economy that needs to play to its strengths. It will be interesting if we get any idea from the Budget about whether the current government has started to think about what the UK’s strategy on encouraging green industries should be, or whether it is continuing with the failed plan of hoping general corporate tax breaks will invigorate the economy.

Budget Postscript (16/03/23)

There were few surprises in this budget, so the comments above still largely apply. The government's strategic vision, in so far as it exists, remains to squeeze public services and to hope giving money to (a few) individuals and (temporarily) to firms spurs a strong recovery. The response to new green subsidies in the US and EU will have to wait until a little later, but when public investment is not expected to increase beyond this year I wouldn't hold your breath. (OBR Table A.1). The budget also confirmed the expected death of any grand levelling up strategy, although the small amounts allocated are perhaps better directed.

The two welcome measures not covered above were abolishing Work Capability Assessments and the expansion of free child care for very young children. According to the OBR the latter should increase GDP by about 0.2%. Although what was announced will certainly increase the demand for child care, questions remain about whether supply of child care will increase to match this (see also here).

As the OBR notes, the main reason labour supply has shrunk in the UK, by far more than in other economies (see chart below), is the increase in long term sickness. To reverse this requires more money for the NHS, and there was nothing in the budget to help with this.

The only other measure to increase labour supply in the budget was a
huge tax giveaway to the very rich. While the motivation might have been to stop senior medical staff retiring early, this could have been done differently and it might have been more productive to use this money to help stop the alarming rate young GPs are leaving the NHS. As a result of the Chancellor's choices, we have another Conservative budget that helps those on high incomes more than anyone else.

Tax breaks for firms to increase investment were announced as expected, but only for three years, meaning that the OBR expects them to do little more than shift investment expenditure forward, as suggested above. As the following OBR chart shows, even this is small compared to the collapse in investment caused by Brexit.

In terms of fiscal electioneering, there was the expected freezing of petrol duty, but otherwise not much. The Chancellor knows he has one more Budget to go before the election. The fact that he is only just meeting his 5 year fiscal rules shouldn't fool anyone. This target will have moved on a year by the next Budget anyway, but more importantly the public spending numbers he has in for the post-election period are largely fiction. If he needs to make them even more fictitious to pay for announced tax cuts next year he will.

Listening to a bit of Hunt's Budget speech, I remembered how I once wrote a few posts pointing out the macroeconomic errors in George Osborne or David Cameron's speeches. I just couldn't do that now, because the posts would be far too long. Almost every sentence is misleading nonsense. I got to sentence number nine before I found something I couldn't take apart: the sentence was “But that’s not all we’ve done.” This may reflect a deterioration in the quality of the Chancellor's speech writers, but I expect it's more that they just have no good material to work with. Can a few tax cuts next year and an economy just starting to grow again really offset in voters minds what has been the most dismal thirteen years for the UK economy since WWII?

Saturday, 11 March 2023

How the political right has used ‘impartiality’ to first gain political power, and then take over the BBC


The BBC has never been completely independent of the government. But that is no reason to ignore its gradual transformation over the last thirteen years into a media organisation that has become increasingly prone to do the government’s bidding. A process that began out of fear has now become institutionalised through the appointment of a once deputy chairman of a local Conservative party and council candidate as director general, a Conservative party donor deeply involved in party politics as Chairman, and a former Communications Director for Theresa May on the BBC Board.

Political appointments have been made to these senior positions at the BBC before, but we have not had a government like this before. A government that is far more prepared to interfere with established institutions to get its own way will mean that its political appointees in public institutions will be prepared to exert far more party political pressure than their predecessors ever have.

The means which today’s political right have used so effectively to make the BBC an instrument to advance their political ends is to elevate their interpretation of impartiality above all else and then to apply that concept selectively.

As I outlined here, the primacy of impartiality as balance between two political sides is a means by which a populist right can obscure truth and create bias. It allowed the populist right (the party of Johnson and the right wing press) to gain power through the Brexit referendum, when the truth about Brexit was buried because the BBC chose balance over facts and explanation. Since then it has allowed the government, through its press, to selectively squash things said by anyone involved with the BBC that embarrasses the government, but ignore equivalent cases involving opposition politicians.

So BBC presenters like Alan Sugar can freely use social media to attack opposition politicians, but because no right wing newspapers splash headlines about this the BBC does nothing. But if Gary Lineker states facts about the government’s latest illegal immigration bill (yes it is cruel to refugees and yes the language used to promote it incites violence) he is fired. The BBC’s rules on impartiality are applied in a biased way.

So when that same BBC presenter criticised Qatar’s human rights record on the BBC before its coverage of the world cup that was fine, because that was “something which is a matter of fact.” But when the same presenter in a tweet stands up for the human rights of refugees coming by irregular means to the UK (yes the proposed bill does break international law protecting the human rights of refugees), facts suddenly become unimportant and the BBC’s notion of impartiality rules. The BBC’s rules on impartiality are applied in a biased way

So the BBC lost no time in responding to complaints from 10 Downing Street in itself criticising its Newsnight team and presenter Emily Maitlis for an introduction about public anger over the way Dominic Cummings had broken lockdown rules. There was no investigation, just a statement that the introduction had not been impartial. There was no attempt to suggest that anything in the introduction was factually wrong, or expressed an opinion about matters that remained uncertain. Instead simply stating facts that put the government in a bad light was sufficient to have something labelled as not impartial. But when the Chairman of a well established right wing magazine chaired a flagship BBC political programme, and tweeted his views freely, the BBC turned a blind eye. Once again, the BBC’s rules on impartiality are applied in a biased way.

It may seem ironic that rules designed to promote impartiality should lead the BBC to become biased and subject to the government’s bidding, but it is inevitable when the government and its press have more power than other politicians and newspapers, and when those in charge at the BBC are appointed by that government. In the past facts and the truth have been an important defence against political inference at the BBC, but once stating facts that embarrass the government is deemed impermissible for anyone working at the BBC that defence against political interference disappears. It is no accident that the current leaders at the BBC promote their definition of impartiality so strongly. It is no accident that the BBC’s impartiality rules apply not just to what its political journalists say on the BBC, but also to what already famous sports presenters say in a personal capacity on twitter. The latter presents no threat to the reputation of the BBC, but it does represent a threat to the government. [see postscript]

The selective promotion of political balance over facts is doing the BBC a great deal of harm. It has lost some excellent journalists as a result, and it is now in danger of losing its flagship sports programme. It is losing the trust of the public. But today’s political right wins either way. A BBC that does its bidding is just fine because it helps them keep power just as it helped them win power. If the BBC loses its reputation and its audience declines, that suits them too, because it gives more space for our equivalents of Fox News to gain an audience.

This is why it is imperative that any future Labour government creates a truly independent BBC, where once again the BBC’s mission becomes to inform, educate and entertain. A BBC where political operatives can no longer take control, and a BBC where broadcasting facts, knowledge and truth are never subservient to party political balance. Until then those who want to see this kind of public service broadcaster should have no hesitation in criticising what the BBC has become, in pointing out how today’s BBC acts in a manner that is biased towards this government and in supporting those working at the BBC who try to tell the truth but are attacked by the BBC as a result. A media independent of the government is crucial to the survival of democracy.

Postscript 13/03/23

The reasons given for restricting Lineker's freedom of speech are absurd. The fact that the public pay for the BBC and the BBC pays Lineker to present a programme about football should never give either the BBC or the public the right to restrict what Lineker says about politics in a personal capacity on twitter. To say "as a license fee payer I don't pay Lineker's salary to hear his political views" is silly because you don't pay him to write on twitter but to present a football programme. You don't have to follow him on twitter. The reason anyone else is reading about his political views is because the Mail, Telegraph and the BBC chose to publicise them!

To say that Lineker owes some part of his twitter following to his role at the BBC is also irrelevant. Does every celebrity have to have their twitter account controlled by the media organisations that made them famous? No one with any sense thinks that Lineker's tweets represent the official position of the BBC, so any sensible BBC management would ignore what he said about refugees on twitter, just as they have ignored his and countless other tweets by BBC presenters in the past.

Tuesday, 7 March 2023

Why Quantitative Easing should always be with us


Quantitative Easing (QE) is not a well loved policy instrument in many quarters. What I want to argue in this post is that this unpopularity is in many cases misplaced, and also why QE will and should always be with us as long as central banks remain independent. To understand why, we need to talk about how fiscal policy (changes in government spending or taxes) is financed, and what happened at the start of the Covid pandemic.

Macroeconomic textbooks are full of discussion and analysis contrasting bond financed and money financed fiscal policy. With a bond financed fiscal expansion the extra spending (or tax cuts) are matched by higher borrowing, while a money financed fiscal expansion is paid for by creating more money. But in the real world governments do not debate whether to finance the deficit by issuing bonds or creating money. That is because money creation has been delegated to their independent central bank.

Central banks in turn typically determine short term interest rates to achieve inflation targets. But a money financed fiscal expansion is still possible, if a fiscal expansion is accompanied by Quantitative Easing (QE). This is what happened in the UK during the pandemic. Furlough was paid for by increasing government borrowing, but the Bank of England bought a very similar quantity of government debt by creating bank reserves (electronic money). So if you treat the central bank as part of the consolidated public sector (as you should here, because central bank profits and losses go to the government), furlough was largely paid for by creating money. It was similar to a classic money financed fiscal expansion. [1]

If QE is very similar to textbook money creation, why was it initially treated as something new, and why has it become so unpopular in some quarters? Before the Global Financial Crisis (GFC) most mainstream economists signed up to the idea that macroeconomic stabilisation (and therefore control of inflation) should be exclusively done by independent central banks varying interest rates. In such a world, there would be no need for fiscal stimulus during recessions, because lower interest rates would do the job more quickly and efficiently. Any money creation done by the central bank would just be a bi-product of its interest rate setting process.

In effect, independent inflation targeting central banks removed the option of governments choosing to finance their deficits by creating money rather than by borrowing. But that was fine, because there was no reason for governments to want to finance fiscal policy by creating money rather than borrowing as long as the central bank was able to control demand and inflation by varying short term interest rates.

That idea broke down during the GFC, because interest rates fell so low they hit a level (roughly zero) that central banks were reluctant to go below. QE was adopted by both the UK and US as an alternative way to stimulate the economy. Money creation was back on the menu. Unfortunately, this also helps explain some of its unpopularity. When fiscal stimulus in 2009 turned to austerity in 2010 in most major economies, too many people who should have known better suggested this wouldn’t matter because QE could do the job interest rates could no longer do.

There is a simple reason why this was not, and will never be, true. Fiscal stimulus has a much more reliable impact on aggregate demand than QE. It is now generally recognised by most academic economists that fiscal consolidation in 2010, at the start of the recovery from the biggest recession since WWII, was a major mistake. But this mistake didn’t happen because of QE. It happened in part because some, including many senior central bankers, oversold what QE was able to achieve.

Quantitative Easing is also unpopular because it’s associated in many people’s minds with increasing wealth inequality. Once again, I think QE is being unfairly judged. What causes asset prices to rise is low long term interest rates. The decline in long term interest rates since the 1980s is in large part outside the control of policy makers. Long term rates are influenced by central banks varying short term rates, but they do this to keep inflation on target and aggregate demand reasonably strong. The contribution of QE to the level of asset prices is marginal compared to other factors, including the impact of the central bank’s interest rate decisions. Of course low interest rates also mean the income received from financial assets is lower, so what the wealthy gain on the wealth side they lose on the income side.

The wealth effect of very low interest rates is also not inherent to interest rate stabilisation, but is instead a reflection of bad fiscal policy. Good fiscal policy should ensure that interest rates never need to fall to zero, except in extreme circumstances where fiscal policy has not had time to have an impact on the economy. The fact that we had interest rates at their lower bound for so long after the GFC reflects the 2010 austerity mistake in the UK, US and the Eurozone.

There is a serious issue involved in reversing QE, which I have looked at in a recent post. Central banks are understandably reluctant to sell the large quantities of government debt they hold quickly (and use it to reduce reserves), which means money creation is slow to be reversed. As central banks pay interest on these reserves, when interest rates are high and rising as they are today the public sector ends up transferring funds to the private banks holding the reserves. But as my post points out, this is not a necessary consequence of QE, and can be fixed in more than one way.

Last, but definitely least, there is an argument some make that the expansion of QE during the pandemic helped cause today's high inflation. This is in my view largely nonsense, and relies on either inflated views of the importance of central bank money creation (a form of monetarism), or incorrect views on what determines bank lending. If pandemic QE hadn't happened we would still have had higher energy prices and the invasion of Ukraine. More generally, given what happened after the GFC, it was important that policy ensured a strong and quick recovery from the pandemic, which is why I still think Biden's fiscal stimulus in 2020/21 was the right thing to do. As I note above, good fiscal policy should always ensure interest rates are well above their lower bound.

While QE is not the evil that some make out, a legitimate question is whether it has any positive virtues. Why do you need an unreliable replacement for cutting interest rates when interest rates hit their lower bound if fiscal expansion is always superior? To answer that we need to go back to the last time a money financed fiscal expansion occurred, which was the pandemic. What the onset of the pandemic showed is that bond markets (the markets for government debt) can be fickle. As the pandemic broke they initially refused to buy government debt (not just in the UK but elsewhere), so without QE the government would have been forced to repeat the mistake of 2010 and cut spending or raise taxes.

This is why the QE option always has to be there, and why QE will always be part of the policy toolkit. When a fiscal expansion is vital but the government cannot sell its debt, there has to be the option of a money financed fiscal expansion.

We can make the same point another way. One of the excuses for 2010 austerity was precisely that without it the bond markets might panic. QE was the key reason why that argument was false, as I outlined in one of my first blog posts. When bond financed fiscal expansion is not possible because of fickle bond markets, yet fiscal expansion is necessary for the health of the economy, money financed fiscal expansion has to be an option. QE is what makes that option possible. It is very ironic that while central banks mis-sold QE as an alternative to fiscal expansion, in reality QE was all you needed to blow the main argument against fiscal expansion out of the water. [2]

So in my view the bad press QE gets is largely unwarranted. It is true that QE is a pretty unreliable stimulus tool in itself, and it should never be a substitute for fiscal expansion during recessions. However QE is an important policy instrument that allows those fiscal expansions when the economy needs it, interest rates are so low they cannot provide it, yet bond markets will not buy government debt. This combination of circumstances is unlikely to happen very often, but even when it doesn't happen the existence of QE knocks down claims that it might.

[1] In a textbook money financed fiscal expansion, the government saves having to pay the current interest rate on the government bonds it would otherwise have had to sell. With QE, the consolidated public sector (government+central bank) saves having to pay the interest on the bonds the central bank happens to buy. Another difference in detail is that furlough was more like fiscal support rather than fiscal expansion.

[2] Is there a problem because governments do fiscal expansions, but central banks do QE? There shouldn’t be, because in recessions caused by deficient demand central banks will want long term interest rates to be low, and if the bond market is reluctant to buy government debt long term interest rates will rise, so the central bank will buy that government debt.

Tuesday, 28 February 2023

The political economy and worldwide implications of the Inflation Reduction Act in the US


In May last year I wrote about a new book by Eric Lonergan and Corinne Sawers called Supercharge Me. The book argued, in essence, that economists should stop thinking about carbon taxes as the way to tackle climate change, what we could call the big stick, and instead think about carrots in the form of subsidies and public investment designed to get green industries to a scale where their rapid growth would be inevitable.

The Inflation Reduction Act (IRA) is essentially a climate bill passed in the US that does exactly that. It is full of carrots, sometimes open ended carrots, designed to promote greener industries, financed not with carbon taxes but higher corporate taxes and lower drug prices for medicare. As I largely agreed with the central idea behind Supercharge Me, I thought it would be interesting to see how that strategy had proved successful in one of the most difficult countries to convince to go green.

The IRA started as Build Back Better, which was a massive programme of infrastructure spending with a large green component and welfare spending. Some of that was diverted into the Infrastructure Investment and Jobs Act, which was passed into law in November 2021, but the climate part became stuck because one Democratic Senator, Joe Manchin from the Coal and Gas state of West Virginia, refused to support it. (The Republican party was of course united in opposition.)

It looked as if once again the US Congress would block effective green action in the US. But then, to the surprise of many and with a name change the IRA was passed in August 2022. So why did Manchin change his mind, and what was lost as a result? What follows leans very heavily on this excellent talk and discussion, so if you want to know more than I can write here have a look.

A key idea from Supercharge Me is to use the story of solar power as a model for how to green large parts (not all) of the economy. Solar power started off as a relatively expensive form of energy that also required large capital costs to install. However, partly as a result of what the book calls Extreme Positive Incentives, costs came down, more solar power was installed which allowed costs to come down even further, until now solar is one of the cheapest forms of energy.

Electric Vehicles (EVs) are another example of where strong incentives or regulations could produce similar effects. In the UK at the moment not many people buy EVs because they cost more to buy and the charging network is far from ideal. However if the government provides incentives for people to buy EVs their costs will fall, and if they ensure the charging network is substantially improved more people will want to buy them. The IRA includes incentives to buy EVs (which are already working), heat pumps and a lot more besides.

So what made Senator Manchin decide to finally support this bill? The answer is complex, and there are certainly some changes in the bill that he insisted on which are far from progressive. One example is that green incentives no longer require union labour. No one is suggesting the IRA is everything those supporting a Green New Deal would want. But something is better than nothing, so it is interesting to see why Manchin changed his mind, and why Big Oil did not fight against the IRA.

One answer is the invasion of Ukraine. As I have already noted, green energy is now cheap energy, and that is intensified when the price of carbon based energy suddenly shoots up. That is one reason for the change of name to IRA. But perhaps more importantly, with US energy producers getting huge profits and exporting large amounts of gas to Europe, green energy seemed less of an existential threat to Big Oil. Republicans pleaded with oil companies to fight the IRA, and they refused.

There are some signs that the IRA may also be robust enough to survive a Republican Congress. There is a new ‘battery belt’ in the US in a similar position to the old bible belt: southern red states which will be reluctant to give up the subsidies the IRA has created.

The other factor that helped get the IRA passed in the Senate was China. Once you see Green Energy as at least part of the future, then most politicians will want their own country to be part of that. As with IT, there was a common concern that China was becoming too successful in providing key parts of the green revolution, and so the IRA is actually a very protectionist measure. Trump’s Make America Great Again has become an insistence that green goods should be Made in America. Again this aspect of the IRA may be far from ideal, but the link between greening the US and protection is not one I would have guessed beforehand. It has also created difficulties for the EU in how to respond.

Hopefully the Ukraine war will also accelerate the global move towards renewable energy. For any significant movement in the UK we will have to wait for a Labour government, which has pledged a substantial programme of green investment, including a publicly owned renewable energy company. The main threat to this happening on the scale required to avoid harmful global warming, both in the UK and elsewhere, is an obsession with the government’s deficit and public debt.

The IRA is fully financed by higher taxes, and that was the only political option Biden had. But whether we are talking about conventional public investment, or incentives to encourage private investment in green energy, using borrowing rather than taxes makes a lot more sense from an economic and political point of view. This is, after all, temporary government spending to spur investment with future benefits, so its costs should be spread over generations. There are strong economic arguments for higher carbon taxes because the polluter should pay, but the political constraints on achieving this seem high. In the UK at least there is a strong argument that permanent revenue from higher taxes should be used to fund permanent increases in current public spending to allow our public sector to recover from 15 years of Conservative governance.

So how do we avoid deficit targets slowing down the transition to a green economy? Once again I need to stress that in an ideal world this would not be a problem. I have argued many times that targets for the total deficit or for falling debt to GDP make no sense, because public investment should not be constrained by fiscal rules. If public investment yields a good social return then it should happen, whatever the implications are for public debt. But unfortunately we are not in that ideal world, and so we need to start thinking about more imaginative ways to get around the obsession with public debt.

One of these has recently been proposed in an interesting article by Peter Bofinger. He makes the case for funding public missions through increases in public debt, which is a kind of ‘project based golden rule’. (This idea of missions for government has recently been championed by Mariana Mazzucato, but it goes back further than this.) In the UK context this would allow the debt to GDP ratio to increase only to the extent that it represented spending to undertake a mission, in this case to green the economy. This generalises an idea I put forward in my post on Supercharge Me, which was to create a ‘green account’ that was outside normal fiscal rules. As I noted there, it would also require monitoring by the OBR to ensure mission spending was clearly defined.

As the IRA illustrates, the obstacles to fighting climate change can with compromise and imagination be overcome. It is a mistake to prevent such compromise when the ideal is not politically possible. Providing incentives for greener energy is politically easier than making the polluter pay. While in an ideal world fiscal rules would not get in the way of such incentives, we live in a world that is obsessed by public debt. This too requires imagination and compromise to ensure this obsession does not get in the way of tackling climate change.

Tuesday, 21 February 2023

In comparing prosperity across countries, productivity and inequality are almost everything


Paul Krugman once said that to improve a country’s standard of living over time “productivity isn't everything, but, in the long run, it is almost everything”. I want to use a recent Resolution Foundation study to examine a slightly different question, which is what determines differences in prosperity across countries. The answer is very similar, but with an important modification.

The Resolution Foundation report by Krishan Shah and Gregory Thwaites compares productivity and (PPP adjusted) incomes per household in the UK with the US, Germany and France, and with France it looks at both 2008 and 2019 so we can look at the comparison over time. But it starts with the following chart which includes many more countries.

This plots GDP per hour (productivity) on the horizontal axis against median income (both logged) for a number of countries. The line passing through the points is the 45 degree line, and the fact that the points are clustered around this line shows that differences in productivity are crucially important. However there are big divergences from that line, suggesting other factors are important.

The first key point, which can get lost in the detail of the report, is that incomes are not the same as prosperity, if you define prosperity in a more general sense. Three of the most important aspects of prosperity that are not captured by incomes are leisure, public goods and investment. Consider each in turn.

Imagine two countries. In one, people work long hours, have few holidays and have a long working life, and as a result their incomes are high. In another, people work less hours, have longer holidays and retire earlier, and their incomes are less as a result. It would clearly be a mistake to call the country where people work more hours a more prosperous country. We could ask the same question where incomes differ because of different levels of tax, where tax goes to pay for more public goods. The country where incomes are higher but less goods are provided by the state is not necessarily more prosperous, particularly if private sector provision of these goods is less efficient (think US healthcare). These are key issues when comparing the US and France, for example.

The final point is that you could raise incomes by not investing in the future. As future productivity depends on investment today, this might raise people’s incomes today, but at the expense of their incomes tomorrow. Differences in investment may occur not just in producing more capital goods, buildings etc, but also with investment in education, or simply in terms of income from overseas assets.

These factors are important to consider when we look at the relationship between comparisons of productivity and comparisons of income per household. Here is the report’s comparison between the UK and France in 2019.

On the left we have GDP/hour worked, a measure of productivity [1]. That shows that France is 17% more productive than the UK. The penultimate column is average household income, where France and the UK are almost equal. Why is France more productive but incomes are no higher? The main answer is the ‘worker/population’ column, which in this case mainly reflects earlier retirement in France (but also longer life expectancy). Does that mean that the average French person is not more prosperous than the average person in the UK, despite being more productive? Almost certainly [2] not, because people in France have decided to use their greater productivity to retire earlier.

Differences in the proportion of workers to the population doesn’t just reflect retirement. There are fewer young people in the workforce in France. This is partly an investment effect (more education) but also reflects high youth unemployment. The other big factor reducing average incomes in France is the ratio of domestic household income to national domestic income. This partly reflects the fact that French firms invest more so the share of profits in GDP is higher (and the wage share lower), but it also reflects higher taxes and (almost certainly) therefore more public goods. [3]

I hope it is now clear why I wanted to stress the distinction between incomes and prosperity. Although average incomes in France may be no higher than in the UK, the French are still more prosperous because they have used their productivity advantage to have a longer retirement, have more public goods and to invest more in the future. So productivity remains crucial to prosperity, but how people enjoy that prosperity can be quite different between countries.

A final but crucial point comes from comparing the last two columns. Median income is the income of the person in the middle of the income distribution, where you have as much chance of having an income above or below that level. If the distribution of income is very unequal, and in particular if it is skewed in favour of those at the top, median income will be below average income. Median incomes are significantly higher in France than in the UK, because the UK is more unequal. So although productivity is crucial in making cross country comparisons of prosperity, inequality is also important. (For a more detailed comparative analysis of different income brackets, see John Burn-Murdoch here. For a discussion of the impact of changes in the proportion of income taken by the top 1% in the UK over time, see here and particularly here.)

The comparison for 2008 rather than 2019 illustrates a key point that is familiar. While the productivity gap in 2019 was 17%, it was only 7% in 2009. The last 10/15 years really has been a period of UK decline. The 2019 comparison with Germany throws up similarities and differences to France that the report goes into. While the productivity gap is similar, the benefits are taken in terms of working less hours rather than less years. Turning to the US, the productivity gap with the UK is similar to the gap with Germany and France, but US income is much higher. Some of that big gap is because workers in the US work more hours, and taxes are lower because public good provision is lower, but there are also differences that must reflect problems with the data used.

This analysis by the Resolution Foundation illustrates two general points. First, comparisons of personal (post-tax) income levels are a partial indicator of relative prosperity, because they ignore leisure, investment and public goods. For that reason, a comparison of productivity levels may be a better indicator of comparative prosperity than relative income levels. Second, what productivity ignores is the often significant impact different levels of inequality can have on the prosperity of the typical household.

[1] GDP/hour worked is a very aggregate measure of productivity, and could reflect different compositions of output as well as how productive similar firms are.

[2] We could drop the almost if we could be sure that the difference in retirement ages represented national preferences, including choices about retirement incomes.

[3] In theory higher profits could reflect higher dividends rather than higher investment, of course. This links to the decoupling debate (between productivity and real wages) I talked about here, based on work by Teichgräber and Van Reenen.