The Chancellor continues his steady fiscal tightening

A few things you probably won’t read about what the Chancellor announced yesterday. You will have read that the budget measures as a whole amounts to a significant fiscal giveaway. In which case the following chart may appear surprising.

Negative numbers represent a current budget surplus, and growing surpluses are a fiscal tightening. You can see that with the exception of this fiscal year, when policy is tighter, the current balance profile of rising surpluses has not changed very much. The reason for this apparent contradiction is simple enough. If nothing had been done, the higher taxes than forecast represents a significant fiscal tightening compared to previous expectations, albeit a tightening that represents forecast error rather than policy decisions. [1] What the Chancellor did yesterday from next year onwards is restore the policy stance to what it was before the forecast error was discovered.

What this means is that the Chancellor has kept his path of modest fiscal tightening over the next five years, As I have said many times, this is simply not appropriate in a situation where interest rates are close to their lower bound and the immediate outlook is highly uncertain. But then this government has never understood about monetary and fiscal coordination.

Labour’s fiscal credibility rule (fcr) allows us to see how differently a Labour government would run the non-investment part of fiscal policy. The ficr requires the government to aim for current balance in 5 years time. That, of course, is zero on this chart. That tells you that, if this is indeed the path the current balance follows, Labour will have extra spending or lower taxes than the Conservatives worth over 1% of GDP. That covers the gap the IFS suggested in their costings from the 2017 manifesto with plenty left over.

As I have already suggested, Labour’s overall fiscal stance if they stick to the fcr makes a lot more sense The Conservatives are trying to reduce the level of debt to GDP by too much prematurely. That does not make sense from a precautionary Keynesian point of view, or from a simple tax/consumption smoothing point of view. But macroeconomics remains an excluded consideration from Conservative/Treasury budgets, and mediamacro pretends the government is just like a household that needs to pay off its debts within its lifetime.  

[1] Suppose the forecast error was X. Then imagine that error had not occurred, but the Chancellor had raised taxes by X. The latter would clearly be a fiscal tightening by the Chancellor. But in macroeconomic terms taxes rise by X in each case, so the two are equivalent.

Why should someone who is anti-austerity care about debt

Most of the posts I have written about austerity have been aimed at countering the idea that in a recession you need to bring down government deficits and therefore debt. But what if you accept all that (you are anti-austerity). Why should you care about debt at all? Why do we have fiscal rules based on deficits? Why not spend what the government needs to spend, and not worry that this resulted in a larger budget deficit?

The story often given is that the markets will impose some limit on what the government will be able to borrow, because if debt gets ‘too high’ in relation to GDP markets will start demanding a higher return. You can see why that argument is problematic by asking why interest rates on government debt would need to be higher. The most obvious reason is default risk. But for a country that can create its own currency there is never any necessity to default.

However there is another reason to demand a higher nominal interest rate on debt, and that is if you think there will be additional inflation in the country. Spending more without raising taxes will tends to increase inflation. But if the government or central bank is sure to raise interest rates to offset this inflationary pressure then the concern about inflation disappears.

In MMT inflation is also the fundamental constraint on how far you can raise spending without raising taxes. MMT also says that you do not need to worry about the deficit, but this is only true if - as they advocate - fiscal policy rather than monetary policy controls demand and inflation. Under MMT the link between the deficit and inflation is direct (assuming no change in the composition of either) .

When inflation is controlled using interest rates the situation is fundamentally different. There is now no single point at which the deficit is consistent with stable inflation. In the short term there are a whole range of interest rate/deficit combinations that keep inflation stable today (e.g. high deficit and high interest rates or low deficit and low interest rate). Does this mean we do not need to worry about the deficit and the debt it leads to because monetary policy will always take care of inflation?

The answer is no, if we think about dynamics. What happens if we choose a high deficit high interest rate combination because we want higher government spending without paying more in taxes? There are two important dynamic effects here. The most basic is that a high deficit raises the stock of government debt. Because of interest rate payments on that debt the deficit rises further. In addition raising interest rates to stop inflation will itself tend to raise debt interest payments. This is an unstable debt interest spiral. You cannot say why not fund the additional debt interest payments by creating money, because that will tend to reduce interest rates and raise inflation.

This means that over the longer term you have to adjust spending and taxes to keep government debt relative to GDP stable, That does not mean debt has to be stabilised at a particular level, but just that if there is not a compelling reason to do otherwise you need to keep debt stable rather than rising upwards. A recession is one such compelling reason, and there are others (like adding to the public sectors stock of assets).

Stability does not mean deficits have to be zero because we have to allow for the growth in GDP. The maths is simple (see [1]). Take the stock of debt to GDP as a fraction of GDP (say 0.8), multiply by the trend rate of growth of nominal GDP as a fraction (say 0.04), and you approximately have what the total deficit should be as a fraction of GDP to keep debt stable (0.032), which is a deficit of 3.2% of GDP. .

There is always the temptation for politicians to raise debt now, and let future governments stabilise debt at a higher level. In the past the US under Republicans and other countries (but not the UK) tended to let this happen in the 30 years before the GFC, and economists call it deficit bias. Fiscal rules began life because it was hoped they would reduce deficit bias.

So why not raise the level of debt by spending more for a period, and then stabilise it by cutting spending or raising taxes a generation later? Here we have to note that the stabilising deficit (the deficit that keeps debt to GDP stable) includes debt interest payment. What we call the primary deficit is the total deficit less interest payments, You should now be able to see the problem with allowing debt to increase and stabilising it later. If you raise the level of debt to GDP and then stabilise it, debt interest payments will be higher and the level of the primary deficit left over is smaller than the one you started with. This is one sense in which letting debt rise today takes from future generations. [2]

This is why it is never a good idea to increase the stock of government debt without good reason, as Trump is doing, because it either cuts spending or raises taxes in the long run. This logic does not mean that future GDP is any lower (although there may be other theoretical reasons why higher debt can reduce output), but it means that if debt to GDP is stabilised, debt interest rates will be higher and so something else has to adjust to compensate, which means higher taxes or lower spending. [3]

There is an important caveat to this dynamic, which becomes clear if you do the maths. You only get a debt interest spiral if the nominal interest rate exceeds the growth rate of GDP (call the difference between the two the ‘very real interest rate’). If the very real interest rate is negative, extra debt for a given deficit allows a higher primary balance. Journalists sometimes look at the level of debt interest as a share of GDP (currently 2% in the UK) and say government spending could be 2% of GDP higher (or taxes lower) if we didn’t have to pay interest on debt. But if you could somehow magic your debt to zero so debt interest rates were zero, the stabilising deficit would fall from a current level around 3% to 0, requiring a 3% fall in the primary balance. This reflects that the current very real interest rate is negative.

Does this mean we do not have to worry about the debt interest rate spiral, and therefore debt? Only if we know that the very real interest rate will stay negative. This is unlikely to happen, particularly if interest rates are having to rise to combat the inflationary effects of high deficits. Because debt levels should never be adjusted down quickly, it is best to act as if the very real interest rate will become positive at some point.

This is not the only reason why raising government debt to GDP in the long run can be detrimental, but this one is simple because it depends only on some basic economics, algebra and logic. This and other reasons will never be enough to justify cutting deficits in recessions, not even close. But being anti-austerity does not mean we can forget about debt completely, as long as we are using interest rates rather than fiscal policy to control demand. (On why you might want to do that see here.)

[1] G is government spending, T taxes, r is the nominal interest rate, and B the stock of debt. Little letters mean as a ratio of nominal GDP (Y). x is the growth rate of nominal GDP, delta means change in. We ignore money for reasons given in the text. The budget identity is

G - T + rB = deficit = delta B

So dividing by GDP gives

g - t + rb = deficit/Y

In continuous time (or approximately otherwise) we can write

deficit/Y = delta b + xb

So for delta b to be zero, deficit/Y = xb

Or equivalently g - t + (r-x)b = 0

[2] More strictly in this case it takes from future generations the benefits of public spending or adds to the cost of taxes, and transfers it to bond holders.

The day Theresa May lied in parliament about something I wrote

When I became part of John McDonnell’s Economic Advisory Council I knew that would put me in the political spotlight. I write about what I helped achieve in that role in my forthcoming book. I left over Labour’s support for Brexit in part because my clear and public anti-Brexit views could be used to attack Labour, when the people driving Brexit were Conservatives. I found out yesterday that at PMQs the Prime Minister was carrying on regardless, although in this case it was over Labour’s 2017 manifesto.

In reality I was strongly supportive of Labour’s overall fiscal stance in 2017. I wrote a lot in my blog before the election, and a summary of my views are in a chapter in a book of essays by various authors published by Verso and edited by John McDonnell. The point I wanted to stress was that it didn’t matter if the IFS were right that the numbers didn’t add up, because the fiscal stance was good for the economy, and could well satisfy Labour's very good Fiscal Credibility Rule.

The paragraph that says all this in the book starts

“Let us suppose the IFS was correct, …”

and I go to argue in that case that the ex ante deficit would have boosted the economy and it might not have added to the deficit ex post.

Unfortunately she said, holding a copy of the book in her hand

“In an article by an economic adviser to the Labour Party, he says about their manifesto, “the numbers did not add up”. That this was a “welcome feature” and “largely irrelevant”Well it may be irrelevant to the Rt Hon Gentleman and the Shadow Chancellor but it’s not irrelevant to the people’s whose taxes go up, whose jobs are lost and whose taxes pay Labour’s debt”

Nowhere in the article did I say I thought the numbers did not add up. I was clearly misquoted. If you say otherwise, imagine I write an article that says ‘suppose austerity is expansionary’ and go on to explain how that generates consequences that contradict reality. It is called a proof by contradiction, and that is similar to the structure of my argument. To report that I said “austerity is expansionary’” would be ridiculous. If it was done to score political points you would conclude it was a lie.

Was this an unfortunate case of misreading? It seems extremely implausible. I’m certain that when the PM or more probably some adviser misquotes someone in a draft PMQ response, someone - possibly even the person themselves - checks that the quote is correct. You have to have serious comprehension difficulties to misunderstand the meaning of “Let us suppose”.

So I tweeted this

“Apparently the Prime Minister quoted me saying about Labour's 2017 manifesto "the numbers did not add up" In fact I said "Let us suppose the IFS was correct" and examined consequences. I have never taken a view on whether they did/didn't add up. If that is what she said, she lied”

I later looked at a recording of PMQs and she did indeed say that. Now maybe I am wrong about a deliberately lie told to gain political effect. If it was an honest mistake she or someone who works for her can explain to me how that mistake was made. I asked CCHQ for an apology, but I am not holding my breath.

The Mirror picked it up here, as did the BBC in their PMQ factcheck. In the scheme of things the issue is very minor, but the Prime Minister lying whatever the context should be important. But the sad thing is that no one is surprised by this kind of thing any more. We in the UK look at Trump’s lying with horror and think this is something uniquely American. But this government has been pulled up countless times (e.g. here) for misleading the public by misusing statistics and of course the lies of the Brexiters are shameless. The majority of press titles will ignore or play down any criticism of Conservative ministers or the PM (unless it is over Brexit), and the BBC is timid to say the least. It is asymmetrical of course: any mistakes the other side makes are examined in great detail. If you do not have the media to call out lies, they will pass as the truth and democracy dies.

MMT and Labour’s fiscal rule

I’m afraid this will probably only interest those familiar with MMT, but in its favour it has to me at least a surprising end. Bill Mitchell has been criticising Labour’s fiscal rule for some time, and my work that lay behind it (with Jonathan Portes) in particular. In one posts he says “Wren-Lewis just should stick to Twitter. He seems to like that. It would save us the time reading the other stuff.” In his latest post on the subject, after he met John McDonnell and his team, involves general assertions that the rule is neoliberal, but he does have two concrete criticisms. He has the following objection to a current balance target.

“But as I’ve written many times in the past, if a nation encounters a serious recession that results in a significant deficit, and then within the last years of the rolling window, it may have to introduce major cuts in recurrent outlays in order to move the recurrent balance towards zero.”

Now that is a cogent criticism of a fixed date rule, which does suffer from the danger of a recession just before its time period ends. The only problem is that Labour’s current balance target involves a rolling window. It is a target for the current balance (what Mitchell calls the recurrent balance) over the next five years. One year later it remains a target for the next five years. That is what ‘rolling’ means. So you never get caught out by an event ‘just before the target date’. With a rolling target this criticism makes no obvious sense.

Incidentally, this rolling window allows the government to pursue a countercyclical policy if it wishes to do so. The standard assumption is that mild booms and downturns are reversed by monetary policy within 5 years, so as long as the fiscal stimulus was not planned to last more than 4 years it is quite consistent with a rolling target. Whether government would want to when interest rates are doing the stabilisation is another matter.

What about a more major recession, where rates hit their ZLB. The rule’s knockout then applies, and fiscal policy becomes the primary stabilisation tool. This brings us to his second criticism.

“I noted that this was another neoliberal aspect of the approach. The reason for that conclusion is that the rule as stated requires the Monetary Policy Committee of the Bank of England to indicate to the Treasury that its monetary policy instruments are no longer effective. So in effect, the elected and accountable Chancellor can only enjoy fiscal freedom when the technocrats in the Bank of England handover the imprimatur to him. That is a basic Monetarist tenet – that monetary policy has primacy over fiscal policy. That is neoliberal central. Moreover, the MPC may not indicate monetary policy ineffectiveness, even if the target interest-rate is at zero (the so-called zero bound). As we have seen in the recent years, central banks have been willing to explore all sorts of weird and wonderful policy interventions to remain relevant in the macroeconomic policy sphere.”

Again its a cogent criticism. But this time Bill must know he is not talking about Labour’s rule, because he talked to Labour’s team. The MPC is asked to indicate when interest rates have reached their lower bound, not when they think all monetary policy instruments are ineffective.

MMTers on twitter tried to defend this line by saying the Bank might deliberately deceive. But think what that would have to involve. In a major recession the MPC would keep rates deliberately high and claim that they could cut them if they wished, but they do not wish to do so. I think the concern in that rather fantastical scenario is whether the MPC is any longer fit for purpose.

For much of the time I was arguing with MMT twitter about all this Bill Mitchell was copied in, but he did not respond to my criticisms of his post. But at one point he did send me this about a particular tweet I wrote

“Stop slandering me or you will face the legal consequences. I have nothing to do with the way others behave on Twitter.”

This is a first for me at least. Given this threat I cannot tell you what I wrote that provoked that, or give you a link to it, because I cannot afford a court case. Of course Bill Mitchell is not responsible for what his twitter followers say, but he is responsible for his distortions about what Labour’s fiscal rule says. I have criticised the way he argues his case in his defence of Lexit here.

After that threat I did then take the opportunity of asking him why he distorted his description of the ZLB knockout in the way I describe above, but he never replied. I wrote this about MMT and its followers, and these events only confirm this view.

Crashed by Adam Tooze

My review of Crash: How a Decade of Financial Crisis Changed the World is finally out at the London Review of Books (subscribers only I’m afraid). From what I’ve read it has received glowing reviews elsewhere, and mine is no exception. Reflecting its ambition it is no quick read (the main text is 600 pages). There is an introduction which does summarise some of the key ideas, but the triumph of the book is that it combines a detailed account of the events of the last ten years with an analytical overview which makes sense of the detail and which makes good sense. It has the additional advantage from my point of view that it is broadly consistent with many of the arguments made on this blog, although I don’t think I ever managed to match the quality of his prose.

The argument that binds the whole book together is that the crisis was not the result of the specific shocks of Subprime debt or the housing markets of Ireland and Spain, but an inevitable consequence of a global banking system that became chronically short of buffers to cushion against any kind of significant systemic shock. To use the technical term the system became over leveraged: lending too much in relation to the capital it had to cover loans going bad. This is the same theme as the book by Tam Bayoumi I discussed here, but in fact the two compliment each other: Bayoumi focuses on the regulatory changes that created global megabanks, while Tooze deals with the consequences of when these banks crashed.

Key to how the crisis played out was how different governments reacted to the crisis, and this is the central part of the book. After the mistake of Lehman, the US government took comprehensive action on a huge scale. To quote Tooze:

“It was a class logic, admittedly – ‘Protect Wall Street first, worry about Main Street later – but at least it had a rationale and one operating on a grand scale.”

The UK did the same, but because there were no widespread defaults in the UK there was no failure to help borrowers.

The contrast with the Eurozone is emphasised by Tooze. First Eurozone countries tried to suggest this was an anglo-saxon crisis, despite their own banks being deeply embedded in this global network, and was particularly rich as the Fed was (as Tooze shows) providing billions of dollars to European banks to keep them afloat. Germany with the help of the ECB refused to participate in a joint Eurozone response, and then later attempted the ‘bait and switch’ of blaming the Eurozone crisis on excessive government debt: bait and switch is the title of my review, and was originally used by Mark Blyth who in his book Austerity: the History of a Dangerous Idea saw earlier than most that the crisis was all about banks. Again to quote Tooze on the Eurozone response:

“‘It is a spectacle that ought to inspire outrage. Millions have suffered for no good reason.”

I have to add for those reading in the UK that this was about how individual Eurozone governments behaved within the Eurozone system, and has nothing to do with the trade relationships and regulation pooling that is the EU.

There is a lot more in my review (LRB gives you the luxury of over 3,000 words), and many important things in the book that I did not have space to comment on. For those into international relations as well as economists and historians this book is a goldmine.

On the subject of books, my own more modest effort is out shortly: it can be ordered at a 20% discount here, rising to 35% if you join the publisher’s mailing list.)

There is a Brexit deal the country can live with, but the government cannot

Brexit logic starts, as it always has, with Ireland. The EU will not do a deal without a permanent backstop, which means Northern Ireland (NI) stays in the Customs Union (CU) and Single Market (SM) for goods. (It could allow for an end to the backstop when both sides agree there is a technological solution that makes it unnecessary, which is another way of saying the backstop will be permanent.)

If the government were prepared for extensive customs checks in NI ports, the UK would still have considerable freedom to choose whatever deal it liked. Some of those arrangements would be very costly in economic terms, but they would be possible. But the DUP, as has been clear from the start, are against any such checks, and they are effectively part of the government because the Conservatives would lose every controversial parliamentary vote if the DUP voted against them.

If there cannot be additional customs checks in NI ports, that implies the whole of the UK has to be part of the CU and SM for goods. While the EU will allow a bespoke deal for NI to preserve the letter and spirit of the Good Friday agreement, it is unlikely to do so for a country that wants out. As a result, the backstop plus no customs checks means the UK has to remain in the full SM, including freedom of movement. In other words BINO (Brexit in name only) or equivalently extended transition: both mean pay, obey but no say. That is the basic logic of Brexit that has been obvious since December 2017 if not before.

A majority of people in this country today want to remain in the EU, but I think they could also live for a time with BINO if it was accompanied by additional controls on EU immigration allowed under EU rules. (These two studies are useful in that respect.) Perhaps the same is true for a majority of Conservative party MPs. But unfortunately a large minority of the Conservative party and the DUP cannot. They are lost to dreams of being free from EU regulations (the SM) and global Britain.

The last nine months have been an attempt by Theresa May to fudge that essential logic. Each time it looks like a fudge might work, she gets pulled back by the Brexiters. Last week was no different..Talks ended up being postponed because five or so cabinet members demanded that an Irish backstop had to be time limited, but there is no way that the EU would agree to that because it negates the whole point of the backstop. And at every stage, except Chequers, May has preferred to kick the can down the road by making impossible demands of the EU to avoid further splits in her government. The clearest example of this is when in December she agreed an Irish backstop only to declare agreeing to it as inconceivable a month or two later. 

At a fundamental level this constant appeasement of the Brexiters does not make sense, because they have nowhere to go except No Deal, and May together with parliament will not allow No Deal. Whatever they may say in public, the Brexiters accept the logic above. They know that any kind of trade deal with the EU has to involve the backstop. They cannot accept the backstop, but are content to see the return of a hard Irish border. Which means No Deal is the only possibility left for them.

So why does May continue to try and keep some of them in government? She cannot do without the DUP of course. But she knows from December that it might be possible, for a short amount of time, to fool enough Brexiters into believing something that is not true.(hence, I suppose, the invention of obscure jargon like a backstop to the backstop). I suspect, however, that the scope for further deception is insufficient for the task in hand. More important is that May probably believes that delay helps her ability to get a deal through parliament, and this is worth any loss of faith in eventually agreeing things that she failed to agree to earlier. 

Finally there are two interesting asides from this basic argument worth making. I talked to a very well known BBC presenter last week who was convinced that Brexit was nothing to do with the BBC. They are wrong on the economic costs, because the BBC did not regularly say that the overwhelming view of academic and business economists was that Brexit would do economic harm. Too often they assumed that this was self evident because all the major institutions (OECD, IMF etc) said this, but the ‘anti elite’ theme of Leave was designed to counter that, and giving equal time to both sides without any context (and of course constant newspaper propaganda) allowed Leavers to believe they would be better off.

But my criticism of the BBC is not just about the economic costs. One of the Leave messages that was attractive to many people was being able to do trade deals with other countries. I do not remember constant reminders from journalists saying that this was incompatible with membership of the SM, and so we had to choose between frictionless trade with the EU or doing these new deals. This statement is not controversial but a simple fact. It is also a fact that anything short of a CU and SM for goods will require a hard Irish border. This was the kind of basic information that the public craved for, and the BBC did not give it because their priority was not to upset either side. It is academic how important this all was to the final vote: the fundamental point is the BBC departed from its mandate to educate and inform at just the point the public needed and wanted it most..

The second aside is about Labour. One of the consequences of a failure by parliament to agree a deal could be a general election. Suppose that resulted in a Labour win. Labour would then have two Brexit options that the current government cannot take. The first is to have a border in the Irish Sea, because they are not beholden to the DUP. Corbyn has said that this would be very difficult, and the reason he gave had nothing to do with some vague idea of sovereignty. The chances are that Labour would end up agreeing something close to BINO. This means that a Labour government can deliver a form of Brexit that the country can live with, while with the current government it is like getting blood out of a stone.

Implications of German export success

I have finally got around to reading this excellent CEPR ebook on Germany’s exceptional recovery. That German GDP growth since the Global Financial Crisis (GFC) is higher than average Eurozone growth or French growth can be seen below.

GDP growth (source OECD Economic Outlook)

However the relative performance in terms of unemployment is remarkable.

Unemployment (national definitions, source OECD Economic Outlook)

The tremendous success in reducing unemployment is discussed in two papers in the book, and both suggest that it had more to do with changes in the nature of firm-union bargaining than the Hartz reforms. (John Springford has a nice chart showing how the German Phillips curve has shifted.) I have for some time noted how wage increases in Germany after 2000 were too low in the context of a 2% inflation target, and this helped drive an export boom and is a factor behind a huge current account surplus of 8% of GDP.

Other chapters in the ebook argue that there were other, perhaps as or more important,  factors behind this export boom, and I’m convinced that other factors did play a role. However the point I want to make in this post is that, as long as these factors are permanent, they imply that the real exchange rate in Germany has to rise at some point. This is exactly the same point as saying that not all of the German current account surplus of 8% is structural. Some of that surplus is because the German real exchange rate is undervalued.

There are two ways the German real exchange rate can appreciate. The first is via an appreciation in the Euro, and the second is for German inflation to be higher than average Euro area inflation. Below is a chart of one measure of competitiveness for both Germany and the Euro area.

The level is arbitrary: it is how the two series move over time and relative to each other that matters. You can see how Germany gained competitiveness.over other Eurozone countries from 2000 to the GFC. You can also see how that gain has been partially but not fully unwound over the last 7 or 8 years. Looking at Euro area competitiveness, it is a little below its average level over the past and also its level in 2010 when I calculated it was close to its equilibrium rate to the dollar. (This work was unpublished, but uses a similar model to the one I used to calculate the optimal entry rate of Sterling into the Euro as part of the 5 tests.)

So there is perhaps some scope for a further appreciation in the Euro, but it seems unlikely that will be enough on its own to achieve the required German real appreciation. German nominal wages have increased by more than the Euro average in recent years, but the differences have been small. That difference needs to increase to get Germany's real exchange rate to sustainable levels. Germany should not think of that as a problem, but rather the way their export success has to be translated into higher incomes for German workers..