The differences between Labour and the Conservatives on fiscal policy

The Conservatives have learnt the lesson of 2017, and have ditched austerity in order to offer higher spending to the electorate.They hope voters decide that there isn't much difference between the two parties on this score. But voters would be wrong to do so. In Labour's case the extra spending is sustainable, whereas for the Tories it will not be. There are two reasons for this.

The first is that the Tories are not proposing large tax increases, while Labour almost certainly will - in the last election corporation taxes and taxes on high earners. (In 2017 the IFS suggested their match between extra current spending and higher taxes wasn’t perfect, but they agreed Labour would keep within its fiscal rule, which is what matters.) That means for a given fiscal stance Labour should have more money to spend on non-investment public spending than the Conservatives. And, assuming there is no collapse in demand ahead, their fiscal stance is now similar. (If there is a collapse, see below).

The second reason is Brexit. The Tories have negotiated a very hard Brexit, leaving the Customs Union and Single Market. I have argued that Brexit will not happen under Labour, but even if it did a much softer Brexit means less economic damage. Soft or no Brexit means higher incomes under Labour which in turn means higher taxes, and so higher spending.

What the Tories are counting on is that analysis by the IFS and others of the two party's programmes will ignore the second difference, and use a common baseline (as the Resolution Foundation does here). Once you factor in Brexit, the Tories extra spending is unlikely to be sustainable. They willl be forced to raise taxes or cut spending to keep to their current balance target. It will be even worse if Johnson throws in some last minute tax cuts in a desparate attempt to ensure he gets a majority. The OBR might have shown all this in its budget forecast, but the budget was conveniently postponed.

Not only will Labour spend more on day to day government expenditure, but they also plan a much more radical increase in public investment spending. Whether you think that is a good idea will depend on how seriously you take the need for a Green New Deal, how much you want to reduce regional inequalities and how much social housing you want the government to build, among other things. That will mean more borrowing under Labour, but public investment of this kind should be financed by borrowing. No one should argue we cannot invest to reduce climate change because it means borrowing more!

Those are the headlines from yesterday. The rest is only of interest to those who worry about fiscal rules. For the details of what each party's new rules are I'm relying on this account by the Resolution Foundation.

1) Both Conservaives and Labour are now targeting the current balance: the deficit minus net public investment. The Tories have given up Osborne's foolish move to target the total deficit, and like Labour's Fiscal Credibility rule will not constrain investment in the deficit part of the rule. There are two differences. Labour targets the current balance five years ahead using a rolling target, whereas the Tories will target it three years ahead with no rolling target. I argue in my paper with Jonathan Portes that in a mature economy with a fiscal council like the OBR a rolling 5 year target makes more sense, because it is more robust to shocks just at the end of the target period.

2) Labour's Fiscal Credibility Rule departed from the suggestions in that paper by having a target for debt. The big change in this election is that this is replaced by a target that includes government assets as well as liabilities, a suggestion that both the Resolution Foundation, INET and the IFS’s Green Budget have made. If you are going to have a stock target (see below) this type of target makes more sense. The Tories have a weak and conventional 'falling debt/GDP' target.

3) Both rules appartently include limits for debt interest in relation to taxes. I'm even less keen on these than debt targets, but they have been suggested by others.

4) Labour’s Fiscal Credibility Rule has a knockout that occurs when interest rates hit their lower bound. This was a key proposal in my paper with Jonathan Portes, and as a result Labour's rule was ahead of its time. When interest rates hit their lower bound, the fiscal rule would be temporarily suspended and fiscal policy would focus on an economic recovery. When John McDonnell launched his rule in 2016 one BBC reporter called the knockout a loophole, despite the fact that it would have created a much faster and quicker recovery and avoided austerity! Other than that mediamacro hardly discussed the knockout.

Since 2016, however, first the IPPR, then INET and then the Resolution Foundation have suggested very similar knockouts, reflecting a growing consensus that fiscal stimulus will be needed for the next recession. In another post I might discuss the small differences between these different knockouts, but the principle is the same and kind of obvious - if conventional monetary policy can no longer do its job fiscal policy should take over. But as we are not yet at this lower bound, Labour were quite right in 2017 not to base policy on the knockout happening, and I suspect they will do the same again in this election. As far as I know there is no knockout in what the Conservatives' propose.

The difference between the rule suggested in Portes and Wren-Lewis and the Fiscal Credibility Rule is that the latter initially contained a target for total debt, and now contains a target for public sector net wealth. While the latter is a definite improvement on the former, I personally think targets for any kind of stock in a fiscal rule are a bad idea. The reason to target the deficit rather than debt is basic to fiscal rules. Adjustment of taxes and spending should as far as possible be done slowly.

Suppose some temporary fiscal shock raises both the deficit and debt. Because the shock is temporary, there will be no impact on future deficits. At most debt interest payments may rise slightly, requiring some very tiny increase in taxes or cut in spending. Debt will gradually fall back to its pre-shock level. That is smooth adjustment. However with a debt target you need a much bigger adjustment in taxes or spending to get the debt stock down within the target period. Exactly the same logic applies to permanent fiscal shocks.

This is the basic logic of preferring deficit target to debt targets This is not to say that the debt ratio or some other stock measure are not important, but they should guide what deficit targets should be, and not be targets themselves. An analogy is a road trip where you are delayed by some congestion. A sensible person does not start taking risks by driving very fast to make up for lost time as quickly as possible, but instead think how they can make up the time gradually over the entire journey. As no one has any good idea of what the optimum level of debt is, the journey in this case is decades not 5 years.

There is a technical argument that you should target both if your deficit target is the current balance, which excludes investment. If that is so, and it should be so, then in theory without some form of debt target the government could increase debt without limit by keeping investment very high. My response is that, if this really is a worry (has it ever happened in the UK over the last 50+ years?), have a target or limit for the investment to GDP ratio, as the new Conservative fiscal rule does. In this one respect I think their rule is better than Labour's, if you ignore their silly change in debt target! An investment target would avoid the dangers of having a stock target.

It would be much more sensible in my view to have just a current balance deficit target, which is occasionally revised after suggestions by the OBR in light of movements in various measures of government debt and wealth. In their recent Green Budget the IFS are very pessimistic, suggesting fiscal rules will never last a long time. I think there is a simple reason for this, and that is that rules generally contain some form of debt target. But they seem very popular with politcians in all countries, and many of those that advise them, which alas may mean fiscal rules may not be as robust as they could be.

Postscript (12/11/19)

I saw it suggested yesterday that you could ignore the points I make here because I once advised the Labour party (that role ended in 2016). Over the last decade I have advised all three of the main parties on various issues. I believe it is an economist's duty to give politicians their expertise if asked, with very mild conditions set out here. Giving that advice on technical issues should never be mistaken for being partisan, just as economists should never let their own political views influence the advice they give on these issues. 

Our new Prime Minister is abandoning austerity and going on a tax cutting spree (if you believe him)

These proposals are not designed to help the economy, but to keep Tory party backers happy amid the chaos of a No Deal Brexit

I was going to write something about some of the detailed fiscal plans of our next Prime Minister, and then I thought that would be pointless. Part of the remit of being a Tory Prime Minister nowadays is to lie all the time. So how do I, or Tory members for that matter, know if either of these two candidates for Prime Minister are going to do any of the things they have promised when they get into power? All they are doing right now is saying whatever they think Tory members want them to say.

However both campaigns do at least raise the possibility that our next Prime Minister will throw caution (and fiscal responsibility) to the wind and embark on some large tax cuts. It is critical to note that these tax cuts have not been carefully crafted to shield the economy against any demand shock that might follow from a No Deal exit from the EU. They are designed instead to make Tory voters happier with a government that enacts the biggest act of self harm in UK history.

How do I know that this is what the tax cuts are for, when I’m sure the future Prime Minister would say otherwise? Let’s just look at some of the big ticket items. Cutting income tax for higher rate taxpayers, cutting stamp duty on buying a house and cutting corporation tax. If you were looking for fiscal policies to provide a quick boost to demand, these would be a long way down the list. Much better would be to give money direct to poorer households, because they are likely to spend most of it, or to add to demand directly by increasing public spending, and in particular public investment. High up on my list would be to increase local authority funding to prevent some local authorities going bust. These kind of demand boosters are, however, not the kind of thing that would be attractive to Tory party members, which is why they are largely absent from the wish list of each prospective Prime Minister.

There is an equally important point about timing. Any demand shock following a No Deal exit is likely to be temporary, like a sudden stop in investment by business or in housing. The best measures to counteract that are ones that can easily be reversed. Again bringing forward public investment is an excellent example. In contrast, cutting taxes is politically difficult to reverse. None of the tax cuts proposed by either leadership candidate are explicitly temporary.

What we are seeing from both candidates is the fiscal policy of Donald Trump, and to be fair to Donald Trump also the policy of the Republican party since the second George Bush. Cut taxes under any pretext you can, and watch borrowing increase. After a suitable interval say that something must be done about borrowing, and propose a raft of cuts in public spending or welfare payments to stop the government debt to GDP ratio rising. It was the right’s preferred way of shrinking the state before the Global Financial Crisis and austerity came along.

There are two traps that the left can fall into by a Trump style give away to the rich. The first, which you may find among Lexiters, is to believe that fiscal stimulus is the means by which you stop permanent damage to the economy from any form of Brexit. The danger this leads to is to support the concept of a large permanent fiscal stimulus, even if you do not like the details. I am all for a large increase in public investment, of the kind that I hope a future Labour government will deliver, but that increase in investment should happen anyway, whatever the outcome on Brexit or aggregate demand. If the investment projects are beneficial, they should be undertaken whatever happens to Brexit.

Brexit’s main impact is to gradually hit the supply side of the economy by reducing UK trade with the EU and most of the countries the EU has trade agreements with. As we do less trade, the UK’s productivity falls. This causal linkage takes many forms, such as dynamic firms choosing to produce elsewhere or UK participation in supply chains ending, but the net result is that the UK produces stuff less productively than it would without Brexit. The empirical evidence for these effects is very strong, and we have already seen some of it happening.

You cannot counteract this long term loss of productivity by pumping up demand. All this will do is create inflationary pressure which will lead to higher interest rates designed to offset the fiscal stimulus. There is nothing the UK government can do to offset the negative impact of higher trade barriers on the UK. What the government can do is help offset any Brexit induced negative shock to demand, where demand falls more quickly than supply or falls temporarily, by using fiscal expansion alongside monetary policy.

This leads to a second trap, which is to think about the Johnson/Hunt proposals in terms of conventional fiscal stimulus to offset this temporary demand deficiency. Or in other words to think about them in macroeconomic terms. That is not their main intent. Their intent is to redistribute money from the poor to the rich, in order to keep the party’s backers (in terms of money or votes) happy despite all the chaos of No Deal. No doubt any actual proposals made after the winner becomes Prime Minister will include sweeteners (this could be a bad pun) designed to distract from this purpose, but reporting and comment should not be distracted.

Which brings us to the issue of how popular any package will be. Stephen Bush rightly points out that our future Prime Minister, if they stick to anything like their current fiscal plans, will blow the Conservatives' reputation for economic responsibility out of the water. The OBR will be quick to tell the next Chancellor that a No Deal Brexit will create one of those famous black holes in the public finances, yet rather than respond as Hammond would by fiscal retrenchment the new Prime Minister wants to shake the magic money tree for all it is worth.

In contrast Aditya Chakrabortty worries that this reputation loss will have little impact on voters, who will instead be dazzled by the goodies that are being thrown at them. If I had to choose I would agree with Chakrobortty on this. Labour are deemed irresponsible on the economy by the media even when they are not, so I suspect the reverse will be true: the Tories will be deemed responsible even when they are not. The IFS and the Financial Times will raise an eyebrow but their impact on most media comment will be regrettably small.

I fear we are returning to an age of deficit bias, which I have to remind younger readers was the tendency in many (not all) countries to gradually increase their debt to GDP ratio during the 30 years before the Global Financial Crisis. There is always the temptation for politicians to cut taxes or increase spending by increased borrowing to gain popularity. Austerity during the Global Financial crisis may be an exception to that rule, or more worryingly deficit bias may be how right wing politicians shrink the state in normal or good times and austerity (deficit deceit) is how they do it in bad times.

As a result, it is entirely legitimate for the left to criticise these plans on fiscal responsibility grounds as well as citicising their impact on the distribution of post-tax income, should these plans survive either candidate becoming Prime Minister. I make no apologies for saying this again: the Labour party is the only UK political party to have set out a fiscal framework that both prevents austerity and also prevents the kind of irresponsible fiscal giveaways that are being proposed by our future Prime Minister.

Why should someone who is anti-austerity care about debt

Most of the posts I have written about austerity have been aimed at countering the idea that in a recession you need to bring down government deficits and therefore debt. But what if you accept all that (you are anti-austerity). Why should you care about debt at all? Why do we have fiscal rules based on deficits? Why not spend what the government needs to spend, and not worry that this resulted in a larger budget deficit?

The story often given is that the markets will impose some limit on what the government will be able to borrow, because if debt gets ‘too high’ in relation to GDP markets will start demanding a higher return. You can see why that argument is problematic by asking why interest rates on government debt would need to be higher. The most obvious reason is default risk. But for a country that can create its own currency there is never any necessity to default.

However there is another reason to demand a higher nominal interest rate on debt, and that is if you think there will be additional inflation in the country. Spending more without raising taxes will tends to increase inflation. But if the government or central bank is sure to raise interest rates to offset this inflationary pressure then the concern about inflation disappears.

In MMT inflation is also the fundamental constraint on how far you can raise spending without raising taxes. MMT also says that you do not need to worry about the deficit, but this is only true if - as they advocate - fiscal policy rather than monetary policy controls demand and inflation. Under MMT the link between the deficit and inflation is direct (assuming no change in the composition of either) .

When inflation is controlled using interest rates the situation is fundamentally different. There is now no single point at which the deficit is consistent with stable inflation. In the short term there are a whole range of interest rate/deficit combinations that keep inflation stable today (e.g. high deficit and high interest rates or low deficit and low interest rate). Does this mean we do not need to worry about the deficit and the debt it leads to because monetary policy will always take care of inflation?

The answer is no, if we think about dynamics. What happens if we choose a high deficit high interest rate combination because we want higher government spending without paying more in taxes? There are two important dynamic effects here. The most basic is that a high deficit raises the stock of government debt. Because of interest rate payments on that debt the deficit rises further. In addition raising interest rates to stop inflation will itself tend to raise debt interest payments. This is an unstable debt interest spiral. You cannot say why not fund the additional debt interest payments by creating money, because that will tend to reduce interest rates and raise inflation.

This means that over the longer term you have to adjust spending and taxes to keep government debt relative to GDP stable, That does not mean debt has to be stabilised at a particular level, but just that if there is not a compelling reason to do otherwise you need to keep debt stable rather than rising upwards. A recession is one such compelling reason, and there are others (like adding to the public sectors stock of assets).

Stability does not mean deficits have to be zero because we have to allow for the growth in GDP. The maths is simple (see [1]). Take the stock of debt to GDP as a fraction of GDP (say 0.8), multiply by the trend rate of growth of nominal GDP as a fraction (say 0.04), and you approximately have what the total deficit should be as a fraction of GDP to keep debt stable (0.032), which is a deficit of 3.2% of GDP. .

There is always the temptation for politicians to raise debt now, and let future governments stabilise debt at a higher level. In the past the US under Republicans and other countries (but not the UK) tended to let this happen in the 30 years before the GFC, and economists call it deficit bias. Fiscal rules began life because it was hoped they would reduce deficit bias.

So why not raise the level of debt by spending more for a period, and then stabilise it by cutting spending or raising taxes a generation later? Here we have to note that the stabilising deficit (the deficit that keeps debt to GDP stable) includes debt interest payment. What we call the primary deficit is the total deficit less interest payments, You should now be able to see the problem with allowing debt to increase and stabilising it later. If you raise the level of debt to GDP and then stabilise it, debt interest payments will be higher and the level of the primary deficit left over is smaller than the one you started with. This is one sense in which letting debt rise today takes from future generations. [2]

This is why it is never a good idea to increase the stock of government debt without good reason, as Trump is doing, because it either cuts spending or raises taxes in the long run. This logic does not mean that future GDP is any lower (although there may be other theoretical reasons why higher debt can reduce output), but it means that if debt to GDP is stabilised, debt interest rates will be higher and so something else has to adjust to compensate, which means higher taxes or lower spending. [3]

There is an important caveat to this dynamic, which becomes clear if you do the maths. You only get a debt interest spiral if the nominal interest rate exceeds the growth rate of GDP (call the difference between the two the ‘very real interest rate’). If the very real interest rate is negative, extra debt for a given deficit allows a higher primary balance. Journalists sometimes look at the level of debt interest as a share of GDP (currently 2% in the UK) and say government spending could be 2% of GDP higher (or taxes lower) if we didn’t have to pay interest on debt. But if you could somehow magic your debt to zero so debt interest rates were zero, the stabilising deficit would fall from a current level around 3% to 0, requiring a 3% fall in the primary balance. This reflects that the current very real interest rate is negative.

Does this mean we do not have to worry about the debt interest rate spiral, and therefore debt? Only if we know that the very real interest rate will stay negative. This is unlikely to happen, particularly if interest rates are having to rise to combat the inflationary effects of high deficits. Because debt levels should never be adjusted down quickly, it is best to act as if the very real interest rate will become positive at some point.

This is not the only reason why raising government debt to GDP in the long run can be detrimental, but this one is simple because it depends only on some basic economics, algebra and logic. This and other reasons will never be enough to justify cutting deficits in recessions, not even close. But being anti-austerity does not mean we can forget about debt completely, as long as we are using interest rates rather than fiscal policy to control demand. (On why you might want to do that see here.)

[1] G is government spending, T taxes, r is the nominal interest rate, and B the stock of debt. Little letters mean as a ratio of nominal GDP (Y). x is the growth rate of nominal GDP, delta means change in. We ignore money for reasons given in the text. The budget identity is

G - T + rB = deficit = delta B

So dividing by GDP gives

g - t + rb = deficit/Y

In continuous time (or approximately otherwise) we can write

deficit/Y = delta b + xb

So for delta b to be zero, deficit/Y = xb

Or equivalently g - t + (r-x)b = 0

[2] More strictly in this case it takes from future generations the benefits of public spending or adds to the cost of taxes, and transfers it to bond holders.

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.

Fiscal rules: politics and economics

Jonathan Portes and I have an article in Prospect, which is a short summary of our discussion paper on fiscal rules (see here or here). In this post I want to use that paper to make two observations on the interaction of politics and economics.

Jonathan and I are frequently accused of being against fiscal austerity for political or quasi-political reasons: either we dislike governments that impose austerity, or we want to increase public spending and think that by advocating temporary increases in government investment at the zero lower bound we can achieve this goal. In which case we would obviously reject any fiscal rule formulated by this government, and more generally we would be against any kind of discipline on public debt or deficits.

If that is what you think, the Prospect article or the discussion paper will have you scratching your head. After a thorough analysis of the principles behind fiscal rules (on which more below), we conclude that the form of the coalitions current fiscal mandate is about right. It makes sense to have an operational target for the deficit rather than debt, and it makes sense to target that deficit always looking five years ahead.

There is one huge caveat, which is that this form of rule is appropriate as long as interest rates are not at, or expected to be at, their zero lower bound. In this recent post I outline what we recommend in our paper should happen in those circumstances, and of course current governments have (since 2010) failed to follow this advice. So our endorsement of the form of the current fiscal mandate only applies to when monetary policy can operate in a normal fashion.

Our paper also endorses another innovation of the current UK government: the formation of the OBR. In fact we suggest that it should have additional duties. So these two structural changes brought in by the coalition, the fiscal mandate and the OBR, were positive innovations. The tragedy is that the former was applied in the one circumstance in which it should have been (temporarily) abandoned.

Of course the form of the fiscal mandate is different from the actual numbers targeted for the deficit in five years time, and I will talk about those in a subsequent post. We also have some minor suggestions to improve the rule: for example if you are targeting a deficit in five years time when monetary policy is working normally, the target does not need to be cyclically adjusted, and we would target the deficit (actual or primary) rather than the current balance, and have a separate target for the share of public investment in GDP.

There is a second sense in which our paper directly addresses the interaction between economics and politics. The way I began thinking about fiscal rules was a standard way macroeconomists think about rules: how close are they to the optimal policy that would be chosen by a benevolent policy maker? This is a perfectly sensible question to ask, but for fiscal policy it is on its own hopelessly incomplete, because we also know that politicians are often not benevolent, in the sense that they act in their own interests rather than in the interests of society as a whole. As a result, we get deficit bias, although this bias may occur for other reasons. The role of fiscal rules is to a large extent to discourage this non-benevolent behaviour.

Take the current UK fiscal mandate, for example. An obvious criticism is that, by always targeting the deficit five years ahead, it allows a government to keep putting off making the adjustments required to achieve the target. Don’t worry that the deficit is above target, a government might say, in five years time it will be on target. And it could carry on saying that year after year. In the paper we say that this rule lacks an ‘implementation incentive’.

So why not make the target for some fixed date in the future, so adjustments cannot be continually delayed. The problem with a rule of that kind is that it can produce very sub-optimal behaviour as we approach the fixed date. Our macroeconomic theory says that the deficit should be a shock absorber, so having to achieve a target at a fixed date whatever shocks hit the economy could be harmful when unexpected shocks occur near that date. Imagine how much worse austerity would have been if the government had tried to achieve current balance by 2015.

Fiscal rules therefore involve a trade-off between optimality and effectiveness in preventing non-benevolent behaviour and deficit bias. The latter depends on a political judgement about policymakers. For the UK, both past evidence and current behaviour suggests that deficit bias is not a huge problem, which is why the rolling five year deficit target can work, but in other countries it might not. This is where a fiscal council like an enhanced OBR can be very useful.

Even the more responsible governments are tempted by devices that allow spending today but which shifts costs into the future (PFI in the UK for example). It is very difficult to devise fiscal rules that involve ‘operational targets’ (i.e. targets that a government can try to meet during its term of office) but also prevent such tricks. This is an important reason to do long term fiscal forecasts, undertaken or assessed by independent institutions, which is where the costs of such schemes become evident. However that alone is not enough. A fiscal council like the OBR should also have a duty to clearly alert the public when such tricks are being played. In addition, when targets are flexible so that the implementation incentive is weak (as in the case of a rolling five year target like the UK fiscal mandate), fiscal councils should also judge on behalf of the public whether meeting the target is being delayed for justifiable reasons or not.

So the choice of a fiscal rule and the mandate of a fiscal council inevitably involve political as well economic issues. However the politics is more about the transparency and accountability of government, rather than left versus right and associated ideologies.

    

More on Naive Fiscal Cynicism

Paul Krugman is absolutely right that one of the rationales for the IMF and others framing fiscal policy in terms of the ‘speed of consolidation’ is a belief that left to themselves politicians will always and everywhere let debt rise. As he points out, the facts for the US tell a rather different story. Here I want to add a couple of additional points by looking at experience outside the US.

As should be well known by now, UK government debt was over a 100% of GDP between the wars, but declined rapidly and consistently to 50% from the second war to the mid 1970s. (See here, or this useful UK site.) The chart below, based on OBR data, takes up the story since then.

UK Debt to GDP ratio (%)

So perhaps the simplest description is that debt to GDP began to level off at around 40% of GDP (which was the target from 1998 to 2008), until the Great Recession hit. There is a lot of interesting detail here, but that would distract from the main point, which is that the UK is another clear counterexample to the idea that governments always let their debt rise.

However deficit bias is not a figment of international policymakers imagination. As I note here with Lars Calmfors, and others have noted before us, government debt in the OECD area as a whole almost doubled (40% to 75%) between the mid-70s and the mid-90s. This deficit bias came not from the UK, and not much from the US, but from Europe and Japan. (To see data on individual countries or country groups, see this nice IMF resource. [1])

So the only reasonable conclusion is that deficit bias is a problem, but not one that afflicts every government at all times. As Lars and I document, there have been various studies that have attempted to draw lessons from this diversity of experience: for example coalition governments may be more prone to deficit bias, but institutional set-ups where the finance ministry is strong less prone. My own support for fiscal councils partly stems from a desire to look for an institutional mechanism to help counter deficit bias. There is no magic bullet here, and institutional solutions will differ depending on national constitutional characteristics.

If this last point seems obviously reasonable, then lets change the dimension from across countries to across time and states of the world. While we may observe a tendency towards deficit bias in normal times, in times like now when government debt is high we seem to be observing a quite different bias - a bias towards austerity. The apparent consensus of 2008/9 that we needed fiscal stimulus looks like the aberration rather than the rule. An international organisation wanting to push sound economics needs to be doing more than arguing for a slower speed of consolidation. By advocating fiscal consolidation when the opposite is required you risk discrediting your advice at other times.

Here is another analogy. Doctors quite rightly encourage us to take more exercise. That is because we have a tendency to sit around too much, but this bias is not universal across people types or ages. Yet when we catch flu, the doctor prescribes rest, not exercise. Indeed, a good doctor may well be specific about the length of rest required, because they know too many patients may think they are better before they have fully recovered. If a doctor told us that while we had flu we should cut down from 30 minutes exercise to 15 or 10, we might begin to doubt their credentials.  

[1] To get the debt series, click on the blue subheading ‘Real GDP growth’.

Costing Incomplete Fiscal Plans: Ryan and the CBO

Some of the regular blogs I read are currently preoccupied (understandably) with the US Presidential election. This is not my territory, but the role of fiscal councils – in this case the CBO – in costing budget proposals is, and the two connect with the analysis of the Ryan budget plan. The Ryan ‘plan’ involves cutting the US budget deficit, but contains hardly any specifics about how that will be done.

There is nothing unique to the US here. In the 2010 UK elections, both main parties acknowledged the need for substantial reductions in the budget deficit over time, but neither party fully specified how these would be achieved. Now as the appropriate speed of deficit reduction was a key election issue, this might seem surprising. In particular, why did one party not fully specify its deficit reduction programme, and then gain votes by suggesting the other was not serious about the issue?

The answer has to be that any gains in making the plans credible would be outweighed by the political costs of upsetting all those who would lose out on specific measures. People can sign up to lower deficits, as long as achieving them does not involve increasing their taxes or reducing their benefits. However, I think it’s more than this. If people were fully aware of the implications of what deficit reduction plans might entail, you would guess that lack of information might be even more damaging than full information. As people tend to be risk averse, the (more widespread) fear that their benefits might be cut could be more costly in electoral terms than a smaller number knowing the truth.

The fact that this logic does not operate suggests to me that (at least among swing voters) there is a bigger disconnect in people’s minds between aggregate deficit plans and specific measures. Saying you will be tough on the deficit does not panic swing voters, but adds to your credibility in being serious about the deficit ‘problem’. Indeed, from my memory of the UK election, claims by one side about secret plans of the other were effectively neutralised as scaremongering.

This can be seen as the reverse side of a familiar cause of deficit bias. A political party can gain votes by promising things to specific sections of the electorate, but does not lose as many votes because of worries about how this will be paid for. The media can correct this bias by insisting on asking where the money will come from (or in the reverse case, where the cuts will come from), but they may have limited ability to check or interrogate the answer. This is where a fiscal council, which has authority as a result of being set by government but also independent of government, can be useful.

For some time the Netherlands Bureau for Economic Policy Analysis (often called the CPB) has offered to cost political parties fiscal proposals before elections. The interesting result is that all the major parties take up this offer. Not having your fiscal plans independently assessed appears to be a net political cost.

What the fiscal council is doing in this case is conferring an element of legitimacy on aggregate fiscal plans, a legitimacy that is more valuable than uncosted fiscal sweeteners. Which brings me to the question of what a fiscal council should do if these plans are clearly incomplete? In particular, suppose plans include some specific proposals that are deficit increasing or neutral, but unspecified plans to raise taxes or cut spending which lead to the deficit being reduced. By ‘should do’ here I do not mean what it is legally obliged to do, but what would be the right thing to do.

It seems to me clear that the right thing to do is not to cost the overall budget. What, after all, is being achieved by doing so? Many people or organisations can put a set of numbers for aggregate spending and taxes into a spreadsheet and calculate implied deficits, and the adding up can easily be checked. By getting the fiscal council to do this fairly trivial task serves no other purpose than to give the plan a legitimacy that it does not have.

In this situation, a fiscal council that does calculate deficit numbers for a plan that leaves out all the specifics is actually doing some harm. Instead of asking the difficult questions, it is giving others cover to avoid answering them. It is no excuse to say that what was done is clear in the text of the report. The fiscal council is there partly so people do not have to read the report. So I wonder if the CBO had any discretion in this respect. If Ryan was playing the system, perhaps the system needs changing to give the CBO a little more independence. 

Is it all Gordon Brown’s fault?

                Someone reading my recent post on major UK macro policy errors asked whether my blog was becoming more political. I hope not, in the sense of being party political for its own sake. However, when the issue involves macroeconomic policy, then I do my best to say what I think is right rather than what is politically expedient. This is in part because I have very negative views about the role of ideology (left or right) in influencing economics. (Incidentally, I do react badly to those who say ‘ah, but all theory is ideological, it’s just that you pretend what you do is ideology free’. I guess this makes me one of those old fashioned fogeys who believe in the possibility of evidence based social science.)

                Perhaps this is why I have not so far explicitly commented on the oft repeated refrain by the current government that austerity is necessary to ‘clear up the mess’ left by excessive deficits under Gordon Brown? It is nonsense of course, but like all the best slogans it contains a half-truth. I think it is certainly true in hindsight, and almost certainly true ex ante, that spending in the later Brown years was underfunded (or excessive, depending on your viewpoint). By exactly how much I plan to explore in more detail for a paper over the next few months. The untruth, of course, is that this problem had to be corrected immediately and quickly during a recession.

                This issue arose from my recent post where I listed what I considered to be the three major UK macroeconomic policy errors over the last 30 years. I said that underfunded spending by Brown was an error, but that I did not consider it a major one because it did not lead to the same scale of welfare losses that occurred when unemployment became unnecessarily high (like now). Chris Brown commented that “The loss in social welfare [caused by excessive deficits in a boom] is never felt at the time of the increase in government spending (the reverse is true) but after the party is over (i.e. today)”.

                I think this comment is right in two ways, but nevertheless it does not imply that Brown’s underfunding was a major error. Let’s start with where I agree. First, additional spending paid for by debt which is then paid off at some future date by cutting spending clearly raises welfare today but reduces it tomorrow. If the additional debt is paid for by raising future taxes (i.e. we are permanently increasing the size of the state) then the situation is more complicated. If consumers are completely Ricardian then the timing of the tax increase does not matter for welfare, but let’s leave that complication to one side. Second, I agree that pro-cyclicality in spending decisions is a common vice, and that because it tends to be asymmetric (it happens more often in booms than recessions) it can lead to deficit bias. This is certainly bad policy.

                But are the welfare costs of this that high? Not, in my view, if the subsequent correction is done at the appropriate time. To take a simple case, suppose monetary policy is able to completely offset the demand impact of both the excessive spending, and the subsequent cut in spending designed to pay off the additional debt. The only welfare cost then is an intertemporal misallocation of public goods. It is my judgement that these costs are of an order smaller than the costs created by raising unemployment by a few hundred thousand for a few years when unemployment is already high. (I have to say judgement here, because most formal analysis of measuring the welfare costs of business cycles takes place in representative agent models where ‘unemployment’ just means everyone working a few less hours. This does not begin to capture the true impact of unemployment on well being.)

                Now if it was true that the additional unemployment caused by austerity today was an inevitable consequence of underfunding in the Brown years, then the comment would be exactly right. But it is not. Paying off the debt created by the underfunding should be done during the next boom, and not now. As a result, Gordon Brown’s error gets relegated to minor status when compared to what is happening now.                

Austerity and not wasting a crisis

                In the austerity versus stimulus debate, I argue from a macroeconomic point of view that this is a false choice if we are talking about economies where markets are eager to buy government debt i.e. pretty well everywhere apart from the Eurozone. In the short term we need stimulus, whereas fiscal discipline is a long term problem. We need to raise taxes and cut spending when times are good, not when times are bad. The Eurozone 2000-2007 is a clear example of when this should have happened.

                The response is often to concede the macroeconomic logic, but say that promises of austerity tomorrow cannot be trusted. It is easy to promise, but when tomorrow comes governments will break that promise. This resonates, but it is less clear what the underlying logic is. We can all agree that governments are subject to deficit bias. There are a number of reasons for this: the common pool problem, over optimistic forecasts, political impatience stemming from elections etc. (See Calmfors and Wren-Lewis, 2011, for a more complete account.) However bias stemming from these causes is fairly constant: it does not disappear when deficits are high and only materialize in good times.

                I sometimes put it this way. Suppose the government did go for fiscal stimulus today, and this helped lead to a macroeconomic recovery. Once the recovery was complete, the underlying fiscal position (i.e. the structural or cyclically adjusted deficit) would be a little worse than today, because the stimulus would have added to debt. So if a politician is prepared to undertake austerity today, they will be even more willing to undertake it tomorrow. Of course following a recovery the actual (rather than structural) deficit may be smaller, but is our macroeconomic discourse that naive?

                In economics we are of course used to the optimal policy changing solely as the result of the passage of time (time inconsistency). A central bank may promise to keep interest rates high for some time to reduce inflation today, but come tomorrow when the policy has done its job it becomes optimal to reduce interest rates. However when it comes to fiscal policy and deficit bias, the role of time inconsistency seems less central. The problem is not that we have a benevolent policy maker that is subject to a time inconsistency temptation; it is that we do not have a benevolent policy maker.

                Having said this, I think many feel that, when governments are prepared to act ‘out of character’ and impose restraints on themselves, this chance should be grabbed before it disappears. It is often possible, when looking at countries where government debt is not a major problem, to trace this back to changes made following a fiscal crisis. Lars Calmfors has a nice account of the Swedish case here. So can we rationalise this idea? Perhaps a crisis, and therefore the chance to act, is not governed by the level of debt (funding problems aside), but by its rate of change. So governments became prepared to impose austerity when debt started rising rapidly following the recession, but if nothing was done and debt remained high, the political imperative would gradually disappear. Higher debt would become the new normal.

                However I still have problems with this line of reasoning. As Lars emphasises, Sweden was successful because it instituted a comprehensive set of reforms following the crisis, including a fiscal target to be achieved over the course of the cycle. It was also successful because a large nominal depreciation boosted output growth, more than offsetting the deflationary impact of fiscal consolidation. The world as a whole cannot use this trick, so an important condition for successful global fiscal consolidation is missing. However countries could establish rules today that were designed to only begin operating when the economy has recovered. Use the current crisis to get the rules established, but recognise that their implementation needs to be delayed because of the recession.

                It is often said that instituting rules that only operate once the recovery is complete will ‘not be credible’. Here is the time inconsistency analogy again, and (funding crisis aside) it seems equally inappropriate. We just need to ask: credible to whom? Is a government that commits to future austerity that begins tomorrow, any more likely to renege in the future than that same government that commits to long term austerity and starts it today? We could argue the opposite: an austerity plan in conjunction with a recession is more likely to come unstuck.

                I think a mistake we can make here is to imagine we are trying to discover the preferences of two different governments. In that case, a government that just promises future austerity tells us very little, because it could just be cheap talk. If a government undertakes austerity now, we know more through its actions. However that is not what the current debate is about. In practice we have governments that are prepared to undertake austerity now. They have demonstrated that they take the debt problem seriously. Are these preferences going to change if we delay austerity until after the recovery?

                So let us, by all means, not waste a fiscal crisis. Use it to set out a combination of rules and institutional changes that avoid deficit bias in the future. However I do not see why it is politically impossible to delay the implementation of those rules until after the recession is over. But maybe I’m just displaying my ignorance of political science.