Fiscal policy during and after the coronavirus pandemic

 

This post was partly inspired by this recent seminar, but also by this excellent paper from The Resolution Foundation. Apologies for the length, but there is a lot to cover. 

This post is in five parts. The first looks at how our understanding of fiscal policy has evolved over the last decade or so. It is an essential background to how fiscal policy should be employed during the pandemic. The second looks at fiscal policy support during the pandemic. The third looks at what could be quite a short period between when the pandemic is effectively over as a result of mass vaccination, and when the economy has fully recovered. The fourth asks whether, once the economic recovery is complete, we should attempt to gradually reduce the debt to GDP ratio. Finally I look at the Chancellor's recent actions and how they are reported by the media.

Background

Just before the Global Financial Crisis (GFC), I talked of a Consensus Assignment between monetary and fiscal policy. Here is a quote from the introduction.

“The consensus assignment from the title refers to the idea that monetary policy (in a closed economy, or a small open economy with flexible exchange rates)5 should normally focus on business cycle stabilisation and inflation control, while fiscal policy (at the macro level) should focus on the control of government debt or deficits. This conventional assignment leaves open the possibility of using fiscal policy in situations where monetary policy is constrained in some way, either by design (such as a monetary union member subject to asymmetric shocks) or misfortune (where interest rates hit a zero lower bound). It is a consensus only if it applies to situations in which monetary policy is unconstrained in its ability to stabilise the business cycle.”

I did not know it at the time, but that caveat concerning the lower bound for interest rates was going to become the Achilles Heel of the Consensus Assignment.

Having written that paragraph, it was obvious to me that when countries hit the lower bound for interest rates during the GFC, fiscal stimulus would be essential to speed up the recovery from that recession. Unconventional monetary policy, almost by definition (‘unconventional’), was not going to be as reliable as fiscal policy and therefore would be an inferior stabilisation instrument.

In the years following the GFC it became clear to many academic macroeconomists that the GFC was not going to be an exception in driving interest rates to their lower bound. What has been called secular stagnation is the phenomenon that the underlying or equilibrium real interest is now so low that downturns would often trigger rates hitting their lower bound. This in turn means that what I called the consensus assignment has to change.

In my view, and the view of an increasingly large number of academics, we need a new assignment that includes fiscal policy stabilisation at least some of the time. The MMT school suggests switching the old assignment around, and using fiscal policy at all times to stabilise demand. However that seems to ignore our pre-GFC history, where monetary policy was very successful at stopping domestically generated inflation expectations exceeding an inflation target.

The alternative I have recently called the state dependent assignment uses fiscal policy to help stabilise recessions, and monetary policy to help stabilise inflation. When fiscal policy is being used to fight a recession, fiscal policymakers should be completely unconcerned about what is happening to government deficits and debt. The time for fiscal policy makers to focus on deficits and debt is when we have largely recovered from a recession. The obvious way to measure when fiscal policy should switch from stabilising the economy to stabilising debt is when interest rates are no longer at their lower bound. (Lags between fiscal policy decisions and the impact of fiscal policy on demand means that the switch point cannot be that simple in practice, but the key point to remember is that the costs of too much fiscal stimulus are far less than the costs of too little.)

Fiscal policy during this pandemic

The need for fiscal stimulus is acute when economies suffer from large demand shocks. There has been endless debate among macroeconomists about whether the pandemic represents a demand shock or a supply shock. When I began looking over a decade ago with public health experts at the economic effects of flu pandemic (paper here), I started off thinking about the pandemic as a supply shock and ended up realising that a severe pandemic would mainly be a demand shock.

With mild flu pandemics, the main economic effects are supply-side, such as people taking a couple of weeks off work. However with severe pandemics, many people take active steps to try and avoid catching the virus. That means they cut back on, or may even stop completely, forms of social consumption: going to shops, pubs or restaurants, going to public sporting or cultural events and so on. What surprised me when thinking about the extent of the demand fall that produces was that social consumption accounts for around a third of total consumption. A government lockdown may enhance and extend that response.

Does that all imply the need for massive fiscal stimulus? Yes and no. First the yes. What should be clear is that whatever reduces the extent of the virus is good for the economy beyond the short term. The economy just will not recover while the risk of catching the virus is perceived to be significant, because social consumption will remain depressed. The most important way fiscal policy can help in eliminating the virus is by providing support to those workers and firms that suffer from the reduction in social consumption. A possible but imperfect analogy is with the automatic stabilisers that work in a normal recession.

The no relates to whether additional substantial stimulus is required beyond that already supplied by rates at their lower bound. As the previous section made clear, for a normal recession that is essential. But the pandemic is not a normal recession, for two reasons. The first is that the demand shock is sector specific. A standard fiscal stimulus like a tax cut is likely to increase demand in sectors that have not been hit by the virus.

You could get round this with a sector specific stimulus, but then we hit the second problem, which is that to the extent that stimulus is effective it will make the pandemic worse. That was the ultimate fate of the Chancellor’s Eat Out to Help Out scheme. The conclusion has to be that if fiscal support measures are comprehensive, then the case for a large additional fiscal stimulus is weak. (For more formal analysis, see Woodford and references therein.) If support is not comprehensive, or largely absent as in the US, then the case for stimulus to reduce unemployment is much stronger.

When the pandemic is over

The Chancellor has indicated that he is prepared to look at measures to boost the economy once the pandemic is over. This would make sense if consumers are slow to resume social consumption even though it is quite safe to do so. The last proviso is critical, if the Chancellor wants to avoid stimulating the pandemic as well as the economy (in only the short term).

But will consumers in aggregate be over-cautious. In that study I did a decade ago looking at a flu pandemic, I made the assumption that consumers might to a limited extent binge on social consumption once the pandemic was over. After all consumers who have continued working or have benefited from fiscal support will have increased their wealth significantly by not spending on social consumption during the pandemic. In realistic models of consumption consumers will begin to unwind some of that when the pandemic ends.

This suggests that any fiscal stimulus during the recovery phase should focus on the public rather than private sector, and particularly public investment. There is little point in trying to second guess how much permanent scarring the pandemic has left, so as I noted earlier it is always better to assume there is a demand gap, because the costs of being wrong (a short term inflation blip) are much less than the cost of assuming potential output is lower than it actually is.

What is clear is that we have a desperate need for public investment. The government is planning investment worth, in net terms, just under 3% of GDP each year. That is high by recent historical standards, but when you think of all we need to do to reduce the extent of climate change and the risks from climate change, it is probably inadequate. There are many other areas where public investment is needed. 

When the economy has recovered

I have not mentioned government deficits or debt until now, for the very good reason that they are irrelevant in a recession. The mistake of UK policy after 2010 should never be repeated. But when short term interest rates rise significantly because of clear inflationary pressure because the recovery is complete, then this the time to switch to monetary stabilisation and allow fiscal policy to focus on government debt.

In my paper with Jonathan Portes, we argued that in normal times a medium term rolling deficit target should be set with the aim of achieving some long term trajectory for the government debt to GDP ratio. However given the need for substantial government investment already mentioned, a better measure might be government net wealth (net worth) to GDP. After the pandemic net wealth will be well below levels seen before the pandemic, and there is a case for setting a deficit to achieve a very gradual increase in that ratio over time. If that requires fiscal consolidation, there is an overwhelming case that this should be achieved using tax increases rather than spending cuts. Indeed in a number of areas there is a strong case for increasing current government spending, and once the recession is over and interest rates are well above their lower bound because domestically generated inflation is likely to permanently exceed its target, these need to be matched by higher taxes.

However even when the economy has recovered from the recession caused by the pandemic, we will not be in normal times. The threat of man made climate change is now both very real and imminent. As I have already argued, public investment aimed to achieve our carbon emission targets, like all public investment, should not be restrained by any fiscal rule. The argument that the polluter pays still holds, which means taxes to discourage carbon production and use are essential.

All of this is perfectly compatible with a gradual increase in the government’s net wealth ratio, and indeed carbon taxes should help here. The political problem that may arise, and anticipated in the Green New Deal in 2008, is that it may be politically impossible to enact the necessary taxes without compensating fiscal rebates of various kinds. We live in an imperfect information world, or more accurately a misinformation world, and as a result it is tempting for some political parties to pretend measures to prevent climate change can be achieved with no costs, or worse still that deny the problem is imminent.

If that turns out to be true, the least important goal is an increase in the net wealth ratio or a reduction in the government’s debt to GDP ratio. If we fail to tackle climate change, and in 50 years time our children or grandchildren are suffering the consequences of significant global warming, they will not forgive us failing to do what needed to be done because we were ‘responsible’ with the public finances.

Austerity redux?

As I have tried to stress, looking after our public finances is a second order problem compared to the first order problems of supporting people during the pandemic, getting a complete economic recovery and tackling climate change. I think most academic macroeconomists would agree with that, and the IMF also agrees with that.

However, you wouldn’t know that from the discourse of the Chancellor and from much of the media. The notion that the government’s finances are like that of a household should have been well and truly buried after the disaster of 2010 austerity, yet they live on among many of the political journalists you will see on the broadcast media. (There are, unlike 2010, a few notable exceptions.)

When we talk about a possible repeat of austerity, we have to be careful what we mean. The original spending cuts from the 2010-18 period have only been partially unwound. What people therefore mean by a second round of austerity is yet further cut backs in spending or tax increases. The first period of austerity was a disaster for two reasons. The first was that the supply of public spending was cut without any attempt to reduce the demand for public services, so problems with services for health, welfare, prisons, police, the justice system and much more were inevitable. The idea that there were substantial efficiency gains in all this provision proved largely mythical.

The second reason it was a disaster is macroeconomic. In a recession due to demand deficiency, taking more demand out of the economy is bound to make things worse if interest rates are stuck at their lower bound. (If demand was not deficient interest rates would be well above the lower bound, and could therefore fall to boost demand and compensate for the demand impact of fiscal consolidation.) If you continue austerity during a period of deficient demand for a number of years there is a significant danger that output will be permanently lower as a result.

Given all this, why does the Chancellor encourage talk of austerity while we are still coping with the pandemic? The obvious answer is that it provides cover for essentially political decisions, like cutting the aid budget or the real wages of public sector employees, while increasing spending on defence. It provides cover because the media (what I call mediamacro) is still largely using the household analogy when it comes to government debt. 

An equally serious problem is that the political cycle in the UK is likely to lead to decisions being taken at the wrong time. If taxes do need to rise, they must only rise after the recovery is complete. That might be in 2023 and 2024. Only then will be know the recovery is complete, because interest rates are significantly higher in an attempt to prevent a rise in inflation becoming permanent. The Chancellor and government might think this timing will jeopardize their re-election chances. This leaves a danger that tax rises (or worse still public spending cuts) happen earlier, which might damage the recovery. The alternative that tax rises are delayed until after the election carries much smaller economic costs.

Some thoughts on Labour's campaign

The importance of this election cannot be overstated. Voters have a choice between re-electing a government that since 2010 has done untold damage to this country and which will be led by someone totally unsuited to be Prime Minister, or giving a minority Labour government a chance to do better for a few years. The fact that the polls suggest the public want more of the same illustrates how close we are to becoming an authoritarian, populist (in the Jan-Werner Müller sense) right wing state where it becomes very difficult for any opposition to break through.

This post looks at some key aspects of Labour's campaign so far, in I hope a helpful fashion.

Tax and spend

One of the dangers Labour faces is that they appear to be promising too much. Voters are skeptical of manifesto promises at the best of times, even though evidence suggests that in the past most manifesto pledges are fulfilled. If you promise so much it is possible voters will just not believe you can do all this.

In contrast the Tory manifesto is positively frugal. But there is a reason for this, and neither Labour nor the Liberal Democrats have emphasized enough why that is. Labour are not used to trumpeting the results of IFS election analysis, but on this occasion they really should. That analysis shows that one economic issue alone dominates the future of the public finances: Brexit. Here is the key chart

What this chart shows is that all these give-aways do not come close to matching the amount of tax we will lose if Johnson keeps his pledge not to extend the transition period. The reason the Tory manifesto is frugal is they cannot afford to do anything with any fiscal cost and implement a hard or no deal Brexit. Both Labour and the Liberal Democrats can afford much more, because they are not planning a hard Brexit. 

Perhaps Labour and the Liberal Democrats are reluctant to talk about this because it is going over ground covered in the referendum, and most Leavers just do not believe the economic consequences of Brexit will be negative. Yet the IFS has considerable credibility, particularly in the media. Furthermore the sparse Tory manifesto is a tactic admission that, whatever they say, the Tories believe the economy will take a hit from Brexit. Labour and the Liberal Democrats should make more of this. 

Protecting minorities

Labour should not just be defensive on charges of antisemitism. These attacks on Labour over the small amount of antisemitism among members distract not only from the more extensive racism in the Tory party and its actions, as Jonathan Lis describes so clearly here. It also distracts from the rise of right wing hate-crime. That the problem is growing is pretty clear. Attacks mostly involve race and sexual orientation, but it includes attacks based on religion: mainly Muslims but also Jews. Commenting on the steady rise in ethnic or religious hate crimes Dr Chris Allen said:

“The statistics show that for the third year in succession, religiously motivated hate crimes have not only increased in number but have again reached record levels. While some try to explain this as a result of better reporting procedures, doing so is over simplistic. From our research at the Centre for Hate Studies, one cannot underestimate the impact of Brexit and the divisive rhetoric employed by politicians and others in the public spaces. Affording permission to hate a whole range of ‘Others’ – especially Muslims and immigrants – it is likely that the upward trajectory of hate crimes numbers will continue for the foreseeable future.”

The police say that the alt-right is the fastest growing terrorist threat in the UK. A third of all terror plots to kill in Britain since 2017 – seven out of 22 – were by those driven by extreme-right causes.There is nothing comparable on the left. One Labour MP was tragically killed by a far-right terrorist during the Brexit campaign, and at least one serious plot against another has subsequently been foiled. The alt-right is well organised at an international level

What has that got to do with this election? The rise of the far right did not come from out of the blue. Campaigns against immigration, and particularly for Brexit, have encouraged racists into the open. So has over the top language used by Brexiters. It has mainstreamed xenophobia, and maxed out on crude nationalism. The media, particularly the right wing media, are happy to give a voice to anti-Muslim writers.

What will the current government, if it wins this election, do when Brexit does not lead to any improvement in people’s lives, and indeed makes them worse? The Tory manifesto has virtually nothing about redistributing opportunities in a more equal way across the country, and Brexit will not help. If the recent past is anything to go by, they will blame immigrants even more than they do now, which will only increase the threat from the far right.

Scotland

Do you remember pictures of Ed Miliband in Alex Salmond’s pocket? These came from the Tories towards the end of the 2015 election, when it became clear that Labour could only win with the SNP’s help. It wasn’t repeated in 2017, in part I suspect because no one on the Tory side believed Labour would do anywhere near well enough to make that attack line effective. I suspect they will not make the same mistake this time around.

The Tory attack was credited by some as helping Cameron get his majority, although I have no idea how true that is. But if Labour is attacked along these lines in a serious way in the final days of the campaign, what should they do? They shouldn’t do what they have done so far, and just say they will not do any deals. This doesn’t work because voters believe maths more than they believe politicians, and they remember the 2010 Coalition talks and the Tory give-away to the DUP.

What Labour should do instead is dig out one of the quotes where Sturgeon has ruled out allowing the Tories back into government and repeat it endlessly. If any interviewer asks why that is relevant simply point out in the most tactful way that the SNP only has bargaining power over Labour if they are prepared to put the Tories in power instead, and they have ruled that out because it would be political suicide for them. Not putting the Tories in power means they have no leverage over Labour.

The last week

The SNP (and of course antisemitism and law & order) are going to be part of the Tory’s lines to take in the final week, and they are likely to throw in a letter from business leaders if they can find enough willing to sign it despite Brexit. What should Labour emphasise? There is an embarrassment of riches to choose from. They could talk about

Revitalising the economy with public investment directed at the regions

Building more social housing

A Final Say on Brexit

Nationalisation and Free Broadband

Education

Revitalising bus services

A Green New Deal

Saving the NHS

And probably much more that I have forgotten about. Talk about them all and there is a danger nothing really hits home. More than ever before there will be an intense battle between the two major parties to get the media to talk about the topic they want talked about. In 2015 the media chose the SNP rather than the NHS which Miliband wanted to be the focus. In hindsight that represented terrible judgement by the media, but importance isn’t their key consideration.

What works best in getting airtime is to present something new. It could be a letter on the Tories climate change policy like this. It could be a new statistic on poor health service performance which should not be hard to find, or some gaffe by a senior Tory (like this). They can always use this. These are also the two obvious issues to focus on in the final day or two.

On climate change you can say that we cannot waste another five years before we take serious action. This is aimed, above all, at getting out Labour’s core younger vote. The NHS will have much greater resonance with the Tory core vote, and might discourage these voters from voting at all. On the morning of the election the newspapers most elderly people read will be full of scare stories about Corbyn, so Labour needs concerns about the safety of the NHS under Johnson, Trump and Brexit to counteract that.

Fiscal policy remains in the stone age

Or maybe the middle ages, but certainly not anything more recent than the 1920s. Keynes advocated using fiscal expansion in what he called a liquidity trap in the 1930s. Nowadays we use a different terminology, and talk about the need for fiscal expansion when nominal interest rates are stuck at the Zero Lower Bound or Effective Lower Bound. (I slightly prefer the latter terminology because it is up to central banks to decide at what point reducing nominal interest rates further would be risky or counterproductive.) The logic is the same today as it was in the 1930s. When monetary policy loses its reliable and effective instrument to manage the economy, you need to bring in the next best reliable and effective instrument: fiscal policy.

The Eurozone as a whole is currently at the effective lower bound. Rates are just below zero and the ECB is creating money for large scale purchases of assets: a monetary policy instrument whose impact is much more uncertain than interest rate changes or fiscal policy changes (but certainly better than nothing). The reason monetary policy is at maximum stimulus setting is that Eurozone core inflation seems stuck at 1% or below. Time, clearly, for fiscal policy to start lending a hand with some fiscal stimulus.

Yet the goal of the new German Finance minister, from the supposedly left wing Social Democrats, is to achieve a budget surplus of 1%. To achieve that he is cutting public investment from 37.9 billion euros in the coming year to 33.5 billion euros by 2020. Yet German infrastructure, once world renowned, is falling apart. Its broadband connectivity could be greatly improved.

The macroeconomic case for a more expansionary German fiscal policy is overwhelming. Germany has a current account surplus of around 8% of GDP. There are some structural reasons why you might expect some current account surplus in Germany, but the IMF estimates that these structural factors account for less than half of the current surplus. It estimates that a third of the excess surplus is a result of an overly tight fiscal policy. As Guntram Wolff points out, the main counterpart to the surplus is saving by the corporate sector. Perhaps more public investment might encourage additional private investment.

But this is not another article about how Germany needs to expand to help the rest of the Eurozone. The problem, as Matthew Klein points out, is that the whole of the Eurozone is doing the same. In the area as a whole, the fiscal position is as tight as it was in the pre-crisis boom. Unemployment in the Eurozone is still too high. And the reason fiscal policy is too tight is that key Eurozone policymakers think that is the right thing to do. “The right deficit is zero” says the French finance minister. He goes on: “ Since France is not in an economic crisis, we need to have a balanced budget, so that we can afford a deficit in tougher times.” You hear the same in Germany: the economy is booming so we must have budget surpluses.

A booming economy is not one that is growing fast, but is one where the level of output and employment is above the level compatible with staying at target inflation. Measures of the output gap are only estimates of what that level is: underlying inflation is the ultimate guide. Core inflation is well below target right now, which is why interest rates are at their effective lower bound. This is why the actions and rhetoric of most European (and UK) finance ministers are simply wrong.

You would think that causing a second recession after the one following the GFC would have been a wake up call for European finance ministers to learn some macroeconomics. (Yes, I know that the ECB raising rates in 2011 did not help, but I expect most macro models will tell you the collective fiscal contraction did most of the harm.) Yet what little learning there has been is not to make huge mistakes but only large ones: we should balance the budget when there is no crisis.

This is not a dispute between left and right as it is now in the UK, but a problem with the policy consensus in Europe. What we are seeing I suspect is a potent combination of two forces: a German obsession with balancing the budget which has it roots in currently dominant ordoliberal/neoliberal ideology, and Keynes famous practical men: advisers who learnt what economics they have in an era of the great moderation where the worst economic problem we had was relatively benign deficit bias. Fighting the last war and all that.

Should we demand ‘fully costed’ programmes?

Chris Dillow says we should not, and indeed that journalists who constantly ask ‘where is the money coming from’ are pandering to the idea that the height of economic competence for any government is to balance the books. I think his argument makes some good points, but taken at face value it is untenable.

To see why it is untenable, imagine a political party that promised to increase public spending, cut taxes, cut back on borrowing and let the central bank control inflation. Should journalists simply let that pass, as if the government budget constraint no longer existed?

You could respond by saying that a government that promised the earth would obviously not be credible. The problem with that argument is that a majority of the British people recently voted for a plan that would damage trade with our largest trading partner and most of that majority still believed they would be no worse off as a result. It is part of a journalist’s job to remind the public that basic trade-offs and constraints exist.

But I think Chris is right about individual policy measures. It makes little sense to require that each item of addition spending is matched to a measure to raise additional revenue, because this is not how fiscal policy actually works in any country. Whether all taxes should be tied to particular items of spending (hypothecation) is an interesting issue well beyond the scope of this post. Given this is not how current fiscal systems work, journalists and politicians should not encourage a belief that it is.

But if Chris is right about individual policy measures, when do we get the discussion of the overall fiscal picture that I argue is necessary? The answer is a simple demarcation. If an individual spending minister or shadow minister is proposing a particular measure, don’t ask them how it will be paid for. Instead ask them whether that measure makes sense on its own merits, and why doing something else within that minister’s remit would not be more preferable. For example ask an education minister whether it wouldn’t be better to avoid coming cuts to school budgets rather than spending money on grammar schools or cutting tuition fees.

On the other hand, if the actual or potential Chancellor is being questioned, it makes sense to ask whether the programme as a whole would increase or decrease borrowing. Chris is right that all a Chancellor can do is plan for a particular level of borrowing, but that alone is insufficient grounds for not asking about their plans. Instead what it suggests is a good line of questioning for journalists: if the deficit unexpectedly increases/decreases what would you do? With any luck that sort of discussion could involve some macroeconomics that went beyond bookkeeping.

It is here that we can judge macroeconomic competency. In the current context, for example, any politician that fails to note that we are in a liquidity trap (interest rates are close to their floor and the central bank is increasing the extent of its unconventional monetary policy) and that therefore some temporary borrowing on current account would be a good thing is either not competent or is for some other reason still attached to austerity. Any politician that says we must target the overall deficit rather than the current deficit and thereby hold back public investment despite real interest rates being approximately zero is not competent.

A really intelligent way of helping the electorate judge these issues during elections is to enable the OBR to cost the programmes of the main political parties, as the Netherland’s fiscal council does. All it would need is a modest increase in resources for the OBR, which would be a small price to pay to improve the level of public debate. Ed Balls asked for that in 2015, but Osborne refused. It was typically short sighted, because at the same time he could have given them the remit to cost the implications of leaving the EU. That would have allowed the OBR to tell us that Brexit would cost the government around £15 billion a year (Table B1) before rather than after the vote. If the assessment of the economic costs of Brexit had come from the independent OBR rather than the Treasury, that alone might have been enough to change the result.

Reactionary Keynesianism

Under Donald Trump we might get what some have called Reactionary Keynesianism. But a stimulus is a stimulus, right, and for those of us who think most OECD economies should be ‘run hot’ to try and make up some of the ground still lost from the Great Recession any fiscal stimulus should be welcomed? So Martin Sandbu writes

“it is hypocritical of anyone to warn that Trump’s promised tax cuts will endanger the public finances if they called for fiscal stimulus under Obama and his putative Democratic successor. …. While the composition of tax cuts and spending increases may matter, the overall size of any deficit increase matters at least as much.”

If by this he means don’t worry too much about the composition, the overall size of the deficit is more important, I think this is terrible macroeconomics. It is foolish to believe that anything that raises the deficit will stimulate.

We know that a part of any Trump stimulus will be large tax breaks for the very rich. The very rich will almost certainly consume virtually none of this tax break in the short term. It is the one part of the population where Ricardian Equivalence almost holds. You might think that therefore it does at least do no harm to short term aggregate demand. But this could be wrong, because the logic of the intertemporal budget constraint still operates. Those tax cuts will not be paid for by higher activity in the short term, so they may mean higher taxes down the road. Now if people who are not very rich think that these might be their taxes that are increased down the road, they will reduce their consumption today. The net effect could be a drop in demand.

You may think that consumers may not be so foresighted, so demand will not actually fall. But the logic of the intertemporal budget constraint still holds. If tax cuts for the rich just raise the deficit with almost no short run demand boost, then that is a transfer to the rich today from the non-rich tomorrow. If tax cuts for the rich were paid for by tax increases on everyone else today many politicians would be up in arms. Delaying the tax increase on everyone else by borrowing is a trick that should be seen straight through.

Yet I fear this is still not the case, and talking about tax cuts for the rich as part of a stimulus just helps confuse politicians. Those on the right understand this: tax cuts for the rich are nearly always part of a general stimulus: when Nigel Lawson did this it helped bust the UK economy. We should just repeat again and again: tax cuts for the rich paid for by borrowing are really tax increases for everyone else.

The example of tax cuts for the rich is the example that refutes the general proposition that the composition of any fiscal stimulus matters less than the overall size of any increase in the deficit.

Trump has also said he wants more investment in public infrastructure. That is something the US desperately needs, but remember that Trump will usher in an era of crony capitalism and politics like never before. The infrastructure that you might get could be far from the infrastructure the US actually needs, and instead may be whatever buys votes or other kinds of deals that help a Trump administration. Now if that infrastructure was produced entirely by those who otherwise would be out of the workforce but would like the jobs involved, then aggregate welfare would still increase: it is Keynes’s famous digging holes example. But in practice that seems unlikely to be completely or even mainly true, and so these white elephants may in practice crowd out better projects. In that case US citizens would not be better off in the short term as a result of this fiscal stimulus, even if GDP did rise. And the stimulus would not pay for itself, so once again other people should worry about the government’s intertemporal budget constraint.

If the economics of Reactionary Keynesian is bad, I think the politics is even worse. Quite simply, by achieving very little beyond redistributing to the rich and unworthy, it gives Keynesian policy a bad name. But we can avoid that, when we can, by not calling every increase in the deficit a stimulus. And by saying tax cuts for the rich paid for by borrowing are really tax increases for everyone else.

Defending George Osborne on Brexit once again

When a good part of the electorate are in cloud cuckoo land, you may have to leave planet earth to talk to them.

Economists are pretty certain - as certain as they ever are - that Brexit will reduce medium to long term growth relative to staying in the EU. A large section of the UK public either do not know that, or do not believe them. They have been told, in some cases by people that should know better, that these assessments by economists are ‘just another forecast’. They are told that economists cannot forecast one year ahead, so how can they possibly know what will happen in 10 years time. [1]

Against this they have the certainty that you cannot control EU migration from within the EU. They feel intuitively that austerity was the right thing to do, and the government confirms this, so the pressure they see on public services must be due to immigration. The papers they read say this day in and day out, and never mention that migration helps the public finances. And then there is the money - however much it is - that we would certainly save by not paying into the EU budget.

As a Chancellor you know this is fantasy. You know the OBR will take account of consensus opinion after Brexit and revise down their projection of UK trend growth over the next decade or two. You know that will inevitably mean lower tax receipts, so you will have to raise taxes or cut spending at some point. But you also know that if you try and add realism, by saying this might not have to happen immediately (and should not happen immediately if Brexit causes a short term recession), you just muddle the message. So to bring home to people this is not just ‘another forecast’, you talk about an emergency budget immediately after Brexit.

Is that scaremongering? Well it is not in the same league as pretending we will soon be ‘flooded’ with Turkish migrants because they are about to join the EU.

When Jeremy Corbyn was asked how he rated his enthusiasm for staying in the EU out of 10, he said 7 to 7.5. It was an honest answer. But the general consensus was that it was not a good answer in terms of the politics of the moment. He needed to send a ‘clear message’ that we needed to stay in the EU, and so should have avoided answering the question. All this makes me glad I’m not a politician. But as far as George Osborne is concerned, I think he just sent a ‘clear message’.

[1] Just in case it needs spelling out, assessments of the long term impact of Brexit are counterfactuals, or conditional forecasts. Of the ‘if the supply of apples falls, their price will go up’ kind. They are much less uncertain than the unconditional forecasts about what will happen to inflation and growth in a year or two.  

Helicopter money and fiscal policy

Both John Kay and Joerg Bibow think additional government spending on public investment is a good idea, and that helicopter money (HM) is either a distraction (Bibow) or fiscal policy by subterfuge (Kay). They are right about public investment, but wrong about HM.

We can have endless debates about whether HM is more monetary or fiscal. While attempts to distinguish between the two can sometime clarify important points (as here from Eric Lonergan) it is ultimately pointless. HM is what it is. Arguments that attempt to use definitions to then conclude that central banks should not do HM because its fiscal are equally pointless. Any HM distribution mechanism needs to be set up in agreement with governments, and existing monetary policy has fiscal consequences which governments have no control over.

Here is where Kay and Bibow are right. At this moment in time, even if a global recession is not about to happen, public investment should increase in the US, UK and Eurozone. There is absolutely no reason why that cannot be financed by issuing government debt. Furthermore, in the event of a new recession, increasing ‘shovel ready’ public investment is an excellent countercyclical tool. Indeed there would be a good case for bringing forward public investment even if monetary policy was capable of dealing with the recession on its own, because you would be investing when labour is cheap and interest rates are low.

Where Bibow is wrong is that the existence of HM in the central bank’s armory in no way compromises the points above. HM does not stop the government doing what it wants with fiscal policy. Monetary policy adapts to whatever fiscal policy plans the government has, and it can do this because it can move faster than governments.

This goes part of the way to answering Kay, but he also suggests that HM is somehow a way of getting politicians to do fiscal stimulus by calling it something else. This seems to ignore why fiscal stimulus ended. In 2010 both Osborne and Merkel argued we had to reduce government borrowing immediately because the markets demanded it.

HM is fiscal stimulus without any immediate increase in government borrowing. It therefore avoids the constraint that Osborne and Merkel said prevented further fiscal stimulus. To put it another way, they did not say that increasing government spending or cutting taxes were bad in itself, but just that they were extremely unwise because they had to be financed by adding to government debt. HM is not financed by increasing government debt.

Many argue that these concerns about debt are manufactured, and that in reality politicians on the right pushing austerity are using these concerns as a means of achieving a smaller state: what I call here deficit deceit. HM, particularly in its democratic form, calls their bluff. If we can avoid making the recession worse by maintaining public spending, financed in part by creating money while the recession persists, how can they object to that? Politicians who wanted to use deficit deceit will not like it, but that is their problem, not ours.

There is a related point in favour of HM that both Kay and Bibow miss. Independent central banks are a means of delegating macroeconomic stabilisation. Yet that delegation is crucially incomplete, because of the lower bound for nominal interest rates. While economists have generally understood that governments can in this situation come to the rescue, politicians either didn’t get the memo, or have proved that they are indeed not to be trusted with the task. HM is a much better instrument than Quantitative Easing, so why deny central banks the instrument they require to do the job they have been asked to do.

Osborne, Cameron and fiscal irresponsibility

Is there anyone left who really believes that George Osborne is cutting public spending because he wants to be prudent with the nation’s finances? Unfortunately I think the answer is far too many.

Most macroeconomists have had deep suspicions or worse for some time, as we could see what damage austerity was doing to the economy. You might say that issue is past as growth has returned, but this would be quite wrong. What is now becoming clear is that the fears that some economists had all along that delaying the recovery in demand would lead to permanent damage to supply have indeed come to pass.

Those who were not macroeconomists should have realised what was going on when the government started cutting taxes. How do you explain cutting inheritance tax one day, and then trying to justify cuts in tax credits because ‘we have to get rid of the budget deficit’ the next, other than helping your own at the expense of the poor?

Even if that did not convince you, I suspect what will happen in the next few years will leave you in no doubt. Everyone knows it is crazy to cut spending that would have generated more income than it costs. Appearing to balance the books by paying for current spending (or tax cuts) by selling off your assets is not being prudent at all. Yet I suspect we will see more and more announcements from the government that do exactly this in the next few years.

To take just one example, we have the announcement of yet more cuts to HMRC, the government’s tax collectors, as part of the new spending review. No doubt we will hear a lot of talk about reorganisations to make the service more efficient. Just as we did with the previous cuts. In March 2015 it took an average of almost 15 minutes to have your phone call answered by HMRC. For the government that is a sign that the service needs less people! I do not know if the OBR allow something for the impact of HMRC cuts in their estimate of overall tax receipts, but if they have not done so already I think they should start.

This is a very obvious example of apparent savings that in fact reduce net revenue. Many more involve cutting public spending in a way that increases costs to the private sector, leading to lower productivity, lower incomes and then lower taxes. But for a politician facing a tame media who just has an eye for the headline numbers none of this matters.

The letter that the Prime Minister wrote to his local council complaining about its cuts has got some publicity. But what I found most revealing was Cameron’s suggestion that the council pay from some ongoing frontline services by selling more assets. The council leader in his reply explains that using the income from these sales to pay for the council’s running costs “is neither legal, nor sustainable in the long-term since they are one-off receipts”. The Prime Minister offered the services of No. 10’s policy unit to help the council. It sounds to me that the council should in turn be offering some of its wisdom next door at No. 11.