No basis in economics

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

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

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

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

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

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

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

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

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

Filling the gap: monetary policy or tax cuts or government spending

Suppose there is a shortfall in aggregate demand associated with a rise in involuntary unemployment in a simple closed economy with no capital. Do we try and raise private consumption (C) or government consumption (G)? If the former, why do we prefer to use monetary policy rather than tax cuts?

If consumers have stable preferences over privately and publicly produced goods, then ideally we want to keep the ratio C/G at its optimal level. So if the aggregate demand gap is caused by a sudden fall in C, we will want to do something to raise C. As real interest rates are the price of current versus future consumption, the obvious first best policy is to set nominal interest rates to achieve the real interest rate that gets C to a value that eliminates the consumption shortfall. That is the basic intuition behind the modern preference to use monetary policy as the stabilisation instrument of choice: part of what I have called the consensus assignment.

In classical or real business cycle models this happens by magic. It normally goes by the term ‘price flexibility’, but it is magic because it is rarely explained how a lack of aggregate demand gets translated into lower real interest rates. In the real world, the magicians are central banks. Note that I have not mentioned anything about implementation lags associated with monetary or fiscal policies, which is one of the reasons you will find in the textbooks for the consensus assignment. My reason for preferring monetary policy is more intrinsic than that.

What happens if the aggregate demand shortfall occurs because ‘supply’ increases through technical progress? Once again the first best policy is to lower interest rates to increase consumption, but we would also want to raise public consumption to keep the optimal C/G ratio.

Finally consider a more difficult shock - a ‘cost-push’ shock to the Phillips curve that raises inflation for a given level of output and aggregate demand. We know that we want policy to reduce output (to create a negative demand gap) to partially reduce inflation, assuming that both the output gap and inflation are costly. However it is less obvious in this case that monetary policy is first best. However, as Fabian Eser, Campbell Leith and I showed in this paper, it still is. It turns out we can complicate the model in some ways (but not others) and the result that we use just monetary policy to maximise social welfare still holds.  

If we return to the case of a demand gap caused by a fall in consumption, suppose we cannot use monetary policy because nominal rates are stuck at zero. As we want to increase private consumption, the obvious alternative to try is a tax cut. If we had access to a lump sum tax (a tax that is independent of income, like the poll tax), and if consumers responded to a tax cut, then this would work pretty well too. There are two problems: Ricardian Equivalence, and there are no lump sum taxes.

If Ricardian Equivalence held completely tax cuts would be totally ineffective at stimulating consumption, but the consistent evidence is that Ricardian Equivalence does not hold. But this evidence does suggest that at least half and perhaps more of any tax cut would be saved, which means that tax cuts would have to be relatively large in money terms compared to the consumption gap. It also adds a degree of uncertainty to their effectiveness. If there is some financial limit on the size of any stimulus package (as often seems to be the case), this puts tax changes that rely on income effects at a severe disadvantage. Even if financial limits are not present, the relative ineffectiveness of tax cuts in stimulating consumption is a problem for another reason.

Lump sum taxes do not exist, so some distortionary tax (a tax that influences incentives) has to be used. This means that a tax cut violates tax smoothing. This is the idea that the best policy is to keep tax distortions constant. A tax rate of 30% is better than a tax rate of 10% in odd years, and 50% in even years. So filling the consumption gap with a cut in the income tax rate (to be followed by increases in that rate) has a cost. The more tax cuts are saved, the bigger the cost. It is highly unlikely that this cost will be sufficient to stop us trying to fill the consumption gap, because unemployment costs are far greater than uneven tax distortions. However there are costs, unlike the first best of changing real interest rates.

In contrast, using public spending to fill any demand gap is much more straightforward, as its impact on demand and employment is more predictable. But it too has a cost: we get the C to G balance wrong (too much G compared to C). Chris House has a recent post on tax cuts versus government spending as alternative means of fiscal stimulus. (Noah Smith wrote a subsequent post and Chris responded.) The proposition he wants to put forward is that government spending should only be used as a stimulus measure if its social benefits outweigh its social costs. I’m not sure that is a very helpful way of thinking about it. Far better, in my view, is to accept that the demand gap must be plugged (because the costs of not doing so are very large), and then work out the way of doing that which leads to the lowest collateral damage. That might well be an increase in G rather than a tax cut. It will almost certainly be so if there is a financial limit on the size of the stimulus.

The same reasoning can and should be applied to unconventional monetary policy, but that has to be another post.

Government debt and the burden on future generations

                In an earlier post, I looked at how we might think about the ‘cost’ of additional public debt, if that debt financed public investment, and our concern was intergenerational equity. Here I want to examine the question of how great the burden of extra debt is on future generations, if that debt financed not investment, but consumption spending or tax cuts that had only current period benefits.

                Our initial instinct would be that this burden is bound to be positive. The current generation gets the benefit of additional spending, or a tax cut, but future generations pay the cost in terms of finding the money to pay the interest on the debt. However, if the additional debt is never paid off, and remains a constant share of GDP, then there is a situation in which it is not a burden, which I discussed in that earlier post. Let the ‘growth corrected real interest rate’ be r-g.[1] Suppose r-g=0. In that case the interest on the outstanding debt each year could be entirely paid for by issuing new debt such that the total debt to GDP ratio remained unchanged. The debt is only a burden on the final generation, but there is no final generation.

                Normally r>g, so taxes do have to rise (or government spending has to fall) to pay part of the interest on the debt. Debt is a burden on that account. There is a trap that we can fall into here, which is the following. Suppose all the debt is owned domestically. What the government does is raise taxes to pay interest on the debt, so this is a transfer from tax payers to debt owners. The government is just taking with one hand and giving back with the other. If society is just paying itself, how can debt be a burden?

                It’s an easy mistake to make – I should know, because I made it in an earlier post, which Nick Rowe pointed out in a comment.  Incidentally, Nick has two excellent posts on these issues, here and here. The argument above is wrong because it can still involve a transfer between generations. This becomes very clear if we consider an unfunded pension scheme, which I will do in a later post. Someone who just gets interest on their wealth is clearly better off than someone who also has to pay tax increases to get that interest.

                If you are still not convinced, think of the following. Suppose the current generation gets a debt financed tax cut, but in a fit of conscience it decides to put it all into a trust fund to compensate future generations. (This is what happens under Ricardian Equivalence.) Suppose also that there is a final generation when all the extra debt is repaid, and it gets the complete trust fund. In real terms the size of the debt will cumulate up at the rate g, as each year a bit of new debt is issued to keep its total a constant proportion of GDP. However the trust fund cumulates with the real interest rate r. If r>g, the trust fund will exceed the amount of debt to be repaid, and so the final generation will be better off. As all this just involves intertemporal transfers, the final generation being better off must mean that the generations in between should have got some of the trust fund – they were losing out too.

                If there is a final generation (when the debt is paid off), then the answer to the question ‘is debt a burden’ is obvious. It is only if we think about never paying the debt off that we need to worry about the r>g condition. The argument I made in one of the earlier posts, and want to repeat now, is that there should normally be a final generation – the debt should be paid off eventually. This argument has nothing to do with intergenerational equity.

                Creating additional debt has two negative consequences aside from any intergenerational equity concerns. First, increasing taxes to pay the interest adds to the scale of tax distortions in the economy. Second, it seems likely that additional government debt will to some extent crowd out investment in productive capital, and this is a cost if, as also seems likely, we currently have less than the optimum amount of productive capital. (Economists will know that I am here assuming we do not have complete Ricardian Equivalence, and that the economy is not dynamically inefficient.) For both reasons, even if we ignored issues of equity, we should not be indifferent to the level of debt.

                So these arguments suggest we should aim to bring debt back to some target level. Those economists familiar with this area will know that there is one special, but frequently used, case where that is not true, and this paragraph is for them. As a consequence of Barro’s famous tax smoothing hypothesis, the short term costs of bringing debt back to some target can outweigh the long term benefits of doing so, if the real rate of interest is not greater than impatience (the rate of time preference). My own view is that this is a ‘knife edge’ result which really tells something different, which is that any adjustment towards a debt target should be very gradual. For more on this see another earlier post of mine.

                What the ideal level of debt should be is a complex question. But once we accept that in theory there is some ideal level of debt, this means that doing thought experiments where we forever depart from it are just that: thought experiments rather than practical policy. To put the same point more topically, if we accept that current levels of government debt are too high, we must have in mind some lower target for debt. If debt rises above this target, it should fall back towards it. In effect, that means there will be a final generation: any additional debt will eventually have to be repaid.

                So the burden of additional government debt for future generations involves the debt itself, and not just the growth corrected interest on that debt. However, the practical importance of this point for any particular generation is not great, because adjustment towards a debt target should be slow. Getting debt right is likely to be a cost for our children’s children as well as those generations currently alive.         

             

               

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[1] If r is the nominal interest rate, g is the growth in nominal income. If r is a real interest rate, g is the real growth rate.