The government and the OBR: why I was very pleased to be wrong

Yesterday, I commented on the Prime Minister’s ‘there is no alternative’ speech, which included the following:

“They [the OBR] are absolutely clear that the deficit reduction plan is not responsible [for depressed growth]. In fact, quite the opposite.”

I wrote this:

“So this statement deliberately misrepresents what the OBR has been saying, to imply that the OBR believes in expansionary austerity. But the Prime Minister knows that the OBR will let this misrepresentation of its views pass – which is a shame.”

I was wrong. Today the OBR published on its website a letter from its director Robert Chote to the PM. It is very polite: after reproducing the same part of the speech that I highlighted, it said

“For the avoidance of doubt, I think it is important to point out that every forecast published by the OBR since the June 2010 Budget has incorporated the widely held assumption that tax increases and spending cuts reduce economic growth in the short term.”

Actually, I think Robert had to do something like this. I wrote what I did because this was no isolated incident - no momentary piece of over enthusiasm by a speech writer. Just read the first part of the Chancellor’s autumn statement. He milks the ‘look the independent OBR agrees with us’ line all he can. In particular he says:

“One of the advantages of the creation of the OBR is that not only do we get independent forecasts, we also get an independent explanation of why the forecasts are as they are. If, for instance, lower growth was the result of the Government’s fiscal policy, they would say so. But they do not.”

Now the Chancellor was a little more careful. By saying lower growth rather than low growth, he could argue that he meant ‘lower than expected’ growth, rather than the actual growth number, even if this subtlety might have been lost on his audience. For that reason, I can imagine the OBR holding back from complaining at that time. But yesterday the Prime Minister went too far. Robert Chote needed to respond, and in doing so will have done the OBR no harm whatsoever.

When the OBR was established, I and others were concerned that its inevitably close relationship with the Treasury and other government departments (inevitable, because it produces the fiscal forecast) might lead some to question its independence. I was also concerned that its limited remit - it is not allowed to look at alternative policies - would mean that its reputation was too closely tied to its forecasts. And I knew that macro forecasting is a mugs game: as forecasts are only slightly more accurate than guess work, getting things right was largely down to luck. So its own fortunes could become too linked to the governments, which might mean it lost influence elsewhere and might not even survive a change of government. For just one example of this tendency, see this recent perceptive piece by Colin Talbot.

Given its restricted remit, the OBR has done what it can to make links with government as transparent as possible, and argued (convincingly in my view) that these contacts with government do not make it into a puppet of the government. Indeed, one could justifiably argue that the OBR has been pulling the government’s strings. While some have been critical of its forecasting methods, I think its actions have been perfectly defensible, as I argued here. I was however worried about the way the government was misusing the OBR’s analysis. With any luck, the OBR with its actions today has called time on that, and the government will be more careful in future.

In the onward march of fiscal councils, Robert’s letter is just one minor skirmish in one particular battle, but lets celebrate it none the less.

Looking for a Robust Defence of Austerity

So, driving home today, I was told by the BBC that the Prime Minister had just made a ‘robust’ defence of his government’s economic policies. One definition of robust (for an object) is ‘sturdy in construction.’ Well let us see, by looking at some of the sections discussing the fiscal strategy.

(1) “First, the deficit. This deficit didn’t suddenly appear purely as a result of the global financial crisis. It was driven by persistent, reckless and completely unaffordable government spending and borrowing over many years. By 2008, we already had a structural deficit of more than 7 per cent – the biggest in the G7.”

UK GDP fell by 1% in 2008. Here is OBR data on public sector net debt before the recession.

As I suggested here, it would have been better if the Labour government had sustained the reduction in debt they achieved in the early years. However this chart does not look like a “reckless and completely unaffordable” policy. But if the Prime Minister says it was, I guess he must have robust reasons for saying so. [a]

(2) “There are some people who think we don’t have to take all these tough decisions to deal with our debts. They say that our focus on deficit reduction is damaging growth. And what we need to do is to spend more and borrow more. It’s as if they think there’s some magic money tree. Well let me tell you a plain truth: there isn’t.”

People and companies borrow all the time. I do not think they believe in a “magic money tree”. People and firms borrow more when the cost of borrowing is very cheap – that is common sense. The government is trying to encourage individuals and firms to borrow more. So why is it good for the private sector to borrow more to invest in good projects when the cost of borrowing is cheap, but when the government does the same thing it involves believing in magic? Strange, but our Prime Minister says it is so, and he is saying it in a robust manner.

(3) “As the independent Office for Budget Responsibility has made clear……growth has been depressed by the financial crisis……the problems in the Eurozone……and a 60 per cent rise in oil prices between August 2010 and April 2011. They are absolutely clear that the deficit reduction plan is not responsible. In fact, quite the opposite.”

If this were true, then one would seriously wonder about the competence of the OBR. There has been much recent debate about the size of multipliers, but not the sign: greater austerity almost surely reduces growth. The theoretical plausibility and empirical evidence for expansionary austerity is practically zero: for more on the former see this short account by Campbell Leith of joint research with Eric Leeper and Huixin Bi recently published in the Economic Journal.

However, as far as I am aware, the OBR has never said that austerity has had no impact on growth. What they have talked about is why growth has been lower than they expected back in 2010. As they had austerity built in to their forecasts of 2010, then they have naturally looked elsewhere for events they were not expecting. [b] So this statement deliberately misrepresents what the OBR has been saying, to imply that the OBR believes in expansionary austerity. But the Prime Minister knows that the OBR will let this misrepresentation of its views pass – which is a shame. [Update - the OBR did not let this pass: see this subsequent post. ] I guess you can robustly misrepresent.

(4) “Last month’s downgrade was the starkest possible reminder of the debt problem we face. If we don’t deal with it……interest rates will rise, homes will be repossessed and businesses will go bust…”

Interest rates might rise if the markets thought that the UK government might default on its debt or if the UK was about to enter an inflationary spiral, but there is no sign of that (in fact, quite the opposite), for very good reasons. Interest rates might rise if the MPC decides they should. At the moment all the talk is whether the MPC will go for more, not less, stimulus, and if the FT is to be believed the government will give the MPC more room to act in this way. So no sign that interest rates might rise on that account either, but I guess there must be a robust logic to this assertion somewhere, otherwise why would the Prime Minister be so certain?

 (5) “So those who think we can afford to slow down the rate of fiscal consolidation by borrowing and spending more are jeopardising the nation’s finances……and they are putting at risk the livelihoods of families up and down the country. Labour’s central argument is exactly that. They say that by borrowing more they would miraculously end up borrowing less. Let me just say that again: they think borrowing more money would mean borrowing less. Yes, it really is as incredible as that. The Institute of Fiscal Studies has completely demolished this argument.”

The argument that by borrowing more you may end up borrowing less has been set out by DeLong and Summers. If you search for references to these authors on the IFS website, or for both on Google, nothing comes up, so I do not know what demolition is being referred to here. [c] Perhaps the Prime Minister has seen something I have not. In any case, given what the Prime Minister has said, I’m sure DeLong and Summers will now retract their patently wild and obviously non robust proposition. [Update - Jonathan Portes finds that in fact the latest IFS Green Budget says almost the complete opposite of what the Prime Minister suggests.]

(6) “But we are making the right choices. If there was another way I would take it. But there is no alternative.”

The resort to TINA is the ultimate ‘reveal’: if the arguments for the policy being pursued have been lost, the evidence is stacking up against you, and there are plenty of perfectly feasible alternatives, then assert as dogmatically ('robustly') as possible that you are pursuing the only possible path. Of course the smart thing to do is to assert this at exactly the time that you actually change your policy in favour of one of the alternatives. Well, we can always hope, although I fear to hope in this way would not be a robust thing to do.

[a] The following quote from the IFS February 2012 Green Budget (page 52) makes the key point:

“To assert that the Labour government should have done even more before 2008, while accepting the latest official estimates for the output gap up to 2007–08, one would have to believe that it should have been able to forecast more accurately the path of trend output growth beyond 2007–08. Over the period from 2007–08 to 2016–17, the OBR’s latest figures imply that trend output will grow on average by just 1.2% a year. This compares with the 2½% a year that underpinned the official public finance forecasts produced prior to the crisis. While at the time Mr Darling’s assessment of the path of trend growth was not seen as being particularly cautious, it also was not widely seen as being unduly optimistic either.”

[b] The OBR could have concluded that they underestimated the size of multipliers in doing their original forecast, and as the numbers they use for the mulitipliers are low (substantially less than one), this would be a reasonable conclusion, as the much quoted recent research by the IMF suggests. (For more details, see Jonathan Portes here.) But the OBR were never assuming negative multipliers, as this passage in the speech suggests.

[c] The 2012 IFS Green Budget does discuss hysteresis, with no refutation of this idea that I could see.

Why politicians ignore economists on austerity

I have written before about fiscal policy in the Netherlands. I have done so in part because that country has a strong macroeconomic tradition, and I regard their long standing fiscal council (CPB) as a model of how to try and get good economic analysis and evidence into the policy debate. It is therefore an indication that something is very wrong when the political consensus there follows the austerity line.

The key target for policy in the Netherlands appears to be the 3% budget deficit number that was at the centre of the old Stability and Growth Pact. The latest CPB forecasts are for deficits of 3.3% of GDP in 2013, and 3.4% in 2014. The main reason is that the economy is in recession: GDP is expected to fall by 0.5% this year (following a fall of 0.9% in 2012), and grow by only 1% in 2014. The governing coalition includes the Labour Party, and its leader Diederik Samsom says it would be unwise to sharply cut government spending in a recession. What he means by this is that they will not try and hit the 3% figure this year, but instead do so next year!. After announcing austerity measures of over 2.5% of GDP in the autumn, the coalition has recently prepared a list of additional cuts totalling  0.7% of GDP. These include tax increases, a pay freeze for public sector workers and extra charges on industry.

So we have a discretionary procyclical fiscal policy, in an economy without its own monetary policy to offset its impact. The one ray of hope is that the trade unions, who have previously been prepared to discuss the details of austerity, no longer wish to do so. The FT reports  the largest labour federation as describing the cuts as “stupid and ill-advised”. The Labour Party is urging the unions to take part in discussions about the cuts, so they can - as one report puts it - “seize the opportunities offered by new measures to stimulate the economy”. This sounds a bit like asking a Christmas Turkey to talks about the recipe for the stuffing. The unemployment rate, which was 4.4% in 2011, is expected to rise to 6.5% in 2014.

So why are politicians, in the Netherlands and elsewhere, pursuing a policy that most economists regard as an elementary error? This was a question raised by Coen Teulings, who is the director of the CPB, the Dutch fiscal council. He was commenting on an IMF sponsored conference in Sweden, at which most economists argued against short run austerity when the economy was weak, and instead advocated dealing with budgetary problems through long term structural reform. The politicians in the audience, led by the Swedish finance minister Anders Borg, disagreed. He summarises their view as follows: “Politicians lack the ability to commit today to austerity measures to be implemented tomorrow. Hence, the only option is to take action straightaway.” (Borg was a driving force behind setting up Sweden’s own fiscal council, but his subsequent interaction with it has been more difficult, as Lars Calmfors and I describe here.)

Tuelings does not take this argument seriously, for good reasons. Instead he provides three suggestions as to why politicians are ignoring the economists. The first is a memory of the 1970s, when Keynesian policies were pursued because many failed to see the structural impact of the oil crisis. Politicians do not want to make the same mistake again. The second is that economists neglected countercyclical fiscal policy for too long, and therefore have failed to provide politicians with a clear guide to what policy should be, like perhaps an equivalent to the Taylor rule for monetary policy. Third, while both structural reform and short term austerity have political costs, politicians can sell the latter more easily, and success can be demonstrated more quickly.

The last argument can be partly seen as the austerity counterpart to the common pool explanation for deficit bias: structural reform can hit particular groups hard, while generalised austerity spreads pain more widely (or perhaps hits particular groups who have a small political voice). There may be something in the second argument, but there is a chicken and egg issue here. As someone who has written papers evaluating fiscal rules for a number of years, I have not noted much interest from European policymakers.

I suspect, however, that most of the interest in Taylor rules for monetary policy comes from central banks rather than politicians. I think this is a key problem with fiscal stabilisation policy: the lack of an institution that fosters research of this kind, that consolidates knowledge and pools wisdom. In my dreams I imagine a linked set of national fiscal councils that could play that role. What is unfortunately very clear is that central banks (or at least those running them) cannot do for fiscal policy what they have done for monetary policy: just look at the detailed and well formulated analysis of austerity in this recent speech (section 3.1) by the president of the Bundesbank. Returning to the Netherlands, it is no secret that the CPB is not part of the austerity consensus, while the Dutch central bank certainly is.

Where Austerity Really Rules

Many of us rightly complain about the damage austerity politics is doing in both the UK and the US. However, in terms of simple numbers, this is nothing compared to what is happening in the Eurozone. The table below, based on numbers from the latest OECD Economic Outlook, may look a little complicated, but it clearly establishes this point.

The first column is the general government underlying primary surplus, where underlying includes an adjustment for the cycle. (The primary surplus is basically taxes less spending, but ignoring interest on existing debt.) This is the best simple measure of fiscal impact on the economy. In the US, UK and particularly Japan, we have deficits, which are entirely appropriate in a situation of little or no recovery and with interest rates at their lower bound. Indeed I have argued that, in the US and UK, these deficits are too small given the nature of the recession: people want to save (or are unable to borrow), so the government needs to do the opposite or else output will fall.

In the Eurozone we have primary surpluses! Not just in the crisis torn periphery economies, but in the heart of the Eurozone as well. (It is for this reason that things would not be much better if the Eurozone was a fiscal union.)  

These numbers on their own could be misleading: a country with a large amount of government debt will need to run a surplus in the long run to pay the interest on that debt. By comparing column 1 with column 2 we can see that surpluses in the Eurozone are high by historical standards, so the picture is the same. However this could just be because of ‘fiscal irresponsibility’ in the Eurozone in the decade before the recession. So we need to try and get a handle on sustainability.[1]

Column 4 shows debt interest payments in 2012, based on the net debt shown in column 3. You could compare column 4 with column 1, but if the two were equal and stayed that way this would mean that debt as a percentage of GDP would gradually fall over time because the value of GDP grows. [2] So, based on the implicit 2012 interest rate on debt in column 5, I’ve made up a growth corrected interest rate in column 6. (This involves subtracting a guess at an underlying growth in nominal GDP, but also increasing the interest rate, because interest rates will not stay this low forever.) The stabilising primary balance in column 7 is this rate applied to net debt, and this is compared to the actual balance in the final column.

Stabilising Underlying Government Primary Deficits (% GDP)

	Underlying Primary Budget Balance		Net debt	Debt interest	Implicit Interest rate	Growth Corrected Interest rate	Stabilising Primary Budget Balance	Actual less Stabilising Balance
	2013/14	95-07	2012	2012	2012			2013/14
France	1.47	-0.79	66.41	2.44	3.67	2	1.33	0.14
Germany	1.72	0.30	50.29	1.80	3.58	2	1.01	0.72
Italy	4.74	2.31	98.09	5.00	5.10	4	3.92	0.81
Greece	7.05	0.22	145.74	5.20	3.57	5	7.29	-0.24
Ireland	2.34	1.55	79.86	4.98	6.24	5	3.99	-1.66
Portugal	4.54	-2.09	82.54	5.45	6.60	5	4.13	0.41
Spain	1.91	0.87	58.02	3.15	5.43	4	2.32	-0.41
Euro area	2.20	0.73	63.28	2.76	4.37	3	1.90	0.30
Japan	-6.13	-4.54	134.33	1.49	1.11	2	2.69	-8.82
United Kingdom	-2.53	-0.05	73.04	2.93	4.01	2	1.46	-3.99
United States	-3.11	-0.04	86.48	1.75	2.02	2	1.73	-4.84
Total OECD	-1.32	-0.16	69.63	1.79	2.57	3	2.09	-3.41

Source: OECD Economic Outlook December 2012

This is all very crude, but the basic message remains unchanged. Once we correct for the economic cycle, the core of the Eurozone are expected to run surpluses that are sufficient to bring down the level of debt, whereas the US, UK and Japan are planning to run deficits. In normal times, and particularly if we were in boom times, the Eurozone could rightly congratulate itself, and make disdainful remarks about policy elsewhere. During the current period in which the private sector is running an unusually high level of net saving it is completely the wrong policy. As the textbooks tell us, without the will or ability to provide offsetting monetary stimulus, this level of austerity will cause a recession, and sure enough it has.

I guess the ruling elite in the Eurozone are telling themselves that the current recession is all a result of the 2010 crisis caused by profligate governments in the periphery, and that if everyone pulls together by cutting spending and raising taxes things will come good. That has been the story for the past two years, and we are still waiting. Those who opposed this policy said that the market crisis could only be solved by ECB action, and that has turned out to be the case. We also said austerity of this kind would kill any recovery, and on that we were also right. So with macroeconomic theory, plenty of empirical evidence and recent events on our side, there is just no contest in terms of which narrative is correct. 

[1] Actually, as the data shows (see, for example, Calmfors and Wren-Lewis), it was in the decades before the mid-90s that Euro area fiscal policy was irresponsible.  

[2] For the debt to GDP ratio to be constant, we need the primary surplus as a share of GDP to equal debt to GDP multiplied by the nominal interest rate less the nominal growth rate.