Public investment and fiscal rules

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

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

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

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

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

Voters making big mistakes

In the last year we will have seen three occasions where large numbers of people voted in ways that seem to fly in the face of expert advice. I’m talking of Brexit of course, where 52% of voters chose a course of action which will make them worse off. The choice of Donald Trump as the Republican’s candidate for President, a con man and egotist who is not fit to hold public office. And finally Labour party members, who are about to elect as leader someone who seems almost certain to badly lose the next election.

The experts were different in each case: economists in the case of Brexit, people with knowledge of government for Trump, and political scientists plus psephologists for Corbyn. Now of course some people who voted for Brexit wanted it even if it cost them, but most did not. Some people think a con man and egotist would work well as President, and some Labour party members are quite happy to lose elections. But I think in every case those people are in a minority.

Why have experts been ignored in these cases? Politicians ignore experts all the time, but that is because of their own self interest or ideology. In the three cases above the experts are advising or have advised that actions will amount to self harm.

I’ve included the Corbyn case because it puts in doubt an explanation for the first two that I have seen elsewhere. It is technically known as the Dunning-Kruger effect, but I like to think of it as Springfield and the Monorail. Basically the idea is that people who know little are unaware of their ignorance, and can be easily conned. The reason this explanation is sometimes invoked is that support for both Brexit and Trump is stronger among those without college degrees. It is an explanation that leads to advocating meritocracy and questioning democracy. But that explanation cannot work for Corbyn supporters, who on average are very politically aware.

One obvious point to make is that in all three cases the expertise gets diluted in three related ways. All three disciplines are ‘inexact’. In all three, you more often see people without expertise talk about these issues in the media. And in all three some experts are subject to political or ideological bias. All that helps, but is not enough to explain self harm.

Another striking commonality is that expertise has become associated with elites who were once trusted and where voters now feel their trust has been betrayed. I talked here about how the Brexit vote was the result of combining two large minorities: those that felt they had been left behind socially, and those that had been left behind in terms of prosperity. I remember on the occasions I have written about the Conservatives continuing drift to the right, I have had comments which in essence say ‘nonsense: gay marriage’. When it came to the referendum the betrayal was the failure to control the social change implied by immigration. More directly concerned with economics were those left behind economically. I’ve been told of one meeting where the response to the argument that EU membership had increased GDP was ‘maybe your GDP but not my GDP’. This association of experts with an elite that has helped leave a whole section of society behind is discussed in this perceptive article by Jean Pisani-Ferry.

With Trump the elite in question are the elder statesman of the Republican party. For fifty years they have pursued a “southern strategy” that made elections about race and culture, and had used this strategy to enact economic policies that were certainly neoliberal but in particular favoured those who were already extremely well off. The cost of this strategy was that Republicans gradually became the party of the white, non-college educated working class which had no interest in lining the pockets of the economic elite. As Lee Drutman so clearly explains, this contradiction could only be disguised by upping the rhetoric that “allowed the party to keep its donor-class activists happy by obscuring these donors' deeply unpopular policy goals under the guise of something else.” The inevitable conclusion of that process was Donald Trump. The warnings against his candidacy by Republican leaders were discounted by an electorate who felt these leaders had given them nothing in economic terms and had failed to stop a black US president.

The Labour party under and after Blair had a model where it tried to occupy the centre ground by being just to the left of the Conservatives (triangulation). From 2010 George Osborne used this to pull Labour this way and that, and then leapfrogged over them with policies like hiking the minimum wage. In contrast the Conservative’s strategy was smarter in terms of winning votes. (A lot of it was imported from the Republicans in the US.) Play on people’s fears after the recession by going on about public debt, and use that as a lever to reduce the size of the state. Reduce welfare payments by demonising claimants as workshy and feckless. This was not triangulation. Corbyn’s election was the understandable reaction to Labour’s fruitless drift to the right. Yet it brought with it a complete distrust of not just of the PLP, but also the language and thinking that had been used by the PLP. The language of needing to be electable, and the means of deciding whether you were achieving that goal, had become tainted by its previous users. It is as if the problem with triangulation was not that it was the wrong model, but just thinking about developing strategies to win votes is wrong.

A key lesson in all cases is that what we saw, or are seeing, is a reaction to failures by an elite. Not entirely: I cannot see that much can be done about people who think gay marriage is a sign that the Conservative party has swung to the left, nor would I want to pander to racism. But the consequences of allowing sections of society to be left behind in terms of prosperity or economic dynamism are clear. Equally it is clear what happens to a political party when the elite lose touch with not just their membership, but also the consequences of profound economic change.

One final commonality is that the people who are rejecting experts are being conned. With Brexit it was the idea that leaving the EU and controlling immigration will make lives better rather than worse for those that have been left behind in economic terms over the last few decades. The people who really mattered in playing that con were not a few bumbling politicians but the right wing press. With Trump they are being conned by the notion that one rich man who is full of himself can turn things around to their advantage, a con perpetrated by both the man himself and the media outlets that give him support.

Labour party members are being conned not by a person or group of people, but by a set of ideas. The idea is that this leadership contest is a battle for democracy, and the most important goal is to create a party whose leadership and MPs reflect members views. The idea that all MPs should all agree with the majority of members, which effectively stops Labour being a broad church. The idea that it is more important to build a social movement than an effective parliamentary party (and to imagine that they are building that movement). The idea that no credence should be given to how voters perceive leaders (see here and here), because the decline in neoliberalism will ensure eventual victory. These are ideas that will destroy the party as an effective political force.  

Brexit: a battle lost but who will fight the war?

The Brexit vote was, in economic terms, an act of self harm. You do not need to just ‘trust the experts’ on this: it is pretty close to common sense. As Rebecca Driver clearly explains, leaving the single market will make it much more difficult for (particularly small) firms to trade in Europe. As Europe is on our doorstep and geography matters, that cannot and will not be compensated for by trading more elsewhere. [1] Finally greater trade is associated, for clear reasons, with higher growth. Lower growth will impact unfavourably on every area in the UK, whether they voted Leave or Remain.

The harm done is not just economic. As Ben Chu writes, “The crude majoritarian politics of this referendum has seen half of the population (a generally poorer, less well-educated and elderly half) effectively strip major freedoms and even a cherished identity from the other half (a more prosperous and predominantly younger half)”. Before the referendum, I had conversations with people arguing that a Brexit vote would be more harmful than a Trump presidency, and this deep sense of anger, loss and despondency will not go away. We therefore need to understand why it happened.

In my last post I argued that Brexit was a protest vote against both the impact of globalisation and social liberalism. The two come together over immigration, and of course the one certainty of the Brexit debate was that free movement prevented controls on EU migration. Globalisation has benefited the majority in the UK, so those who had not benefited could not alone have won a Brexit vote. Equally social conservatives have lost battle after battle in the UK on specific social issues. Brexit was the perfect storm where these two groups came together, and combined they just managed to win.

Explanations do not imply inevitability, but instead tell us why the result could easily have been different. We need a sensible discussion about immigration, rather than assume it is always and everywhere a problem. However to follow the social conservative route and say concern over immigration is just xenophobia is not helpful. [2] We need to challenge the view the right wing press has patiently built up that immigration is responsible for declining public services and making it difficult to get housing. Too many people continue to discount the power and influence of the media: that is a mistake, as this research on Fox news shows. It is not difficult to get across the benefits of immigration, given how much the NHS and our construction sector depend on immigrants, but it is not something many of our leading politicians have done for some time.

More generally it is becoming increasingly clear how destructive the doctrine of neoliberalisation has been. Neoliberalism combines the encouragement of globalisation with demands for a much reduced role for the state. In the advanced economies the deindustrialisation implied by globalisation and the growth of China and elsewhere has been beneficial overall, but there are sections of society that have lost out, which invites a backlash. As Kevin O’Rourke shows, globalisation has often led to fierce resistance in the past. Dani Rodrik has demonstrated how state spending can protect, and has often in the past protected, the losers from trade. [3] (As an economist mights say, globalisation is a Kaldor/Hicks improvement, but in recent times the compensation part has been missing.) Brexit, like the financial crisis and perhaps also Donald Trump, are in this sense problems created not by globalisation alone but by neoliberalism.

For the UK it is worse than that. It is not just that austerity is the real cause of declining public services, and a failure to build houses is the cause of rising prices and rents. (See Chris Dillow or Mariana Mazzucato) It is that this government in particular has connived with the right wing press to transfer blame for an NHS in crisis and unaffordable housing from their own policies on to immigration. The Remain campaign was Cameron and Osborne, and neither were prepared to change their tune and start talking about how limiting immigration would mean there was even less money for public services. As I noted in the previous post, the NHS was an important concern for Leave voters, and they thought Brexit would make things better. Can you imagine a worse background for the EU referendum vote than a government that continually stressed the importance of limiting immigration, but failed to achieve those limits so spectacularly. [4]

This was not the only problem with the Remain campaign. In terms of getting the message across, Leave seemed to understand their target audience much better. (It is not my field, but this from Mark Hind makes sense.) To get the message across the Remain campaign relied on the institutions of the establishment: the Treasury, Bank of England, IMF etc. Fine for those for whom the establishment is respected, less so for those who regard it as remote and detached from their lives. Remain made very little use of academics, despite the fact that this group is trusted by the public. [5] Leave did seem to understand this, which is why they went to ridiculous extremes to discredit these experts. The broadcast media hardly ever noted the consensus among economists that Brexit would reduce everyone's standard of living, and instead did their ‘he says, she says’ thing. This media also failed to point out the lies Leave told, preferring ‘balance’ over truth.

All this implies that while the potential for a Brexit vote was always there, reflecting the perfect storm of anger against globalisation and social liberalism, it might not have been realised if the Remain campaign had been better, the Leave campaign had been honest and the broadcast media had not departed from its mission to educate and explain. The lies of the Leave camp are already apparent. The depreciation in sterling that immediately followed the vote is a cut in living standards for everyone in the UK with no lasting compensation. It is permanent unless the markets have got things spectacularly wrong. The economic downturn that is underway is as predicted. In both cases voters were told this was fear mongering by the Remain side: now those that promoted Leave are in the ludicrous situation of arguing that markets and firms have somehow been deceived by Project Fear.

In normal circumstances this would all be a cause for optimism. We do not need many voters to realise that they were conned by the Leave campaign before Leavers become a minority, or at least for the majority to favour a deal that can keep the UK in the single market with essentially free movement of labour. (There may have even been such a majority on the day of the vote.) To call this the denial stage in some ‘grieving process’ by Remain voters misunderstands the nature of the decision. Leaving is compatible with a whole range of alternative arrangements: some quite close to EU membership, some not. In that sense the vote only gave the green light to an ongoing struggle over what these arrangements will be. (For a discussion of the politics involved, see here but also here.) Thus those who say we should accept the verdict of the people are wrong, because a great deal is still to play for.

Yet circumstances are far from normal, and there seems little ground for optimism. Our new Prime Minister - who was as complicit in the sham targets for immigration as Cameron and Osborne - has appointed those who supported Leave to handle negotiations. She knows that the only way she can unite her party is to end free movement and therefore leave the single market.

Worse still, the government will do whatever it wants to do when it comes to the type of Brexit we have. Our official opposition will, if the polls are right, be the same opposition that was both ineffective and conflicted in the Brexit campaign, preoccupied as it will almost certainly be with cleansing the PLP rather than the details of trade arrangements. There is no alternative opposition with any strength. The SNP cannot speak for the rest of the UK, and anyway will be focused on trying (and probably failing) to drum up enough support for independence. As a result the 48% or more who did not want an end to the single market will not be able to do much about it. I fear that if you want a vision of what Britain after Brexit will become, you just need to look in the pages of the newspapers that were a vital part in bringing Brexit about.

[1] My impression was that discussion on broadcast news programmes, which is the main source many people have to unbiased news coverage, or even the debates never got to this point. We had someone from Remain saying trade with Europe would suffer, and someone from Leave saying we would be ‘free’ to trade with other countries. You do not need the Treasury’s gravity equations to make this simple point about geography and trade, but you need to go a little beyond soundbites.

[2] A similar point can be made about nationalism, which is hard to combat and may be a symptom rather than a cause.

[3] Rodrik, D. (1998), "Why do More Open Economies Have Bigger Governments?" Journal of Political Economy 106(5): 997-1032

[4] None of this was hard to see before the last general election. Those who in 2015 voted Conservative but also wanted to Remain need to ask why they took no notice of the warnings that some of us made. Those ‘business leaders’ who seemed to unanimously endorse Cameron need to ask, or be asked, why they were gambling with their company’s future in doing so.

[5] Part of the problem is that Leave voters tended not to trust anyone. This, by Jean Pisani-Ferry, is good on experts and trust.

Cyclically adjusted deficits and instability

Jean Pisani-Ferry, currently advising the French government and former director of Bruegel (the Brussels-based economic think tank) has written a heartfelt plea for more stability in the Commission’s estimates of potential output. The reason is straightforward. The Eurozone’s fiscal rules require meeting targets for cyclically adjusted deficits within the next year or two. Every time estimates of potential output change, the target for the actual deficit also changes, and policy often has to respond immediately to meet the new targets.

Pisani-Ferry of course understands why this happens, and why cyclical adjustment makes sense in principle. He is not advocating returning to the days when targets ignored the economic cycle. However the problem he clearly has is in communicating to policy makers who are not economists why they need to change actual policy simply because someone in Brussels has revised their estimate of potential GDP. He writes

“Members of parliament – who are not technicians – are understandably disturbed when they are asked to pass a revised budget in response to an updated estimate. Not knowing the whys and wherefores, they end up perceiving such revisions as a source of artificial instability.”

However an obvious objection to his proposal might involve the following scenario. To meet its target the government is embarking on austerity which is also reducing GDP. The Commission gets new information which leads it to revise up its estimate of potential GDP, implying the need for less austerity. Should the Commission ignore this information for the sake of stability?

I would suggest that the ‘non- technical’ instincts of policymakers are right in this case, but the reason is more basic. Short term fixed date targets for the deficit are a source of instability. There is no economic reason to have such short term deficit targets, and there are plenty of very sound economic reasons not to have targets of this kind. In essence this is because the deficit should be a shock absorber, but by targeting it you make taxes or spending the shock absorber. Hence the perceived, and actual, instability.

It would be much better, as Jonathan Portes and I argue, to have deficit targets for 5 years ahead. Whether these should be fixed date or rolling targets would depend on how trustworthy the government was, and whether there was an independent and robust fiscal council that could provide an ‘implementation incentive’ for the government. (We would argue in addition that fiscal policy in the Eurozone needs to play a countercyclical role, both at the individual country level to correct imbalances within the zone, and at the aggregate level if interest rates are at the Zero Lower Bound.)

Would such targets need to be cyclically adjusted? In the context of an economy with its own monetary policy we would argue not, because within five years the central bank should have eliminated any output gap (in expectation). Whether cyclical correction via competitiveness effects works so quickly is less clear, and if it does not cyclical correction would still be required. However I suspect that if targets were for five years ahead, revisions caused by new estimates of potential would be less problematic, because the need for an immediate policy change would be reduced. (As an example, when the OBR first revised its estimate of potential in the UK, Osborne’s response was to extend austerity into the next parliament, rather than intensify current austerity.)

The key point is that targets for the deficit just one or two years ahead are foolish things to have, and cyclically correcting the target only makes them slightly less foolish. Indeed, I would go so far as to say they are primitive in macroeconomic terms. It is like telling consumers that they shouldn’t smooth their consumption, but instead vary their spending or income to keep their wealth at some fixed target level. You would only want to do that to a child, and policymakers should not be treated as children.