The macroeconomic magic button

In a recent post on the Eurozone, I talked about an idea from Greek economist Yanis Varoufakis, where he imagined leaders were presented with a magic button that would end their countries macroeconomic woes. He said that leaders in the US and UK would surely press the button, but he was doubtful about Germany. I commented as an aside that I thought he was wrong about the UK, because that button exists, and it is called balanced budget fiscal expansion. (I think he is right about the US, if the only hand needed to press the button was the President. However my arguments below probably also apply to many Republicans.)

The idea is to temporarily increase government spending, and pay for it completely by temporarily raising taxes. There is no increase in government budget deficits or debt. This may seem like giving with one hand and taking with the other, but it has the effect of raising demand, because some of the taxes come from reduced saving, rather than lower consumption. Once demand rises, incomes increase, and theory suggests that in a closed economy the multiplier would be one. (For those who want more detail, see here, and for specific past proposals to implement this policy, see here for the UK and here for the US.) The only argument I have seen that it would not raise demand is if all consumers believed the tax increase was permanent. That seems highly unlikely.

Of course many of us would argue that debt financed fiscal expansion is also a magic button, but many other people do genuinely worry about government debt. With the balanced budget button they do not have to.

I have heard people say that the balanced budget multiplier might be quite a lot less than one in an open economy like the UK. But this depends entirely on where the extra government spending goes. If it is all spent on goods or services produced in the UK, the multiplier is still one.

So why is the government not pushing this button? The answer is that I do not know for sure, because as far as I know they have not addressed this question. That in itself is quite revealing. The obvious thought is that no Chancellor likes raising taxes, but that alone cannot be a full answer, because this government has raised taxes.(1)

Imagine, if you can, that as a price of joining the coalition, the Liberal Democrats had insisted on having the post of Chancellor rather than deputy PM. Would the LibDem Chancellor not have pushed this magic button? The benefits are clear. The cost? Some short term political embarrassment perhaps in relaxing austerity that was before deemed unavoidable. But there is a perfect excuse – the Euro crisis. Unlike their Conservative partners, the LibDems would not be burdened with claiming that fiscal stimulus didn’t work when they were in opposition.

So I am left with only one plausible reason why the current Chancellor has not pushed the magic button and that is because he does not want to. Why? Well an obvious problem with balanced budget fiscal expansion is that it increases the size of the state. Even though it is only temporary, as a Conservative this is not something you want to do. In addition, if one of the ‘benefits’ of a debt crisis is that it gives you a pretext to shrink the size of the state, then undertaking balanced budget fiscal expansion stops that goal being achieved. You would, in this sense, be wasting a crisis.

Postscript

I originally wrote this before the latest fall of 0.7% in second quarter GDP was announced. (Note for US readers, this is a quarter on previous quarter fall, not annualised!) When I saw the Chancellor talking about these figures, he was being filmed outside a government funded construction project, and I had the feeling he had been doing quite a lot of this recently. This was confirmed in this Stephanie Flanders piece. She notes that this particular construction project was agreed by his Labour predecessor, but then delayed by this Chancellor when he came into office. In addition, a major contributor to the recent GDP fall was construction, in large part because of a decline in public investment!


This reminded me of George Orwell's 1984, where he made famous the idea that the best way to disguise the true purpose of something was to call it the opposite, like the Ministry of Peace that wages perpetual war. Perhaps we are seeing the televisual equivalent. So do not be too surprised, if the UK economy carries on being this successful, to hear that the U.K. Treasury has been renamed the Ministry of Growth. 


(1) Recently the Chancellor has undertaken, with the Bank, various measures designed to stimulate private investment. These are welcome, although they are also generally consistent with the argument I'm making here. Although there may be doubts about some of these measures as an alternative to public investment, to the extent that the market for borrowing for private investment is currently distorted by excessive caution and the rebuilding of banks balance sheets, effective subsidies for borrowing make sense. However their uncertain overall impact means they are no magic button.

Sector Financial Balances as a Diagnostic Check

                Martin Wolf has a nice post explaining the financial crisis using sector financial balances. He rightly attributes this way of looking at things to Wynn Godley. It goes way back – I remember using them as a cross-check on forecasts in the UK Treasury in the 1970s, but it was probably Godley’s influence that helped that happen too. They are not a substitute for thinking about macroeconomic behaviour, but they can often be a very useful check on whether your thoughts (or forecasts) make sense.

                Take the example of a balanced budget temporary increase in government spending, which I used recently as a challenge to heterodox economists to come up with an alternative analysis that did not use either representative agents or rational expectations. (I’ve had plenty of responses telling me of all the defects of rational expectations, but no one has as yet given me an alternative account of the impact of this particular policy measure. As Godley is respected among heterodox economists, I thought maybe retelling my analysis using sector balances might help.)

The policy itself does not directly change the government sector’s financial balance (by definition). Theory tells us that consumers will smooth the impact of temporarily higher taxes, so their sector will move into deficit. But if we were foolish enough to think the story stopped there, thinking about financial balances tells us that has to be wrong. Consumers are in deficit, and no sector has moved into surplus. Keynesian theory then tells us what happens to put things right: output and incomes increase until the point that the consumer sector is no longer in deficit. If you think about it (and given consumption would always fall by less than post-tax income because of smoothing), this has to be the point at which income has increased by an amount equal to the tax increase i.e. a balanced budget multiplier of one. We could talk about this as a dynamic multiplier process, or we could talk about rational consumers working this out, and so not bothering to reduce their consumption in the first place.

As Martin Wolf and others have pointed out many times, thinking about financial balances also tells us the foolishness of cutting government deficits when the private sector has moved into surplus to restore their asset/liability position. In a global economy, if governments are successful in cutting deficits then the private sector surplus has to diminish. That makes the idea that nothing will happen to output as a result of deficit reduction rather improbable. With interest rates stuck at zero, real interest rates cannot move to persuade the private sector that they no longer need to correct their financial position. So the only possibility left is that output falls until they no longer want to do so. (Because of consumption smoothing higher short term income would imply a rising, not falling, private sector surplus.)

Looking at sector balances are not a substitute for thinking about behaviour, but they can and should demand that we are able to tell stories about them that make sense. Where I think criticism of the mainstream macroeconomic profession is correct is that there were not enough people telling convincing stories about why the household sector balance was evolving the way it did over the two decades before the recession. (I talk more about this here.) What was I doing? The answer is writing papers looking at the impact of fiscal policy in DSGE models, and not looking at this kind of data at all. In that sense I was definitely part of the problem, although it did kind of come in useful later on.

The heterodox versus the superhuman representative agent

                Following this post, I’ve been reading the blogs of quite a few heterodox economists. There is a lot that I have read which is challenging, and which has made me think about things in different (for me) ways, which is good. But there is also lots of stuff that seems less helpful, which when it is repeated over and over becomes (for me) somewhat annoying.

                Stuff like we cannot possibly take microfounded macro seriously, because it is based on an all-embracing representative actor equipped with superhuman knowledge and forecasting abilities. To which I feel like shouting – where else do you start? I always say to PhD students, start simple, understand the simple model, and then complicate. So we start with a representative agent. What else could we do? We could start with aggregate relationships, but unless these are purely statistical, they will almost certainly appeal to theory about what individuals do. 

                What about superhuman knowledge and forecasting abilities? That seems like an extreme position. But the alternative is to assume we know what kind of mistakes agents will make. Where does this knowledge come from? I’m sure different agents are using different models from the one I’m using, but I have no idea what these models are. To keep things simple, I therefore assume I do not know what mistakes they will make, which implies rational expectations. If I want to be more realistic, I can look at the huge mainstream literature on models of learning. It is not a field I know well, but if there is a message there that we should go back to assuming adaptive expectations, I have missed it.  

                Some of the commentators on recent posts seem genuinely puzzled about why it is useful to have a representative agent or assume rational expectations. Others seem to believe that doing so must inevitably lead to laissez-faire results. The ultimate test is empirical relevance of course, and I have tried to make that case elsewhere. However I thought it might be useful to give an example of why I find thinking about a representative agent and rational expectations gives more plausible answers than using pre-microfoundations textbook analysis. It is an example where I’m genuinely curious about what heterodox economists who condemn using representative agents with rational expectations would do instead. As this is a post I’ll keep things as simple as I can and leave out most caveats and qualifications.

                The question is quite topical: what is the impact on output of a balanced budget increase in government spending in an open economy stuck at the zero lower bound (ZLB)? Well the first thing we have to do is ask whether the increase is permanent or temporary. If it’s permanent, if the import content of government spending is similar to consumer spending, and if taxes are lump sum, the answer is nothing. As the tax increase is permanent then consumption falls by the same amount, with no net impact on the demand for domestic output. That is pretty obvious, although anyone using a first year textbook would get this wrong (because they would have the mpc<1).

If the government spending increase is temporary, then the tax increase is also temporary. Thinking about an optimising consumer immediately gets us the result that consumption will initially fall by less than government spending, so there is a short run net increase in demand. (I am assuming that investment is unchanged, for standard reasons described here.) Higher demand raises output and income. If inflation does not change we get a multiplier that would be one if there were no imports. The analysis without imports is here, but we do not need it to show that output must rise.  

                In an open economy, we need to ask what will happen to the exchange rate if we have a temporary balanced budget increase in government spending, lasting no longer than the period interest rates are stuck at zero. Everyone remembers their Mundell Fleming – under flexible exchange rates fiscal policy is ineffective, because the exchange rate appreciates to crowd out the additional demand. But that is completely wrong in this case. Agents in the foreign exchange markets will note that there is going to be no increase in interest rates and no change in the steady state (so no long run appreciation or depreciation), so there is no reason for the exchange rate to move in the short run either. There is no crowding out through the exchange rate, so the analysis in the previous paragraph stands.

                This is pretty simple stuff, but it gives different – and in my view better - answers than many undergraduate textbooks. And both the representative intertemporal consumer and rational expectations were central in getting the answer. Now you may want to complicate in various ways, but that normally means building on this analysis rather than overturning it.

                So this is microfounded intertemporal macro telling us that a balanced budget fiscal expansion works at the ZLB. If you think this is obviously wrong because I’ve assumed all-embracing representative actors equipped with superhuman knowledge and forecasting abilities, tell me how you would do the analysis differently.  

The IMF calls for a more expansionary UK policy

                The preliminary findings of an IMF Article IV mission are always a highly political document, as Paul Krugman points out. That is why you can spin today’s report on the UK as support for the current government line, or implicit criticism of it. And a lot of the reporting focuses on just this political angle. This is a shame, because it misses the clear message of the report, which is that UK macroeconomic policy is too restrictive.

                On monetary policy the report is absolutely clear. A bold heading reads “Further monetary easing is required”. The detail calls for more QE, and perhaps a further interest rate cut. One reason why the economists at the Fund are prepared to make such a clear criticism of the current MPC stance may be outlined in my recent post.

On fiscal policy, the Fund continues to call for balanced budget fiscal expansion. The heading here is a little more opaque:  “There is scope within the current overall fiscal stance to improve the quality of fiscal adjustment to support growth.” However this from the text below is pretty clear: “Fiscal space for further growth-enhancing measures could be generated by property tax reform, restraint of public employee compensation growth, and better targeting of transfers to those in need. This fiscal space could be used to fund higher infrastructure spending, which has a high multiplier and raises potential output. It will also be important to shield the poorest from the impact of consolidation.” For more detail see Ian Mulheirn here.

Finally we should note that good policy is about allowing for risk, which is what the current government did not do when embarking on additional austerity. The IMF knows this, which is why it says, in another heading: “Fiscal easing and further use of the government’s balance sheet should be considered if downside risks materialize and the recovery fails to take off.” For downside risk read the Euro blows up. Now I would argue that the outlook even if the Euro survives is pretty grim: the latest OECD forecast is for growth of 0.5% this year, and 1.9% next. As a result, fiscal easing seems appropriate even without downside risk.

But the question I have is this. We are told that the government is making contingency plans if Greece exits the Euro. Presumably it is thinking about what it would do if there was a severe recession in the Euro area. Do they agree with the Fund that fiscal easing should be considered in these circumstances? 

On successful fiscal consolidations

In a recent Vox piece, Alesina and Giavazzi argue that “adjustments achieved through spending cuts are less recessionary than those achieved through tax increases”. At first sight this seems to contradict basic macroeconomics. As I and others have pointed out on many occasions, the impact of cuts in government spending on goods and services are passed straight through to demand, while the income effect of temporary increases in tax will be smoothed by consumers. That is why balanced budget but temporary cuts in government spending are deflationary.

However, what we may have here is just another example of failing to condition on monetary policy. One of the most comprehensive studies of this issue, discussed by Alesina and Giavazzi, is contained in an IMF report, which uses a ‘narrative’ approach to identifying episodes of fiscal consolidation. (This approach was applied to monetary policy by Romer and Romer here: the detailed catalogue of fiscal events is in this IMF working paper. See Jeremie Cohen-Setton (Bruegel) for more on this.) As Alesina and Giavazzi are a little unfair in the way they characterise this report, I will quote extracts from its first four conclusions.

1)    “Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point.”

2)    “Reductions in interest rates usually support output during episodes of fiscal consolidation”

3)    “A decline in the real value of the domestic currency typically plays an important cushioning role by spurring net exports and is usually due to nominal depreciation or currency devaluation.”

4)    “Fiscal contraction that relies on spending cuts tends to have smaller contractionary effects than tax-based adjustments. This is partly because central banks usually provide substantially more stimulus following a spending-based contraction than following a tax-based contraction. Monetary stimulus is particularly weak following indirect tax hikes (such as the value-added tax, VAT) that raise prices.”

The reaction of monetary policy is crucial here. As the report makes clear, if interest rates cannot fall to offset the impact of fiscal consolidation, or if currencies cannot depreciate because everyone is implementing austerity, the deflationary impact will be much greater.

            To quote Alesina and Giavazzi, the report’s authors “agree that spending-based adjustments are indeed those that work – but not because of their composition, rather because almost ‘by chance’ spending-based adjustments are accompanied by reductions in long-term interest rates, or a stabilisation of the exchange rate, the stock market, or all of the above.” That is unfair. As the quotes above show, and any reasonable reading of the whole report confirms, the impact of consolidation is directly linked to the way monetary policy works. Perhaps the crime committed by the IMF report is that it didn’t stress enough the effects of taxes on the confidence of entrepreneurs that Alesina and Giavazzi seem to think is central.

            Point (4) does indeed imply that cutting spending is less contractionary than raising taxes, but again the reaction of monetary policy is crucial. If, as is suggested, monetary policy does not reduce interest rates following tax increases because of the impact of taxes on prices, then it is monetary policy that is leading to the difference in the impact of spending and taxes.

            There is another interesting, if tentative, result from this analysis. Government spending here includes transfers as well as consumption and investment. The report finds that cutting transfers is mildly expansionary, while the costs of cutting consumption or investment are greater, although they do caution about small sample sizes. As cuts in transfers can be smoothed, this fits with basic theory. Alternatively, it may be that cutting transfers is signalling some kind of intent, which may in turn encourage the monetary authority to ease monetary policy more.

            The reason for stressing the role of monetary policy in all these findings should be obvious. At the zero lower bound, monetary policy cannot compensate in the normal way for the deflationary impact of fiscal consolidation. We cannot use evidence from the past when monetary policy was not so constrained to tell us what will happen today. This is well known for austerity in general, but it applies equally to the composition of fiscal consolidation.

           

What should be in the 2012 Budget?

                The UK budget is presented on Wednesday 21^st March.  Speaking yesterday, the Chancellor said he had “secured the country’s economic stability”. He is absolutely right: in contrast to previous recoveries, when the economy grew, he has managed to stabilise output. GDP was 0.16% higher at the end of last year compared to the quarter after his first budget. Per capita GDP is over 5% below its peak at the end of 2007.

                Jonathan Portes, in a recent post/article, rightly condemns the current pessimism and inaction of the UK government about growth and unemployment. There is so much that could be done, even at this late stage, to start bringing unemployment down quickly. Jonathan suggests a fiscal stimulus (relative to current plans) involving

(1) A temporary cut in national insurance contributions for young and low-paid workers.

(2) Infrastructure investment. (No, it would not take time to find such projects – just reinstate those that were cancelled, like modernising run down school buildings.)

(3) Building more houses by helping social-housing providers to borrow and build. The UK, unlike some other countries, suffers from a structural shortage of housing supply.

I would add a fourth

(4) Reversing some of the changes about to take place in tax credits. This would go a little way towards correcting the fact that proposed budget changes are decidedly regressive in their impact, as I noted here. For more details see this discussion from the Resolution Foundation.

These four proposals would involve more borrowing in the short term. But what if the markets panic? The Chancellor could set in place two contingent policies to deal with this. First, authorise the Bank to undertake more Quantitative Easing if a risk premium on UK government debt begins to emerge. Such a program would be entirely consistent with the Bank’s mandate. Second, set out tax increases that would fully fund measures (1) to (4). This could involve bringing forward the tax increases that are pencilled in for later years, as suggested by the Social Market Foundation here. It could also involve raising taxes that will come largely out of savings, like increasing inheritance tax from the current 40% for example. These taxes would only be increased if the markets showed they could not stomach additional borrowing. They would diminish the expansionary impact of measures (1) to (4), but not by that much because of the balanced budget multiplier. Until now the majority party in the coalition has shown no interest in this way of expanding the economy without increasing debt, but we can always hope.

                The government has expressed concern about the evidence (see also Adam Posen here) that small and medium scale firms (SMEs) are being starved of (or priced out of) borrowing by excessively cautious banks. In the UK these firms are unusually dependent on borrowing from banks. Quantitative Easing by the Bank of England has focused on buying government debt, which may have eased the corporate bond market, but has done little for SMEs. The government has so far tried encouraging banks to lend more, with a predictable lack of success. Proposals are due to be announced in the budget, but one of the Bank of England’s leading thinkers suggests radical changes to the UK banking industry are required. Such changes are possible, because the public sector currently owns a good proportion of the banking sector.

                Last and not least, the Chancellor should instigate an immediate investigation into the possibility of replacing the inflation target by a nominal GDP target. There is a significant amount of evidence, from the Great Depression and more recently, that expectations of rising prices can provide a strong stimulus to demand. A nominal GDP target, suitably constructed, could help generate those expectations.

                If this strikes you as a bit too much, consider the following. In the highly unlikely event that the Chancellor took my advice and the economy started to expand too rapidly, we can cool things down very quickly by using monetary policy. In contrast, being stuck at the zero lower bound means monetary policy with the current inflation target is having little impact on rising unemployment. So for once being incautious is the sensible option.

                The unemployment rate among under 25s in the UK is currently 22.5% and rising, the highest since records began in 1992. This is no unfortunate accident beyond the government’s control:  over 100,000 public sector jobs were cut from education and the NHS in 2011. It is ironic that one of the positive things this government has done is to start publishing survey data on happiness. Alas at the same time its macroeconomic policies are leading to a substantial increase in unhappiness in the UK. 

The Balanced Budget Expansion Debate Begins?

                Less than a week ago, I wrote in a post on my blog: “So there is something we can do with fiscal policy, without increasing government debt. Why does hardly anyone talk about this?” Two days ago Ian Mulheirn from the Social Market Foundation published a detailed proposal exactly along these lines. (There is also a short piece in Monday’s Financial Times.) A coincidence of course, but very welcome.

                This proposal involves bringing forward by four years £15 billion of tax increases pencilled in for after 2015, and using that money for temporary infrastructure spending in those four years. This is a specific example of a more general idea, that you can stimulate demand through additional but temporary increases in government spending financed by temporary increases in taxes. The proposition that this will stimulate aggregate demand is a pretty robust bit of macroeconomic theory. In fact we can go further, and say that the benchmark multiplier for such a policy will be at least one. This suggests that this proposal, by using OBR figures, may be rather conservative in its estimate of the impact on UK growth.

The multiplier will be one if consumers are of the simple Keynesian type who consume some constant fraction of their current income. Higher taxes will reduce their income, but as long as their propensity to consume is less than one, there is a net positive effect on demand, which gets translated into higher output and higher income. But higher income leads to higher consumption, and we get the famous ‘balanced budget multiplier’ of one which every first year undergraduate learns how to prove. However, as Professor Michael Woodford has recently shown, we get exactly the same multiplier of one if consumers are much more sophisticated, and look at their entire lifetime income when planning their consumption. The basic intuition here is that any temporary tax increase gets smoothed over their lifetime, so the impact on current consumption is small. As the simple Keynesian case shows, any short term impact there is will be offset by higher incomes generated by higher government spending.

                This all assumes an unchanged level of real interest rates. Higher aggregate demand should lead to some increase in expected inflation. If the Bank of England keeps nominal interest rates unchanged (which, with inflation falling, they should), then real interest rates will fall, which will provide an additional stimulus to demand. That is why the benchmark multiplier will be at least one. If the government spending is in the form of useful infrastructure projects, this has the additional bonus of increasing future supply.

                Why have tax financed temporary increases in public investment not been part of the austerity versus stimulus debate so far? For those who oppose austerity, I think the problem is a (correct) belief that debt financed increases in spending would be even more effective at stimulating demand (because ‘Ricardian Equivalence’ does not hold), and that the short term dangers of increasing debt are vastly overblown. While I think this line is right in principle, I fear this debate is unwinnable so long as the Eurozone crisis continues, and the media obsesses about ratings agencies. We can argue till the cows come home that the Eurozone is different, because these countries do not have their own central bank, and that the market takes no notice of ratings agencies, but these arguments are drowned out by the daily news about Greece and other Eurozone economies.

                On the other side, among those who favour austerity, I think there is a reluctance to consider policies that increase the size of the state, even though this would only be for a few years. There is also the obvious unpopularity of tax increases. However there is now a real danger that by the time of the next election UK unemployment may still be rising and the recovery will be modest. It is going to be very hard to win an election with this record. (I do not think Argentina will distract attention again as it did in 1982!) The great advantage of tax financed increases in spending is that they stimulate the economy without going back on the austerity pledge. Indeed, because they stimulate growth, they reduce headline budget deficit figures and so increase the likelihood that austerity will be successful in bringing down the ratio of debt to GDP.

                So these proposals from the Social Market Foundation are very welcome indeed. They show that something can be done to stimulate the economy without increasing debt. Of course there is a great deal of discussion still to be had on what taxes to increase, and what investment to fund. However from a macroeconomic point of view most combinations will succeed in stimulating the economy. With unemployment continuing to rise, there is still time to act. It is imperative that we do. 

On Hidden Motives

                Chris Dillow has a nice follow-up to my earlier blog on balanced budget fiscal expansion. I first read the Kalecki paper when I was at Cambridge, but for better or worse this is not part of the macro lectures I give at Oxford. We all miss Andrew Glyn a lot.

                Is this what I had in mind when I said that if the government argued against all the possible balanced budget spending and tax measures that might stimulate the economy, we might suspect other motives? Before trying to answer that, I should say that part of my complaint was that such policy ideas are not part of the public debate, so we do not know what the government’s response would be. (We could infer, from the fact that none of these policies are being pursued, that they would be against them). I should also note that the FT suggests that the Liberal Democrats are thinking about tax switches, although I have my doubts about whether raising the £10K tax threshold would be particularly effective at stimulating demand.

                When I drew parallels in an earlier post between the current UK situation and 1981, I mentioned by way of anecdote a little speech I made at the internal meeting of Treasury economists at the time. What I did not report was that at that meeting I made exactly the argument Kalecki puts forward. (Needless to say Kalecki was not normally quoted in discussions about budgets in the Treasury! - I was young, and probably knew I was going to leave fairly soon.) I think what Kalecki says made a good deal of sense in that particular context: as we were to find out, part of the Thatcher agenda was to take on the power of organised labour.

                Whether it makes sense in the current context I’m less sure. Some of the factors identified by Chris in a later post could simply be attempts to deflect sympathy for the unemployed (which in turn would translate into criticism of the government) rather than the more strategic design he suggests. What I probably had more in mind on this occasion were two things.

                The first involves the point about ideology which I have mentioned several times. If your ideological perspective is that ‘government is always the problem’ and that the private sector is best left alone, then blaming all our ills on the excesses of the previous government (rather than the financial system), and pursuing austerity by government as the means of correcting those ills fits well with that perspective. To use government intervention as a way of correcting a problem with the private sector (insufficient demand) does not.

The second is that nearly all the fiscal proposals I suggest involve redistributing money from the rich to the poor. This makes macroeconomic sense, because the poor are more likely to be credit constrained than the rich. It would also make sense from an equity point of view: the poor are suffering most as the result of austerity, as the chart below from the IFS illustrates. Unfortunately it does not make political sense for the current government.

                  There is also a familiar but important point here about political influence and recognition. Issues to do with debt and financial markets are reported daily and major players in this area have almost guaranteed access to politicians – from whatever party. They tend to be rich, and will complain about being taxed at 50%. The young unemployed, who now make up nearly a quarter of the 16-24 age group, have by comparison very little political voice. Even when they are talked about when monthly figures are released, we are likely to get stories about motivation and how to brush up your CV, rather than recognition that with many times more people looking for a job than there are vacancies no amount of self help will make the problem go away. (See this by Zoe Williams.) These are the political reasons why the ‘counsels of despair’ that Jonathan Portes rightly complained about are able to endure.

Can Nothing Be Done?

Or why is no one talking about balanced budget expansion?

                As UK unemployment continues to rise, Jonathan Portes asks why the government seems to accept this as inevitable. The same question could be asked in many other countries. The answer is invariably that nothing can be done by way of fiscal stimulus because debt and deficits are so high. Jonathan argues (rightly in my view) that concerns about debt in the short term are hugely exaggerated. I’ve suggested this is particularly true when we have Quantitative Easing. We seem to be in a strange prisoners dilemma where it is absolutely clear that the world wants more safe assets (the rate of interest on indexed debt is zero if not negative), but every individual government thinks that if it provides them lenders will suddenly panic, and think they are no longer safe.

                I think this fear is irrational, but unfortunately events in the Eurozone feed this fear on a daily basis. (It should not, because governments without their own central banks are in a different position from those that have, but that is a rational argument.) Taking notice of ratings agencies is also irrational (see Jonathan again), but it adds to the fear. So even though I think it is fairly easy to win the intellectual debate on debt, this may not be what is decisive.

                If governments believe that they cannot add to government debt and deficits, does that mean nothing can be done? Absolutely not. A temporary increase in government spending financed by an increase in taxes will still raise demand. First year economics undergraduate students will know about the balanced budget multiplier of one: every £1 spent by the government will lead to £1 extra demand, because what consumers lose with lower taxes they gain through higher income. Readers of Michael Woodford (2011) will know that we get exactly the same multiplier with much more sophisticated consumers, if real interest rates are fixed. (I try and explain why here.) So it does not matter what sort of consumers we have, the tax increase comes out of saving, and so demand and output rises by the full extent of the spending increase. (For those who think lower savings will mean lower investment, see here.)

                The news is better still if interest rates are stuck at the zero lower bound. Higher demand and output will imply some increase in inflation, and any increase in expected inflation will reduce real interest rates, further stimulating activity. The size of the multiplier will be above one.

                So there is something we can do with fiscal policy, without increasing government debt. Why does hardly anyone talk about this? (One exception is Robert Schiller.) I suspect the problem is as follows. Those favouring stimulus think debt is not a constraint, and know that there are many reasons why a fiscal expansion financed by issuing more debt will be even more expansionary that one financed through taxes. So why argue for second best? But why do those who do think debt is a constraint not welcome this alternative possibility of raising demand? The reason is obvious:  a tax financed fiscal expansion requires taxes to rise.

                The problem is not an economic one. The distortionary effects of temporarily higher taxes are likely to be small relative to the resources wasted and permanent damage caused by high unemployment. (See Chris Dillow as well as Jonathan Portes on this.) The problem is political, particularly for countries with right of centre governments. However, just because something may be politically difficult should not stop the argument being made.

                Once we get on to this territory, then there is further ground to explore. As well as tax financed government spending, we could think about tax and transfer switches that would stimulate demand. The marginal propensity to consume out of a benefit increase is likely to be quite high, whereas that out of reducing the tax relief on pension contributions for high earners would be pretty small. (Remember any tax switch need only be temporary.) Redistributing money from the old to the credit constrained young would also be likely to raise demand: raise child benefit by increasing death duties, for example. Some companies are not that short of cash at the moment: how about tax incentives to encourage them to invest today rather than tomorrow.

                The idea that there is no alternative to doing nothing about rising unemployment could not be further from the truth. If governments find objections to all these ideas, one might begin to suspect that there are other motives at work.

Consumption smoothing and the balanced budget multiplier

Only for economists

                In some of the debate following this post, and then this, there often seems to be a big distinction drawn between models based on consumption smoothing, and the old fashioned balanced budget Keynesian multiplier. Even Paul Krugman felt it necessary to say that he ‘never said a word about the balanced budget multiplier’. Now of course the models are different. However I want to suggest that in the context of fiscal expansion in a recession caused by demand deficiency, the balanced budget multiplier story can be retold in a manner consistent with consumption smoothing.

                The most basic model of consumption smoothing involves two periods. Let period 1 be a demand deficient recession, and so output is determined in a Keynesian manner by aggregate demand. Period 2, which is much longer, is Classical, and nothing changes in period 2. (If having a two period model of unequal lengths is a worry, think of period 2 as being divided into a large number of sub-periods of equal length to period 1, but where every sub-period is Classical.) We keep monetary policy neutral by assuming the real interest rate is constant. Optimising consumers will then spend a fixed proportion of their permanent income in period 1: that is consumption smoothing. Let’s call this proportion c, which could be quite small. There is no investment, and the economy is closed.

                The government now increases government spending by G in period 1 only, and taxes rise by the same amount in period 1. The ‘direct’ or ‘first round’ effect is that consumption in period 1 falls by less than G, because the impact of higher taxes on consumption is smoothed via permanent income. That is as far as I needed to go in my ‘Mistakes’ post to make the point I wanted to make. However it is obviously not the end of the story, because higher output implies higher income. What happens to output eventually (call the answer Y)? Well consumption rises/falls by Y-G times the fixed proportion c, so we solve Y=G+c(Y-G), which of course implies Y=G, a multiplier of one. This is not only the same result as given by the Keynesian balanced budget multiplier, but the mechanics are identical. Consumption does not change at all: higher period 1 income offsets the higher taxes. We do not need to worry about any knock on effects in period 2, because permanent income ends up unchanged. So the simple Keynesian balanced budget multiplier need not be considered some ancient fossil that we are forced to teach undergraduate students, but a simple expression of what consumption smoothing implies in a particular context.

                We could get to the same result using consumption smoothing alone, by noting that consumption in period two is tied down by (classical) Y and permanent G. Second period consumption and the Euler equation then fixes period 1 consumption, as real interest rates are unchanged by assumption. So any change in government spending in period 1 leads to an equal increase in output.

Woodford, in section 2 of the paper noted by Krugman and myself, does something with similarities to this, but with more elegance. My period 2 becomes the steady state, a steady state in which (given the usual assumptions) the real interest rate equals the rate of time preference. With real interest rates fixed at this value in all periods, consumption is equal in all periods, so any temporary change in government spending leads to an equal temporary change in output. We get a multiplier of one. With this benchmark, it is then intuitive to see how the multiplier will fall if real interest rates are not constant but rise. Equally, if we are at a zero lower bound, the multiplier will be greater than one because higher output generates inflation, which reduces real rates.

Now I am not trying to say here that the simple, most basic Keynesian multiplier apparatus is in any sense ‘as good as’ consumption smoothing. In fact, if I was writing an introductory macro textbook, I would start with the two period consumption model and consumption smoothing, and mention the current income Keynesian consumption function only in passing. (My reasons for doing this are explained here.) All I want to suggest is one way of reinterpreting the balanced budget multiplier that is consistent with consumption smoothing. I think it is also nice that all this stuff ends up with the same result, a multiplier of one. If someone wants to argue that the multiplier is zero they need some additional argument, and as I suggested here, I have yet to see one that seems appropriate to the current situation.