Does it make sense to target a budget surplus in normal times within five years, as George Osborne suggested at the Mansion House last night?
I’m afraid any answer to that has to first respond: define ‘target’ and
‘normal’. We do not have those details at the moment, so I’ll try and finesse
them by asking whether it makes sense for the budget to be on average in
balance within five years: more surpluses than deficits, but the occasional (abnormal) large
deficit. [1] In this post I’ll ignore problems associated with the Zero Lower
Bound for interest rates, which is a very
good (irrefutable?) reason why we should not be seeing any fiscal
tightening right now. Here I’ll focus on the longer term.
This question is really the same as asking what the long run
target for government debt should be. I recently discussed an IMF paper which suggested that,
as long as the market was happy buying the debt, there was no need for the
government to reduce the level of debt from current levels (around 80% of GDP).
That policy would imply running deficits of around 3% of GDP, which is a long
way from a surplus. I also said that might be an extreme position. In this post I gave various paths for deficits and
debt, where the other extreme was balancing the budget. A balanced budget could
involve debt falling rapidly to around 40% of GDP by 2035, and by 2080 the debt
to GDP ratio would be close to zero. I also gave various paths in between these
two extremes.
So which should it be: keep the debt to GDP ratio at around 80%
as the IMF suggest, or get it to fall rapidly as George Osborne suggests, or
something in between? Consider some popular arguments for going with George
Osborne.
1) It provides scope to respond to another Great Recession
without running out of what the IMF call fiscal space.
This is right in principle, but the numbers do not imply we
need to get debt down that fast, unless we are expecting the equivalent of
Great Recessions to happen in the future much more often than in the past. The
IMF paper
has some calculations on this (pages 12 and 13), and I looked at a particular
experiment here.
2) We need to reduce the debt burden for future generations.
Under the assumptions in the IMF paper, the costs of getting
debt down now exceed the future benefits. Again, that might be too extreme, but
it would be very hard to justify a quick Osborne like reduction in debt on
distributional grounds. That would mean that the costs of reducing debt would
largely fall on the same generation that suffered as a result of the Great
Recession, which would seem perverse.
3) Any individual would always want to pay back their debts quickly
Bad analogy. Here a country is more like a firm. Firms
typically plan to live with permanent debt, because it has paid for its
capital. The state has plenty of productive capital. To
put the point in distributional terms, if we paid back most government debt
within a generation, we would be giving that capital to later generations
without them making any contribution towards it.
So it is hard to justify aiming for budget surpluses within the
next five years. But I want to make one final point. How quickly you should
reduce debt involves difficult technical issues. While I’m reasonably sure that
the extremes of keeping debt at 80% of GDP or going for surpluses within the
next five years are not optimal, that leaves a wide range of possibilities in
between, and neither theory nor evidence gives us much guidance at the
moment. This really is an area where more research is needed [2], and it would
be good if the Treasury - the main interested party - was promoting that
research. What we get instead are jokes about reactivating the
Commissioners for the Reduction of the National Debt. (It was a joke, surely?)
Sign of the times, I’m afraid.
[1] It makes no sense to target any deficit/surplus number on
an annual basis. The budget deficit should be a shock absorber, to prevent
volatility in things that matter, like tax rates and spending decisions.
(Shocks can be cyclical, but they can arise from other sources, so cyclical
correction - even if it could be done well - does not negate this point; see Portes
and Wren-Lewis.) That is why the coalition originally had a target for the
deficit in five years time, which makes sense because it allows the deficit to
be a shock absorber.
[2] Yes I know this is what academics always say, but on this issue it is absolutely true. Compared to the oceans of work on monetary policy, work on optimal government debt amounts to a puddle. One reason may be that central banks are good at encouraging and utilising academic research, whereas finance ministries are less so.
