Avoiding Fiscal Fudge

There has been some recent disquiet in the UK about politicians before the election failing to offer voters a clear account of how they would achieve their fiscal plans. The Financial Times has taken the lead, but others have concurred. A point I have stressed is that each party’s aggregate fiscal plans are quite different, even though Labour in particular seems to want to hide this fact. But the complaint I want to focus on in this post is about something different - it is about failing to make it clear how plans will be achieved in terms of detailed policy changes.

While I think journalists and bloggers are right to complain, I think it is even more productive to suggest what can be done about it. Politicians do what they think is most likely to get them votes. In a time of austerity, they have calculated that any bonus they might get by being transparent will be more than offset by votes they will lose from coming clean on specific cuts or tax increases. This is hardly a unique UK phenomenon - the phrase ‘magic asterisk’ comes from the US, and Paul Ryan managed to fool quite a few ‘serious people’ by deploying it before the last US election. If the factors that enter this calculation do not change, neither will the behaviour of politicians.

In 1996 I wrote a paper with the title of this post. It was the first time I proposed setting up an independent fiscal institution, or fiscal council, like the OBR. One of the few examples of such a body at the time came from the Netherlands. Those who complain about lack of transparency on fiscal matters before elections should really examine what happens today in that country. There the Dutch equivalent to the OBR offers to cost the fiscal plans of any opposition party before an election. They take up this offer, because failing to do so would be seen as a clear sign that plans were not credible. The detail that the Bureau for Economic Policy Analysis (CPB) go into is extraordinary, as I noted at the beginning of this post: here (pdf) is an example.

So in the Netherlands we have a situation where the fiscal plans of each party before an election are transparent, detailed and independently costed. There is no fiscal fudge. To use a bit of economics jargon, it is a political economy equilibrium which each individual party finds it too costly to depart from. In most other countries we have an alternative equilibrium that involves plenty of fiscal fudge, from which it would be too costly for any individual party to try and break. Is there something peculiar about the Netherlands that means their set-up could not work elsewhere? I have heard excuses along those lines, but none which I find convincing.

So how might we get from where we are now to something like the Dutch example? Well it so happens that in the UK we have a unique opportunity if Labour forms the next government. Ed Balls recently asked the OBR to cost their post election plans, but this would involve an extension of the OBR’s current mandate, and George Osborne did not want that to happen. Of course political advantage was behind both the request and the refusal. However, given the request, if Labour forms all or part of the next government, it will be very difficult for them to reject extending the OBR’s remit in this way. Those who complain about lack of fiscal transparency should help make sure this happens. Of course the details of how the OBR might do this need to be worked out, and it may not be appropriate to do it exactly as they do in the Netherlands. But the UK also has another piece of good fortune on this front: the previous director of the Dutch fiscal council, Coen Teulings, is currently a member of the economics department at Cambridge, so is easily on hand to give advice. We should not miss this opportunity to end fiscal fudge.  

Here we go again

1) Government embarks on austerity, to try and maintain the confidence of the bond markets. We must preserve the AAA rating for our government’s debt, says the finance minister.

2) Austerity reduces demand, helping create flat or negative growth.

3) As a result, deficit targets keep being missed. Additional austerity is imposed, and growth declines again.

3) Country loses its AAA rating, and the credit rating agency gives concerns about poor growth as an important factor for the downgrade.

4) This confirms our fears, says the finance minister. We must redouble our efforts to reduce our debt.

This will sound familiar to UK ears, but it is also what has just happened in the Netherlands.

I do not like using decisions by the credit rating agencies as an excuse to write posts, because when it comes to the major economies they have no particular expertise. (Typically markets show no reaction to the ‘news’ that a country like the Netherlands has been downgraded.) This useful post by Bas Jacobs (HT MT) argues that the S&P analysis for the Netherlands does not deserve any serious attention. On credit rating agencies generally, see Jonathan Portes. The media report what these agencies say because downgrades are convenient hooks to hang existing stories on, and it is a shame and a continuing source of puzzlement that officials and politicians bother with them.

So why am I writing this post? Because it seems important to record the progress of another country beside my own that is going down a depressingly predictable path. When I last wrote about the Netherlands, some positive growth was expected for 2014, but the OECD’s latest forecast shows GDP flat next year. These forecasts also have consumer price inflation below 2% in 2014 and below 1% in 2015. The output gap is currently over (negative) 4%, and is expected to reach -5.5% in 2015. Unemployment, which was only 4.3% in 2011, is expected to rise to 8.1% in 2015.

Like the UK, the Netherlands is a country with no problem selling its debt. It has no macroeconomic need to achieve an expected (by the OECD) underlying general government surplus by 2015. As Jacob’s notes, there is no question of an unsustainable long run fiscal position. The only major lever the government has to do something about lack of growth and rising unemployment is fiscal policy, yet it is using this lever in completely the wrong (pro-cyclical) direction, making everything worse.

A crazy policy. Yet it is followed by both centre-left and centre-right parties, even though this means these parties are haemorrhaging support to those further left and right. It is a policy supported by the central bank, which was one of those voting against the recent cut in ECB interest rates. The CPB, the country’s fiscal council that used to be a voice of sanity on fiscal matters, appears silent on the issue. Everyone can blame the Eurozone’s Fiscal Compact of course, but among the political centre they do not.

Coen Teulings, the former head of the CPB, speculated about why politicians seem so attached to austerity, when it is so clearly doing their popularity such harm. They seem to be stuck in an equilibrium (the ‘austerity trap’) where they fear that if any of them broke free, by declaring austerity harmful, they would lose out because other parties in the centre would declare them irresponsible, or ‘not serious’ to use Paul Krugman’s language. Yet they would all be better off, in terms of not losing support to the further left or right, if they could simultaneously break free of the austerity trap. Within any single Eurozone country the ‘irresponsibility’ charge is reinforced by the Eurozone’s Fiscal Compact, which in turn keeps the Eurozone as a whole in the austerity trap.   

Why politicians ignore economists on austerity

I have written before about fiscal policy in the Netherlands. I have done so in part because that country has a strong macroeconomic tradition, and I regard their long standing fiscal council (CPB) as a model of how to try and get good economic analysis and evidence into the policy debate. It is therefore an indication that something is very wrong when the political consensus there follows the austerity line.

The key target for policy in the Netherlands appears to be the 3% budget deficit number that was at the centre of the old Stability and Growth Pact. The latest CPB forecasts are for deficits of 3.3% of GDP in 2013, and 3.4% in 2014. The main reason is that the economy is in recession: GDP is expected to fall by 0.5% this year (following a fall of 0.9% in 2012), and grow by only 1% in 2014. The governing coalition includes the Labour Party, and its leader Diederik Samsom says it would be unwise to sharply cut government spending in a recession. What he means by this is that they will not try and hit the 3% figure this year, but instead do so next year!. After announcing austerity measures of over 2.5% of GDP in the autumn, the coalition has recently prepared a list of additional cuts totalling  0.7% of GDP. These include tax increases, a pay freeze for public sector workers and extra charges on industry.

So we have a discretionary procyclical fiscal policy, in an economy without its own monetary policy to offset its impact. The one ray of hope is that the trade unions, who have previously been prepared to discuss the details of austerity, no longer wish to do so. The FT reports  the largest labour federation as describing the cuts as “stupid and ill-advised”. The Labour Party is urging the unions to take part in discussions about the cuts, so they can - as one report puts it - “seize the opportunities offered by new measures to stimulate the economy”. This sounds a bit like asking a Christmas Turkey to talks about the recipe for the stuffing. The unemployment rate, which was 4.4% in 2011, is expected to rise to 6.5% in 2014.

So why are politicians, in the Netherlands and elsewhere, pursuing a policy that most economists regard as an elementary error? This was a question raised by Coen Teulings, who is the director of the CPB, the Dutch fiscal council. He was commenting on an IMF sponsored conference in Sweden, at which most economists argued against short run austerity when the economy was weak, and instead advocated dealing with budgetary problems through long term structural reform. The politicians in the audience, led by the Swedish finance minister Anders Borg, disagreed. He summarises their view as follows: “Politicians lack the ability to commit today to austerity measures to be implemented tomorrow. Hence, the only option is to take action straightaway.” (Borg was a driving force behind setting up Sweden’s own fiscal council, but his subsequent interaction with it has been more difficult, as Lars Calmfors and I describe here.)

Tuelings does not take this argument seriously, for good reasons. Instead he provides three suggestions as to why politicians are ignoring the economists. The first is a memory of the 1970s, when Keynesian policies were pursued because many failed to see the structural impact of the oil crisis. Politicians do not want to make the same mistake again. The second is that economists neglected countercyclical fiscal policy for too long, and therefore have failed to provide politicians with a clear guide to what policy should be, like perhaps an equivalent to the Taylor rule for monetary policy. Third, while both structural reform and short term austerity have political costs, politicians can sell the latter more easily, and success can be demonstrated more quickly.

The last argument can be partly seen as the austerity counterpart to the common pool explanation for deficit bias: structural reform can hit particular groups hard, while generalised austerity spreads pain more widely (or perhaps hits particular groups who have a small political voice). There may be something in the second argument, but there is a chicken and egg issue here. As someone who has written papers evaluating fiscal rules for a number of years, I have not noted much interest from European policymakers.

I suspect, however, that most of the interest in Taylor rules for monetary policy comes from central banks rather than politicians. I think this is a key problem with fiscal stabilisation policy: the lack of an institution that fosters research of this kind, that consolidates knowledge and pools wisdom. In my dreams I imagine a linked set of national fiscal councils that could play that role. What is unfortunately very clear is that central banks (or at least those running them) cannot do for fiscal policy what they have done for monetary policy: just look at the detailed and well formulated analysis of austerity in this recent speech (section 3.1) by the president of the Bundesbank. Returning to the Netherlands, it is no secret that the CPB is not part of the austerity consensus, while the Dutch central bank certainly is.