Is the German Debt Brake the worst fiscal rule ever?

The answer is probably not: a simple balance budget is worse. The German Schuldenbremse fixes the total cyclically adjusted deficit at 0.35% of GDP, which implies a gradually falling debt to GDP ratio. If actual outturns exceed this figure, there is a control mechanism which reduces the permitted deficit to get the path of debt back on target. So this debt brake improves on a simple balance budget by allowing a very modest deficit and cyclically adjusting. On the other hand it is worse than a simple balanced budget because it error corrects.

The fundamental mistake the rule makes is to make control of debt its central aim. Doing this only makes sense if you ignore macroeconomic common sense. The deficit and debt are macroeconomic shock absorbers. Running a variable deficit allows taxes and spending to be reasonably stable, which is beneficial for obvious and not so obvious reasons. Trying to tightly control the deficit and debt does the opposite. It makes sense to smooth taxes and government spending, but no sense whatsoever to smooth the deficit and debt.

The aim of a good fiscal rule is to eliminate deficit bias, which is the tendency of government debt to rise over time because, for example, politicians always want to spend more and tax less. The timescale for deficit bias is decades rather than years, so there is no need in principle to tightly constrain year to year deficits, or worse still to try and stay on some path for debt, and as I have already noted it is actually harmful from a macroeconomic point of view to do so.

Doesn’t the debt brake make some concession towards the macroeconomic stabilising role of the deficit by cyclical correction? There are two problems here. First, cyclical correction is a very imprecise art, and there is evidence the method used in the German debt brake and elsewhere does not work very well. Second, cyclical shocks are not the only thing that disturbs the government’s deficit. In practice all kinds of things can lead to erratic movements in the deficit, and it makes no sense to have to adjust tax rates or spending to exactly offset this erratic behaviour.

As Jonathan Portes and I explain in our paper on fiscal rules, a better way of keeping the stabilising role of deficits while still ensuring they do not steadily increase over time is to have a rolling target for the future deficit. Five years is the typical length of an economic cycle, so looking ahead five years makes sense, and also avoids the need for imperfect cyclical adjustment.

This kind of rolling future target is open to cheating, because the government can always promise but never intend to deliver on meeting the target. The problem here is that governments can cheat in so many ways when it comes to fiscal planning. No rule, even a draconian one like the debt brake, will stop all forms of cheating. The best way to avoid cheating is to establish a fiscal council with political weight that can distinguish between a government that fails to meet its targets through bad luck and one that fails because of cheating.

Do we need the debt error correction in the debt brake? A consistent result in academic research is that debt correction should be very slow, if it happens at all. That happens automatically with a deficit target, while the debt brake corrects too quickly. So the answer is no.

Another problem with the debt brake, alongside many other fiscal rules, is that it has a target for the overall deficit which includes public investment. Public investment should not be included in any deficit target, because there is no reason the current generation should pay for something that will benefit future generations. As investment is less painful to cut than current spending (or raising taxes), rules for the total deficit often lead to under investment, and we can see this in Germany. That only hurts future generations.

This is not about Anglo-Saxon economists telling Germany what to do. There are plenty of German economists who also see that the German debt brake makes no sense, and anyway economics is universal. The debt brake is a bad fiscal rule. It is doing the German people harm. It needs to change.

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.

2016 Autumn Statement

Got back from a trip to London to give my lecture (pics above: thanks to everyone at SPERI and New Statesman, plus Beth Rigby for chairing and everyone else for coming) looking forward to not thinking about economics for the rest of the day, only to find the Chancellor had given an Autumn Statement. Luckily the whole thing appears to be a damp squib compared to the expectations raised beforehand, so here are just a few points. On helping the so-called just about managing, see the ever excellent Ben Chu.

Public investment

Remember all the talk beforehand about substantial increases in public investment? What we got is increases of 0.3% or 0.4% of GDP in each of the financial years from 2017 to 2020. These increases give us figures that are slightly above the numbers we saw from the Labour government in the years immediately before the financial crisis. We should be spending much, much more when interest rates are so low.

Fiscal rules

There was also much speculation that we might return to more sensible fiscal rules, now that Osborne’s had been busted. Instead the new Charter for Budget Responsibility is honestly not worth the paper it is written on. We have a target for the total cyclically adjusted deficit (including investment) for a fixed year. Whatever the number involved, this makes two mistakes: having a fixed rather than rolling date, and by including public investment in that target. It is a recipe for panic cuts in public investment a year or two before the target date.

There is also a target of a falling debt to GDP ratio by the same date. I’m at a loss to understand why you need a target for this as well as a target for the deficit. The change in the debt to GDP ratio is after all just the change in debt (which is the deficit) and the change in GDP. So targeting the change in the debt to GDP ratio just adds to the deficit target some things that you cannot control: GDP growth and your position in the business cycle. I knew there would be no zero lower bound knock out, because that would be a clear admission that 2010 austerity was a mistake. But I did hope for something more intelligent than this.

I fear George Osborne has totally discredited the idea of a fiscal rule. Remember that Labour stuck to its fiscal rules for 10 years, before they inevitably fell victim to the largest recession since the 1930s. Yes there was fiddling at the margin, but the important point was that they did have a strong influence on what the Chancellor did. I now suspect that, by breaking a whole series of rules within a shorter period of years, whatever a Conservative Chancellor says has become pretty worthless.

The fuel duty fiddle

There is this great chart in the OBR’s autumn statement document.

It shows how Conservative Chancellors keep postponing rises in fuel duty. One obvious question is why. But the OBR is also concerned about whether this makes a mockery of its forecasts. Each year they are obliged by parliament to continue to assume that in all subsequent years the government will raise fuel duty after each ‘one-off’ cut. And almost each time the Chancellor announces a ‘give away’ for motorists: they will postpone any increase ‘just for this year’. You can see why they do it: it allows the papers to write favourable headlines. But if they really are going to go on doing this, it means that really their policy is to have no increases in fuel duty. Fiscal forecasts based on the assumption that they will increase fuel duty will be much too optimistic. The government is fooling parliament and the public, but the OBR cannot do anything about it because of the restrictive rules it is forced to operate under.

The cost of Brexit

The big news was of course the higher levels of borrowing. As this table shows, a significant part of that is due to the fiscal costs of Brexit.

Surprise surprise - there will actually be less money available for the NHS and other public services after leaving, rather than more. It is as if that red Leave bus just crashed and rolled over so it is now upside down. The two big factors are lower productivity growth and lower immigration. The OBR has, unsurprisingly, followed their own previous analysis (immigration) and the consensus economist view (productivity growth).

I can almost guarantee that the Sun and Mail will make no mention of this - or if they do it will only be to rubbish the OBR. So, following the theme of my lecture, I really hope that the broadcasters’ nightly news programmes pick this up. Channel 4 news did do so, but I didn’t watch the others (let me know in comments).

The NHS and squeezing the public sector

Not a penny more for an NHS in crisis. Make no mistake, as this blog has shown before, the current crisis in the NHS is simply because it has been starved of resources for the last six years. I really wish Labour (it has to be them, because they are the only party who the media will take any notice of) would run a campaign that busted the myth of a ‘protected’ NHS. But what Hammond’s refusal to do anything about this shows is that this government is continuing the squeeze of the public sector begun by the Coalition. Here is the relevant chart from the OBR. 

Public investment and fiscal rules

When I started writing this paper with Jonathan Portes, I was genuinely unclear about whether fiscal targets should be for the total deficit (which includes public investment) or for the current balance (which excludes it). This was partly because some of the conventional reasons for excluding investment seemed poor. For example, to assume all investment paid for itself in the form of higher activity and therefore higher taxes is obviously wrong. To avoid this by having each project treated on its own merits (it would happen if it generated a social return greater than some cut-off or interest rate) is better but ignores the uncertainties that any such calculation inevitably involves.

By the time the paper was finalised, and later when it came to proposing a rule that the Labour party could adopt, it was clear to me that any target should be for the current balance, with a separate target for the public investment to GDP ratio. We can see a very strong argument for doing that right now. Jean Pisani-Ferry is one of a steady stream of economists saying that it really is time to increase public investment, and they are backed up by international organisations. But despite all this being true for some time, there is very little sign of governments taking much notice. As Pisani-Ferry notes: “On average, governments are using the gains implied by lower interest rates to spend a bit more or to reduce taxes, rather than to launch comprehensive investment programs.”

The political economy reason why this is happening is straightforward enough. When both current and capital spending have been squeezed for some time, if this constraint is partially relaxed governments have a choice. Public investment generally benefits future generations as well as voters today, while current spending all goes to the current generation. Governments who aim to maximise votes for themselves will therefore tend to ignore investment spending.

Exactly the same process happens in a recession. It is generally easier and less painful to cut an investment project than fire some nurses or teachers. The danger with deficit targets is therefore than whenever these targets bite, public investment is the first to suffer. This is exactly what happened in the UK in 2010 and 2011, which accounted for a great deal of the deflationary impact of the Coalition government’s fiscal consolidation.

Those in the know will point out that the Coalition’s main fiscal target was for the current balance. That is why it is vital to also have a separate target for the public investment to GDP ratio. That would ensure that over the next few years governments do not just pretend to do something about infrastructure and other public investments by funding one or two high profile projects, while continuing to keep overall public investment low. That is what George Osborne did, with planned investment over the next five years between 1.5% and 1.9% of GDP. If Philip Hammond does not change these plans to something more like 3%, we will have another Chancellor who talked the talk on investment but is not prepared to put money where his mouth is.

Does public investment have to pay for itself?

A key distinction between Labour’s new fiscal rule and Osborne’s fiscal charter is that the former allows borrowing for investment. When supporters of the fiscal charter treat borrowing as if it was inherently sinful (‘Labour will borrow forever’) it is natural to remind them that firms often borrow to invest and grow, and consumers invariably borrow if they buy a house. We also note that public investment can enhance economic growth. But this can lead to a confusion about whether such investment has to ‘pay for itself’.

When a firm borrows to invest, it hopes to make enough profits to pay back the borrowing. There may be forms of public investment which could raise future GDP (and therefore income and spending) such that eventually taxes rise by enough to pay at least the interest on the borrowing that made the investment possible, or even start paying back the borrowing itself. But there are two other important reasons why it makes sense to borrow to invest.

The first involves intergenerational equity. Suppose we have a public investment project which significantly enhances the quality of life, but there is no pecuniary benefit: GDP does not rise. So taxes will have to rise at some point to pay for that borrowing. But who should pay those taxes? When we are talking about investments that are long-lived, the obvious answer is those that benefit from the investment, which means future generations as well as the current generation. That can happen if investment is paid for by borrowing rather than raising current taxes.

This helps answer a point that is often raised, which is what should count as public investment and what should not. With this reasoning it makes sense to borrow whenever the social benefits of public spending are long lasting. When the benefits are short lived, spending should be paid for by higher taxes. So the relevant metric for what should count as investment in this context is who benefits most. While paying doctors or teachers more may have some knock on benefits for the future, the main beneficiary will be today’s doctors or teachers. The benefits of new schools and hospitals are longer lasting. 

The second reason for using borrowing to pay for investment is if the increase in investment is a one-off. As taxes are distortionary at the margin, it makes sense to smooth those taxes over time. Once again, that can be achieved using borrowing.  

If a lot of public investment does not pay for itself, wouldn’t borrowing only to invest mean that debt just went on increasing and increasing? What matters here is the debt to GDP ratio. If you want to keep that ratio constant, and you always run a zero current balance, then that tells you how much investment you can do. The numbers are fairly simple to work out. If the economy grows in nominal terms by 4.5% on average, and debt is 80% of GDP, net investment could be around 3.5% of GDP to keep the debt to GDP ratio constant. Osborne plans net investment over this parliament averaging 1.6% of GDP.

This leads to one final, important point. You cannot have separate goals for all three of debt to GDP, the current balance, and public investment. In Labour’s new rule, the commitment to reduce borrowing as a share of trend GDP over the lifetime of a parliament, coupled with the zero current balance target, puts an upper limit on the amount of investment the government could do. Whether that is a sensible upper limit in economic or political terms, and what you do if it is not, I will leave as an exercise for the reader.

A (much) better fiscal rule

Today the Labour Shadow Chancellor John McDonnell will give a speech where he puts forward an alternative fiscal rule to George Osborne’s fiscal charter. It involves a rolling target for the government’s current balance: within 5 years taxes must cover current spending. It leaves the government free to borrow to invest. Investment cannot be unbounded, as there is a commitment to reduce debt relative to trend GDP over the course of a parliament.

No doubt we will hear the usual cries from the opponents of sensible fiscal rules: Labour plan to borrow billions more than George Osborne and they plan to go on borrowing forever. The simple response to that should be that it is right to borrow to invest in the country’s future, just as firms borrow to invest in capital and individuals borrow to invest in a house. Indeed, with so many good projects for the government to choose from, and with interest rates at virtually zero, it is absolute madness not to investment substantially in the coming years.

This part of the rule is similar to the main fiscal rule Osborne himself adopted under the Coalition, which in turn is not unlike previous rules adopted by Labour. What is new is that McDonnell’s rule involves what could be termed a ‘zero lower bound knockout’: if interest rates hit their lower bound following a recession, the focus of fiscal policy shifts from deficit targets to helping monetary policy support the economy. It reflects the knowledge we have gained since the global financial crisis.

Again critics will claim that the knockout would have meant building up even more debt after the last recession. But what matters with debt is its relationship to GDP, and it is far from clear whether more stimulus in 2009 and 2010 would have increased the debt to GDP ratio, because you are increasing GDP as well as debt. But even if debt to GDP did rise, this reflects the right choice. It means prioritising the real economy - jobs and wages - over an obsession with government debt.

We will no doubt be told by government supporters that this would have led to financial disaster, just as we are also told that the coalition saved us from disaster. We will be told this by some economists working in the financial sector - a sector that created the Great Recession. But there is no evidence for this impending disaster, and plenty of evidence that it is a complete myth. As Paul Krugman might say, in a country with its own central bank the bond vigilantes just keep failing to turn up.

Recessions come and go, you might respond, but higher debt will always be with us. That ignores two key points. First, prolonged and deep recessions cause lasting damage. UK GDP per head is currently over 15% below pre-recession trends. Does none of that have anything to do with the slowest UK recovery from a recession in centuries? Second using fiscal policy to end recessions quickly does not mean higher debt forever. The key point is that debt can be reduced once the recession is over and interest rates are safely above their lower bound. Doing that will be no cost to the economy as a whole, as monetary policy can offset the impact on demand. Obsessing about debt during a recession, by contrast, costs jobs and reduces incomes, as every economics student knows and as the OBR have shown.

The rule happens to mean that pretty well all of the additional austerity Osborne has detailed since the election is unnecessary. But that is a byproduct of adopting a sensible rule. If there is any ‘reverse engineering’ going on, it is with the fiscal charter, which some argue was adopted with the political purpose of making Labour look less prudent before the election. As McDonnell notes, no economist has attempted to defend Osborne’s fiscal charter.

Yet I know this point worries some Labour MPs and commentators. They say, quite rightly, that one of the main reasons the 2015 election was lost was because Labour were not trusted on fiscal policy. But the basic truth is that you do not enhance your fiscal credibility by signing up to a stupid fiscal rule. Apart from getting attacked for doing so by people like me, your collective heart is not really in it and it shows. You get trapped into proposing to shrink the state as Osborne is doing, or hitting the poor as Osborne is doing, or raising taxes which makes you unpopular. And if by chance it ever looks like you might be getting that trust back, Osborne or his successor will move the goalposts again.

The far more convincing way to get trust back is to adopt a fiscal rule that makes sense to both economists and the public (‘only borrowing to invest’), and actively talking about it. When the Conservatives accuse you of borrowing, you do not try and change the subject, but remind people that is what firms and consumers do. Borrowing is not a dirty word, particularly when it is on vital investment and you can do it for almost nothing! Indeed borrowing to invest shows you are optimistic about the future and are prepared to do things to make it better. In contrast those who would turn down these investment projects in order to reduce debt as fast as possible have a negative outlook that fears the future.

The Conservatives know they are vulnerable on public investment. Osborne tries to give the impression that he is doing a lot of it, but the figures do not lie. In the last five years of the Labour government the average share of net public investment in GDP was over 2.5%. During the coalition years it fell to 2.2%, and for the five years from 2015 it is planned to average just 1.6%. That is not building for the future, but putting it in jeopardy, as those whose homes have been flooded have found to their cost.[1]

[1] Besides cutting spending on flood prevention while part of the coalition, Damian Carrington revealed yesterday that UK funding for research on flooding has been cut by 62%! There can be no better indication of the madness of George Osborne’s deficit obsession.   

Understanding the austerity obsession

It has often been argued, loosely following Keynes, that economists should be like doctors

Martin Wolf writes “The austerity obsession, even [sic] when borrowing costs are so low, is lunatic”. The IMF, the OECD and pretty much the whole of informed opinion agree. Yet those subject to this austerity obsession are in charge of levels of public investment in the the US, Germany and the UK. One interesting question that arises is whether they are all suffering from the same disease?

The diagnosis in the case of the Republican party in the US is reasonably clear. Judging from the remaining presidential candidates and the actions of Congress the main economic goal is to cut taxes, particularly for the very rich. That requires, sooner or later, less public spending. What about evidence that more public investment would help everyone in the economy, including the rich? The problem is that this group suffers from the delusion that the only way to help the economy is to tax the rich less and starve the beast that is the state. It is a clear case of the patient being infected by the neoliberal ideology virus.

The condition of the ruling class in Germany, however, is much more difficult to diagnose. Some local doctors have labelled it the Swabian syndrome: a belief that the economy is just like a household, and the imperative is to balance the books. This seems like a case of labelling rather than explaining a disease. There may be an allergy involved: an aversion to Keynesian economics, and anything that sounds vaguely Keynesian. But the microeconomic case for additional public investment in Germany is also strong: although German roads are not in such a bad state of repair as those in the US, the German public capital stock has been shrinking for over a decade. One possibility is that Swabian syndrome is being encouraged by an ageing population that worry about their pensions. It will be interesting to see how this is influenced by recent injections of the refugee vaccine.

The nature of the illness in Germany is therefore more of a mystery than in the US. Unfortunately as contacts between German officials and those in the rest of Europe are frequent, we have seen numerous cases of this disease - whatever it is - spreading elsewhere, and in one particular case (Greece) the patient remains in a critical condition. The disease also produces complications after accidents: here Finland - currently in intensive care - is a case in point.

The Conservative Party in the UK also seem to have the symptoms associated with Swabian syndrome. As with Germany, the outbreak reached a peak around 2010/11. For a time it was thought that UK cases might be in decline, but last year saw a renewed outbreak. There are some, however, who argue that in reality the party are feigning the symptoms as a means of winning elections, while still others claim that tests have revealed clear traces of the ideology virus.

What has become clear is that the traditional way of treating the austerity obsession, which involves occasional counselling with well trained economists, is having little effect. We also now know that the financial crisis shock treatment only makes the neoliberal virus more virulent. Extended therapy is the only known cure for this virus. As for Swabian syndrome, our best hope may be that the public gradually develop an immunity to the disease as its consequences become clear.  

Austerity's apologists on the left

The rational case for imposing yet more austerity on the UK has all but disappeared.  Economists are almost united in saying that now is the time for substantial increases in public investment, with government borrowing costs almost negative in real terms and low real wages. Even city economists have given up trying to pretend that the market is on the point of giving up buying UK government debt: the serious market analysis talks about a continuing shortage of safe assets.

In the political world, and mediamacro, things are very different. The right pushes continued austerity for the obvious reason that it shrinks the state: some are honest about this and some are not. My concern in this post is with those on the left who insist that Labour must play the austerity tune. Their argument is straightforward: the public has become convinced that Labour was irresponsible with the public finances, so the way to win back trust is to match Osborne on austerity.

This is a strange argument. The idea that it was Labour profligacy that required austerity is false. That many people believe it is undeniable, but to argue that this requires Labour to also pretend it is true, and promise to be less profligate next time, is bizarre. Myths like this are not set in stone, and can be challenged. To fail to do so concedes defeat.

Large numbers of the public believe many myths that have been encouraged by the right. They believe that a large proportion of those on welfare are scroungers: should Labour therefore pretend this is true? The public believe that large numbers of immigrants are just here to claim benefits, whereas in reality immigration improves the public finances. Should Labour base it's policy on this misperception?

What the left should be doing is uniting behind a clear narrative that challenges these myths head on. The strategy of trying to change the subject was tried in 2015 and failed. The strategy of pretending to believe the myths both fails to convince the public who believe them (Labour politicians tend not to be good actors), and alienates those who know they are untrue.

One thing Labour can learn from it opponents is consistency and simplicity of narrative. The alternative narrative should be that now is the time to invest in the future, and the public sector must take the lead in this. The failure of the Conservatives to invest over the last 10 years, in everything from housing to flood defences, needs to be reiterated at every opportunity, together with the statistics that reveal this failure. A fiscal rule that ensures that in the medium term the government only borrows to invest, with the key proviso that if monetary policy runs out of effective ammunition fiscal policy will support the economy, not only makes economic sense but also matches this narrative.

The days that UK macroeconomic policy was run by second rate accountants need to come to an end.  

Public investment: has George started listening to economists?

I have in the past wondered just how large the majority among academic economists would be for additional public investment right now. The economic case for investing when the cost of borrowing is so cheap (particularly when the government can issue 30 year fixed interest debt) is overwhelming. I had guessed the majority would be pretty large just by personal observation. Economists who are not known for their anti-austerity views, like Ken Rogoff, tend to support additional public investment.

Thanks to a piece by Mark Thoma I now have some evidence. His article is actually about ideological bias in economics, and is well worth reading on that account, but it uses results from the ChicagoBooth survey of leading US economists. I have used this survey’s results on the impact of fiscal policy before, but they have asked a similar question about public investment. It is

“Because the US has underspent on new projects, maintenance, or both, the federal government has an opportunity to increase average incomes by spending more on roads, railways, bridges and airports.”

Not one of the nearly 50 economists surveyed disagreed with this statement. What was interesting was that the economists were under no illusions that the political process in the US would be such that some bad projects would be undertaken as a result (see the follow-up question). Despite this, they still thought increasing investment would raise incomes.

The case for additional public investment is as strong in the UK (and Germany) [1] as it is in the US. Yet since 2010 it appeared the government thought otherwise. Public net investment, which was 3.2% of GDP in financial year 2009/10, has fallen to an expected 1.5% of GDP in 2015/6. We are about to have a spending review where non-exempted departments have been asked to look at cuts of at least 25%. One of those departments is the department of transport, which is responsible for almost a quarter of public investment.

However since the election George Osborne seems to have had a change of heart. First he has implemented Labour’s proposal of a national infrastructure commission, which was in turn one of the ideas of the LSE’s growth commission. If it works it should reduce the number of political white elephants that US economists worry about. Second, he has talked about spending £100bn on these projects before 2020. That is a huge sum: the total for annual gross public investment is currently around £70 billion.

So how do you square £100bn extra public investment with the government’s goal of achieving surplus by 2019/20? Is the £100bn a smoke and mirrors number? We will find out when the Autumn Statement is published. Ignore any numbers quoted by the Chancellor. Instead have a look at the OBR’s figures for net public investment as a percentage of GDP (you can find a time series in their databank here). In the June budget public investment was expected over the next 5 years to stay at or below the 1.5% of GDP figure. If the numbers in the Autumn Statement forecast are significantly above that, we will know that the Chancellor really has started listening to economists.

[1] Postscript. An IMF study on German infrastructure investment is here.

More (dark) thoughts on interest rates

The following has numbers for the UK, but the logic if not the numbers also apply to the US: see Mark Thoma here.

Imagine the following lottery. If you win, you receive a total of £5000 over the next few years. The cost of a ticket? The risk that inflation will be 0.5% higher than it would otherwise have been for a couple of years, where inflation includes the rate that wages increase.

To enter the lottery in the UK you need to cut interest rates. This lottery is just another way of describing the key argument I made in Monday’s Independent article (now complete with chart).

Of course you want to know the odds of getting the prize. The odds come in the form of a puzzle. What are the chances that the economy has, over the last ten years, permanently lost 15% of its normal ability to produce goods and services. Something that has probably never happened to the UK before. [1] Those are the chances of you NOT winning.

We can of course discuss those numbers. But in the UK that discussion appears largely absent. Instead all the talk is about interest rate increases. We seem to have collectively written off 15% of national GDP with just a shrug. ‘Oh that must be supply and there is nothing conventional macro policy can do’ is the general view. That view may be right, but it is important enough that this should be the centre of the national debate. Instead we talk about the need to normalise interest rates, as if the real economy was doing just fine.

Time for a DeLong type lament. If you had told me ten years ago that a decade hence UK output per head would be 15% below the 1955-2008 trend, inflation was zero and yet people would be talking about raising interest rates I would have said you were mad. If you had said that at a time when interest rates and real wages are at record lows the government was proposing to not invest for the future because that was the best way to prepare for the next crisis I would have said you knew nothing about business and economics. If you had said that just years after a huge financial crisis, followed by a host of financial scandals, the City regulator would be sacked because the Chancellor wanted less tough regulation I would have said you were thinking about some corrupt state and not the UK. If this is all a bad dream, what will it take to wake people up?

[1] Economies do appear to suffer some permanent loss to potential output after financial crises: there is a handy summary of studies here (table 4.1) - HT Andrew Goodwin   

Public Investment and Borrowing Targets

Often fiscal rules, designed to keep a lid on public deficits or debt, exclude borrowing for public investment from any deficit target. This is true of the UK government’s fiscal mandate, which seeks to achieve a cyclically-adjusted current budget balance within five years. The idea, in simple language, is to only borrow to invest. What could be wrong with that?

Most of the time public investment is not like private investment. A successful private investment will generate future income which can pay back any borrowing. A successful public investment project may raise future output, and this may increase future taxes, but there is no sense in which we would only undertake the project if we could be sure of paying off the borrowing with these extra taxes. A public investment project should be undertaken if discounted future social benefits exceed its costs. This cost has to be paid for by higher taxes at some point, so the question is simply when taxes will increase to do so.

In thinking about when to raise taxes, the obvious principle is tax smoothing. If taxes are distortionary, it is better to spread the pain. So if we need some additional public spending for just this year, one way to pay for it is to borrow, and use higher taxes just to pay the interest on that borrowing. That smooths the distortion over time. This is true whether the public spending involves consumption or investment. In contrast, if we are planning to raise public spending permanently, taxes should be raised by the amount of the increase in spending, and no borrowing should take place. Again this is true whatever the form of the additional expenditure. Now it is true that public investment projects tend to be temporary, while additional public consumption can be permanent, but the principle here is how taxes are distributed, rather than the nature of the spending.

This simple application of tax smoothing takes no account of distributional issues. If we believe that government consumption only benefits those paying taxes at that time, we might want taxes to rise with a temporary increase in government consumption rather than being smoothed. Why should future generations pay for the consumption enjoyed by the current generation? Here public investment would be different if it benefits both current and future generations. So from a distributional point of view, it might make sense to treat government consumption and investment separately. There are two problems here though. The first is that the distinction between public investment and consumption in the statistics does not necessarily follow this distributional logic. Education is classed as consumption. Second, how in practical terms do you allocate taxes paid to benefits received from public investment? (I touch on this here.)

One of the key points that Jonathan Portes and I stress in our discussion of fiscal rules is that rules have to balance optimality when governments are benevolent against effectiveness when they are not. One feature of periods of austerity is that public investment often gets hit hard. The reason this happens may also reflect intergenerational issues. To the extent that public investment benefits future generations, they are unable to complain when it is cut.

This can be one reason why rules sometimes use current balance targets rather than targets for the overall deficit. If public investment does not influence the target, it need not be cut. (This does not seem to have worked with George Osborne, as the victims of flooding found out!) However such rules are inevitably incomplete, because they say nothing about the overall level of public debt. In the case of the last Labour government, there were two rules: one involving the current balance over the cycle (only borrow to invest), and one specifying a total debt ceiling. There was an implicit target for public investment implied by the conjunction of the two rules, but it is unclear how sensible that implicit target was.

Jonathan and I suggest that the simpler and perhaps most effective way of preventing public investment being squeezed in times of austerity is to have a specific target for the share of public investment in GDP. Of course this target should also influence any overall deficit target, but if you want to protect public investment, it seems best to do so explicitly. If you do that, then it makes more sense to have just one target for the overall deficit (primary or total) that includes borrowing to invest, rather than a target for just the current balance.

Austerity and Flood Damage

This picture is what happened to part of the mainline between the South West of the UK and London after the latest storms. I used to travel on this stretch when I lived in Devon. On bad days the waves could splash on to the trains, but luckily there were no trains running when this happened.

Large parts of the UK have their wettest January on record, leading to widespread and severe flooding, and I blame the government’s austerity policy. Ridiculous? Quite the reverse. Under a sensible macroeconomic programme for public investment, the last few years would have seen a very large increase in spending on flood prevention. Instead we saw cuts, because flood prevention had to take its share of austerity. This was a government decision, for which they alone are responsible.

But it gets worse for the government. Extreme weather events like the one we are now suffering are a predictable consequence of climate change. Just have a look at this helpful DEFRA (Department for Environment, Food and Rural Affairs) and Environment Agency webpage. It says: “Global temperatures are rising, causing more extreme weather events, like flooding and heatwaves.” As the page makes clear, this applies to the UK. So there is a need to increase spending on flood protection, and realistically that has to be public spending.

Any government minister in charge of the environment would know this. They might not believe it, however, if they were a climate sceptic. Sure enough, the environment minister Owen Patterson is just such a sceptic. Spending by DEFRA on finding ways to cope with climate change had risen by almost 20% under Paterson's predecessor, Caroline Spelman, but fell 41% after Paterson replaced her in September 2012, according to the Guardian. Patterson has noticeably failed to back David Cameron’s “suspicion” that climate change was behind our current severe weather. But of course Patterson was appointed by Cameron.

Now there is “controversy” over whether spending on flood prevention has been cut by this government or not. Except there is no real doubt, as one look at the chart in my previous post shows. (Dear BBC. This chart comes from a House of Commons document. Why isn’t it on your website?) This is only controversial because the government has tried to claim otherwise, by for example including spending in the year it took office as its own, even though it was planned by the previous government. If you want to get into how the government has tried to bend the figures, see Guy Shrubsole or Jim Pickard (HT Jonathan Portes). Yet this “debate” nicely diverts attention from two key points: spending should have been rising because of the increased threat, and the recession gave the government the ideal opportunity to accelerate this process (cheap labour, cheap borrowing). It failed on both counts, and cut instead.

As I have noted before, most macroeconomists agree that public investment should rise in a recession, including some like Ken Rogoff who have been quite supportive of austerity more generally. However, the standard response when I make this point is that it is very difficult to find “shovel ready” projects to invest in quickly. This is one reason why I originally talked about flood prevention - it was a clear example of potential UK public investment that was in a very real sense shovel ready!

So this looks like a major scandal. Except, that is, in a country in which the political right directly or indirectly controls most of the media. If you search using the three words “UK flooding austerity” in Google or Yahoo the first item that comes up is my post, followed in Yahoo by a report from Al Jazerra! Of course, the right wing media need someone to blame, so knives are out for the chairman of the Environment Agency Chris Smith, who also happens to have previously been a Labour minister. This just a month after it was announced that the Environment Agency is being forced to cut 1,500 jobs, which it says will “have an impact on flood operations such as risk management, maintenance and modelling.” As yet, those responsible for these decisions have not been held to account.

UK Flooding: another austerity Christmas present

The big news in the UK over the Christmas period has been flooding caused by heavy rain. The Prime Minister naturally toured some of the worst affected areas, but the reaction he got was not what he might have hoped in terms of media coverage. Was this hostility fair? Here are some facts. (Source (pdf): Flood defences in England, House of Commons Library, SN/SC/5755.) 

Until 2010, flood defence spending by the government had been steadily increasing: between 1997 and 2010 spending increased by 75% in real terms. There are good reasons why spending should be increasing. One is that climate change is likely to substantially increase the chances of periods of severe rainfall. Flood damage currently costs over £1 billion a year, but the Environment Agency has estimated this figure could rise to £27 billion by 2080.

When the current government came to power, their 2010 comprehensive spending review reduced spending by 20% in real terms, according to the Committee on Climate Change. Following floods in 2012 the government provided a small amount of additional money - shown in purple on the chart. So instead of continuing to raise spending to deal with a growing threat, the government cut back spending as part of their austerity programme.

It is a distraction to try and link specific episodes of flooding to spending cutbacks. These things work on probabilities. It is also a distraction to obsess about whether spending has gone up or down in real terms. The government will claim that spending on ‘frontline’ defences has not fallen because of ‘efficiency savings’ elsewhere and partnerships with local authorities, but the real point is this. The recession presented the government with a huge opportunity, to bring forward the many existing plans to enhance the UK’s flood defences at a time when labour was cheap and borrowing costs very low. They chose not to take advantage of that opportunity, ostensibly because of a potential debt crisis but in reality because of an ideological distaste for public spending. Over the next decade or two, many people will pay the price for that decision, either directly as their homes and businesses are flooded, or indirectly through higher insurance premiums.

Postscript - see also this later post