Labour and the deficit

A constant refrain from those who help make Labour party policy goes like this. I know what you economists say makes sense, but we tried that policy at the last election, and failed horribly. We have to listen to what the people are telling us.

So, for example, we cannot oppose George Osborne’s deficit plans, because we tried that at the last election and lost. We cannot talk about the problem of rent seeking by the 1%, because we tried that and it was seen by voters as anti-aspiration. We cannot argue for a higher minimum wage because that will be seen as anti-market and anti-business - oh wait.

I would draw exactly the opposite conclusion from the election result. On the deficit Labour tried to avoid discussion, and let the Conservatives spin the idea that austerity was the last Labour government’s fault. By failing to challenge both this nonsense [1], and the austerity policy enacted in 2010 and 2011, and the austerity policy proposed after 2015, in terms of perception it adopted the Conservative policy on the deficit. [2] That was why it lost heavily.

Some will say that come the next election the government will be running a budget surplus anyway, so why oppose the process of getting there? The answer to that is aptly illustrated by Labour’s decision not to oppose Budget plans to limit child tax credits to the first two children, or plans to reduce the benefit cap. Both are terrible policies, and it is incredulous that Labour is not opposing them. But once you concede the need for austerity, it becomes much more difficult to oppose the measures that come with it.  

Another argument is that Labour has to accept Osborne’s surplus target, because nothing else will stop Labour being accused of being fiscally spendthrift. (See Hopi Sen for example - HT Simon Cox ‏@s1moncox) This just sounds politically naive. George Osborne (as Chancellor or PM) will not suddenly drop the spendthrift argument just because Labour adopts his plans. Instead the argument will change to focus on credibility. He will say: Labour now admits that it was spendthrift in government, and in opposition it has changed its mind so often, you just cannot believe what they say – so any future Labour government will be as spendthrift as the last.

Others will respond to the above by saying how can you argue Labour lost because it was not left wing enough! But challenging austerity is not ‘left wing’, it is just good macroeconomics. The idea that opposing austerity, or advocating less inequality, is akin to what Labour did between 1979 and 1983 is absurd.

If there are examples to draw from, it is to see how your opponents succeeded where you failed. The Conservatives did not regain power in 2010 by moving their policies to the left. They did it by changing their image. Until a couple of years before 2010 they had promised to match Labour on spending. But when circumstances changed, they seized their chance to change policy and focus on the deficit. It was a smart move not because of the economics, but because of how it could be spun.

In 2015, the SNP saw that times had changed compared to 2010. The idea that we might become like Greece was no longer credible, and voter attitudes on the deficit were much more divided. So they campaigned against austerity, and partly as a result wiped Labour out. (Their actual policy proposals were not very different from Labour, but unfortunately few voters look at the numbers: it is perception that matters.)

The lesson is that when the external environment changes, you try to exploit this change in a way that enhances the principles you stand for and gains you votes. As the deficit falls, putting this at the centre of policy will seem less and less relevant. In contrast, the costs of austerity and rising poverty that are the result of ‘going for surplus’ will become more and more evident. Osborne, by going for an unnecessarily rapid reduction in debt by means of increasing poverty, has thrown a potential lifeline to Labour. Unfortunately, Labour appear to be swimming away from it.

   

[1] Chuka Umunna writes: “Some economists reject this [supporting going for surplus] approach as it would, in their view, necessarily entail simply capitulating at the feet of George Osborne. In their view all we need to do is – in ever more strident and louder terms – shout back at the electorate that it was not profligacy on the part of the last Labour government that caused the crash, but a banking crisis. And, in respect of borrowing, far from acknowledging that we understand the need to reduce national debt, we need to enthusiastically go about making complex arguments for different types of borrowing. Do this and the public will see the light.”

I guess I am one of those economists. I would respond that Labour in 2015 made no attempt to seriously debate this issue, let alone shout about it. The only people challenging the myth that Osborne and much of the media were telling were ‘some economists’. I do not think it is ‘complex’ to argue that you should borrow to investment when interest rates are low, and I think this argument can be effective - which is why Cameron called the people making it dangerous voices.

[2] The SNP saw that Labour were endorsing the importance of deficit reduction, and exploited this by arguing against austerity.

No basis in economics

That was the claim about George Osborne’s plan to outlaw government deficits in normal times made in the letter signed by 79 economists. It is a strong claim. To see why it is a tenable claim, it is important not just to think about the short term situation and the usual controversies that go with it.

Before I do that, I have a confession. I had until recently assumed that the surplus target would be inserted into the kind of rule he set up when he became Chancellor, which allowed considerable flexibility in how quickly that target was achieved. However while writing this post I realised I may be wrong: he could be planning to replace that kind of flexible rule with legislation that simply outlaws deficits in normal times. That is important, because it would mean one of two things. The first is that the government would attempt to hit some target for a small surplus (say 0.5% of GDP) each and every year. That means that in response to quite normal shocks and forecast errors that hit the public finances, taxes or government spending would be pushed up or down to compensate. [1] The second is that the government would have to aim for surpluses somewhere around 2% of GDP, to provide a sufficient buffer to absorb those shocks and forecasting errors.

The most basic of macroeconomic theories when it comes to thinking about fiscal policy is due to Robert Barro, who is hardly an active supporter of Keynesian stimulus spending. It is called tax smoothing, but it can easily be applied to government spending as well. (It forms the basis of much of what economists call the dynamic optimal taxation literature.) This says it is taxes and spending that matter, not debt or deficits, and it is best to plan such that the path of taxes and spending is smooth. Another way of putting the theory is that the deficit should be a shock absorber, and planned reductions in debt should be slow. (This was the theory behind the recent IMF paper I discussed here.)

So how does the plan to outlaw deficits look in the light of this literature. If the plan involves targeting a small deficit each and every year, that is the complete opposite of tax smoothing. Taxes and spending would become volatile so the deficit could be smooth. That is crazy, because it is taxes and spending that impact on people and not the deficit.

If the plan involves going for a larger surplus on average, that would allow smoother taxes and spending in the short term. However average surpluses of 2% would imply an incredibly rapid reduction in government debt. Coupled with 4% nominal GDP growth they would cut the ratio of debt to GDP from the current 80% to Gordon Brown’s 40% target within a decade. Within two decades government debt will have largely disappeared, which allows taxes to fall or spending to rise. [2] But that will also violate tax smoothing, this time at a frequency involving generations rather than years. You could put this in terms of intergenerational equity: the current young, who suffered most from the Great Recession, will bear the full burden of reducing debt. Future generations will get the benefits of existing public capital while contributing nothing towards it. 

So both versions of outlawing deficits in normal times violate the tax smoothing idea. But it gets worse. If real interest rates and wages vary over time, it is best to invest when borrowing and labour are cheap: that is not just basic economics but common sense. Both borrowing and labour are currently cheap. Yet to meet the surplus target, the government plans to keep public investment on infrastructure lower than at any time over the last twelve years.

So even if you put all the short term Keynesian concerns to one side (which of course I would not), outlawing deficits makes no economic sense. Yet Philip Booth of the IEA takes exception to this claim. But the only theory he can come up with to support the plan is the idea that sometimes it is better for the government to tie its own hands. He says “the 79 seem unaware of these basic ideas”. Of course the 79 are aware of the pros and cons of commitment (for a full discussion applied to fiscal rules see Portes and Wren-Lewis), but what you should never do is commit to rules that make no sense. Following daft rules will always be daft. Outlawing deficits is a daft rule.

[1] The rule then is virtually identical to a policy of always running a balanced budget. Students learn the problems with that rule in their first year studying economics.

[2] The only way you could make sense of this policy is if the surpluses continued even when debt had disappeared, and the government built up a large sovereign wealth fund. Although I have explored this possibility in an academic paper with colleagues, the current government has never mentioned this goal, so I think we can discount it here.  

Labour’s growing macroeconomic illiteracy

I’ve devoted many blogs to criticising George Osborne’s macroeconomics, so for the sake of variety this post turns to a senior member of the current Labour party. Chuka Umunna is Labour’s spokesman on business, innovation and skills, and in this article for The Independent he discusses what Labour did wrong on the economy. Here is just one paragraph.

“In 2007, before the crisis hit, the UK government was running a deficit. By historical standards, it was small and uncontroversial – it averaged 1.3 per cent from 1997 to 2007, compared with 3.2 per cent beforehand under 18 years of Tory rule. And yet to be running a deficit in 2007, after 15 years of economic growth, was still a mistake. My party’s failure to acknowledge that mistake compromised our ability to rebuild trust in 2010 and in 2015. If a government can’t run a surplus in the 15th year of an economic expansion, when can it run one?”

The first two sentences say that Labour was actually more fiscally conservative than the Conservatives, and that the deficit in 2007 was small. No problem with that, although to imply that the small deficit in 2007 was uncontroversial is not right: many suggested at the time that it should have been smaller, with good reason. The next sentence and the last say that it would have been even better to have run a surplus, because the economy had been growing for 15 years. To which a macroeconomist can only respond - what?

Of course economies normally grow, in real and nominal terms. That means that if you want to keep the ratio of government debt to GDP stable (Labour’s target for this ratio was effectively 40%), you need to run budget deficits, not surpluses. A surplus, or even a balanced budget, will gradually reduce the debt to GDP ratio, because debt will not be growing but GDP will be.

What Umunna is saying here is much the same as George Osborne’s proposed rule: in normal times when the economy is growing run surpluses. But Osborne is saying that in the context of the current debt to GDP ratio of 80% of GDP. Umunna is implying that policy still made sense back in 2007 when the debt to GDP ratio was below 40%, the output gap was thought to be small and no one was expecting a global financial crisis. I cannot remember anyone before 2008 suggesting Labour's debt limit should fall over time. Yet Umunna says the mistake was so serious it helped lose Labour two elections.

I would love to know who the economists are that gave Umunna the advice that led to this article. Certainly not any of the 79 that signed this letter, or advice from the Economist or FT. You would think that the advice would have to be pretty convincing, given how this line plays into the Conservative narrative about how Labour profligacy was the cause of 2010 austerity, and that therefore it is Labour rather than Osborne and Cameron who are responsible for the slowest UK recovery from recession since almost forever.

If you think I’m being too hard, perhaps over-interpreting a couple of sentences, here is another extract:

“reducing the deficit is a progressive endeavour – we seek to balance the books because it is the right thing to do. We will not stand by while the state spends more paying interest every year to City speculators and investors holding government debt, than we do on people’s housing, skills or transport. It will be far too late to leave this to the 2020 general election campaign.”

Would he give the same advice to UK businesses: refrain from borrowing and focus on paying back your debt? Somehow I think not. The Conservatives have a kind of excuse for deficit fetishism - it is a useful device for shrinking the state. That excuse should not apply to senior Labour figures.

An interview that will never happen

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

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

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

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

Interviewer. Even with interest rates already near zero?

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

Interviewer. Is that why inflation is currently negative?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Should we aim for budget surpluses?

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

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

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

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

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

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

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

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

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

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

 

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

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