The burden of government debt, again

Here is an attempt to clear up some of the confusion that still exists on this issue.

1) Government debt can be used to redistribute income to current generations from future generations, even if the aggregate level of consumption in each period remains the same. Proof by example: see here (or many similar proofs from Nick Rowe - his latest post on this is here).

Note: I think people get confused because although the first part of the proposition seems intuitive (if the government cuts taxes and pays for this by borrowing, surely those receiving the tax cut could spend it on themselves and be better off as a result), the ‘even if’ part seems wrong (if we are taking from the future to give to the present, current consumption must rise and future consumption fall). Those who have worked with OLG models, like Roger Farmer, find it easier to work through the logic as to how this is possible.

2) The size of government debt is not a good indicator of any burden. It is possible that government debt is positive, but there has been no attempt at intergenerational transfer. Proof 1: taxes on the young are cut, and the young save all the tax cut by holding the extra debt. Proof 2: borrowing for a capital project that benefits current and all future generations equally.

Note: This is important, as Noah Smith notes in this post. The size of government debt is not equal to the ‘burden’ on future generations. Indeed, positive debt is compatible with there being no burden at all.

3) There are probably much more important mechanisms going on right now that are transferring consumption from the future to the present: in some countries rising house prices, and climate change. No proof, just an opinion.

Note: despite this, if you think your grandchildren will have such a wonderful life compared to yours because of technological progress, you might not be too bothered. It is also worth remarking how potentially inconsistent it is to argue that we have to reduce debt now for the sake of future generations, and at the same time argue that it is too costly to take action now to mitigate climate change. 

4) Even if no intergenerational transfer is involved, high government debt could reduce future consumption for two quite plausible reasons: productive capital may be crowded out, and the tax required to pay the interest on the debt is distortionary (i.e. reduces output below optimal level). Proof: countless papers in the literature.

Note: I think it is wrong to describe both mechanisms as model specific, because you have to make quite extreme assumptions to avoid them. It is for this reason that I worry about high government debt in the long term. I have not heard anything to convince me that either mechanism is unimportant, or of any countervailing mechanism. (The need for safe assets could argue for high gross government debt, but not net debt, where the difference could be a large sovereign wealth fund.)

5) None of these arguments justify austerity at the Zero Lower Bound. Proof: countless posts by various people, including myself.

Note: For example, crowding out happens through high real interest rates, which are hardly a current problem. Nor is scarcity of labour arising from tax distortions.

Final thought. Think about government debt as a way of providing intergenerational insurance against negative demand shocks. When those shocks happen, the state pays out by cutting taxes (say) and increasing its debt. In normal times taxes rise again and the debt is gradually reduced. In this case allowing debt to rise following one of these shocks is no burden.  

Policy, risks and public discourse

Another post where I use the UK as an example to illustrate a more general point

Along with their normal forecast, the National Institute has also used their model NIGEM to analyse the macroeconomic impact of the different political parties fiscal plans post 2015, which is published in the latest Review. (Chris Giles has a FT write-up.) There is no great surprise here: the more fiscal austerity you undertake, and if monetary policy fails to perfectly offset the impact on demand, the lower output will be.

This is not the main reason why I am against further fiscal consolidation post 2015. If you go back to 2010, the OBR’s main forecast didn’t look too bad: the recovery was continuing, and interest rates were able to rise as a result. But good policy does not just look at central projections, but it also looks at risks. Then the risks were asymmetric: if the recovery became too strong, interest rates could always rise further too cool things, but if the recovery did not happen, interest rates would be stuck at their lower bound and monetary policy would be unable to keep the recovery on track.

In 2010 and beyond that downside risk came to pass, and the recovery was delayed. Fiscal policy put the economy in a position where it was particularly vulnerable to downside risks, which is why it was an entirely foreseeable mistake. Quite how large a mistake is something I discuss in my article in the same Review (see also this recent post). Exactly this point applies to 2015 and beyond. The problem with further fiscal consolidation while interest rates remain at their lower bound is that it makes the economy much more vulnerable to downside risks.

This is something that all economists understand, and economists do their fair share of complaining about how difficult it is to get policymakers, let alone the public, to recognise the importance of risk analysis. However in writing about the role of fiscal policy in creating a weak recovery not just in the UK but the world generally, I was struck by how little public model based quantification of this there was even after the event, let alone before. (For some of the few ex post studies related to the Eurozone, see here.) Central banks nearly all maintain models capable of doing the kind of risk analysis I am talking about, but how much of that work gets into the public domain, or is even seen by fiscal policymakers? In the UK there has definitely been technological regress in this respect, as I note here.

So we have a paradox. In academic macro there has never been so much quantified model based policy analysis, some of it analysing just the kind of robustness to risks that I have been talking about. Yet in public discussion of macro policy, it is quite rare to see this. Central banks tend to keep what they do to themselves, and they appear to have a taboo on analysing alternative fiscal policies. In the UK the OBR, which does the government’s fiscal forecasting, is not allowed to look at alternative fiscal policies in the short term. I think I know why this paradox has arisen, but that will have to wait for a later post.

  

The Divine Coincidence in a parallel universe

The Divine Coincidence is the idea that by controlling inflation we also bring the output gap to zero, so we do not need separate targets for both. I talked about this in a recent post, but in writing that I realised I could make my point in another (and perhaps more effective) way. The Divine Coincidence essentially works both ways. So imagine a parallel universe where the monetary authority targeted the output gap, and not inflation. [1] [2] The authority said that by targeting the output gap they also controlled inflation.

Now you may make a practical objection at this point, which is that it is obvious to target inflation rather than the output gap because the latter is so difficult to measure. I think that argument becomes weak once we recognise that by targeting inflation, we are in fact trying to reduce the costs of inflation, and the published inflation rate may be a poor indicator of these costs. In a Woodford type framework, for example, inflation is costly because prices are sticky, so we should focus on those goods (and labour) where prices are sticky. This is one rationale for looking at core inflation, but core inflation is hardly a perfect measure of sticky prices. Arguably our proxies for the output gap, like unemployment, are at least as good at capturing the true costs of a non-zero output gap.

In this parallel universe they too had a Great Recession, and (being parallel and all) their recovery was of a very similar shape to ours. How would the output gap targeting monetary authority in this parallel universe perceive its performance? The story would be one of complete failure. After six years of trying, the output gap had still not been closed. A huge amount of resources had been wasted as a result. In fact, I suspect by now the monetary authority would have said quite explicitly that it just did not have the tools to do its job any more. Furthermore, they probably would have made it clear that one reason they did not have the tools (i.e. why interest rates were still stuck at the Zero Lower Bound) was because of fiscal austerity. If they did not try and blame someone else, they would look utterly incompetent.

I do not think, in our inflation targeting world, the monetary authorities have this view. Instead, based on the limited information I have, and at least outside the Eurozone, they believe performance over the last six years has not been too bad. Inflation was a bit high around 2011, and is maybe a bit low now, but nothing too serious. Yet the data they are looking at is exactly the same as the data in the parallel universe. The only difference is that they are targeting inflation, while in the parallel universe the focus is on the output gap. And by the Divine Coincidence, this difference should not matter!

My parallel universe idea illustrates two points. First, over the last six years, the Divine Coincidence has been distinctly unholy. Second, as a result it is terribly misleading to focus on inflation (and consumer price inflation in particular) rather than the output gap. I suspect in thirty years students will look back on this period with the same disbelief that we look back on the 1930s. How could they have allowed the recession to continue for so long, they will ask, when they had the tools to do much better? Part of the answer will be inflation targeting.

   

[1] It’s not quite that simple, because with either a traditional or New Keynesian Phillips curve, getting inflation to target ensures a zero output gap, but a zero output gap alone does not ensure hitting the inflation target. However I do not think this point is crucial here.

[2] Because of the dual mandate, the US Fed could in principle be in either universe. In practice they seem to focus on inflation.  

Inequality, business leaders and more delusions on the left

Those who think current levels of inequality are not a problem can skip this one

The Blair governments did a lot to fight poverty, but were famously relaxed about inequality, or more specifically the earnings of the 1%. For many in those governments this reflected their own views, but it also reflected a political calculation. The calculation went as follows. To win, Labour needed to be seen as competent to run the economy. The media all too often look to business leaders to answer that question. So Labour needed to be business friendly. Now being business friendly should mean creating an environment that business can thrive in. However to get the approval of business leaders you also need to create an environment where business leaders can thrive personally, and they are very much part of the 1%. QED.

Labour today is not following this strategy. First, Miliband has said quite clearly that he sees tackling inequality as a major issue: "Now I have heard some people say they don’t know what we stand for. So let me take the opportunity today to spell it out in the simplest of terms. It is what I stood for when I won the leadership of this party. And it is what I stand for today. This country is too unequal. And we need to change it." Second, it has two policies that directly impinge on the 1%: the mansion tax and restoring the 50p income tax band.

There are some on the left who dismiss these measures as marginal. One of the comments on my earlier post said that “When it comes to the broad trend of ever greater inequality there really is no meaningful difference between the main parties.” This seems to me a colossal tactical error. To see why, you only have to note what has happened over the last week in the UK. Various business leaders have proclaimed that a Labour government would be a disaster. Stefano Pessina, who among other things runs the Boots chain, declined to elaborate on why exactly Labour would be a disaster. In contrast, he was quite clear that the UK leaving the EU would be a big mistake, which of course is much more likely to happen under a Conservative government!

There is an obvious inference. Labour would not so much be bad for business, but bad for business leaders personally. [1] They, unlike some on the left, recognise that Miliband is not Blair, and that there has been a key shift in the direction of Labour policy. So they will do what they can to stop Labour winning. Labour in turn has responded by attacking the tax avoidance practiced by many of these companies. This is the beginnings of a major battle.

There are at least two important implications. First, the non-partisan media need to understand what is going on. Getting business leaders to comment on the relative merits of the two main parties programmes is no longer a neutral decision - it is giving additional airtime to one side. Second, everyone who cares about inequality needs to realise the importance of this election. Inequality is a key election issue, and there is a very meaningful difference between the two main sides. Certain business leaders clearly understand that.

[1] Another possibility is that they think Labour would be much tougher on business tax avoidance than the Conservatives, but saying this in public would be embarrassing.  

Asymmetries and Uncertainties

This post starts off talking about the UK, but goes on to make more general points about why we may have wasted resources on a huge scale over the last five years, and why this waste may be continuing.

I presented my new National Institute Economic Review paper on the macroeconomic record of the UK Coalition government yesterday, and reaction mainly focused on my conservative estimates of the cost of the move to austerity in 2010 and 2011: a cumulated loss of 5% of GDP or £1500 for each adult and child. The basis for those figures is outlined here, and their conservative nature comes from taking OBR estimates for the impact of fiscal contraction, and assuming (rather improbably) that the output lost through austerity was entirely recovered by 2013.

The key issue with numbers of this kind involves monetary policy. Some argue that without austerity monetary policy would have been more contractionary: the ‘offset’ argument. Of course some of the large increase in UK inflation in 2011 was the direct result of austerity: the VAT increase is the obvious example. In addition, the inflation of 2011 was not foreseen in 2010, so it does not alter the fact that austerity was a policy mistake, but just influences any calculation of the size of the mistake.

The paper addresses the offset argument. I use Bank of England forecasts to suggest that monetary policy was not able to hit its target for forecast inflation for much of this period, implying that the Zero Lower Bound (ZLB) constraint was biting. If the ZLB constraint bites, there will be no offset. Not surprisingly, when that target for expected inflation was not met, the Quantitative Easing programme was expanded. There was only a brief period in 2011 when this was not true, which was the period in which 3 out of 9 MPC members voted to increase rates. So if we had not had 2010 austerity, then at most interest rates might have begun rising in 2011, which given lags might have reduced GDP to some extent that year. But crucially the OBR numbers that I use already embody some monetary offset, because they are based on empirical estimates of average multipliers over the past. To use these OBR numbers and then do some monetary offset involves double counting.

However, I want to stay with my ‘no austerity’ counterfactual to make a more fundamental point. If interest rates had been raised in 2011, and this had reduced GDP in 2011 and 2012, we would now be talking about the MPC’s 2011 mistake, rather than the government’s 2010 mistake. I would be calculating how much GDP had been wasted in 2011 and 2012 as a result of premature monetary tightening. I would be right to do so, because the costs of delaying a recovery from a deep recession dwarf any benefits from reducing inflation a bit following a commodity price shock.

This indicates a fundamental problem, which policymakers have still not taken on board. For whatever reason (resistance to nominal wage cuts being the most obvious), inflation ceases to be a good indicator of underutilised resources when inflation starts off low and we have a major negative demand shock. Policymakers are continuing to make this mistake today: core inflation is not too far away from target, and growth is quite healthy, so it is OK to do nothing (or in the Eurozone, it is OK to wait for ages before doing anything). However it seems quite possible that GDP continues to be quite a few percentage points below where it could be without inflation exceeding its target, so we continue to waste resources on a huge scale. This is money down the drain that we will never get back. It is like taxing households thousands of pounds or dollars or euros a year and burning that money.

One way to put this point is to go back to the basic rationalisation behind flexible inflation targeting. It is OK to have a target based on inflation alone, with no mention of the output gap, because you cannot in the long run keep inflation at target without also keeping the output gap at zero. This is sometimes called the divine coincidence. However if, at low inflation rates, inflation becomes a noisy, weak and asymmetric indicator of the output gap, then focusing on inflation is going to perform badly. In these circumstances it could be many years before it becomes clear that we have been continually running the economy under capacity, and needlessly wasting resources. Unfortunately even when that point of realisation arrives, for obvious reasons monetary policymakers are going to be reluctant to acknowledge the mistake.

Going for balance

The Green Budget analysis just released by the IFS contains a lot of material. (For a very reasonable summary, see this from the FT.) One point that a number of papers have picked up is, to quote the Independent, that the UK “Coalition’s fiscal plans for the next Parliament imply the largest dose of austerity anywhere in the developed world”. Actually the analysis appears to come from the IMF’s World Economic Outlook forecast. Here is a chart of the IMF's estimated and forecast structural budget deficits for a number of countries as a proportion of potential GDP.

The extent of additional consolidation planned for the UK beyond 2015 is clear. It is important to note that structural balance (zero on this chart) is not in any sense a neutral position. It means that debt to GDP will be falling as long as GDP is growing. That is what Germany is currently doing, and France is aiming for, while both the US and Japan are only going for a roughly stable debt to GDP ratio.

As I have emphasised many times, the critical issue is not whether it is desirable to gradually reduce net government debt as a percentage of GDP (I think it is), but when you try to do this. Theory and evidence clearly tell you not to try during a liquidity trap, when interest rates are stuck at their Zero Lower Bound. This will waste a great deal of resources, and cause unnecessary hardship. In my recent VoxEU piece, I argued that real GDP in 2014 could have been up to 4% higher in the US, UK and Eurozone if government consumption and investment had followed a fairly neutral trajectory, rather than being cut back substantially.

That result did not come from assuming some outrageous multiplier, but largely reflects the extent of austerity already undertaken. Compared to that neutral path, government consumption and investment were between 10% and 15% lower by 2014 in those countries or country blocs.

One explanation for the extent of austerity is that it represents political opportunism by those who seek a smaller state. Now I know that some do not like to entertain such thoughts: they think to suggest such things indicates a lack of political balance. However as I discussed here, there seem to be compelling reasons to at least explore that possibility. If we do, then the size of these cuts in spending are important, because they clearly show that - for the moment at least - opportunism has been remarkably successful in its own terms. By this measure the size of the state has been substantially reduced by making deficit reduction the number one macroeconomic priority.

This is in turn important because it influences the lessons to draw from this experience. To a macroeconomist, losing up to 4% of GDP a year is a huge cost. Such a cost might be excusable if it had been required to get inflation down from some high level, but instead it has lead to inflation well below target. The obvious question to ask therefore is how to avoid such costs happening again. If the basic cause has been political opportunism, and that opportunism has been successful in its objectives, then it seems highly likely that it might happen again the next time we have a major global recession. If that is the case then macroeconomists need to rethink how policy is made after major recessions. In the meantime, if political opportunism is what is driving policy, we will see in countries like the UK how far that opportunism can be pushed.

The Conservatives follow the Republicans on climate change

In a post last weekend where I was very critical of George Monbiot for suggesting that those on the left should no longer vote tactically to prevent a Conservative government, I prefaced my remarks by saying that his journalism consistently told me more than most others. Some comments poured scorn on that remark. So let me give you an example.

In an earlier article, George Monbiot noted a part of the innocently titled ‘Infrastructure Bill’ currently going through parliament. Section (36, p39) is headed ‘Maximising economic recovery of UK petroleum’. Its principle objective is to do just that. Now it does not take a climate scientist to realise that trying to restrict our use of fossil fuels to avoid climate change requires leaving quite a lot of them in the ground. So this bill suggests that whatever the UK government says about climate change, the UK contribution in terms of limiting extraction of oil will be exactly zero. It is so important that we extract every last economical drop that we need legislation to guarantee it! I wonder who ‘we’ is in this case?

Over a year ago I wrote a post entitled “Will the UK Conservatives become like the Republican Party?” It included this paragraph.

I would argue that attitudes to climate change represent an acid test of whether ideology has overtaken evidence in parties of the right. The UK in particular appears to be at a critical point in this respect. While the official Conservative line recognises the importance of trying to deal with man-made climate change, a significant proportion of Conservative MPs are now promoting climate change denial. Deniers are given wide coverage (and often support) in the largely right wing UK press, and perhaps as a result the UK Chancellor, George Osborne, has been quite antagonistic towards ‘green’ policies.

With this legislation that line has clearly been crossed. 

The Conservatives know that in the UK a great many people regard the US Republican Party as slightly mad. So they will never come out and say they intend to do nothing about climate change. In fact they will say exactly the opposite. But legislation speaks louder than words. It has been apparent for some time that George Osborne has no time for any of this green nonsense. Now it is official, in legislation going through parliament.

We therefore need to ask in what other ways will the Conservatives follow the Republicans. 
The Republican congress has already mapped out its strategy for unwinding many of the controls on Wall Street implemented after the financial crisis. If the Conservatives win in 2015, given who provides [1] a large amount of their funding, do we really think the same thing will not happen here? Not all at once, but quietly by slipping in the odd bit of legislation here and there. In a similar manner to including a commitment to extract all the UK’s oil in an infrastructure bill.

[1] From this link note the summer party guest list at £1000 a ticket, and who is number 4 in the list. Now you know who 'we' is when it comes to this part of the UK infrastructure bill.