Fiscal rule redux

Although this discussion is about the UK, the macroeconomic issues involved apply equally elsewhere.

Most of the media discussion of Labour’s new fiscal rule presented before the budget focused on the commitment to balance the current budget. The media did this because ‘the hook’’ was the similarity between this aspect of the rule and the rules proposed by Brown or Balls. As I noted at the time, no one in the media seemed to want to compare this goal to the Chancellor’s overall surplus objective, which remains rather extraordinary.

In some ways this element is the least interesting part of the rule. Two other key parts are that current balance is a rolling five year target, and the knockout if interest rates hit their zero lower bound (ZLB). Both are more difficult to explain quickly in a mediamacro world where the deficit is considered all important, although at least with the rolling 5 year target a quick response is that the coalition government adopted exactly that form of target. If they had adopted the less flexible target of current balance by 2015, the economy would have been even more screwed by austerity than it actually was.

The really new feature of the rule is the knock out. (This was described as a ‘loophole’ by one political reporter: mediamacro again.) The rule is deliberately suspended to allow for fiscal stimulus when interest rates hit their ZLB. How much stimulus? Whatever it takes to get interest rates to rise above the ZLB. In Portes and Wren-Lewis we suggest the Bank of England are the obvious people to advise on this (the size of stimulus, not its form in terms of spending increases or tax cuts). The focus of fiscal policy switches from deficit control to stabilising demand, but only because monetary policy can no longer do that job effectively.

If such a rule had been in operation during the Great Recession, we would have seen a continuation of the fiscal stimulus we saw in 2009 into later years. That would have meant, for sure, that government debt would have risen by more than it did, but it would also have meant, for sure, that output would have recovered more quickly. What would have happened to the debt to GDP ratio we cannot know for sure, but the important point is that this does not matter.

It is this last point which is the most difficult to convince people about in the mediamacro world. In this (imaginary) world, we have to worry about the deficit because if we do not there might be a financial panic, with interest rates on government debt rising and perhaps even an inability to sell that debt. The best response to this concern is it would not matter even if it happened, because the Bank of England would buy the debt and keep interest rates on that debt down. Of course the market panic scenario will not happen anyway, because there is zero chance that the government will default, but trying to convince people that the financial markets will behave rationally after the global crisis is hard.

Many non-economists think creating money to cover the deficit sounds outlandish, until you point out it is already happening with QE. The potential size of the QE programme is unlimited. The whole point of QE is to keep long term interest rates, like the interest rate on government debt, low. QE happens when short interest rates are at their ZLB. That it why, when rates are at the ZLB, fiscal policy can focus on stimulating the economy. [1]

There are some who think that any kind of fiscal rule represents appeasement of the austerity position. As I discussed in my post on MMT, I do not think that is very good economics, particularly for a party (like Labour) that is committed to maintaining an independent central bank that uses monetary policy to stabilise demand. In that regime, when you are not at the ZLB, deficit bias is a potential problem. I think intergenerational fairness is important, and we shouldn’t ignore it just because the argument is misused to support austerity. I am reminded of this every time I look at Norway, and recall how Mrs. Thatcher effectively used oil revenues to cut taxes rather than build up a sovereign wealth fund. There is a certain irony that George Osborne’s current policy of going for surplus, while totally wrong for today, would have been the right policy in the late 80s and 1990s.

Ellie Mae O'Hagan recalls how many on the left (in my recollection all shades of the left) argued that when austerity started to bite there would be a popular revolt against the policy. That did not happen, in part because of mediamacro, but also because there was not a clear alternative to unite behind. Labour tried to have it both ways, expressing worries about what austerity was doing but also agreeing that the deficit was a current concern. In Labour’s new fiscal rule we have a policy that sets out clearly how we should deal with any new crisis, and also how we should have dealt with the last one. It is a policy the left should unite behind, because overcoming mediamacro’s obsession with deficits will not be easy.

[1] You can only do this if the government controls the currency its debt is issued in. When that does not happen, as many developing countries have found to their cost, you do have to worry about the bond markets. That was exactly the problem that led to the Eurozone crisis, until the ECB came up with OMT.

A more elaborate argument for countries that do borrow in their own currencies is that a market panic over government debt would be accompanied by a run on the currency. Paul Krugman tackles this, but following discussions with the FTs Martin Sandbu I do plan to discuss this issue further at some point.  

Scotland and the SNP: Fooling yourselves and deceiving others

There are many laudable reasons to campaign for Scottish independence. But how far should those who passionately want independence be prepared to go to achieve that goal? Should they, for example, deceive the Scottish people about the basic economics involved? That seems to be what is happening right now. The more I look at the numbers, the clearer it becomes that over the next five or ten years there would more, not less, fiscal austerity under independence.

The Institute for Fiscal Studies is widely respected as an independent and impartial source of expertise on everything to do with government spending, borrowing and taxation in the UK. It has produced a detailed analysis (recently updated) of the fiscal (tax and spending) outlook for an independent Scotland, compared to what would happen if Scotland stayed in the UK. It has no axe to grind on this issue, and a considerable reputation to maintain.

Their analysis is unequivocal. Scotland’s fiscal position would be worse as a result of leaving the UK for two main reasons. First, demographic trends are less favourable. Second, revenues from the North Sea are expected to decline. This tells us that under current policies Scotland would be getting an increasingly good deal out of being part of the UK. To put it another way, the rest of the UK would be transferring resources to Scotland at an increasing rate, giving Scotland time to adjust to these trends and cushioning their impact. Paying back, if you like, for all the earlier years when North Sea oil production was at its peak.

The SNP do not agree with this analysis. The main reason in the near term is that they have more optimistic projections for North Sea Oil. The IFS analysis uses OBR projections which have in the recent past not been biased in any one direction. So how do the Scottish government get more optimistic numbers? John McDermott examines the detail here, but perhaps I can paraphrase his findings: whenever there is room for doubt, assume whatever gives you a higher number. In my youth I did a lot of forecasting, and I learnt how to be very suspicious of a series of individual judgements all of which tended to move something important in the same direction. It is basically fiddling the analysis to get the answer you want. Either wishful thinking or deception.

I personally would criticise the IFS analysis in one respect. It assumes that Scotland would have to pay the same rate of interest on its debt as the rUK. This has to be wrong. Even under the most favourable assumption of a new Scottish currency, Scotland could easily have to pay around 1% more to borrow than rUK. In their original analysis the IFS look at the implications of that (p35), and the numbers are large.

So what would this mean? Could Scotland just borrow more? I am all for borrowing to cover temporary reductions in income, due to recessions for example, which is why I have been so critical of current austerity. However, as the IFS show, North Sea oil income is falling long term, so this is not a temporary problem. Now it could be that the gap will be covered in the longer term by the kind of increases in productivity and labour supply that the Scottish government assume. Governments that try to borrow today in the hope of a more optimistic future are not behaving very responsibly. However it seems unlikely that Scotland would be able to behave irresponsibly, whatever the currency regime. They would either be stopped by fiscal rules imposed by the remaining UK, or markets that did not share the SNP’s optimism about longer term growth. So this means, over the next five or ten years, either additional spending cuts (to those already planned by the UK government), or (I hope more realistically) tax increases.

Is this a knock down argument in favour of voting No. Of course not: there is nothing wrong in making a short term economic sacrifice for the hope of longer term benefits or for political goals. But that is not the SNP’s case, and it is not what they are telling the Scottish people. Is this deception deliberate? I suspect it is more the delusions of people who want something so much they cast aside all doubts and problems.

This is certainly the impression I get from reading a lot of literature as I researched this post. The arguments in the Wee Blue Book are exactly that: no sustained economic argument, but just a collection of random quotes and debating points to make a problem go away. When the future fiscal position is raised, we are so often told about the past. I too think past North Sea oil was squandered, but grievance does not put money into a future Scottish government’s coffers. I read that forecasting the future is too uncertain, from people who I am sure think about their future income when planning their personal spending. I read about how economists are always disagreeing, when in this case they are pretty united. (Of course you can always find a few who think otherwise, just as you can find one or two who think austerity is expansionary.)

When I was reading this literature, I kept thinking I had seen this kind of thing before: being in denial about macroeconomic fundamentals because they interfered with a major institutional change that was driven by politics. Then I realised what it was: the formation of the Euro in 2000. Once again economists were clear and pretty united about what the key macroeconomic problem was (‘asymmetric shocks’), and just like now this was met with wishful thinking that somehow it just wouldn’t happen. It did, and the Eurozone is still living with the consequences.

So maybe that also explains why I feel so strongly this time around. I have no political skin in this game: a certain affection for the concept of the union, but nothing strong enough to make me even tempted to distort my macroeconomics in its favour. If Scotland wants to make a short term economic sacrifice in the hope of longer term gains and political freedom that is their choice. But they should make that choice knowing what it is, and not be deceived into believing that these costs do not exist. 

Was the UK government’s use of North Sea Oil a scandal?

Aditya Chakrabortty of the Guardian thinks so, as do many on the left. The evidence appears at first sight quite strong, if we compare the UK to Norway. The Norwegian government invested the proceeds from its share of North Sea oil in a sovereign wealth fund, and as a result each Norwegian citizen is currently about $150,000 richer. The fund holds on average 1% of the world's shares. In contrast, there is no equivalent UK sovereign wealth fund, but just a lot of UK government debt. QED?

Not so fast. The opposing argument can also be stated in an equally compelling way. Why should the government decide on what to do with the oil revenue? The democratic thing to do with the money is to give it to the people, and they can decide what to do with it. To the extent that they choose to invest it, so the argument goes, individuals are much better at making good investment decisions with their own money than the government is. Seen this way, the complaints from the left are just another example of the paternalistic belief that the state knows better what is good for people than people themselves. What Mrs Thatcher’s government did was allow individuals to create their own wealth from North Sea Oil revenues, if they so wished.

There are essentially two issues here: one involving distribution between generations, and the other distribution between individuals. Few would argue that the generation who paid taxes in the 1980s deserved exclusive rights to the benefits of North Sea Oil: most would agree that this resource should also benefit future UK generations. Now the current generation could look after future generations by investing rather than consuming a large part of the revenues. The standard macroeconomic model assumes this happens to some extent (agents care about their children etc), although in a way that heavily discounts the welfare of future generations. Did they do this?

It is difficult to know for sure, but when I looked at the evidence from current accounts and net national wealth here, it was hard to believe that most of the UK’s North Sea Oil money was invested. So on this occasion at least, the Norwegian government appears to have looked after the interests of future generations rather better than the average 1980s UK taxpayer did. Whether that is because these taxpayers were selfish or badly informed I have no idea. (For a fascinating account of how a sovereign wealth fund might be useful in a world with selfish agents and animal spirits, see these papers (pdf, pdf, pdf) by Roger Farmer.)

The other problem with the defence of the UK government’s approach is more straightforward. If North Sea Oil revenue was used to reduce taxes, this means that the revenue was distributed unequally rather than democratically. Those who didn’t pay any taxes at the time received nothing. Those that paid the most taxes, which of course means those with the highest incomes, received most. An alternative would have been to distribute equal oil ‘dividends’ to each citizen, for example as the US state of Alaska has done. (For more general discussion of how best to handle resource discoveries, see some of the papers produced by OxCarre.)

So was the UK government’s policy a scandal? One definition of scandal is “an action or event regarded as morally or legally wrong and causing general public outrage”. Well, general public outrage it did not cause: giving the majority of people at least some money rarely does, and that those who were better off got most was a feature of the decade. On the other hand the fact that so little of the wealth was left for future generations, in contrast to the ‘statist’ Norwegian alternative, does seem to pose serious problems for neoliberalism, as well as the core intertemporal macroeconomic model.

 

Safe Assets and Sovereign Wealth Funds: Norway, the UK and Oil

Miles Kimball was ahead of me in thinking about the safe asset problem. It was interesting that we seem to have reached similar conclusions thinking about very different things. He focused here on the immediate problem of what the Fed was buying as part of QE, whereas I was in a fictional (and perhaps utopian) world centuries ahead when the government owned net assets rather than net debt. A sovereign wealth fund can be helpful in both cases: the monetary authority can ask the fund to make the decisions about what assets to buy, and the fund can provide the assets to either match against government debt or help reduce the need to raise taxes to pay for government spending. A short list of his posts on this issue can be found here. They are especially relevant for the UK if you are worried that all the Bank has been doing with QE is buying Gilts.

The discovery of a finite natural resource is an ideal experiment in teaching macro. It uses the intertemporal consumption model to illustrate why current account deficits (pre-extraction phase) and surpluses (extraction phase) can be optimal things for economies to have. I’m afraid I use the discovery of North Sea oil as my example, and luckily there is still enough there that no student will ever say to me ‘so there was once oil under the North Sea?’ [1] But my excuse for showing my age is that it also allows a very nice contrast between what happened in Norway and what happened in the UK, and a nice way to throw Ricardian Equivalence into the teaching mix.

For anyone who does not know, Norway invested (and continues to invest) most of its tax receipts from North Sea Oil into a Sovereign Wealth Fund (which used to be called the Petroleum Fund, but is now rather misleadingly called the Government Pension Fund.) It was not a token exercise - its assets are around $654 billion, which is larger than Norway’s GDP. The UK, mostly under the Thatcher government, decided instead that it was better to give this money to the people, so it cut taxes using its receipts from North Sea Oil. Under Ricardian Equivalence, where agents who care about their children as themselves also internalise the government’s accounts (which include any oil fund), what the UK and Norway did will have identical effects.

They will have identical effects, because those receiving the tax cuts will invest much of the proceeds so that when the oil runs out, they (or their children) will be able to carry on as if nothing had happened because they can consume the returns from those assets instead of revenues from the oil. It is a classic example of consumption smoothing: saving or borrowing to smooth out the impact of variations in income. We know people do sometimes try and consumption smooth, because most save for their retirement. Yet did UK consumers save the proceeds from oil to create their own personal equivalents of Norway’s oil fund?

The data is not very promising. While the UK ran some current account surpluses in the early 1980s, there were also deficits, and by the late 1980s there were only (large) deficits. We almost got back to current account balance in the late 1990s, but have had large deficits ever since. No obvious sign of saving the revenues from oil there. Looking at our net foreign asset position is initially a little more hopeful, as it’s positive value increased in the first half of the 1980s, but that disappeared for good by 1990, and the UK is now a net debtor. Perhaps a more detailed study might come to different conclusions, but I do not know of any that does.

Nor did the government set a very good example. It should at least have been running down its net debt position while North Sea oil revenues were at their peak, so that it could reduce the need to raise distortionary taxes once the money ran out. Net government debt did fall in the second half of the 1980s, but it went straight back up again in the early 1990s, suggesting this was just a cyclical effect.

What has this got to do with safe assets? Only this. One of the arguments against establishing a Sovereign Wealth Fund is that, even if the fund is nominally independent, governments cannot be trusted not to interfere, and so it is better to give the money to the people. Miles Kimball discusses this ‘libertarian’ view here, and I alluded to the ‘communism by the back door’ idea at the end of my earlier post. That, presumably, was part of the justification for not establishing an oil fund in the UK in the 1980s. I suspect if you asked most people who were born in the UK in the decade after North Sea oil started flowing whether the UK or Norway made the better decision, they would say Norway. In Norway, I suspect they would say Norway too.[2] The evidence seems to suggest they would be right. So in this case at least, not setting up a Sovereign Wealth Fund for ideological reasons was a mistake.

[1] How to use resource revenue is a critical issue for many developing countries, and is discussed in many places by my colleagues at the end of my corridor, including here.

[2] Of course many would not have a view, but I cannot help feeling that strengthens the case for a Fund. Interestingly it seems that it is the right in Norway that want to spend more of the Fund today, and the left that (financial crisis aside) want to stick to their 4% rule.