Going backwards on fiscal rules

I was preoccupied when it first came out, but I wanted to note the excellent discussion by Jonathan Portes of the government’s new fiscal rules. It draws heavily on our joint paper on the same subject. (The published conference volume version is now available online for those with access: working paper version here.) Jonathan gives a typically measured analysis, and in my opinion the analysis is fully consistent with the sentiments expressed in the letter I discuss here.

Before some you say what’s new, note that in terms of the form of the rule, our paper and Jonathan’s discussion is rather supportive of the framework that Osborne introduced in 2010 as a way of conducting fiscal policy in normal times. Remember that this aimed to hit a rolling target for the cyclically adjusted current balance within five years. (The target happened to be zero, but there is no reason why the target could not be a number other than zero for the surplus or deficit.) The big problem was to apply this rule in a situation when interest rates were at their lower bound. That aside, the rule makes a lot of sense because it exerts some control while still allowing the deficit to be a shock absorber, which is what economic theory tells us it should be.

As Jonathan points out, and as I have discussed in earlier posts, Osborne’s new surplus rule goes backwards in two major ways. First, it is for the total deficit rather than the current balance, so it puts a squeeze on investment just at a time that investment should be high. (Aside to journalists: I cannot recall reading a single economist who disagrees that now is the time to increase public investment.) Second, even with the get-out clause on growth, the new rule is likely to make the deficit much less of a shock absorber, and so lead to unnecessary volatility in taxes or spending.

The question that naturally arises is how could a Chancellor replace his own (normal times) good rule with such a poor rule? A lot of the credit for the good rule should probably go to Rupert Harrison, and no doubt his background at the IFS probably helped here too. (Even more credit should be laid at his door for the establishment of the OBR.) Harrison has now left, but not before the surplus rule was proposed, so the puzzle still remains, particularly as Harrison must know that in economic terms his/Osborne’s original rule is clearly superior to the new one.

The simple answer is politics. All too often, Osborne’s budget decisions seemed to have been designed to embarrass the opposition (for which, I should add, the opposition have only themselves to blame). Short term political expediency once again triumphs over sensible long term economics. This is one reason we have independent central banks. It also seems to be another example of the failure of the knowledge transmission mechanism that I talked about here.

On this occasion I’m inclined to put some of the blame for this failure on academics. There is quite a bit of academic research which has relevance to fiscal rules, but few academics have tried to translate this into practical knowledge that governments can use. This in turn is because there is no incentive for them to do so: papers like Jonathan and mine are not the kind of thing that normally gets into the top journals. I have always thought that this is an obvious gap which fiscal councils like the OBR could fill, but at present the OBR has no remit to do so.     

Do politicians need to pander to myths?

About UK politics, but raising some general issues about politicians and popular prejudices

Paul Bernal has a powerful post (HT Chris Dillow) where he says Labour lost the election long before 2015, by pandering towards three big myths: the myth that Labour created a huge deficit which required austerity in the midst of a recession, the myth of the ‘scrounger’, and the myth that Labour made a mistake in allowing excessive immigration. I obviously agree about deficits, I’m appalled at the hostility to welfare recipients stoked by the right wing tabloids and the harm done by inept reform, and I’m dismayed that politicians shy away from putting the positive case for immigration. For that reason I should agree that in England at least one of the three major parties should be standing up against all these myths. The Conservatives and Liberal Democrats helped manufacture the first myth, and the Conservatives contributed to the second and pander to the third (although some of their supporters would not favour costly immigration controls). Labour failed to combat all three.

The media have, predictably, reached a consensus about why Labour lost: it was too left wing, it was anti-business, it failed to be aspirational (it wanted to raise some taxes on the rich) blah blah blah. But as Peter Kellner and others have pointed out, there is no clear evidence for these assertions. Instead, they just happen to represent the things that much of the media dislike about Labour’s policies. Watching at least some of Labour’s potential future leaders, who the media as a whole describe as ‘modernisers’, fall in line with the media’s diagnosis makes the Parliamentary Labour Party look pathetic. Perhaps it is?

And yet, Peter Kellner also points out that being tough on scroungers and immigration is very popular. And these issues mattered for many voters. In a tweet about Bernal’s post, I asked was it better to lose telling the truth than lose being complicit in a lie? But it would be better still if a political party could tell the truth and win! Yet that seems a hopeless task. Jonathan Portes has championed the evidence on immigration, but as the BBC’s Nick Robinson put it, he would not get elected in any constituency as a result.

It is tempting at this point to blame the media for this state of affairs. In one sense I agree: I think newspapers should have a responsibility to tell the truth, rather than pander to prejudice when it suits their owners to do so. But in terms of practical politics this does not get you very far. One of the depressing conclusions that will be drawn from the election result is that it is fatal to stand up to Rupert Murdoch. [1]

Is it also true that cutting the deficit is widely popular? Here I think the evidence is less clear. I agree with John McDermott that perceived competence is vitally important, and not only in relation to self-interest. That is why Labour made a strategic mistake in not challenging with more force the coalition’s blatant myth making on the deficit issue. As Jonathan Hopkin and Mark Blyth point out, it is incredible how the blame for our current problems has so easily been transferred from the finance sector to fiscal profligacy, and not just in the UK. (But not so incredible if you follow the money, and take media power seriously.) 

Perhaps I can also make a very personal point here. As one of only a few academics who have written an academic paper on the Labour government’s fiscal record, which concluded that Labour profligacy was a myth, you might have expected Labour at some stage to have used some of the many words I have written on this to support their case. As far as I know they did not. Perhaps they were put off by some of the my criticism of other aspects of Labour’s programme. But this didn’t put off Alex Salmond, who was happy to quote my support of the SNP’s line on austerity, suggesting it had all the more force because I was not an SNP supporter.

Talking of which, I think there is one more piece of received wisdom that needs exposing, and that is Scottish exceptionalism. As I hinted at the beginning, there was one major UK party that did campaign against austerity, was pro-immigration and supportive of welfare. No doubt other factors also led to the huge success of the Scottish national party, but their position on these three issues didn’t seem to do them any harm, and in some cases probably helped a lot. This example suggests the answer to the question posed in the title is a clear no. 

It is generally presumed by the media, both sides of the border, that this is all because Scots are inherently more left wing than the English. But the evidence suggests differences in social attitudes between Scotland and England is not that great. The question Labour (or at least somebody) should be asking is why the SNP can avoid pandering to these three myths and win decisively, when the consensus is that doing the same in England would be electoral suicide.   

[1] Some people who comment on this blog say that when I voice concerns like this I’m being a bit passé, but on other occasions I’m accused of being anti-democratic! Somehow a politician choosing to delegate macro policy to experts reduces democracy, but allowing rich media barons to control the information that much of the electorate receives, and as a result have a considerable influence on politicians, is just fine.

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.

Labour's austerity problem

One of the political/economic soap operas over the last year has been the UK Labour Party’s agonising over the perception of its economic competence. The story always starts with current polling data: either Miliband’s personal ratings or Labour’s rating for economic competence. It then often seeks to find the answer to these problems in the past: either the last years of the Labour government, or the first year of opposition when Labour was preoccupied with electing a new leader.

The latest example can be found in an article today by the Guardian’s chief political correspondent, Nicholas Watt. Here Gordon Brown’s call to invest rather than cut in 2009 is blamed, and this is contrasted with an alternative that would acknowledge the need to cut, but focus on the idea that cuts would have been fairer under Labour.

I know nothing about internal Labour politics, but it seems to me that what is going on here is confusion over what the right policy should have been, rather than how to frame it. I also suspect that what really puts the electorate off is when a political party appears confused or divided about a key aspect of policy. The taboo in Labour circles over mentioning the word borrowing is a case in point, which I made fun of before Ed Miliband fell into the same trap.

So what should Labour’s line have been? As it does not have a hidden agenda to reduce the size of the state, its line should have been based on sensible macroeconomics. As my paper with Jonathan Portes suggests, the policy should have been to avoid cuts and to invest while interest rates were stuck at ‘zero’. In other words, the recovery takes priority, and the deficit should be dealt with after the recovery has been assured. Sometimes translating good macroeconomics into simple messages can be difficult, but not in this case.  

Public Investment and Borrowing Targets

Often fiscal rules, designed to keep a lid on public deficits or debt, exclude borrowing for public investment from any deficit target. This is true of the UK government’s fiscal mandate, which seeks to achieve a cyclically-adjusted current budget balance within five years. The idea, in simple language, is to only borrow to invest. What could be wrong with that?

Most of the time public investment is not like private investment. A successful private investment will generate future income which can pay back any borrowing. A successful public investment project may raise future output, and this may increase future taxes, but there is no sense in which we would only undertake the project if we could be sure of paying off the borrowing with these extra taxes. A public investment project should be undertaken if discounted future social benefits exceed its costs. This cost has to be paid for by higher taxes at some point, so the question is simply when taxes will increase to do so.

In thinking about when to raise taxes, the obvious principle is tax smoothing. If taxes are distortionary, it is better to spread the pain. So if we need some additional public spending for just this year, one way to pay for it is to borrow, and use higher taxes just to pay the interest on that borrowing. That smooths the distortion over time. This is true whether the public spending involves consumption or investment. In contrast, if we are planning to raise public spending permanently, taxes should be raised by the amount of the increase in spending, and no borrowing should take place. Again this is true whatever the form of the additional expenditure. Now it is true that public investment projects tend to be temporary, while additional public consumption can be permanent, but the principle here is how taxes are distributed, rather than the nature of the spending.

This simple application of tax smoothing takes no account of distributional issues. If we believe that government consumption only benefits those paying taxes at that time, we might want taxes to rise with a temporary increase in government consumption rather than being smoothed. Why should future generations pay for the consumption enjoyed by the current generation? Here public investment would be different if it benefits both current and future generations. So from a distributional point of view, it might make sense to treat government consumption and investment separately. There are two problems here though. The first is that the distinction between public investment and consumption in the statistics does not necessarily follow this distributional logic. Education is classed as consumption. Second, how in practical terms do you allocate taxes paid to benefits received from public investment? (I touch on this here.)

One of the key points that Jonathan Portes and I stress in our discussion of fiscal rules is that rules have to balance optimality when governments are benevolent against effectiveness when they are not. One feature of periods of austerity is that public investment often gets hit hard. The reason this happens may also reflect intergenerational issues. To the extent that public investment benefits future generations, they are unable to complain when it is cut.

This can be one reason why rules sometimes use current balance targets rather than targets for the overall deficit. If public investment does not influence the target, it need not be cut. (This does not seem to have worked with George Osborne, as the victims of flooding found out!) However such rules are inevitably incomplete, because they say nothing about the overall level of public debt. In the case of the last Labour government, there were two rules: one involving the current balance over the cycle (only borrow to invest), and one specifying a total debt ceiling. There was an implicit target for public investment implied by the conjunction of the two rules, but it is unclear how sensible that implicit target was.

Jonathan and I suggest that the simpler and perhaps most effective way of preventing public investment being squeezed in times of austerity is to have a specific target for the share of public investment in GDP. Of course this target should also influence any overall deficit target, but if you want to protect public investment, it seems best to do so explicitly. If you do that, then it makes more sense to have just one target for the overall deficit (primary or total) that includes borrowing to invest, rather than a target for just the current balance.

Fiscal rules: politics and economics

Jonathan Portes and I have an article in Prospect, which is a short summary of our discussion paper on fiscal rules (see here or here). In this post I want to use that paper to make two observations on the interaction of politics and economics.

Jonathan and I are frequently accused of being against fiscal austerity for political or quasi-political reasons: either we dislike governments that impose austerity, or we want to increase public spending and think that by advocating temporary increases in government investment at the zero lower bound we can achieve this goal. In which case we would obviously reject any fiscal rule formulated by this government, and more generally we would be against any kind of discipline on public debt or deficits.

If that is what you think, the Prospect article or the discussion paper will have you scratching your head. After a thorough analysis of the principles behind fiscal rules (on which more below), we conclude that the form of the coalitions current fiscal mandate is about right. It makes sense to have an operational target for the deficit rather than debt, and it makes sense to target that deficit always looking five years ahead.

There is one huge caveat, which is that this form of rule is appropriate as long as interest rates are not at, or expected to be at, their zero lower bound. In this recent post I outline what we recommend in our paper should happen in those circumstances, and of course current governments have (since 2010) failed to follow this advice. So our endorsement of the form of the current fiscal mandate only applies to when monetary policy can operate in a normal fashion.

Our paper also endorses another innovation of the current UK government: the formation of the OBR. In fact we suggest that it should have additional duties. So these two structural changes brought in by the coalition, the fiscal mandate and the OBR, were positive innovations. The tragedy is that the former was applied in the one circumstance in which it should have been (temporarily) abandoned.

Of course the form of the fiscal mandate is different from the actual numbers targeted for the deficit in five years time, and I will talk about those in a subsequent post. We also have some minor suggestions to improve the rule: for example if you are targeting a deficit in five years time when monetary policy is working normally, the target does not need to be cyclically adjusted, and we would target the deficit (actual or primary) rather than the current balance, and have a separate target for the share of public investment in GDP.

There is a second sense in which our paper directly addresses the interaction between economics and politics. The way I began thinking about fiscal rules was a standard way macroeconomists think about rules: how close are they to the optimal policy that would be chosen by a benevolent policy maker? This is a perfectly sensible question to ask, but for fiscal policy it is on its own hopelessly incomplete, because we also know that politicians are often not benevolent, in the sense that they act in their own interests rather than in the interests of society as a whole. As a result, we get deficit bias, although this bias may occur for other reasons. The role of fiscal rules is to a large extent to discourage this non-benevolent behaviour.

Take the current UK fiscal mandate, for example. An obvious criticism is that, by always targeting the deficit five years ahead, it allows a government to keep putting off making the adjustments required to achieve the target. Don’t worry that the deficit is above target, a government might say, in five years time it will be on target. And it could carry on saying that year after year. In the paper we say that this rule lacks an ‘implementation incentive’.

So why not make the target for some fixed date in the future, so adjustments cannot be continually delayed. The problem with a rule of that kind is that it can produce very sub-optimal behaviour as we approach the fixed date. Our macroeconomic theory says that the deficit should be a shock absorber, so having to achieve a target at a fixed date whatever shocks hit the economy could be harmful when unexpected shocks occur near that date. Imagine how much worse austerity would have been if the government had tried to achieve current balance by 2015.

Fiscal rules therefore involve a trade-off between optimality and effectiveness in preventing non-benevolent behaviour and deficit bias. The latter depends on a political judgement about policymakers. For the UK, both past evidence and current behaviour suggests that deficit bias is not a huge problem, which is why the rolling five year deficit target can work, but in other countries it might not. This is where a fiscal council like an enhanced OBR can be very useful.

Even the more responsible governments are tempted by devices that allow spending today but which shifts costs into the future (PFI in the UK for example). It is very difficult to devise fiscal rules that involve ‘operational targets’ (i.e. targets that a government can try to meet during its term of office) but also prevent such tricks. This is an important reason to do long term fiscal forecasts, undertaken or assessed by independent institutions, which is where the costs of such schemes become evident. However that alone is not enough. A fiscal council like the OBR should also have a duty to clearly alert the public when such tricks are being played. In addition, when targets are flexible so that the implementation incentive is weak (as in the case of a rolling five year target like the UK fiscal mandate), fiscal councils should also judge on behalf of the public whether meeting the target is being delayed for justifiable reasons or not.

So the choice of a fiscal rule and the mandate of a fiscal council inevitably involve political as well economic issues. However the politics is more about the transparency and accountability of government, rather than left versus right and associated ideologies.

    

Good and Bad Blog Debates

One of the things I really like about blogs is that they can generate considered and informed debates about ideas. But not all blog debates are like that. Debates can get too personal - they begin to become about the people involved in the debate, rather than the ideas. They become a debating contest. Sometimes this can be a contest between two people, or it can be a contest between two groups. This may be a fun sport for those committed fans of either side, but I do not think it is a very good means of informing those who are not committed but who want to know more about the issues involved.

Take the debate involving Mark Sadowski (MS) that started with this post. MS disagreed with a number of things I said, and we had a short back and forth in the comment thread to that post. MS also combined his points as a separate post. All well and good. This debate led me to write two subsequent posts. One was about how the US recovery had continued despite fiscal contraction. The other, actually written following a subsequent post by Giles Wilkes, was an attempt to try and explain in very general terms where the two sides agreed and disagreed on fiscal policy. I wrote neither as sequels in a debate between MS and myself, because they were not intended to be that. I wanted to talk about facts in the first case and ideas in the second, rather than have a debating contest.

I think MS saw it differently. Here he responds to my post on the US recovery, imagining it to be a ‘response’ to his earlier post. Here he responds to my second post. Both are written in a quite personal style, as the titles suggest. Not a style I like, but so what?

Well, if you are going to do this kind of thing, you need to be especially careful that you get your facts right, because it has become personal. In the second half of the second post, he writes:

“At what point will fiscalists stop wringing their hands over the “liquidity trap” and start to worry about what is the consensus assignment of fiscal policy, which is debt stabilization? What I sense is they aren’t really interested in the consensus assignment of fiscal policy.

 And who can blame them? Debt stabilization is dull. It is *really* dull. Why worry about something so dull when you can worry about something which is so much more exciting, which is obviously aggregate demand stabilization.

 And this I think is the crux of the real asymmetry. Monetarists are genuinely interested in the consensus assignment of monetary policy, which is aggregate demand stabilization. Fiscalists show no interest at all in the consensus assignment of fiscal policy, which is debt stabilization.”

Now here he talks about ‘fiscalists’ rather than mentioning me by name, but anyone reading this post would assume that I was among the people he is talking about. Another fiscalist named in this debate is Jonathan Portes. Now it just so happens that Jonathan and I have just written a substantial paper, which is all about debt stabilisation! Whoops.

An unlucky error? No, it’s much worse. A quick look on my homepage will show you that much of my academic research since 2000 has been about debt stabilisation. Unlike MS, I do not think the subject is really dull. Issues like what the long run target for debt should be, how quickly we should get there, what happens to monetary policy when debt is not controlled by the fiscal authority, seem to me rather interesting.

Hopefully that corrects the impression created that these particular 'fiscalists' are not interested in debt stabilisation. But has this post been very informative for someone interested in the issues, rather than the personalities? I learnt very soon after I started this blog, thanks to another market monetarist, that it is generally better to focus on the ideas rather than the individuals putting these ideas forward. This can be difficult, and I do not always get it right, but that at least was what I was trying to do in my last post.

Privatisation and government debt

Possibly the worst argument for privatising part of the public sector is a supposed ‘need’ to reduce public sector debt. I think the problem with this argument is obvious to most economists, but as it is repeatedly ignored by politicians, it is worth spelling it out.

As I argued in a previous post, decisions to privatise or contract out should be based on considering the microeconomic pros and cons, which will vary from case to case. This analysis should include political economy considerations, like the extent of public sector corruption, or the ability of firms to extract rents from the public sector.

Suppose that such an analysis left the decision to privatise evenly balanced. Should macroeconomic factors, like the need to reduce public sector debt, ever be used to sway the decision in favour of privatisation? In our recent paper, Jonathan Portes and I argue (here or here) that a government should have some view about what the long run desirable level of public debt relative to GDP should be. Two arguments that could be used to argue for lower long term debt are that paying interest on debt requires raising taxes, which are ‘distortionary’ (they tend to reduce GDP and welfare), or that public debt may crowd out private capital and investment (assuming those are thought to be too low).

If we start out with public debt above its long run target, why not use privatisation to help get us towards that target? To see why that is nonsense, consider the two reasons for reducing debt given above. The first was to reduce the need to raise taxes to pay interest on that debt. While privatisation might reduce debt, it will also reduce future revenues or increase future public sector payments. Privatisation will either mean that the public sector loses the revenue that the privatised activity produced, or the private sector will have to be paid to undertake the outsourced activity. So the net impact on taxes will be zero.

What about the point that public debt may crowd out private investment? Once again privatisation does nothing to encourage additional private sector investment. All that happens is that existing capital and any investment that goes with it are relabelled private rather than public. No additional savings are released to encourage new private sector activity.

Consider an extreme example: Greece. The country is desperate to show that debt can be at least be brought to some sustainable level. So what is wrong with selling off some state asset, like part ownership of a water company for example, to help reduce this debt? Now there may or may not be good microeconomic reasons for doing this, but is there a good macro reason? Selling the asset would allow the Greek government to reduce its debt, but it would also have to raise future taxes, or cut future spending, to make up for the revenue lost from no longer owning that company. If microeconomic efficiency is unchanged, this sale would make no difference to the balance between taxes and spending required to make debt sustainable. Debt interest payments would fall, but so would receipts.

To make the same point another way, if we valued public sector assets and calculated the public sector’s net asset position, privatisation would have no effect on that net number. So why should anyone think that the position of the Greek government had been improved by this asset sale?

Obvious though this point may be, it illustrates a problem with most fiscal policy rules. Most rules need to involve what Jonathan and I call realisable operational targets: goals that politicians can aim for (and be judged by) within the lifetime of administrations and parliaments. Privatisation is one of a number of devices that flatter the short term public finances with no impact (or worse) on the long term position. (Considerably worse if the asset is sold far too cheaply, as in the most recent UK case for example.) Because fiscal rules inevitably focus on the next few years, politicians will always be tempted to use these devices to in effect cheat those rules. This is why it is vital to have effective fiscal councils to work alongside any rules. These independent institutions need to be able to shout when they believe only the letter and not the spirit of these rules is being met. The UK’s fiscal council, the OBR, does not have this kind of mandate, and can therefore only note when policies have this kind of effect (see here, paras 1.8-9).  

How to avoid the austerity mistake next time

In recent posts (e.g. here) I have been rather pessimistic about what might happen the next time we have a large negative demand shock that puts interest rates to their zero lower bound (ZLB). In theory fiscal policy can come to the rescue, and we can avoid a severe recession. But many of the reasons that did not happen this time persist. The political right will see rising debt as a chance to shrink the state. The financial sector will argue a funding crisis (the ‘bond vigilantes’) are just around the corner. Central banks will do what central banks have nearly always done: advise either privately or publicly that we need fiscal restraint.

We can hope that, as recent lessons are learnt, economists speak with more of one voice on what should happen. I like to think this will occur to some extent, as the influence of the anti-Keynesians fades, but the importance of ideology in the discipline is such that economists will never be united on this issue. And in any case, will the majority of economists have more influence than the financial sector and the central bank? I think not, particularly if there is another Greece.

What I think macroeconomists can do is start talking about fiscal rules, and the importance of fiscal councils. This is what Jonathan Portes and I try to do in a new paper (here or here). The paper discusses a number of issues involved in formulating fiscal rules (which I will write about in subsequent posts), and it also stresses the importance that fiscal councils can have in supporting (or modifying) these rules. It also has something very clear to say about what should happen the next time we experience a large negative demand shock. (With unchanged inflation targets and perhaps a lower natural real interest rate, this may happen rather more often than we would like.)

Suppose, for the sake of argument, that the fiscal rule involves some target for the deficit in five years time. A negative demand shock hits, and the central bank judges there is more than a 50% chance that interest rates could end up at the ZLB. At that point, the deficit target would no longer apply. Instead the central bank and fiscal council would be obliged to cooperate in formulating a fiscal stimulus package that would enable interest rates to rise just above this lower bound. Both institutions would then recommend this package to the government. The central bank and fiscal council would continue to cooperate in this way (suggesting modifications to the package as new data became available) until the central bank expected interest rates to rise. Call this the ZLB procedure.

Why do we propose cooperation between the central bank and fiscal council? The central bank should be involved for four reasons. First, they probably have more resources working on short term forecasting. Second, they could help design a package that was effective at raising demand, rather than one that pandered to political preferences. (Fiscal councils on their own would be wise to avoid making judgements about how deficit targets should be achieved.) Third, a government would find it difficult to go against these two institutions acting together. Forth, the central bank would also probably want to implement some form of unconventional monetary policy, and the size of any fiscal stimulus would need to allow for that.

Now you could say that a central bank would be reluctant to make this call, for the reasons I gave at the beginning of this post. However, the central bank bears responsibility here. If interest rates did go to zero, they will clearly have made a mistake, and can be held accountable for that. And once interest rates had hit the lower bound, the ZLB procedure would operate anyway.

Why should the fiscal council be involved? Because part of the package would be an assessment by the fiscal council of what should happen to deficits and debt once interest rates did rise above the lower bound. The previous deficit target would have to be revised. A government that accepted the stimulus package would be asked to sign up to meeting any new deficit target after the recession was over.

This ZLB procedure should be part of any ‘fiscal rule’. This may seem odd, because it is really an account of how the normal rule should be suspended and what should replace it in ‘exceptional’ circumstances. Why not instead simply say that the normal rule should no longer apply when interest rates hit the ZLB and leave it at that? The reasons are those given at the start of this post. Making up policy in a crisis is fraught with dangers, and macroeconomic rationality can easily give way to vested interests and biases, as we discovered in 2010. The whole point of fiscal rules and fiscal councils is to overcome those interests and biases, and they apply at least as much in a crisis as in normal times.  

Economics and the Immigration debate

As the storm force winds blew, I wondered to what extent the debates on immigration and austerity shared a common feature. In both cases economists might feel like someone trying to walk against high winds: it is hard, perhaps painful, and you seem to be getting nowhere fast. To be less metaphorical, in both cases the economic arguments seem to be irrelevant to the public debate, and the politicians want to go in the opposite direction to the one suggested by the economics.

I have talked a great deal about austerity before, but not about immigration. A typical example of the economic arguments is this NIESR study by Lisenkova, Mérette and Sanchez-Martinez (pdf, blog post), which models the impact of the current UK government’s attempts to reduce net migration. (As this Bruegel post shows, the UK debate is fairly typical.) Although the paper uses an OLG model, and allows for some quite elaborate differences between migrants and natives, the basic results are intuitive. As migrants tend to be younger, reducing migration reduces GDP per capita (by about 2.5% in 2060), because there are less workers for each pensioner. For this and other reasons, migrants make less demands on the state, so a reduction in migration raises government spending per person (e.g. the elderly use the NHS more) which requires higher tax rates.  One interesting result is that although restricting migration raises pre-tax wages (less labour supply), after a time post-tax wages are lower because of the higher tax rate.

In short, migration is beneficial for the economy as a whole, and for households as a whole. For a short summary of other empirical evidence, see this article by Jonathan Portes, or this from the OECD. Yet the political debate presumes the opposite. It is taken as read that migration causes all kinds of harmful effects, and the debate revolves around measures to prevent these. It is summed up by this quote from BBC political journalist Nick Robinson.

“What Jonathan Portes has helped us do is define the difference between an economist and a politician," said Robinson. "A fine economist he might be, but I suggest he would not have a chance of getting elected in a single constituency in the country. It is a widespread view that there is exploitation of the benefits system by migrants.”

So you see why I think there is a potential parallel with the austerity debate. The evidence suggests that migrants make a net fiscal contribution relative to natives, just as all the evidence suggests that austerity is harmful in a liquidity trap. However the ‘public’ believe otherwise, and (by implication) economists should get real and stop going on about evidence so much.

There is a difference, however. Government debt is not a ‘doorstep issue’, whereas immigration is. In 2010 the Eurozone crisis brought the issue of debt to the fore, but since then in most countries it has been the politicians and sections of the elite that have kept the debt problem alive (to justify austerity). The ‘need’ for austerity is accepted by the public because it is portrayed as governments doing what households do in bad times: tighten their belts. But I do not think excessive government debt is an issue that many politicians encounter when they go canvassing for votes, but migration certainly is. Equally I doubt that the current UK government would have made migration such a big issue if it wasn’t perceived as a vote winner, and if it was not for UKIP.

Does this make a difference to how economists react in each case? We plug away at the economics of course, but how do we explain why the economics seems to be ignored? With austerity most explanations involve thinking about how politicians and sections of the elite think: why they may be irrationally worried about market panics, or why debt may be a cover for other agendas. With migration the focus has to be about why large sections of the electorate believe that migration harms them.

I see three strands of thought here, although none are mutually exclusive. The first is to acknowledge that there is a natural tendency for communities to be concerned about outsiders, but blames the media and some politicians for playing on this concern. This can explain why popular concern about immigration can be so high in areas where there is very little. The second is to grant that migration may be beneficial for the economy as a whole, but acknowledge that for some the immediate (and therefore personally verifiable) impact is negative (e.g. less unskilled vacancies, lower wages, higher rents). This article by John Harris exemplifies this strand. A third takes the concern about outsiders more seriously, and talks about the benefits and costs of social diversity.

A second difference involves politics. To the extent that austerity is a cover for sections of the elite to push for a smaller state, then austerity morphs into a standard debate between right and left. This helps explain why what on the surface should be a technical macroeconomic discussion about multipliers and the effectiveness of unconventional monetary policy is in reality so politically polarised. This is not the case with migration. As this letter from members of various UK right wing think tanks indicates, restricting migration runs counter to the neoliberal agenda. Others argue that public concern about migration reflects the failure of the left to oppose (or worse, pursue) this agenda.

Perhaps I can sum things up this way. While I find the macroeconomics of austerity interesting (it’s my field), I believe the reasons why the economics is ignored are fairly straightforward and much less interesting. In the case of migration, I think understanding why the economics is ignored is much more of an intellectual challenge.

A New Year Aside

Many thanks to Alex Marsh for saying nice things about this blog, but Chris Dillow absolutely deserves the No.1 spot. To see why, read this. I would have loved to have thought of this counterfactual, but whereas I would have ended with something predictable on the economics or politics, Chris talks about the importance of luck. Brilliant!

Inconvenient truths, probably

I recently noted the exchange between Jonathan Portes (Director of NIESR) and Jesse Norman (Conservative MP for Hereford) on the Treasury Select Committee. Now reading too much into transcripts of oral evidence can be dangerous: people often do not say quite what they mean, and I’m not a fan of gotcha type political journalism that makes a big deal of such inexactitude. However Dr. Norman, formally a philosophy fellow at UCL, has now clearly set out the reasoning behind his complaint, which I think is rather revealing.

He sums up his views as follows:

1.  Economics is not an exact science.  Its substantive claims can only ever be more or less probable, though that probability can sometimes confer knowledge.

2.  So:  absolutely categorical statements—statements like “all of the interest rate differential was due to low economic activity, and none due to government policy” or “Plan A is failing” cannot be purely economic in character.

3.  Those in positions of public authority should be capable of being held to account.  This applies to politicians of course—but also to civil servants and academics.

4.  As Director of NIESR, Jonathan is in a position of public authority.  Indeed NIESR is an academic institution (NB its website is www.niesr.ac.uk), and so subject to academic standards of rigour; as well as partly or wholly funded by public money.

There is no disagreement on (3) and (4), although note that his arguments apply to all academics (like me and other academic bloggers) and not just directors of well known public institutions. I would also agree with (1), if claims are about the real world rather than models of the real world. So Dr. Norman’s problem, to paraphrase, is that Jonathan should have said ‘Plan A is probably failing’ rather than ‘Plan A is failing’.[1]

Does this mean that in future posts I should insert a ‘probably’ in any statement that makes a claim about the real world? Take some recent news, like figures released today showing UK earnings rising at 1.4%, compared with inflation over the same period of 3.5%. Instead of writing

“This decline in real wages is due to the high level of unemployment, caused by the recession that followed the financial crisis. Workers are suffering today because of irresponsible behaviour by the banks before the crisis.”  

I should, to preserve academic standards, write

“This decline in real wages is probably due, at least in part, to the high level of unemployment. This in turn may have something to do with the recession, although we cannot rule out that other factors are at play. The recession itself could well have been triggered by a global financial crisis, although we can never know this for sure. Some people suggest that this crisis reflected poor lending decisions by banks, so there just might be some connection between irresponsible behaviour by banks before the crisis and people’s declining wages today. However it is all very uncertain.”

Would you class the second as economics, but the first as a political attack on the banks?

So why is Dr. Norman so keen that I or Jonathan Portes insert all these qualifiers to what we write? Well lets just imagine what might happen if I take Dr. Norman’s advice, and if I am ever asked to appear in front of the Treasury Select Committee again.

Wren-Lewis: “In my view Plan A has probably failed”
Conservative MP: “But you cannot say for sure - you admit it is possible it has worked”
Wren-lewis: “Well of course, but I think the balance of probability is that it has failed”
Conservative MP: “Ah, the balance of probability. Would you care to put a number on that professor?”
Wren-Lewis: “Well that is very difficult to do, but my guess is that the probability that it has failed is over 95%”
Conservative MP: “Your guess! My dear professor, I suggest you stop guessing and come back to this committee when you have something a little better than guesswork. In the meantime, I can tell you that Plan A has clearly worked, and I can say that without qualification.”

What I find revealing about all this is that while I am supposed to say ‘Plan A has probably failed’ as an academic economist, it is OK to say ‘Plan A has failed’ as a political statement. Political statements, apparently, do not need qualification even when qualification is due. Is this because they have no truth value whatsoever? Perhaps this was what was going on when certain well known US economists claimed that “the negative effect of the administration’s ‘stimulus’ policies has been documented in a number of empirical studies.” Here it did not matter that nearly all such studies had found the stimulus policy had been effective, because it should have been understood that here they were making a ‘political statement’, which should not be confused with the ‘economic statements’ they normally make. (Fortunately members of the Conservative Party have not as yet started making ‘political statements’ denying evolution, although climate change denial is doing pretty well.)

The reality of course is that most people now realise Plan A has failed, and those that cannot admit that only have low interest rates to point to as any kind of success. So when macroeconomists point out that interest rates would be expected to be low for an economy that is so depressed, and that the experience of certain Eurozone countries just does not apply to us, these economists become dangerous voices that need either to be discredited as partisan, or intimidated into silence. Such tactics can be quite effective when used against an organisation as timid as the BBC: lets see if it can also work with an institution like NIESR.

[1] The more normal criticism by politicians of economists is the opposite, which is that we are always hedging. ‘Give me a one-handed economist’ President Harry Truman is reported as saying.  

The impact of austerity in the UK and Eurozone

When I wrote this recent post on the impact of austerity in the UK, I was slightly nervous about the numbers. I suggested that the 2011 and 2012 cuts in spending on goods and services alone would have reduced GDP in 2012 by between 1.25% and 2.5%, but this was a back of the envelope calculation using simple aggregates and static multipliers, and it left out the impact of important tax increases and transfer cuts. However luckily we today have a rather more systematic analysis from Dawn Holland and Jonathan Portes at NIESR. This adds in the impact of tax increases and transfer cuts, and comes to a figure of over 4% for the impact of 2011 and 2012 austerity on UK GDP in 2012. 

Now at this point I should declare an interest of sorts. Holland and Portes use the Institute’s global econometric model NIGEM. I built the first version of this model. However that was so long ago, and I’m sure that the improvements subsequently made by Ray Barrell, Dawn Holland and others mean that nothing is left of my original construct.

What is especially interesting about the NIESR study is that they also do the analysis for the Eurozone economies. If we extend the calculations to 2013, Greek GDP in 2013 is over 13% lower as a result of 2011-13 austerity, Portugal’s GDP nearly 10% lower and Spain’s 6.7% lower: UK GDP is ‘only’ 5% lower. Now a cut in average incomes of 5% or more is a big deal, and it is why I keep saying that the welfare costs of these measures dwarf other considerations. But we know that this pain is not evenly spread: many people are not much affected by austerity, while others are receiving much larger cuts in their incomes.

The key point, which the NIESR study also puts numbers to, is that this pain is not in any way inevitable. It comes because austerity is being undertaken when monetary policy can do very little to counteract these effects. In more normal times, which means once the recovery is sufficiently underway such that interest rates begin to rise again, this scale of austerity will have a much smaller impact on GDP. In principle, its impact could be completely offset by monetary policy. So the argument that these large income cuts are inevitable because debt has to be brought down at some point is simply wrong.

However the NIESR study does miss one thing out of its calculations. Nowhere is there a confidence fairy that will magically persuade the private sector to spend because government debt is coming down. (As the NIESR study shows, the debt to GDP ratio actually rises because GDP falls by more than debt, but hey that’s a detail – GDP will recover one day, probably.)  Now to believe in fairies you need pretty good evidence, and that is just what we do not have. A few economists think they saw some in the data, but that is not enough - nothing like enough - to justify inflicting this scale of pain on so many. (Others, of course, saw nothing (e.g. pdf).) Unfortunately too many people just wanted to believe in the confidence fairy. Normally we find those who really do believe in 'real' fairies either rather amusing or rather strange. Unfortunately some of those who believed in the confidence fairy were put in charge of running our economies.  

The UK and Austerity: some facts

There has been some recent debate about whether UK austerity is responsible for the poor performance of the UK economy (which remains poor, despite the Q3 growth numbers). The debate could be summarised thus:

Austerity Critics (e.g. Paul Krugman): “The UK has gone for strong austerity, and since it did so GDP has stagnated – told you so.”

Austerity Apologists (e.g. Tyler Cowen): “But if you ignore tax increases, and public investment, actually there has not been much austerity. The weakness of the UK economy reflects other factors.”

So, for those who are confused, here are some facts.[1]

Austerity can involve tax increases, cuts in transfers and spending cuts, so it is natural to look at the overall deficit. As I have suggested before, the best figure for the direction and impact of policy is the cyclically adjusted primary deficit. Both IMF and OECD estimates show substantial austerity.

UK Cyclically adjusted primary deficit

	2010	2011	2012	2013
IMF[2]	-6.1	-3.9	-2.8	-1.5
OECD[3]	-5.8	-4.1	-3.0	-1.9

However any deficit figure may not be a good guide to the aggregate demand impact of policy, because many tax and transfer changes will have smaller multipliers than changes in spending on goods and services. As I noted here, the IMF suggest that UK austerity over the full 2009-2013 period is relatively focused on government spending rather than taxes. However what about 2011 and 2012 in particular? The table below looks at the government spending on consumption and investment numbers that go into the national accounts.

Growth Rates in UK Government Spending on Goods and Services, and Employment

Government consumption		2011	2012	2013
	OBR March	0.3	0.5	-1.1
	OECD June	0.1	-0.7	-1.8
Government investment
	OBR March	-13.0	-5.0	-3.6
Government employment
	OBR March[4]	-4.0	-2.0	-1.9

The OBR’s forecast is quite old, but the new one will not come out until 5^th December. I’ve included the OECD’s June numbers because their 2012 figure is a clear outlier compared to other forecasts, and because many people (myself included) use these forecasts. If they are right it will make a significant difference, but for the rest of this post I’ll assume they are not, and use the OBR numbers.

Government investment makes up only about a tenth of government spending on goods and services (G for short), so putting the two together the OBR numbers suggest a fall in G of 1% in 2011, about flat in 2012 and a fall of almost 1.5% in 2013. So, the ‘contribution to growth’ of G to GDP is to reduce it by a bit more than a quarter of one percent in 2011 and 2013, with no impact in 2012. (OBR forecast (pdf), Table 3.4.)

However this ‘contribution to growth’ number in effect compares what actually happens to a counterfactual in which there was no growth in G. A better counterfactual is if G had increased by, say, 2% a year in each year, which would be a kind of neutral, average sort of figure.[6] On that basis cuts in G directly reduce total GDP by about three quarters of a percent in 2011 and 2013, and by half of a percent in 2012. If the multiplier was only one, these are still big numbers, but if it was two they become really large. It would mean that the UK economy might have grown by over 2% in 2011 rather than by less than 1%, without allowing anything for the impact of higher VAT.

So whichever way you look at it, it seems that austerity has had a major impact on UK growth. Of course other things have been important too, but I’m not sure anyone has actually claimed that austerity is the only thing holding back the UK economy.

But in one important sense this is all beside the point. Those who criticise austerity only require three things to be true:

(1) Austerity is real, rather than something imaginary. The figures above make that clear.

(2) Multipliers at the Zero Lower Bound are significant.

(3) If we had not had austerity, monetary policy would not have offset stronger growth.[5]

This is why the multiplier debate is so important. There is a lovely non-sequitur in Chris Giles FT piece on this recently, which Jonathan and Richard Portes have already commented on. Chris correctly notes that theory suggests that multipliers are larger if interest rates are stuck at zero, and then says “so theory tells us very little about the likely effect of fiscal policy on economic growth”. As I have argued many times, theory is pretty clear that multipliers on G will be greater than one in current circumstances, and could be a lot greater than one. And as Paul Krugman quite rightly keeps reminding us, it is theory that has stood up pretty well since the crisis.  

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[1] My thanks to Jonathan Portes for some discussion on this issue, but I alone am responsible for what appears here.

[2] Source: IMF Fiscal Monitor October 2012 Statistical Table 2.

[3] Source: OECD Economic Outlook June 2012.

[4] Final quarter of financial year, so 2011 figure is actually 2012Q1/2011Q1.

[5] Unfortunately we cannot be certain that (3) is true, as I have discussed before. However we cannot be certain the other way either, which is sufficient in my view to continue to criticise UK austerity. 
[6] Postscript. We are interested in why the UK economy did not grow by, at the very least, 2% pa. So the natural counterfactual is where G grew in line with GDP at 2%. It is nonsense to say that G did not contribute to zero growth because it also did not grow.