An interview that will never happen

Interviewer. Chancellor, in your Mansion House speech you said we must reduce government debt rapidly to prepare for an uncertain future. What uncertain future do you have in mind.

Osborne. As my colleague the Prime Minister put it just six months ago, red warning lights are once again flashing on the dashboard of the global economy. There is Greece, the Middle East, and Ukraine.

Interviewer. But Chancellor, economists are agreed that any imminent global downturn will be more difficult to deal with if fiscal austerity is also being a drag on growth.

Osborne. I am confident that the Bank of England can deal with any immediate threats to the economy.

Interviewer. Even with interest rates already near zero?

Osborne. As the Governor has often said, he has the tools to do the job.

Interviewer. Is that why inflation is currently negative?

Osborne. As you know that has a great deal to do with the fall in oil prices. More generally I think we should celebrate the fact that prices have stopped rising so that real wages and living standards can at last increase.

Interviewer. But isn’t core inflation, that excludes oil prices, at 0.8%? The 2% inflation target is yours, Chancellor. Mark Carney has also said that reducing fiscal deficits will be a drag on growth.

Osborne. To repeat, I have complete confidence in the Governor of the Bank of England to keep the economy on track. I have not been disappointed in my choice of Governor so far, but if I need to reprimand him for any failures in the future I will not shirk from that responsibility.

Interviewer. Going back to the proposed legislation to outlaw deficits, you have also made election commitments to cut some taxes, and intend to legislate to outlaw raising others. That means that public spending will have to be cut to achieve these surpluses. Some people have suggested these laws are just a backdoor means to achieve an ideological objective of a smaller state.

Osborne. That is nonsense. I just think it is important not to place any further burden on this country’s hard working families. These families also know that you cannot go on borrowing forever.

Interviewer. Many people borrow for years to buy a house, and many successful companies continue to borrow to grow. These companies also know that it is best to borrow when interest rates are low, and interest rates on UK government debt are currently very low.

Osborne. And I will never stop trying to take credit for that. But as a prudent Chancellor, I need to ensure we have room to run deficits safely in abnormal times.

Interviewer. Is that to enable the government to undertake fiscal stimulus to support the economy during a major recession?

Osborne. No, that would not be appropriate, as I said in 2009. But as I have also said many times, it is important to allow the automatic stabilisers to operate.

Interviewer. The automatic stabilisers operate even during mild economic downturns, because low growth reduces tax revenues for example. So does your definition of abnormal simply mean when growth would be below average?

Osborne. No, I am talking about more serious events than that, but I will leave the experts at the OBR to decide precisely what is abnormal.

Interviewer. I am sure they would welcome your guidance. But if abnormal does not include mild downturns, and you want to make it a legal requirement to run surpluses during those times as well, that will require either switching the automatic stabilisers off during these mild downturns, or running pretty large surpluses when the economy is on track so as to avoid going into deficit if a negative shock of the normal kind hits.

Osborne. As I said, I think it is important to allow the automatic stabilisers to operate.

Interviewer. Chancellor, I may be being stupid here, but why is it important to allow taxes to fall automatically in a recession, but wrong to actually cut taxes further to help bring the recession to an end quickly, particularly if interest rates are stuck at zero?

Osborne. I think the experience of 2010 shows us the limits of what governments should do. It was right to let the automatic stabilisers increase the deficit following the 2009 recession, but any action by the government to increase those deficits puts our credibility at risk.

Interviewer. Now I’m a little confused. You and your colleagues said repeatedly during the recent election that the deficit in 2010 was so large due to the profligacy of the last Labour government, and not because of the recession. Austerity was because you had to clear up the mess that Labour created. It also seems that a significant proportion of the public sees it that way too. Are you now saying that is wrong?

Osborne. Look, no one is denying that 2008 saw a global financial crisis. It is to prepare for that kind of event that we need to run surpluses, perhaps as you suggest quite large surpluses when the economy is growing normally, to get debt down quickly.

Interviewer. So we need to bring debt down rapidly so that we can afford to bail out the banks again when the next financial crisis hits. I thought you had taken the measures necessary to prevent us having to rescue the banks again.

Osborne. We have done what we can, but it is important to maintain London as the leading financial centre, which means keeping banks profitable and allowing them to pay large bonuses to attract the best international talent. We do not want to impose regulations so severe that these banks and other financial companies go elsewhere. We made these points many times before 2008.

Interviewer. Thank you, Chancellor. That has been very helpful in understanding why you believe we need to legislate for budget surpluses. One last question if I may. Can you tell me what percentage of donations to the Conservative party come from the financial sector?

Should we aim for budget surpluses?

Does it make sense to target a budget surplus in normal times within five years, as George Osborne suggested at the Mansion House last night? I’m afraid any answer to that has to first respond: define ‘target’ and ‘normal’. We do not have those details at the moment, so I’ll try and finesse them by asking whether it makes sense for the budget to be on average in balance within five years: more surpluses than deficits, but the occasional (abnormal) large deficit. [1] In this post I’ll ignore problems associated with the Zero Lower Bound for interest rates, which is a very good (irrefutable?) reason why we should not be seeing any fiscal tightening right now. Here I’ll focus on the longer term.

This question is really the same as asking what the long run target for government debt should be. I recently discussed an IMF paper which suggested that, as long as the market was happy buying the debt, there was no need for the government to reduce the level of debt from current levels (around 80% of GDP). That policy would imply running deficits of around 3% of GDP, which is a long way from a surplus. I also said that might be an extreme position. In this post I gave various paths for deficits and debt, where the other extreme was balancing the budget. A balanced budget could involve debt falling rapidly to around 40% of GDP by 2035, and by 2080 the debt to GDP ratio would be close to zero. I also gave various paths in between these two extremes.  

So which should it be: keep the debt to GDP ratio at around 80% as the IMF suggest, or get it to fall rapidly as George Osborne suggests, or something in between? Consider some popular arguments for going with George Osborne.

1) It provides scope to respond to another Great Recession without running out of what the IMF call fiscal space.

This is right in principle, but the numbers do not imply we need to get debt down that fast, unless we are expecting the equivalent of Great Recessions to happen in the future much more often than in the past. The IMF paper has some calculations on this (pages 12 and 13), and I looked at a particular experiment here.

2) We need to reduce the debt burden for future generations.

Under the assumptions in the IMF paper, the costs of getting debt down now exceed the future benefits. Again, that might be too extreme, but it would be very hard to justify a quick Osborne like reduction in debt on distributional grounds. That would mean that the costs of reducing debt would largely fall on the same generation that suffered as a result of the Great Recession, which would seem perverse.

3) Any individual would always want to pay back their debts quickly

Bad analogy. Here a country is more like a firm. Firms typically plan to live with permanent debt, because it has paid for its capital. The state has plenty of productive capital. To put the point in distributional terms, if we paid back most government debt within a generation, we would be giving that capital to later generations without them making any contribution towards it.

So it is hard to justify aiming for budget surpluses within the next five years. But I want to make one final point. How quickly you should reduce debt involves difficult technical issues. While I’m reasonably sure that the extremes of keeping debt at 80% of GDP or going for surpluses within the next five years are not optimal, that leaves a wide range of possibilities in between, and neither theory nor evidence gives us much guidance at the moment. This really is an area where more research is needed [2], and it would be good if the Treasury - the main interested party - was promoting that research. What we get instead are jokes about reactivating the Commissioners for the Reduction of the National Debt. (It was a joke, surely?) Sign of the times, I’m afraid. 

 

[1] It makes no sense to target any deficit/surplus number on an annual basis. The budget deficit should be a shock absorber, to prevent volatility in things that matter, like tax rates and spending decisions. (Shocks can be cyclical, but they can arise from other sources, so cyclical correction - even if it could be done well - does not negate this point; see Portes and Wren-Lewis.) That is why the coalition originally had a target for the deficit in five years time, which makes sense because it allows the deficit to be a shock absorber.

[2] Yes I know this is what academics always say, but on this issue it is absolutely true. Compared to the oceans of work on monetary policy, work on optimal government debt amounts to a puddle. One reason may be that central banks are good at encouraging and utilising academic research, whereas finance ministries are less so.