Budget deficits, fiscal councils and authoritarian regimes

Budget deficits are a constant temptation for politicians. If you want to cut some taxes it is politically easier to do this by borrowing than by raising other taxes or reducing spending. If the electorate were fully informed this should not be the case, but they are not fully informed. We have clear evidence that many (not all) politicians succumb to this temptation: economists call it the problem of deficit bias. Running deficits are attractive because in most cases they do no immediate harm. In the past I have likened them to drinking or eating too much: do it once and no great harm is done, but do it repeatedly and problems arise, if only because taxes have to increase to pay the interest on the mounting debt.

This point about no immediate harm is vital to understand. It means that if there is a good reason to run large deficits that increase government debt, like an economic downturn (automatic stabilisers), or fighting a deep recession (interest rate lower bound) or high return public investment projects or disasters (natural or man made), then you should do so. Like eating too much, you can always eat less later. Fear that you might not eat less later should never be a reason for not using fiscal policy to fight a recession, or undertake much needed investment. It would be like stopping Christmas because you might eat too much.

If that is all obvious to you then skip the next three paragraphs. Some MMT economists or their followers sometimes argue that deficits never matter. If monetary policy cannot control demand and inflation and fiscal policy has to do it instead, then this is correct. It is the fighting a deep recession point above. But in reality, outwith the interest rate lower bound, interest rates are used to control demand and inflation. MMT would like fiscal policy to control inflation always, in which case the deficit is whatever it needs to be to do that task, but for the moment monetary policy is used instead. That means that the need to control inflation is not a direct constraint that removes the deficit temptation for politicians.

That is why we had deficit bias in most countries before the global financial crisis, and it is why Trump is cutting taxes and raising the deficit now. To say mounting government debt as a result of deficit bias does not matter is not credible. Even if you think the higher taxes required to cover servicing higher debt has no disincentive effect, the political consequences of high taxes cannot be favourable. To say that governments could pay for tax cuts by creating money misses the point that the bond/money mix is delegated to central banks for inflation control.

I can completely understand where MMTers are coming from. We have just been through a period where politicians have pretended the deficit was all important, and this pretense has inflicted great harm. But that does not make the opposite point of view that the deficit never matters right. As so often happens, the political right have abused economics (pretending the government is like a household) for political ends, and some on the left have reacted not by pointing out what economics actually says, but by saying we need a new economics.

Fiscal councils are a vital part of combating deficit bias for many reasons.They are no longer the oddball idea that a few of us kept going on about just 15 years ago, but as this VoxEU ebook shows they are now a standard part of how fiscal policy is done in (almost?) every advanced economy. My chapter in this ebook argues that they are a necessary part of what I call the consensus assignment. In most places they work with fiscal rules rather than being a substitute for them. They are necessary because sometimes governments try a cheat fiscal rules (PFIs in the UK) and sometimes simple fiscal rules need to be broken for some of the reasons outlined earlier.

Fiscal councils are almost always advisory bodies. (Although the more politicians do the wrong thing with fiscal policy, the greater will be calls to change this.) They have no power to tell governments what to do, and their only influence comes from their ability to adequately scrutinise what the government is doing, which in turn depends on both the voice they have within the political system, their competence [1] and their independence. Establishing that, preserving that and sometimes enhancing that are a constant battle, precisely because these bodies take away the ability of politicians to pull the wool over the voters’ eyes.

Because an effective fiscal council acts as a watchdog over the decisions of finance ministers, they become vulnerable to political attack. We now have networks that can help defend them. Fiscal councils within the EU have established their own Network. In addition within the EU the new Fiscal Board has a dual role, of both being a kind of fiscal council for the European Commission, but also to act as a champion of independent, effective EU fiscal councils as Michal Horvath suggests here. It was therefore good to see this Board warn and the Network warn against moving the Danish fiscal council away from Copenhagen. The OECD also conducts valuable assessments of fiscal councils (see Spain here), although whether the OECD has the ability and agility to defend a fiscal council under attack outside the EU is less clear.

These defences are important, because it is so easy for governments to compromise fiscal councils, by denying them information and resources, or by appointing political heads. Governments that go even further and dismiss existing fiscal councils are even more worrying. The first time I became aware of what was happening in Hungary, as I relate here, was when they abolished a strong and very active fiscal council lead by George Kopits. Far worse has happened since in Hungary, but perhaps from this experience abolishing a fiscal council is a good early warning signal of authoritarian regimes. We have also seen unprecedented attacks on the CBO by Republicans in the United States. Ironically these attacks show us that fiscal councils in some cases have become, and in other cases can become, a vital part of a pluralist democracy.

[1] That competence includes understanding when high deficits are sensible and when government debt should rise. Any fiscal council which only ever advises deficits should be lower will lose any reputation for competence.

Do Trump’s deficits matter?

Should Democrats complain about the large deficits that Trump and the Republicans are creating? Or is this playing into the Republican narrative that made the stimulus in 2009 inadequate and gave us austerity from then onwards?

The answer that mainstream economics gives is straightforward. In a recession when interest rates have hit their lower bound [1] you do not worry about the deficit and you ignore those that do worry. Deficits should be whatever size is required to enable the economy to recover. Enough stimulus so that central banks feel they need to raise interest rates above their lower bound. Politicians failed to follow that advice during the last recession.

In contrast, when the economy is not in a recession, and interest rates are perfectly able to control aggregate demand, then deficits at a level where government debt starts rising may well be a problem. For various reasons, not least the chance of a recession, it is best to have deficits at a level which very gradually reduces the ratio of government debt to GDP, unless you have a good reason for doing otherwise.

There are many reasons why, outside of a recession, deficits that, if sustained, would steadily increase the debt to GDP ratio may be bad for the economy, but let me give the most obvious here. For a given level of government spending, interest on debt has to come out of taxes. The higher the debt, the higher the taxes. That is a problem because high taxes discourage people from working, and it is also unfair from an intergenerational point of view.

This last point is obvious if you think about it. The current generation could abolish taxes and pay for all spending, including any interest on debt, by borrowing more. That cannot go on forever, so at some point taxes have to rise again. A whole generation has avoided paying taxes, but at the cost of future generations paying even more.

As a result, unless there is a very good reason like a recession [2], a responsible government will not plan to sustain a deficit over time that raises the debt to GDP ratio. The problem though is that it is very tempting for a government not to be responsible. The current US government, which is essentially a plutocracy, wants above all else to cut taxes for the very wealthy, and if they do it without at the same time raising taxes on other people but instead by running a deficit they think they can get away with it. Democrats have every reason to say that is irresponsible, although of course the main thing they should focus on is that the last people who need a tax cut are the very rich.

Unfortunately being responsible can seem rather dull and boring, so it may be tempting to hype things up a bit by predicting some disaster that will come from rising deficits. That is not a good place to go, because you are crying wolf. Large deficits are like overeating. Do it once or twice and you will survive. Do it every day and you will die young. The only difference from overeating is that you do not die young, but your children do.

So much for mainstream economics. What about MMT, which is often characterised as implying that deficits do not matter? That is an incorrect characterisation: what MMT actually says is that inflation should determine what the deficit should be. If inflation looks like staying below target you can and should have a larger deficit, and vice versa. The reason they say that is that they think the central bank, in changing interest rates to control inflation, is wasting its time, because they believe rates do not have a predictable impact on demand and inflation. If that were true, then even mainstream economists would agree that the deficit should be at whatever level keeps inflation at target. The difference between MMT and the mainstream is whether the central bank is or is not wasting its time.

In an important sense, whichever perspective you take, thinking about stabilisation policy or long run deficits can just muddy the waters when it comes to the Republican tax cuts. The reason that Republicans mainly fund tax cuts for the very wealthy by borrowing is that it appears this is not costing anyone anything. If nobody’s taxes are going up, the argument goes, why should we mind too much if the richer get even richer. The key point to get across is this. There are two possibilities. The first is that if it is possible to permanently cut some taxes forever without raising others or cutting spending, why should the tax cut not go to those who need it rather than those who don’t. The second more likely possibility is that it is not sustainable, in which case at some point tax paid by ordinary people will go up or spending on ordinary people will be cut to pay for tax cuts to the very rich. Either way, ordinary people are losing out. To focus on deficits or inflation just detracts from this basic truth.

[1] The lower bound is either where the central bank thinks it is or the point that interest rate cuts become an unpredictable and therefore ineffective instrument.

[2] A natural rather than man made disaster might be another good reason to run deficits. Public investment on high return infrastructure is another.

How Brexit will constrain a future Labour government

Those who suggest that Brexit is of second order importance to getting a Labour government need to think about what that government will be able to do and how long it will survive if we leave the Single Market and customs union. The OBR did a rough and ready estimate of the near term impact of Brexit [1], and concluded that productivity growth would fall (which means lower GDP and real wage growth) and the government deficit would deteriorate by around £15 billion by 2020. That sum is about a third of the current defence budget, or a tenth of the entire health care budget.

It is simply wrong to imply that this can be ignored, because Labour is anti-austerity. That large deterioration in the deficit due to Brexit is mainly the result of low productivity and less immigration, not the consequence of an economic downturn. It cannot be undone by the government spending more on infrastructure: public investment is not some magic instrument that can get you any GDP you want.

No economic theory that I know of suggests you can safely ignore the public finances outside of a recession. In a world where monetary policy regulates demand (absent the lower bound) then a build up in government debt risks crowding out private capital, discouraging labour supply (because higher debt has to be serviced through higher taxes) and redistributing income between generations. This is why Labour’s fiscal credibility rule aims to balance current public spending outside of a recession. Every £billion lost to Brexit is a £billion that cannot be spent on public services, or has to be raised in taxes.

The same logic meant that Labour’s election manifesto in 2017 had a large increase in current public spending entirely financed by higher taxes. Their programme is anti-austerity because their fiscal credibility rule would do the opposite of what Osborne did in 2010 if interest rates were at their lower bound. It also sensibly allows public investment to rise when borrowing costs are so low.  But once interest rates begin to rise, the Labour government would have a current deficit it needed to finance, and its difficulty in doing this would be made much worse by Brexit. [2]

In all this it is vital to not be distracted by some of those who see Brexit as an opportunity for Corbyn-bashing. Those that do so seem to forget two key points. First, the attitude of a large number of Labour MPs in Leave voting areas is just as much of a problem as the views of the leadership. Second, there is a purely political argument for Labour being just a bit less supportive of Brexit than the government right now. My own view is similar to this discussion by Mike Galsworthy.

However I feel I have to end by responding to a second post from Owen Jones. Let me do so by imagining the following scenario. Suppose the Conservative leadership changed, and the new leader said this on being elected: “we tried as hard as we could to respect the result of the referendum, but we found there was no way of doing so without causing the economy great harm. As a result, I have regrettably decided to revoke Article 50, and remain in the EU.” What should Labour’s response to that be? The logic of Owen’s position is that Labour should oppose this, and side with the Hard Brexit faction of the Tories and defeat the new Tory leader.

A highly unlikely scenario I agree, but it helps establish this point. Owen, unlike many Corbyn supporters, is not arguing that Labour should remain pro-Brexit while in opposition as simply a strategic move to gain votes. He is saying that Labour has to support leaving the EU because of the referendum demands it. Indeed he says anyone arguing otherwise because the referendum was advisory is “beyond delusional”: It seems I have become a beyond delusional ‘Hard Remainer’.

Does democracy mean being bound by a referendum that was called only to appease the hard right, decided by lies using a rigged electorate, and apparently made mandatory as a result of the words of a now departed Prime Minister? Is it a democracy when we are unable to change course because new facts clearly deviate from promises made, resulting in a decision that imposes costs on the young largely as the result of votes by the old? These are difficult questions, but not delusional questions.

I doubt it will happen, but would ignoring the referendum destabilise democracy? Let me turn the question around. If the final Brexit deal involves staying in the Single Market and therefore accepting free movement, will that destabilise democracy? The number of people who voted Brexit but wanted to stay in the Single Market may be more than 2% of the population, but it is bound to be small. There will therefore be plenty of people who will say that accepting free movement ignores the referendum, and plenty of aggrieved voters to back them up. Is that going to produce a reaction which is very different from the reaction to actually ignoring the referendum?

The hard truth is that any deal which avoids serious economic costs for the UK is going to make most of the 52% pissed off. And they will remain pissed off until either we reduce immigration, with the economic costs that will bring (less schools, less hospitals, higher taxes), or senior politicians start being honest about the benefits of immigration.

[1] Stupidly, the OBR were not asked to estimate the impact of Brexit before the referendum, and their mandate prevented them from doing so themselves.

[2] And please no MMT inspired comments about how taxes are not needed to finance spending. The MMT world is very different from our current world: fiscal policy rather than monetary policy regulates demand. In that case you never worry about the deficit, but spending is constrained by inflation.  

Economics reporting without any economics

Mike Berry explains in this article how the UK media began to see the increase in the deficit in 2009 as a serious problem, and sometimes as a crisis. The government were “court[ing] disaster by borrowing too much”. In terms of basic economics - the economics that anyone doing Econ101 (a first year undergraduate course) would know - there was nothing surprising or problematic about a rising deficit in a recession. It is what you expect to happen. The UK deficit hit record levels because it was a record recession. There was no evidence whatsoever that financing this deficit might be a problem: again basic Keynesian economics shows how in a recession an increase in the supply of government debt is accompanied by an increase in the private sector’s demand for financial assets. [1]

It was a case of economics reporting without any economics. It is a bit like a weather forecaster who reports the weather without any reference to the time of year. (In the Autumn they say ‘Its getting colder and colder - at this rate in nine months time all the rivers will freeze over’) Add politics and you have a dangerous mix, particularly when the partisan press has a significant influence on the non-partisan media.

I have sometimes put this down to a lack of economic knowledge among most political journalists. Of course political journalists talk about economics a lot, yet there seems to be a curious lack of interest in what those that study the subject have to say. I find the story of our ‘lost’ Brexit letter, which I summarised in this piece for The Conversation yesterday, rather scandalous: the mission to educate and inform thrown out of the window. [2]

Which I guess is one reason I started writing a blog. I say I guess because it all happened rather accidentally, so I never had any clear plan. Its success really did surprise me, and I soon realised that I had multiple audiences: many economists in the big economic institutions, but also many interested non-economists. It makes writing challenging and I know I often fail to adequately explain, but I was encouraged by whoever wrote the commentary on my blog in this knowledgeable list of the 100 top economics blogs.

But the people who most need to read economics blogs are I suspect one group that fail to do so: political journalists who talk about economics all the time, and the people who write and research economic news. It is not who appears on Newsnight debates that concerns me, but the unwritten assumptions of those who decide what is news, and write news bulletins. It was these people who decided that the growing deficit in 2009 was ‘courting disaster’, and made the tragedy of austerity possible.

[1] One comment I often get when I say this is that a good part of that deficit has proved to be structural. But if that is the case it is because a large part of the fall in GDP relative to trend following the recession seems to have been permanent. That means you do need to worry about the deficit at some point (after the recession is over), but your immediate focus should be on why GDP has departed from previous trends.

[2] In case you are unconvinced of this: the economic cost of Brexit is critical for most voters, the Remain campaign says this cost will be large but Leave dispute this, and who knows most about the basis and validity of the large cost claim?        

A way forward for the centre left on deficits

When it comes to fiscal policy the politics of the right at the moment [1] could be reasonably described as deficit fetishism. The policy of the centre left in Europe could also with some justification be described as growing appeasement towards deficit fetishism. Given its success for the right in Europe, it seems unlikely that this side of the political spectrum will change its policy any time soon. [2] Things appear a little more malleable on the centre left. In the UK, in particular, we will shortly have new leaders of both Labour and the Liberal Democrats. In addition, the Scottish Nationalists have adopted the rhetoric of anti-austerity, even though their fiscal numbers were not far from the other opposition parties during the elections.

Attempts to get the centre left to avoid deficit fetishism need to fight on two separate fronts. First, politicians and/or their advisers need to be taught some macroeconomics. Academics too often assume that politicians either know more than they actually do, or have behind them a network of researchers some of whom do know some macroeconomics, or who have access to macro expertise. (I used to believe that.) The reality seems to be very different: through lack of resources or lack of interest, the knowledge of left of centre politicians and their advisers often does not extend beyond mediamacro.

The second front involves the politics of persuasion: how can politicians successfully persuade voters that deficit fetishism, far from representing responsible government, in fact represents a simplistic approach that can do (and has done) serious harm? I think for academics this is a far more difficult task for two reasons. First our skills are not those of an advertising agency, and we are trained to follow the scientific method rather than act as a lawyer arguing their case (although, if you believe Paul Romer, the scientific method is not universally adopted among macroeconomists). Second, the experience of the last five years on the centre left is that deficit fetishism helps win elections.

It my last post I tried to argue why the success of deficit fetishism was peculiar to a particular time: the period after the recession when households were also cutting back on their borrowing, and where the Eurozone crisis appeared to validate the case for austerity. In other times households try to borrow to invest in a house, and firms try to borrow to invest in good projects. As a result, once the debt to GDP ratio has begun to fall, and yet interest rates remain low, the power of alternative narratives like ‘it makes sense to borrow to invest in the future when borrowing is cheap’ will increase.

Yet responding to deficit fetishism by implying the deficit does not matter, or that we can print money instead, or even that we can grow our way out of the problem, is unlikely to convince many. [3] It just seems too easy, and contradicts people’s personal experience. The trick is to appear responsible on the deficit, but at the same time suggesting that responsibility is not equivalent to fetishism, and other things matter too. I think this provides a powerful motivation at this time for a policy that is designed to obtain balance on the current balance (taxes less non-investment spending) rather than eliminating the total deficit. This is far from ideal from a macroeconomic point of view, as I discuss here, but as a political strategy in the current context it has considerable appeal. In the UK it allows you to attack the ‘excessive and obsessive austerity’ of Osborne, who is ‘failing to invest in the future’, while following a policy that it is difficult to label irresponsible. [4]

Of course this policy was close to that adopted by Labour, the Liberal Democrats and the SNP at the last election, so many will just say it has already failed. I think this is nonsense for three reasons. First, the policy I’m advocating is a combination of targeting a zero current balance, and at the same time arguing aggressively against excessive austerity. Labour deliberately avoided being dubbed anti-austerity during the election. (The Liberal Democrats were handicapped by arguing for austerity for the previous 5 years as part of the coalition.) The only party to adopt an anti-austerity line was the SNP, and it did them no harm at all. Second, the reason Labour wanted to avoid pushing the policy at the election was that they felt they had tried this a few years before and failed, but as I argued in the previous post deficit fetishism only shrives in a particular context, and that context is passing. Third, what sank Labour on fiscal policy was that people swallowed the Conservative line that it was Labour’s profligacy that caused the need for austerity, essentially because this line went unchallenged for five years.

This last point is worth expanding on. Too many in the Labour party think that because many people now believe this idea, the best thing to do is pretend it is true and apologise for past minor misdemeanours (knowing full well it will be interpreted by everyone else as validating the Conservative line). This is almost guaranteed to lose them the next election. It will just confirm that the last Labour government was fiscally profligate, and the Conservatives will quote Labour’s apology for all it is worth. To believe that this will not matter by 2020 is foolish - it is the same mistake that was made in the run up to 2015. It is no accident that political commentators on the right are arguing that this is what Labour has to do. So the first task for Labour after the leadership election is to start to contest this view. They should follow the advice that Alastair Campbell is said to have given after 2010, and set-up an ‘expert commission’ to examine the validity of the Conservatives claim, and then follow through on the inevitable findings. [5]

I can understand why it may seem easier right now to avoid all this, adopt deficit fetishism and ‘move on’. But to do this accepts the framing of economic competency as being equivalent to deficit fetishism, and therefore forfeits a key political battleground to the right. In addition, once you accept severe deficit reduction targets, it becomes much more difficult to argue against the measures designed to achieve them, as on every occasion you have to specify where else the money would come from. (In the UK, that partly accounts for the disaster we saw on the welfare bill. In Europe it leads to the travesty of what was recently done to Greece, where Greece was only allowed to stay in the Eurozone at the cost of adopting harmful additional austerity.) As we have seen in the UK and elsewhere in Europe, there is a large amount of popular support for an anti-austerity line, and if the centre left vacates that ground the vacuum will be filled by others. Arguing against deficit fetishism (or in more populist terms ‘obsessive austerity’) while pursuing fiscal responsibility through a balanced current budget can become a winning strategy for the centre-left in Europe over the next few years.

[1] It is easy to forget that there is nothing that makes this the inevitable policy of the right. George W. Bush took the reduction in the US deficit under Clinton as a cue to cut taxes and raise the deficit.

[2] This sentence is just for those who like to ask why I tend to write more posts giving advice to the centre-left rather than to the right on this issue.

[3] I have argued for ‘QE for the people’, but always as a more effective tool for the Bank of England to stabilise the economy and not as a more general way for governments to finance investment. (Even if this becomes ‘democratic’ along the lines suggested here, the initiative must always come from the Bank.) As for growing your way out of debt, this is much closer to the policies that I and many others have argued for, but it may unfortunately be the case that at the low point of a recession this line is not strong enough to counter deficit fetishism.

[4] It was also the main fiscal mandate of the last coalition government, of course. This could be supplemented by targets for the ratio of government investment as a share of GDP. As long as these are not excessive, an additional debt or deficit target seems unnecessary.

[5] The question should not be ‘did Labour spend too much before the recession’, because that is not the line that did the damage. The question should be more like ‘did the Labour government’s pre-2008 fiscal policy or the global financial crisis cause the 2009 recession and the subsequent rise in the UK deficit?’  

Labour and the deficit: a Tristram Hunt follow-up

My recent post on this was in one way generous to some Labour party figures. It assumed that they knew that George Osborne’s ‘going for surplus’ was a bad policy, but felt they had to follow it to regain credibility in handling the nation’s finances.

However there is an alternative and more straightforward explanation for Labour politicians proposing to follow Osborne’s policy, and that is that they do not know it is a bad policy. Some evidence for the second explanation is provided by this recent speech by Tristram Hunt. He is not trying to resurrect Blairism, as he agrees with Miliband that tackling inequality has to be at the core of Labour’s mission. But on fiscal policy it is hopeless. Here is one particular excerpt:

“the economy is growing and the deficit stands at around five per cent.  Even John Maynard Keynes would be arguing for retrenchment in this context.”

The idea that because the economy is growing we should be having fiscal retrenchment makes the schoolboy error of confusing levels and rates of change, and this is certainly not an error that Keynes would have made. In the 1920s and 1930s, when UK unemployment was never below 6% and often much higher, UK growth was often positive and sometimes strong - was that a good time for fiscal retrenchment? Tristram Hunt was originally a lecturer in modern British history, so maybe is unaware of this letter from Keynes to Roosevelt after the disastrous US return to austerity following strong growth in 1937.

Putting Keynesian issues to one side, Tristram Hunt repeats the idea that fiscal retrenchment is sensible because of the amount that the government pays in debt interest. Paying debt interest may be costly because of the distortions created by the taxes needed to pay it (or the missed opportunities for public spending), but taxes also have to rise (or spending to fall) to reduce debt. As I discussed here, a recent paper from the IMF makes it clear that this is not a good argument for austerity.

All of which raises an intriguing question. Where is this nonsense economics coming from? Tristram Hunt makes many of the same mistakes as Chuka Umunna made in a speech I also criticised – is that coincidence? I cannot believe that any academic economist, whatever their views on fiscal rules, would make errors as obvious as these. Are they simply parroting stuff that comes from the Conservative Party, which is repeated in much of the press? Does it come from some City economist? If anyone knows, please tell me (confidentially by email if necessary).

Mediamacro myth 3: the 2007 boom

The only way you can sustain the myth that Labour was fiscally profligate is by suggesting that immediately before the recession the UK was experiencing a massive boom. In an economic boom tax receipts are high and spending on transfers low, so the budget should be in surplus. If it is in fact in significant deficit, that indicates serious fiscal laxity.

There are two half-truths here. First, everyone remembers talk of a housing boom, and a housing boom sounds pretty similar to a more general economic boom. But more seriously, the idea that there was a huge boom in 2007 appears to be backed up by data from the IMF and OECD. Let us take each in turn.

This chart of house prices clearly shows a housing boom in the middle of the last decade. But does it indicate a general economic boom in 2007? There are two problems: there is clearly an underlying trend in the data, and house prices rose most rapidly at the beginning of the decade. When you take any trend into account, the middle years of that decade look like a plateau.

The upward trend in house prices is likely to be due to two factors: a growing mismatch between demand (encouraged in part by inward migration) and supply (very few new houses being built), and lower real interest rates. (The reason why low rates are important is explained here, and the link with demand and supply here.) As all these factors can also vary in the short term, this indicates that the house price cycle need not always be correlated with the more general economic cycle. The clearest indication of this is what has happened to London and South East house prices over the last two years, which are now well above 2007 levels. Does that mean the region is in the middle of an even more massive boom? Of course not.

If you look at both the OECD and IMF’s current measures of the output gap (the difference between actual output and the level that would keep inflation constant), they suggest a large positive gap for the UK in 2007. (3.5% in the latest OECD Economic Outlook.) That is a pretty large boom. The problem here is that in 2007, the OECD only thought the output gap at the time was less than 0.5%, which is no boom at all. Why the change in view? The answer is the recession, and the UK’s slow recovery. To cut a long story short, the OECD in effect retrospectively fit a gradually moving trend through the data (for productivity rather than output, but it comes to the same thing), so the longer the UK fails to catch up with its pre-recession trend, the more the OECD has to bend that trend over the past. The more it bends the trend, the more 2007 looks like a boom.

Could the OECD be right now and wrong back in 2007? The big problem here is that none of the more reliable measures behaved in 2007 as you would expect in a large boom. Inflation was happily bobbing around the Bank’s 2% target. Interest rates were rising, but not rapidly. Unemployment was a little higher than a couple of years before. Consumer debt was rising, but mainly because of rising house prices and mortgages. As the Bank’s Ben Broadbent points out, in the subsequent recession “losses on most domestic loans have actually been unexceptional. Instead, it is UK banks’ substantial overseas assets that caused much of the damage.”

This gets us to the key point as far as Labour profligacy is concerned. What is relevant to this issue is not what we think about the 2007 UK economy today, but what the general consensus was at the time. As we have already noted, the 2007 OECD Economic Outlook thought at the time that the UK economy was pretty close to trend. As far as I can see, this was a consensus view. The IFS Green Budget for 2007 had an output gap of effectively zero. The IMF’s Article IV assessment published around Budget time in 2007 came to a similar conclusion. The reason this was the consensus view is the data noted in the previous paragraph.

One final look at the numbers. If we assume real growth of 2.5% (again a consensus view at the time) and 2% inflation, then a debt to GDP ratio of 40% would imply that the sustainable deficit was 1.8% of GDP. As the estimate of the output gap at the time was around zero, there was no reason to adjust this for the state of the cycle. The actual deficits for financial years 2006-7 and 2007-8 were slightly over 2.5% of GDP. The difference is what I call mild imprudence, and would have been fairly easily to correct in subsequent budgets. By 2009-10 the deficit had risen to 10.2% of GDP because of the recession. So the deficit in 2010 was a consequence of the recession, not Labour profligacy before the recession.

And if you cannot shake off that idea that Gordon Brown was profligate, one final set of figures. Between financial years 1979 to 1996 (the 18 years of Conservative government), the deficit averaged 3.2% of GDP. From 1997 to 2007 it was 1.3%. Now maybe the Conservatives were a bit unlucky with having two recessions on their watch, so the equivalent cyclically adjusted figures are 2.6% and 2.1%. One last time: Labour fiscal profligacy is as mythical as the unicorn.

Previous posts in this series

(0) UK mediamacro myths: an introduction

(1) 2010 Britain faced a financial crisis

(2) Labour profligacy

My New Statesman article that provides a summary of this series is also now available online.

Mediamacro myth 1: 2010 Britain faced a financial crisis

The idea that the Coalition rescued Britain from a crisis is routinely put forward as fact by both the Conservatives and Nick Clegg. Every time the media let such statements pass (as they invariably do), the language seems to get more florid: Clegg’s latest is that the coalition was born in the “midst of an economic firestorm”. [1]

The facts say this is pure nonsense. The economy had begun to recover from the recession, and this recovery might have continued if it had not been hit on the head by domestic and Eurozone austerity. As Larry Elliott makes clear (see also here), there was no sign of any market panic, either in the markets for Sterling or government debt. 

But the government’s budget deficit was very large, and debt as a proportion of GDP was therefore growing. If, through a separate myth, you have created the idea that the major (perhaps only) goal of aggregate fiscal policy is to reduce deficits, this seems like a serious problem. But the deficit was rising because of the recession. It always does rise in a recession and fall in a boom, as the chart below shows. It was particularly high in 2010 because this recession was particularly deep.

Any economist would cringe at the idea that policy should try and eliminate deficits and surpluses created by the economic cycle, because that would mean destabilising the economy. This is sufficiently well known (cyclical deficits and surplus are called ‘the automatic stabiliser’) that it could undermine the idea that the high deficit was an immediate problem. This is one reason why it is important to push another mediamacro myth - the idea of Labour profligacy, which we debunk tomorrow. [2]

So where is the half-truth that gives the ‘firestorm’ myth some credence? It is of course the Eurozone crisis, and the idea that the UK could suffer a similar fate to the Eurozone periphery. But academic macroeconomists understand that the situation of a country with its own central bank, like the UK, is quite different from a country without, because the central bank can (and in the UK will) act as a lender of last resort, so the government will never ‘run out of money’. That simple fact is sufficient to prevent any crisis happening for an economy like the UK. Greece was profligate, and had to default, but the crisis in the rest of the Eurozone ended the moment the European Central Bank agreed to act as a lender of last resort in 2012.

Why is it so important to keep up the pretence that in 2010 the UK economy was ‘on the brink’ of a financial crisis? Because only then can the pain of the subsequent few years be excused. The truth is that the failure to recover until 2013 was not the inevitable cost of rescuing the economy from crisis, but an avoidable choice by the Coalition government. The delayed recovery, and the damage that did to living standards, was at least in part a direct consequence of attempts to reduce the deficit far too early, and there was no impending crisis that forced the government's hand. [3]

Previous posts in this series

(0) UK mediamacro myths: an introduction

[1] There is something about Clegg that wants me to see him in the best possible light. So I imagine that, when confronted just after the 2010 election by briefings from the Treasury and the Bank about the dire economic situation, he really believed what he was reading. He did not realise that, from the Treasury at least, it is standard practice to say this to any incoming government. (One of the interesting untold stories of austerity is the extent to which it was encouraged by senior Treasury civil servants.) But I suspect my imagine of 'Clegg the naive' is, well, imaginary.

[2] If the financial crisis had permanently lowered UK GDP, or the tax potential of GDP, then that would also imply the need to reduce government spending at some point. But, as most economists agree, you do that when monetary policy can offset the impact of these cuts on demand. You do not choose to undertake austerity when short term interest rates cannot fall any further.

[3] The clear majority of macroeconomists agree that austerity when short term interest rates cannot fall any further will reduce output. The OBR calculate that austerity cut growth in financial years 2010-11 and 2011-12 by 1%, but there are good reasons for thinking this may be an underestimate. 

Deficits, Mediamacro and Popular Opinion

The level of the government’s budget deficit is not the most important macroeconomic problem facing countries today. In the UK, for example, the fact that labour productivity has been stagnant since the recession is potentially far more important. If we fail to regain this lost productivity growth in the next few years, the average UK citizen will be substantially poorer as a result, in terms of consumption of both private and public goods and services. If the budget deficit rises by a few tens of billions, leading government debt to eventually rise or fall by even ten or twenty percentage points of GDP, the consequences will be negligible by comparison. To misquote George Osborne, the world will not fall in.

Yet mediamacro presents a very different picture. When Labour leader Ed Miliband forgot to mention the deficit in his party conference speech, the media could talk of almost nothing else but this ‘huge gaffe’. When Prime Minister David Cameron said nothing about the productivity slowdown in his party conference speech, no one in the media bothered to even mention this.

One of the fall back positions of the media on issues like this is that they are only reflecting popular opinion. In the case of the deficit it would hardly be surprising if this were true. If people are not told otherwise, they are bound to think about the government’s budget as they think about their personal budget. The Eurozone crisis was in the news constantly for two years, and the number of people explaining that the Eurozone was special because of the ECB was dwarfed by those who suggested it could happen here. A popular fear of market reaction is also not surprising as we are still suffering from the impact of the financial crisis.

But is mediamacro reflecting public opinion? Here is a question that YouGov recently asked in a poll for the Sunday Times (full poll results here, HT Duncan Scott).

Thinking about how the next government handles the issue of Britain's deficit, which of the following best reflects your view?

A.    The next government should prioritise reducing the deficit, mainly through making cuts to spending on public services

B.    The next government should prioritise reducing the deficit, mainly through increasing the level of taxation

C.   The next government should not prioritise reducing the deficit, and should spend more on public services or cutting taxes to try and promote growth instead

(A) could be described as the Conservative view, (B) as maybe the Labour or Liberal Democrat view, and (C) is the position taken by some nutty academics. Of those that chose one of these three options, 27% went for option (A), 25% for option (B) and 48% for option (C).

So around half said not only that cutting the deficit should not be a priority, but also agreed that fiscal policy should be used to promote growth. For these people, none of the major political parties represent their position. Of course Labour’s positioning could still be shrewd politics. It may be correct in thinking that this 48% will still prefer to vote Labour because they intend to reduce the deficit by (a lot) less than the other parties, but by pledging to make cutting the deficit its first priority it may attract some of (B), and also get mediamacro off their back.

The other implication is that maybe forgetting to mention the deficit is not, for many people, quite the gaffe that mediamacro thinks it is. Of course a large part of the UK media decided it was a major gaffe for purely political reasons, as another stick to beat Ed Miliband with. If the non-partisan part of the media went along with this because they thought reducing the deficit should be the top macroeconomic priority, they are simply wrong, as most economists will tell them. If they went along with this because they thought they were just reflecting public opinion, then maybe they should think again. If mediamacro continue to obsess about the deficit, the only conclusion to draw will be that we have a media consensus driven by a partisan press.

  

Can we have our instrument back?

This is a rather long post about how one of the instruments of macroeconomic policy has been taken away, and replaced by a fetish about government deficits. It is not technical.

The latest Bank of England forecast has inflation returning to the 2% target by the end of 2017, which is in three years time. That is an unusually long time to be away from target. So what is the MPC proposing to do about this long lapse from target? Absolutely nothing. Tony Yates goes through all the detail, but remains mildly shocked. Much the same thing is happening in the US. In both countries the main discussion point is not what to do about this prolonged target undershoot, but instead when interest rates will rise. Two members of the MPC are voting to raise rates now! [1]

Cue endless discussion about whether the Bank or Fed think Quantitative Easing does not work anymore, or has become too dangerous to use, or whether the target is really asymmetric - 1% is not as bad as 3%. [2] All this is watched by a huge elephant in the room. We have a tried and tested alternative means of getting output and inflation up besides monetary policy, and that is called fiscal policy. We teach students of economics all about it - at length. But in public it has become like the family’s guilty secret that no one wants to talk about.

Once upon a time (in the 1950s, 60s and 70s) governments in the US, UK and elsewhere routinely used both monetary and fiscal policy to manage the economy. Governments did not stop using fiscal policy for this end because it did not work. Instead they found, and economists generally agreed, that when exchange rates were not fixed monetary policy was a rather more practical (and probably more efficient) instrument to use. They certainly did not stop using it because it caused the rise in inflation in the 1970s. That rise in inflation was the result of oil price shocks, combined with in many countries real wage resistance by powerful trade unions, and policy misjudgements involving both monetary and fiscal policy.

When, in the previous paragraph, I wrote ‘economists generally agreed’, I am talking about what could be described as the academic mainstream. However there were also two important minority groups. One, and the less influential, argued that the mainstream was wrong, and fiscal policy was better than monetary policy at stabilising demand. The other, often among those labelled monetarist, not only took the opposite view, but had a deep dislike of using fiscal policy. For example, many believed its use would be abused by politicians to increase the size of the state (and almost all in this group wanted a smaller state). For some there was the ultimate fear that politicians would run amok with their spending, which would force central banks to print money, leading to hyperinflation - we can call this fear of fiscal dominance. However, as I noted above, the rise in global inflation in the 1970s was not an example of fiscal dominance. I shall use the label ultra-monetarist for this second group: ultra, because it is not clear Friedman himself would be among this group.

These minorities aside, the mainstream consensus was that monetary policy was the instrument of choice for managing demand and inflation, but that fiscal policy was always there as a backstop. So, when Japan suffered a major financial crisis and entered a liquidity trap (interest rates fell to their Zero Lower Bound (ZLB)), the government used expansionary fiscal policy as a means of moderating the recession’s impact. At the time the results seemed disappointing, but following the experience of the Great Recession Japan’s performance in the 1990s does not look so bad.

The key event that would eventually change things was the creation of the Euro. For countries within the Eurozone, monetary policy was set at the union level, so to control demand within each country fiscal policy was the only instrument left. Unfortunately the influence of ultra-monetarists within Germany had always been very strong, and for various reasons the architecture of the Eurozone was heavily influenced by Germany. This architecture essentially ignored the potential use of the fiscal instrument. Instead the influence of monetarism led to what can best be described as deficit fetishism - an insistence that budget deficits should be constrained whatever the circumstances.

Within the Eurozone individual governments no longer had their own central banks who could in extremis print money. The worry among the ultra-monetarists who helped design the Eurozone architecture was that some rogue union members would force fiscal dominance on the union as a whole, so they put together fiscal rules that limited the size of budget deficits. This was both unnecessary, and a mistake. It was unnecessary because the Eurozone set up a completely independent central bank, and made fiscal dominance of that Bank illegal. It was a mistake because it completely ignored the issue of demand stabilisation for countries within the Eurozone - in practice it either took away the fiscal instrument (in a recession) or discouraged its use (in a boom [3]).

While the design of the Eurozone reflected the obsessions of ultra-monetarists within Germany, in the rest of the world the academic mainstream prevailed. So when the financial crisis hit, and interest rates fell to the ZLB across the globe, governments in the UK and US again used fiscal stimulus as a backup instrument to moderate the recession. The IMF, normally advocates of fiscal rectitude, concurred. The policy worked. But two groups were not happy. The ultra-monetarists of course, but also many politicians on the right, whose main aim was to see a smaller state, and who saw deficit reduction as a means to achieve that goal. Both groups began to warn of the dangers of rising government debt, which was rising mainly because of the recession, but also because of fiscal stimulus where that had been enacted.

What happened next was that the Eurozone struck back, although not in a calculated way. It turned out that it did contain just the kind of rogue state the architects had worried about: Greece. The fiscal rules failed to prevent excessive Greek government borrowing. Did this lead to fiscal dominance and hyperinflation in the Eurozone? - of course not, for reasons I have already given. But it did lead governments in the Eurozone to make a fatal mistake. What should have happened, and always does happen to governments that borrow too much in a currency they cannot print, is that Greece should have immediately defaulted on its debt. But instead Greece was initially encouraged to borrow from other Eurozone governments, perhaps because some countries worried that default might lead to contagion (the market would turn on other countries), but perhaps also because default would have hit commercial banks in the larger Eurozone countries who owned this Greek debt.

Eventually contagion happened anyway, and Greece was forced into partial default, although not until it had taken the poison of loans from other Eurozone countries which were conditional on crippling austerity. Equally important was the impact that Greece had on the use of fiscal policy in the rest of the world. Those ultra-monetarists and right wing politicians that had been warning of a government debt crisis used the example of the Eurozone to say that this proved them right. Many (but not all) economists in the mainstream began to believe it was time to reverse the fiscal stimulus, as did the IMF. 

From that point on, the idea that you could - and when monetary policy became ineffective should - use fiscal policy to stimulate the economy became lost. Even in 2009 it had been a difficult policy to sell publicly: why should government be increasing debt at a time that consumers and firms had to reduce their own debt? For those who had not done an undergraduate economics course (which included most political journalists), politicians of the right who said that governments should act like prudent housewives appeared to be talking sense. Greece and the subsequent Eurozone crisis just seemed to confirm this view. Deficit fetishism became pervasive.

Of course this about turn was just what both ultra-monetarists and politicians on the right wanted. The focus on government debt had an additional advantage in certain influential quarters. What had started out as a crisis caused by inadequate regulation of the financial sector began to appear as a crisis of the government’s making, which if you worked in the financial sector which had just benefited from a massive public subsidy was a bit of a relief. You could be really cynical, and say that austerity made room for another big financial bailout when the next financial crisis hit. 

But those with a more objective perspective watched the years after 2010 unfold with growing concern. There were no government debt crises in the major economies outside the Eurozone - instead interest rates on government debt fell to record lows. The market appeared desperate to lend governments money. The debt crisis was confined to the Eurozone. However austerity within the Eurozone, undertaken across the board and not just in the crisis economies, did nothing to end the crisis. The crisis only ended when the ECB offered to back the debt of the crisis countries. The offer alone was enough to halt the crisis, and interest rates on periphery country debt started to fall substantially. But austerity’s damage had been done, creating a second Eurozone recession. The fiscal policy instrument works, even when you use it in the wrong direction! Austerity delayed the UK’s recovery, and while growth was solid in the US, austerity there too meant that the ground lost as a result of the recession was not regained.

So those with a more objective perspective, including many in the IMF, began to realise the fiscal policy reversal in 2010 had been a big mistake. The world had been unduly influenced by the rather special circumstances of the Eurozone. Furthermore within the Eurozone the crisis that austerity had meant to solve had actually been solved by the actions of the ECB. It began to look as if austerity - in perhaps a milder form - had only been required in a few periphery Eurozone countries.

All this should have meant another policy switch, at least to end fiscal austerity and perhaps to return to fiscal stimulus. But deficit fetishism had taken hold. This was partly because it suited powerful political interests, but it was also because it had become the pervasive view within the media, a media that liked a simple story that ‘made sense’ to ordinary people. Politicians who appeared to deviate from the new ‘mediamacro consensus’ of deficit fetishism suffered as a consequence.

So as 2014 ends, we have at best an incomplete recovery and inflation below targets, yet central banks are either not doing enough, or have given up doing anything at all. A huge amount of ink is spilt about this. But if central banks really do believe there is nothing much they can do, with a very few exceptions they fail to say the obvious, which is that it is time to use that other instrument, or at least to stop using it in the wrong direction. Perhaps they think to say this would be ‘too political’. The media in the UK and US continue to obsess about government deficits, even though it is now clear to almost everyone with any expertise that there is no chance of a government funding crisis, so the obsession is completely misplaced. Within the Eurozone deficit fetishism has achieved the status of law!

There are some who say we cannot use the fiscal instrument to help the recovery, and get inflation on target, because debt will become a problem in 30 years time. It is as if a runner, who normally gets their fuel from eating carbohydrates but has run out of energy in mid-race, is denied a food with sugar (HT Peter Dorman) because a high sugar diet is bad for you in the long term. Others in the Eurozone say we must stick to the rules, because rules must be kept. But rules that create recessions with no compensating benefits are bad rules, and should be changed. Rule makers can make mistakes, and should learn from these mistakes. [4] It is perfectly possible to design rules that both ensure long term fiscal discipline, but which do not throw away the fiscal instrument when it is needed.

So every time someone writes something about what monetary policy could or should do to get inflation back to target, they should say at the outset that this goal could be achieved - in a more assured way - by a more expansionary fiscal policy. Political journalists who presume that more borrowing must be bad should get a severe telling off from their economist colleagues. For one thing that should now be clear is that rising debt since the recession has done no harm, but austerity policies that tried to tackle rising debt have done considerable damage. The 2010 Eurozone crisis was a false alarm. Macroeconomics needs to get its fiscal instrument back, and deficit fetishism has to end, but this is being prevented by an alliance between the political right, the ultra-monetarists, and I’m afraid the media itself.

[1] In the UK there is a certain irony here. When inflation was above target in 2010-13, most of the MPC was brave enough to avoid raising rates. Although they forecast that inflation would come back to 2% within two years, this forecast was met with considerable skepticism. Three members of the MPC in 2011 voted to follow their ECB colleagues and raise rates. Perhaps as a result, the Treasury wrote a paper in 2013 which said that on occasions like that (when inflation was above target in a recession) the MPC could be a little more relaxed about the speed at which inflation returned to target. The irony is that this latitude is being used (abused?) now, when inflation is below target and we are still recovering from a recession.

[2] Maybe in the US the target is asymmetrical - but shouldn’t be - but in the UK it is symmetric by law.

[3] In a boom, when fiscal policy should have been contractionary, budget deficits were low as a result of the boom, so the rules suggested no action was required.

[4] Equally those that lent money when they should not have lent money have to accept that they made a mistake.