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.

    

More on Naive Fiscal Cynicism

Paul Krugman is absolutely right that one of the rationales for the IMF and others framing fiscal policy in terms of the ‘speed of consolidation’ is a belief that left to themselves politicians will always and everywhere let debt rise. As he points out, the facts for the US tell a rather different story. Here I want to add a couple of additional points by looking at experience outside the US.

As should be well known by now, UK government debt was over a 100% of GDP between the wars, but declined rapidly and consistently to 50% from the second war to the mid 1970s. (See here, or this useful UK site.) The chart below, based on OBR data, takes up the story since then.

UK Debt to GDP ratio (%)

So perhaps the simplest description is that debt to GDP began to level off at around 40% of GDP (which was the target from 1998 to 2008), until the Great Recession hit. There is a lot of interesting detail here, but that would distract from the main point, which is that the UK is another clear counterexample to the idea that governments always let their debt rise.

However deficit bias is not a figment of international policymakers imagination. As I note here with Lars Calmfors, and others have noted before us, government debt in the OECD area as a whole almost doubled (40% to 75%) between the mid-70s and the mid-90s. This deficit bias came not from the UK, and not much from the US, but from Europe and Japan. (To see data on individual countries or country groups, see this nice IMF resource. [1])

So the only reasonable conclusion is that deficit bias is a problem, but not one that afflicts every government at all times. As Lars and I document, there have been various studies that have attempted to draw lessons from this diversity of experience: for example coalition governments may be more prone to deficit bias, but institutional set-ups where the finance ministry is strong less prone. My own support for fiscal councils partly stems from a desire to look for an institutional mechanism to help counter deficit bias. There is no magic bullet here, and institutional solutions will differ depending on national constitutional characteristics.

If this last point seems obviously reasonable, then lets change the dimension from across countries to across time and states of the world. While we may observe a tendency towards deficit bias in normal times, in times like now when government debt is high we seem to be observing a quite different bias - a bias towards austerity. The apparent consensus of 2008/9 that we needed fiscal stimulus looks like the aberration rather than the rule. An international organisation wanting to push sound economics needs to be doing more than arguing for a slower speed of consolidation. By advocating fiscal consolidation when the opposite is required you risk discrediting your advice at other times.

Here is another analogy. Doctors quite rightly encourage us to take more exercise. That is because we have a tendency to sit around too much, but this bias is not universal across people types or ages. Yet when we catch flu, the doctor prescribes rest, not exercise. Indeed, a good doctor may well be specific about the length of rest required, because they know too many patients may think they are better before they have fully recovered. If a doctor told us that while we had flu we should cut down from 30 minutes exercise to 15 or 10, we might begin to doubt their credentials.  

[1] To get the debt series, click on the blue subheading ‘Real GDP growth’.

Costing Incomplete Fiscal Plans: Ryan and the CBO

Some of the regular blogs I read are currently preoccupied (understandably) with the US Presidential election. This is not my territory, but the role of fiscal councils – in this case the CBO – in costing budget proposals is, and the two connect with the analysis of the Ryan budget plan. The Ryan ‘plan’ involves cutting the US budget deficit, but contains hardly any specifics about how that will be done.

There is nothing unique to the US here. In the 2010 UK elections, both main parties acknowledged the need for substantial reductions in the budget deficit over time, but neither party fully specified how these would be achieved. Now as the appropriate speed of deficit reduction was a key election issue, this might seem surprising. In particular, why did one party not fully specify its deficit reduction programme, and then gain votes by suggesting the other was not serious about the issue?

The answer has to be that any gains in making the plans credible would be outweighed by the political costs of upsetting all those who would lose out on specific measures. People can sign up to lower deficits, as long as achieving them does not involve increasing their taxes or reducing their benefits. However, I think it’s more than this. If people were fully aware of the implications of what deficit reduction plans might entail, you would guess that lack of information might be even more damaging than full information. As people tend to be risk averse, the (more widespread) fear that their benefits might be cut could be more costly in electoral terms than a smaller number knowing the truth.

The fact that this logic does not operate suggests to me that (at least among swing voters) there is a bigger disconnect in people’s minds between aggregate deficit plans and specific measures. Saying you will be tough on the deficit does not panic swing voters, but adds to your credibility in being serious about the deficit ‘problem’. Indeed, from my memory of the UK election, claims by one side about secret plans of the other were effectively neutralised as scaremongering.

This can be seen as the reverse side of a familiar cause of deficit bias. A political party can gain votes by promising things to specific sections of the electorate, but does not lose as many votes because of worries about how this will be paid for. The media can correct this bias by insisting on asking where the money will come from (or in the reverse case, where the cuts will come from), but they may have limited ability to check or interrogate the answer. This is where a fiscal council, which has authority as a result of being set by government but also independent of government, can be useful.

For some time the Netherlands Bureau for Economic Policy Analysis (often called the CPB) has offered to cost political parties fiscal proposals before elections. The interesting result is that all the major parties take up this offer. Not having your fiscal plans independently assessed appears to be a net political cost.

What the fiscal council is doing in this case is conferring an element of legitimacy on aggregate fiscal plans, a legitimacy that is more valuable than uncosted fiscal sweeteners. Which brings me to the question of what a fiscal council should do if these plans are clearly incomplete? In particular, suppose plans include some specific proposals that are deficit increasing or neutral, but unspecified plans to raise taxes or cut spending which lead to the deficit being reduced. By ‘should do’ here I do not mean what it is legally obliged to do, but what would be the right thing to do.

It seems to me clear that the right thing to do is not to cost the overall budget. What, after all, is being achieved by doing so? Many people or organisations can put a set of numbers for aggregate spending and taxes into a spreadsheet and calculate implied deficits, and the adding up can easily be checked. By getting the fiscal council to do this fairly trivial task serves no other purpose than to give the plan a legitimacy that it does not have.

In this situation, a fiscal council that does calculate deficit numbers for a plan that leaves out all the specifics is actually doing some harm. Instead of asking the difficult questions, it is giving others cover to avoid answering them. It is no excuse to say that what was done is clear in the text of the report. The fiscal council is there partly so people do not have to read the report. So I wonder if the CBO had any discretion in this respect. If Ryan was playing the system, perhaps the system needs changing to give the CBO a little more independence. 

Is it all Gordon Brown’s fault?

                Someone reading my recent post on major UK macro policy errors asked whether my blog was becoming more political. I hope not, in the sense of being party political for its own sake. However, when the issue involves macroeconomic policy, then I do my best to say what I think is right rather than what is politically expedient. This is in part because I have very negative views about the role of ideology (left or right) in influencing economics. (Incidentally, I do react badly to those who say ‘ah, but all theory is ideological, it’s just that you pretend what you do is ideology free’. I guess this makes me one of those old fashioned fogeys who believe in the possibility of evidence based social science.)

                Perhaps this is why I have not so far explicitly commented on the oft repeated refrain by the current government that austerity is necessary to ‘clear up the mess’ left by excessive deficits under Gordon Brown? It is nonsense of course, but like all the best slogans it contains a half-truth. I think it is certainly true in hindsight, and almost certainly true ex ante, that spending in the later Brown years was underfunded (or excessive, depending on your viewpoint). By exactly how much I plan to explore in more detail for a paper over the next few months. The untruth, of course, is that this problem had to be corrected immediately and quickly during a recession.

                This issue arose from my recent post where I listed what I considered to be the three major UK macroeconomic policy errors over the last 30 years. I said that underfunded spending by Brown was an error, but that I did not consider it a major one because it did not lead to the same scale of welfare losses that occurred when unemployment became unnecessarily high (like now). Chris Brown commented that “The loss in social welfare [caused by excessive deficits in a boom] is never felt at the time of the increase in government spending (the reverse is true) but after the party is over (i.e. today)”.

                I think this comment is right in two ways, but nevertheless it does not imply that Brown’s underfunding was a major error. Let’s start with where I agree. First, additional spending paid for by debt which is then paid off at some future date by cutting spending clearly raises welfare today but reduces it tomorrow. If the additional debt is paid for by raising future taxes (i.e. we are permanently increasing the size of the state) then the situation is more complicated. If consumers are completely Ricardian then the timing of the tax increase does not matter for welfare, but let’s leave that complication to one side. Second, I agree that pro-cyclicality in spending decisions is a common vice, and that because it tends to be asymmetric (it happens more often in booms than recessions) it can lead to deficit bias. This is certainly bad policy.

                But are the welfare costs of this that high? Not, in my view, if the subsequent correction is done at the appropriate time. To take a simple case, suppose monetary policy is able to completely offset the demand impact of both the excessive spending, and the subsequent cut in spending designed to pay off the additional debt. The only welfare cost then is an intertemporal misallocation of public goods. It is my judgement that these costs are of an order smaller than the costs created by raising unemployment by a few hundred thousand for a few years when unemployment is already high. (I have to say judgement here, because most formal analysis of measuring the welfare costs of business cycles takes place in representative agent models where ‘unemployment’ just means everyone working a few less hours. This does not begin to capture the true impact of unemployment on well being.)

                Now if it was true that the additional unemployment caused by austerity today was an inevitable consequence of underfunding in the Brown years, then the comment would be exactly right. But it is not. Paying off the debt created by the underfunding should be done during the next boom, and not now. As a result, Gordon Brown’s error gets relegated to minor status when compared to what is happening now.                

Austerity and not wasting a crisis

                In the austerity versus stimulus debate, I argue from a macroeconomic point of view that this is a false choice if we are talking about economies where markets are eager to buy government debt i.e. pretty well everywhere apart from the Eurozone. In the short term we need stimulus, whereas fiscal discipline is a long term problem. We need to raise taxes and cut spending when times are good, not when times are bad. The Eurozone 2000-2007 is a clear example of when this should have happened.

                The response is often to concede the macroeconomic logic, but say that promises of austerity tomorrow cannot be trusted. It is easy to promise, but when tomorrow comes governments will break that promise. This resonates, but it is less clear what the underlying logic is. We can all agree that governments are subject to deficit bias. There are a number of reasons for this: the common pool problem, over optimistic forecasts, political impatience stemming from elections etc. (See Calmfors and Wren-Lewis, 2011, for a more complete account.) However bias stemming from these causes is fairly constant: it does not disappear when deficits are high and only materialize in good times.

                I sometimes put it this way. Suppose the government did go for fiscal stimulus today, and this helped lead to a macroeconomic recovery. Once the recovery was complete, the underlying fiscal position (i.e. the structural or cyclically adjusted deficit) would be a little worse than today, because the stimulus would have added to debt. So if a politician is prepared to undertake austerity today, they will be even more willing to undertake it tomorrow. Of course following a recovery the actual (rather than structural) deficit may be smaller, but is our macroeconomic discourse that naive?

                In economics we are of course used to the optimal policy changing solely as the result of the passage of time (time inconsistency). A central bank may promise to keep interest rates high for some time to reduce inflation today, but come tomorrow when the policy has done its job it becomes optimal to reduce interest rates. However when it comes to fiscal policy and deficit bias, the role of time inconsistency seems less central. The problem is not that we have a benevolent policy maker that is subject to a time inconsistency temptation; it is that we do not have a benevolent policy maker.

                Having said this, I think many feel that, when governments are prepared to act ‘out of character’ and impose restraints on themselves, this chance should be grabbed before it disappears. It is often possible, when looking at countries where government debt is not a major problem, to trace this back to changes made following a fiscal crisis. Lars Calmfors has a nice account of the Swedish case here. So can we rationalise this idea? Perhaps a crisis, and therefore the chance to act, is not governed by the level of debt (funding problems aside), but by its rate of change. So governments became prepared to impose austerity when debt started rising rapidly following the recession, but if nothing was done and debt remained high, the political imperative would gradually disappear. Higher debt would become the new normal.

                However I still have problems with this line of reasoning. As Lars emphasises, Sweden was successful because it instituted a comprehensive set of reforms following the crisis, including a fiscal target to be achieved over the course of the cycle. It was also successful because a large nominal depreciation boosted output growth, more than offsetting the deflationary impact of fiscal consolidation. The world as a whole cannot use this trick, so an important condition for successful global fiscal consolidation is missing. However countries could establish rules today that were designed to only begin operating when the economy has recovered. Use the current crisis to get the rules established, but recognise that their implementation needs to be delayed because of the recession.

                It is often said that instituting rules that only operate once the recovery is complete will ‘not be credible’. Here is the time inconsistency analogy again, and (funding crisis aside) it seems equally inappropriate. We just need to ask: credible to whom? Is a government that commits to future austerity that begins tomorrow, any more likely to renege in the future than that same government that commits to long term austerity and starts it today? We could argue the opposite: an austerity plan in conjunction with a recession is more likely to come unstuck.

                I think a mistake we can make here is to imagine we are trying to discover the preferences of two different governments. In that case, a government that just promises future austerity tells us very little, because it could just be cheap talk. If a government undertakes austerity now, we know more through its actions. However that is not what the current debate is about. In practice we have governments that are prepared to undertake austerity now. They have demonstrated that they take the debt problem seriously. Are these preferences going to change if we delay austerity until after the recovery?

                So let us, by all means, not waste a fiscal crisis. Use it to set out a combination of rules and institutional changes that avoid deficit bias in the future. However I do not see why it is politically impossible to delay the implementation of those rules until after the recession is over. But maybe I’m just displaying my ignorance of political science.