Blanchard on Fiscal Policy

I was recently rather negative about the way the IMF frames the fiscal policy debate around the  right speed of consolidation. In my view this always prioritises long run debt control over fiscal stimulus at the zero lower bound (ZLB), and so starts us off on the wrong foot when thinking about the current conjuncture. Its the spirit of 2011 rather than the spirit of 2009.

Blanchard and Leigh have a recent Vox post, which allows me to make this point in perhaps a clearer way, and also to link it to a recent piece by David Romer. The Vox post is entitled “fiscal consolidation: at what speed”, but I want to suggest the rest of the article undermines the title. The first three sections are under the subtitle “Less now, more later”. They discuss the (now familiar from the IMF) argument that fiscal multipliers will be significantly larger in current circumstances, the point that output losses are more painful when output is low, and the dangers of hysteresis. I have no quarrel with anything written here, except the subtitle, of which more below.

A more interesting section is the one subtitled “More now, less later”. This section starts by noting that the textbook case for consolidation is that high debt crowds out productive capital and increases tax distortions. Yet these issues are not discussed further. The article does not say why, but the reason is pretty obvious. While both are long term concerns, they are not relevant at the ZLB.

Instead the section focuses on default, and multiple equilibria. After running through the standard De Grauwe argument, the text then says: “This probably exaggerates the role that central banks can play: Knowing whether the market indeed exhibits the good or the bad equilibrium, and what the interest rate associated with the good equilibrium might be is far from easy to assess, and the central bank may be reluctant to take what could be excessive risk onto its balance sheet.” This is more a description of ECB excuses before OMT than an argument.

More interesting is what comes next. Does default risk actually imply more austerity now, less later? I totally agree with the following: “The evidence shows that markets, to assess risk, look at much more than just current debt and deficits. In a word, they care about credibility.” “How best to achieve credibility? A medium-term plan is clearly important. So are fiscal rules, and, where needed, retirement and public health care reforms which reduce the growth rate of spending over time. The question, in our context, is whether frontloading increases credibility.”

So here we come to a critical point. Does more now, less later, actually increase the credibility of consolidation? If it does not, then the only argument for frontloading austerity disappears. The next paragraph discusses econometric evidence from the crisis, and concludes it is ambiguous. The whole rationale for more now, less later, is hanging by a thread. And there is just one paragraph left! Let me reproduce it in full.

“The econometric evidence is rough, however, and may not carry the argument. Adjustment fatigue and the limited ability of current governments to bind the hands of future governments are also relevant. Tough decisions may need to be taken before fatigue sets in. One must realise that, in many cases, the fiscal adjustment will have to continue well beyond the tenure of the current government. Still, these arguments support doing more now.”

Is this paragraph intentionally weak and contradictory? If credible fiscal adjustment requires consolidation by future governments, why does doing more now add to credibility? You could equally well argue that overdoing it now, because of the adverse reaction it creates (‘fatigue’ !?), turns future governments (and the electorate) away from consolidation, and so it is less credible.

So what we have is an article that appears to be a classic ‘on the one hand, on the other’ type, but is in fact a convincing argument for ‘less now, more later’. Perhaps that is intentional. But even if it is, I’m still unhappy. Although the arguments on multipliers, output gaps and hysteresis appear under the subtitle ‘less now, more later’, they in fact imply ‘stimulus now, consolidation later’, once you take the ZLB seriously. If you are walking along a path, and there is a snake blocking your way, you don’t react by walking towards it more slowly!

Why does this matter? Let me refer to recent comments David Romer made about the ‘Rethinking Macro’ IMF conference, which he suggests avoided the big questions. For example he notes “I heard virtually no discussion of larger changes to the fiscal framework.” He goes on (my italics)

“Another fiscal idea that has received little attention either at the conference or in the broader policy debate is the idea of fiscal rules or constraints. For example, one can imagine some type of constitutional rule or independent agency (or a combination, with a constitutional rule enforced by an independent agency) that requires highly responsible fiscal policy in good times, and provides a mechanism for fiscal stimulus in a downturn that is credibly temporary.”

As I argued here, it is not a matter of having a fiscal rule for consolidation that allows you to just ease up a bit at the ZLB. What we need is a rule that obliges governments to switch from consolidation to stimulus at or near the ZLB. Otherwise, the next time a large crisis hits (and Romer plausibly suggests that could be sooner rather than later), we will have to go through all of this stuff once again.

The ECB as a Lender of Last Resort to Governments

John McHale rightly points out that in my earlier post on the European Commission’s justification for austerity, I said little about the Lender of Last Resort to governments (LOLR) issue. What I did say is that OMT should have been established much earlier, and that this might have allowed Ireland and Portugal to continue to sell government debt to the markets at tolerable interest rates, which in turn might have allowed them to implement budget consolidation at a less damaging pace. (Whether they would have taken that opportunity is another matter.)

However this begs an obvious question, which is how OMT conditionality should operate. One possibility is that the ECB imposes as least as harsh conditions as the current Troika. Alternatively the ECB passes responsibility for imposing conditions to the Troika, and the Troika continues to do what it has already done. It would be wrong to say nothing would be gained as a result. If OMT works and the governments continue to borrow from the market, then we avoid some of the toxic intergovernmental lending that is in danger of tearing the Eurozone apart. However we will still have excessive fiscal deflation.

Do we need any conditionality at all? Unfortunately we do. To offer OMT unconditionally would take us back to the pre-2007 situation, where default was not thought possible. It revitalises the arguments that gave rise to the disastrous Stability and Growth Pact and the more recent Fiscal Compact. As Charles Wyplosz and others have emphasised, it is very difficult to run any kind of system where component parts have autonomy to borrow without having the discipline of default, unless you resort to a degree of central control that is not feasible for the Eurozone.

Conditionality should not come naturally to any independent central bank. There is no significant example of a country delegating fiscal decision making to an unelected body, and even if it did so there are reasons not to use a central bank for that task. But before addressing this dilemma, we should establish what the nature of conditionality should be.

The remit of the central bank should be short run macroeconomic stabilisation and long run price stability. OMT can be justified under this remit, as I argued here, because if a country finds itself in a bad market equilibrium, this will have a negative impact on the monetary transmission mechanism and short run macroeconomic stability. Conditionality can also be justified under this remit, because a complete failure of fiscal control in one country in a union when default is not allowed will compromise monetary policy for the union as a whole. (One of my own papers with Campbell Leith looks at this in a two country case. [1]) By complete lack of fiscal control, I essentially mean that a government is insolvent at a level of interest rates consistent with normal monetary policy. [2]

In other words, all the ECB needs to worry about is whether fiscal policy is sustainable in the long run. It should have no concern about which of the many possible sustainable fiscal paths a government chooses - that is up to the national government. There is a analogy with the well established rules for central bank support of private banks. If the bank is solvent but suffering from liquidity problems, support should be unequivocal and unlimited. If the bank is insolvent, no support should be forthcoming. [3]

The problem with this analogy is that solvency for a government involves a political as well as a technical judgement. Suppose a government submits fiscal projections that are sustainable. This could involve government debt initially rising but stabilising at some high level. If it then starts falling again so much the better. There could be two things wrong with this projection. The first is technical: for example growth assumptions may be too optimistic or tax receipts given growth are too optimistic. The second is political: the plan may involve cuts in spending, or increases in taxes, that are unlikely to be realised because the political costs are too high.

No central bank should like to be in a position where it has to make these political judgements. It would like to offload the problem on someone else. The obvious someone else is the market, but that will not work because all the market tells you is that there exists a bad equilibrium, and not whether a good equilibrium exists. To use Keynes’s famous analogy, the market is judging who the market thinks is beautiful, and not who is actually beautiful. The ratings agencies seem ‘market like’, but are in effect just a bunch of people with a (perhaps informed) opinion, and a not very good track record.

Who else could the ECB delegate conditionality to? Delegating to EU heads of state would be a bad idea, for reasons that I hope are obvious. [4] Delegating to the Commission seems too close to that. A better possibility would be the IMF. The IMF certainly knows all about this issue: see this research for example. However all of these agencies have a recent track record that does not inspire confidence. An acid test is how any arrangement would have worked in the case of Greece. What should have happened, as soon as the true extent of Greece’s fiscal problems had become clear, is that whatever body the ECB had delegated its conditionality assessment to should have concluded that default was more likely than not, and therefore OMT should not have been provided.[5]  

I have an alternative suggestion, which regular readers will not find surprising. A number of Eurozone countries now have fiscal councils, whose very job is to assess the sustainability of fiscal policy. They are the obvious people to ask. Putting such an important question to the relevant national fiscal council may be politically unwise - could that council survive a decision that led to default? It would be better, for this and other reasons, for fiscal councils to act as a group in advising the ECB on the sustainability of national fiscal plans. That way expertise could be pooled, and experience shared.

Let me be quite clear what I am suggesting here. As soon as a country specific default premium began to emerge on a Eurozone member’s government debt, the ECB would ask the collective of Eurozone fiscal councils whether they thought current fiscal plans would result in a sustainable level of debt. If they did, the ECB would announce that OMT would apply to that country i.e. it would buy whatever quantity of that debt that could not be sold to the market. That decision could be reviewed annually until the default premium faded away. If the fiscal councils collective did not think current fiscal plans were realistic and sustainable, OMT would not be forthcoming. In these circumstances, there would be no bailing out by the Eurozone or IMF, and default would almost certainly follow.

The Commission plays no part in this. However, I think the Commission still has a very important role to play. The ECB, as part of the role it should have in preventing deficient aggregate demand in the Eurozone as a whole, should publicly state that because of the zero lower bound they cannot use monetary policy to fulfill this function. They should ask the Commission to coordinate fiscal actions to provide additional support to demand. In doing this, the Commission would clearly not ask that much of countries on OMT, so most of the ‘burden’ would fall on others, like Germany or the Netherlands.

Which brings me back to my previous post, and why I think what I said there was quite compatible with LOLR issues. Now some commented on that earlier post that it was not politically feasible, by which they mean Germany would not countenance it. I am sure that is right, although what has disappointed me (and others - see Kevin O’Rourke) is that the election of Hollande did not emboldened countries like France and Italy to provide any kind of counterweight to German views.

One of the advantages of being an academic is that your advice does not have to be bound by what is politically feasible. It is important that someone sets out what is best as they see it, and others can then modify it to satisfy political constraints. However the problem in this case is not so much that fiscal stimulus rather than austerity, and the ECB acting as a LOLR, are not in the German national interest. I think you could make a case that they are in fact in Germany’s long term national interest, because a well functioning Eurozone is in their interests. The problem seems more that policy makers throughout Europe have two economic blindspots. [6] Those blindspots are the fallacy of austerity at the Zero Lower Bound, and the necessity of a LOLR. What I will not do is give advice which accepts that those blindspots cannot be removed.

 

[1] See also Canzoneri, M. B., R. E. Cumby and B. T. Diba (2001), “Fiscal Discipline and Exchange Rate Systems”, Economic Journal, No. 474, pp 667-690.

[2] Using Eric Leeper’s terminology, it means the fiscal authority is active: for a discussion of the active/passive idea and its application to the ECB and OMT see here.

[3] One problem with the Bagehot dictum is contagion: if an insolvent bank is allowed to fail, this may create a liquidity (or even solvency) crisis for others. These contagion arguments have much less weight when it comes to countries in the Eurozone, once OMT has been established and the conditionality involved is clear and non-political.

[4] See, for example, Cyprus. Colm McCarthy describes it well here (HT Kevin O’Rourke)

[5] This may be a little unfair on the IMF, who almost certainly came under intense political pressure from the Eurozone to provide funds before the inevitability of default was conceded. I do not know whether this assistance, which allowed default to be delayed, was provided against the better judgement of some of those in the Fund.

[6] See a shrill Kevin O’Rourke here.

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

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

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

I wrote this:

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

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

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

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

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

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

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

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

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

Why politicians ignore economists on austerity

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

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

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

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

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

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

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

Democracy in the northern Eurozone: you can choose austerity, or austerity.

Imagine that before the US election the Congressional Budget Office published a detailed analysis of the economic implications of each candidate’s policies for different categories of government spending and taxation, and their impact on GDP, unemployment and much more. These were based on detailed and comprehensive accounts provided by both parties, and not unspecified aggregate numbers with no policies attached such as in the Ryan plan. You would have to agree that this would give voters a more informed choice, but you might also say that it was politically impossible in any country. Well have a look at the Netherlands, which will hold elections on 12^th September. That is exactly what happens there, with the analysis provided by their fiscal council, the Bureau for Economic Policy Analysis (CPB). (If you are at all interested, the detail provided in the CPB’s analysis is extraordinary (pdf) – for example, it predicts what impact each party programme will have on greenhouse emissions.)  

That is the positive news. The not so good news is that unemployment is expected by the CPB to rise by 1% over the next two years, and almost none of the major parties are planning to do anything to try and stop this. How could they stop it? Being part of the Eurozone means that fiscal policy is the only aggregate policy tool available. As a result political parties should be planning to raise budget deficits – increasing government spending or cutting taxes – on a temporary basis to keep demand rising in line with supply. Yet only one major party is planning to do this: the far right ‘Party for Freedom’, whose refusal to vote for the deficit reduction plans of the previous coalition brought down the government and sparked this election.

Now increases of 1% in unemployment may seem small beer compared to what is happening in Spain, for example. But unlike Spain, there is no market pressure in the Netherlands to reduce budget deficits. Instead the pressure comes from the Eurozone’s fiscal rules. And it matters because if countries like the Netherlands and Germany are reducing output and increasing unemployment by trying to cut budget deficits, then this makes the task for countries like Spain much more difficult.

General developments in the Eurozone are proceeding as I thought they might when I recklessly forecast that the Euro would survive. Because the process involves a power struggle between different economic ideologies, and countries, it is slow and painful and full of potential hazards and uncertainties: will the conditionality imposed on Spain and Italy to obtain ECB help be light enough to be politically acceptable to these countries, for example. (Paul Collier has an interesting post on this here.) I still worry that Germany might demand Greek exit as a token victory, but I’m relying on wise heads, and the IMF, to make sure that does not happen. However survival will still come at the price of a prolonged Eurozone recession, and here the fiscal rules are the central problem, as the Netherlands illustrates all too clearly.

The voters of the Netherlands are being given some choice, as Matthew Dalton points out . The Liberals (right of centre) want to cut the deficit by reducing spending, while the socialists want to raise taxes on high earners, and would increase the deficit compared to baseline in 2013 (but not 2014). However according to the CPB: “For almost all parties, unemployment will increase, compared to the baseline.” The exception is the right wing Freedom Party: it has the only programme that raises growth (slightly), and it is the only party that plans to increase the deficit in both 2013 and 2014 (all relative to baseline). So voters can vote against what I have previously called budget madness, but only by voting for a party that wants to abolish the minimum wage and halt immigration from non-Western countries.

I started this post with the CPB, so let me finish with them as well. The CPB is in a delicate position, as it wants to retain the trust of all the political parties for being impartial. However, in the FT (£) in February (also available here), the Director of the CPB Coen Teulings wrote an article entitled “Eurozone countries must not be forced to meet deficit targets” (jointly written with Jean Pisani-Ferry).  The Dutch central bank, on the other hand, has been calling for the urgent ‘rationalisation’ of the public finances.  (Its head was appointed by the previous coalition that proposed deficit cuts.) Which goes to show that fiscal councils tend to be wise, but central bankers talking about fiscal policy can be – well - not so wise.

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. 

Fiscal councils: births, and the trials of youth

                Fiscal councils, or independent fiscal institutions, are growing in popularity. In the last year or so they have been established in Portugal, Ireland, Australia and most recently, Slovakia. (See my fiscal council web page for details.) They provide an independent check on the fiscal numbers produced by government. The councils differ widely in focus, structure and remit (see Calmfors and Wren-Lewis, 2011, for a comparison), with some concentrating on the macro numbers, and others also doing substantial microeconomic project costing along the lines of the Congressional Budget Office in the United States. For just one example of why independent analysis is useful, see here.

                Establishing a fiscal council is only half the battle. Almost by definition, fiscal councils will be an inconvenience to governments. They are also highly vulnerable, as the government provides their funding. This is particularly true in their earlier years, when councils have not had time to build up public support. A contest between a fiscal council and the government is a David and Goliath encounter where the only weapon the council has is public support. A cynical view might be that therefore they are unlikely to be truly independent – why annoy the hand that feeds you? However experience suggests otherwise, largely as a result of the integrity of those that lead them.

 A recent example comes from the Parliamentary Budget Office (PBO) in Canada. The PBO has had a number of antagonistic brushes with government. The latest involves government departments refusing to disclose data. Now it appears a no-brainer that a fiscal council needs data to do its job – but then, as an active supporter of fiscal councils, maybe I’m biased. So read this report and this blog, and make up your own mind.

As the only weapon fiscal councils have in battles like these is public opinion, then it is very important that economists do what they can to provide their support when appropriate. I was shocked at the ease with which in 2011 the Hungarian government effectively closed down their two year old fiscal council (see here for details). Economists have long been champions of the independence of central banks, but independent fiscal councils are just as important, and arguably they are far more vulnerable than central banks. 

Budget Madness in the Netherlands

                While all the current focus is on the challenge to austerity thrown up by the French and Greek elections, it may be salutary to look at an equally recent challenge that failed. Towards the end of April the Dutch conservative coalition government collapsed, when the far right party refused to discuss further budget cuts. The Prime Minister resigned. And yet a few days later other parties rallied round to give their support to a similar package of austerity measures, which now have majority support in parliament.

                This austerity was not required by the bond markets. The government can borrow at very low interest rates:  2.3% on 10-year bonds. (Predictably a ratings agency made noises about the country losing its triple AAA after the government collapsed, although not the same one that infamously downgraded US debt last year.) It is definitely not required by the state of the Dutch economy: GDP is expected by the IMF to fall by 0.5% this year (that’s a -0.5% growth rate), with unemployment rising from 4.5% to 5.5%. So what could have led a government to try and cut spending and raise taxes at such a time to the extent that it brings the government down? The answer is the ‘Excessive Debt Deficit Procedure’ (EDF) of the EU’s Stability and Growth Pact. The budget deficit as a percentage of GDP was 4.7% in 2011, down from 5.6% in 2009. Without these measures it would probably have stabilised at around 4.5% of GDP, and the objective of these additional cuts is to bring it down to 3% by 2013.

            This is worse than trying to balance the budget in a recession – it is trying to reduce the budget deficit in a recession. (A small caveat – part of the package is an increase in VAT, which if delayed and phased could stimulate demand in the short run.) Now these measures, like raising the retirement age, may be perfectly sensible from a longer term perspective. But, VAT aside, they should not be introduced in a recession. What is really depressing from a Eurozone perspective is why the package appears to have been implemented now at such great political cost. The timing is all about the EU’s deficit limits, and a belief that Netherlands has to show the rest of Europe an example. The finance minister said the plan would send Europe “a signal of solid government finances”.

            An irony here is that the Netherlands has a longstanding and very well regarded fiscal council in the form of the Central Planning Bureau (CPB). One of things the CPB does is cost both government and opposition budget plans before an election, something Simon Johnson has recently suggested the CBO could do in the US. So the argument that austerity has to be implemented now rather than later because institutions are weak is even flimsier in the Netherlands than elsewhere. Unfortunately, it appears the CPB has not managed to educate the majority of politicians about the foolishness of pro-cyclical fiscal policy.

            From a Eurozone perspective this is a disaster. The Eurozone is cutting its cyclically adjusted deficit faster than the US or even the UK and heading for a second recession, and possible political disintegration. As I and others have discussed, with Germany there is at least an argument that with unemployment falling there is no scope for any fiscal stimulus there. Yet unemployment is rising in the Netherlands. There is no, and I repeat no, good macroeconomic reason why a stimulus package should not be implemented here. And yet we get exactly the opposite.

            "This is an unbelievable achievement," the now caretaker Prime Minister told MPs after clinching the new deal.

             

Fiscal policy heroes

                Have you ever wondered why anyone becomes a football (soccer) referee? You are almost certain to be hated by one team and its fans because of the decisions you make. Any mistakes you make will be subject to detailed media scrutiny. Your financial rewards are dwarfed by those earned by the people you attempt to control, and to thank you for that they regularly abuse your attempts to do your job.

                One final thought from my trip to Paris is that we can ask the same question of those who run national fiscal councils. There is no glory and little power to their positions. At some time or other, they will almost certainly incur the wrath of some senior politician, who will publicly assert that the head of the fiscal council is either incompetent or politically motivated. They will have committed the sin of questioning the financial logic behind the minister’s pet project, or the assertion that certain tax breaks or spending projects can be afforded on a sustainable basis. While sections of the media can be the fiscal council’s friend, because they recognise unbiased analysis when they see it often enough, other – more partisan – sections of the media will have no scruples in doing the politician’s dirty work by slandering the fiscal council and its head.

                Who are the people who run fiscal councils, and why do they take on this thankless role? They are people like Alice Rivlin, the first director of the Congressional Budget Office in the US, who would not go along with Reagan’s optimism about self financing tax cuts. Or like Lars Calmfors, the first director of the Swedish Fiscal Council, about which the finance minister said “I have established the earned income tax credit and the Fiscal Policy Council. I am convinced that at least one of the two is very useful. I am very doubtful of the other” (Calmfors and Wren-Lewis, 2011). Like George Kopits, director of the Hungarian Fiscal Council which was abolished after only two years existence. Like Kevin Page, head of Canada’s Parliamentary Budget Office, whom the Finance Minister recently called “unbelievable, unreliable, incredible” after he questioned the rationale for pension reform.

                Having talked to them all, I can suggest one common motivation: a belief that economic decisions should be based on sound analysis rather than political calculation or whim.  A view that not only should a proper analysis be done, but that the public has a right to know about it.

                As I have suggested, this role can be thankless at the time. The silver lining is that in the longer term it may be more appreciated. It has been said that Alice Rivlin is now one of the most respected figures in Washington. Like the public finances themselves, short term unpopularity may be appreciated in the longer term. 

Government debt in Europe: some good and bad news.

                Readers of this blog will know that I am an evangelist for fiscal councils. Fiscal councils are publicly funded independent bodies that provide analysis of national fiscal policy. (They are sometimes called ‘watchdogs’, but some – such as the CBO in the US or PBO in Canada – see themselves as serving the legislature rather than the public directly, so they flinch from that term. As some are not councils as such, but institutions with a standard hierarchical structure, then the term Independent Fiscal Institutions (IFI) may be better, but I use the term fiscal council on my webpage and elsewhere so I’ll stick to that.)

                The good news is that in amongst the various directives/regulations/treaties that have recently been agreed by the European Union, there are clauses that encourage the formation of fiscal councils, together with the need for independent fiscal forecasting. (In some countries, like the UK, the fiscal council (OBR) is all about independent forecasting, while in others, like Sweden, forecasting was already reasonably independent before the council was formed.) This is a case of better late than never. Some EU countries have recently established fiscal councils through their own initiative as a response to the debt crisis (such as Ireland, Portugal and Slovakia), so this EU initiative is playing catch-up in their case.

                The bad news is that the rest of the EU’s response to the debt crisis makes life difficult for these new fiscal councils, and may in effect hinder the formation of new ones. In essence this is because the broad thrust of the EU’s crisis management has been to take away national autonomy in making fiscal decisions. I complained about this in the context of the new treaty here. What I had not fully appreciated until recently is that you now almost need a fiscal council just to try and work out what the huge number of sometimes conflicting EU directives actually mean in terms of what a country is allowed and not allowed to do.

                I think some economists view this development as benign, because they see it as part of an inevitable transition to a fiscal union. When others point out that so far it is no such thing, it is suggested that a fiscal union has to be done in stages for (largely German) political reasons, and that large scale European transfers will emerge once national fiscal responsibility is nailed down. Even if this was the planned pathway, I have severe doubts that it is a feasible path politically.

                I have even greater doubts that the new European regime will be able to deliver fiscal responsibility. As I have often argued, simple rules that produce severely suboptimal outcomes are not sustainable. (For a recent discussion of this sub-optimality, see Karl Whelan.) This was true with the original SGP, and it is just as true now. The idea that you can have effective legally binding rules based on something as difficult to measure as a structural budget deficit is bizarre.

                As Tyler Cowen suggests, a far better path would be one built on mutual trust. How can Germany begin to trust fiscal policymaking in other countries? Not, I would suggest, by placing monitors inside those countries – this is control, not trust. I far better way starts with recognition that it is in each country’s own interest to maintain fiscal discipline. The original Stability and Growth Pact was based on seeing fiscal policy as a free rider problem, where market discipline had been removed. We now know that this was a misreading, perhaps encouraged by a similar misreading by markets themselves. The pain caused by current austerity will linger long in the national memory. Once we recognise that debt responsibility is in the national interest, the aim should be to encourage the creation of national institutions that support that interest – national fiscal councils. These institutions can then be seen by other countries as their allies in maintaining fiscal discipline at the European level.

                I fear the major barrier preventing this happening may be the European Commission itself. I remember attending a Commission conference soon after the Euro was formed, where I presented a paper that, among other things, explored the possibility of new institutions involved in national fiscal policy. I had a discussion with a senior Commission official, who thought this was an excellent idea - because the Commission could be that institution! Like any bureaucracy, the Commission is all about super-national control, and not subsidiarity.

                One recent episode is a case in point. The Commission has recently suggested withholding funds from Hungary because it believes that country has not taken sufficient action to control its deficit.  Yet only a little over a year ago Hungary had a newly created and highly effective fiscal council under George Kopits. It was abolished by the Hungarian government largely because it was doing its job (for more information on this, see my earlier post). Where was the Commission then? 

Uncertain times in Hungary

Changes to the constitution in Hungary have provoked protests and critical comment. There have also been concerns about media control. I first became aware of the problem over a year ago, when the Hungarian government effectively abolished the newly established Hungarian Fiscal Council.

                As I suggested in a recent post, fiscal councils are a good thing. The webpage I set up for easy links and basic information on the various councils throughout the world was inspired by attending the first ever public conference of virtually all the fiscal councils, organised by George Kopits, then head of the Hungarian Fiscal Council.

                The story of the Hungarian Fiscal Council is told in Kopits, G (2011) “International Fiscal Institutions: Developing Good Practices,” OECD Journal on Budgeting, November (an early version of which can be found here.) It was doing its job effectively, which is to ask important but potentially tricky questions about the government’s fiscal plans. The whole idea of a fiscal council is that it should make life difficult for a government that gives insufficient attention to the longer term consequences of its overall fiscal plans. The Hungarian Fiscal Council did not go out of its way to pick fights with the government: it just did its job. Effective abolition came despite widespread protest by the heads of other fiscal councils and academics. Unfortunately that decision now seems part of a trend.

2011: The year the OBR came of age

2010 was a disastrous year: the year when global fiscal policy moved from (mild) stimulus to austerity. 2011 was the year of the Euro crisis. But I wanted to be a bit more positive, and original, so let’s highlight 2011 as being the year when the UK’s Office for Budget Responsibility (OBR) came of age. This is mainly of UK interest, but I think it says something more generally about how macro fiscal policy can be improved.

                The OBR is the UK’s fiscal council. Fiscal councils are independent fiscal institutions set up by governments to act as a watchdog over aggregate fiscal policy. They differ in shape and size around the world, but they are becoming increasingly popular. (See this webpage  or Calmfors and Wren-Lewis (2011) ‘What do fiscal councils do?’ Economic Policy.) The OBR is fairly limited in its scope, but what it does is important – it provides the forecast on which budget decisions are based.

                I first argued for a UK fiscal council many years ago, and have actively campaigned for one over the last few years. The OBR is not ideal from my point of view – in particular I think it is daft that it is not allowed to use its considerable expertise to look at alternative policies. However it is still a very important innovation that should certainly improve the fiscal policy debate in the UK, and might even at some stage improve policy.

                But why say this now, when the ‘interim’ OBR was first established in 2010 by the incoming coalition government? Well I think you can argue that November 2011 saw the first occasion when the OBR made the government do something that it did not like doing, and that might not have been done if the OBR had not been there. What the OBR did was revise down its estimate for the size of the UK’s output gap. As the output gap is the difference between actual output and the level output could be without any domestic inflationary pressure, then that is equivalent to saying that it revised down its estimate of what output will be once we have recovered from the recession. Less output means less taxes, so it also means the government can afford less spending. So the OBR said that if the Chancellor stuck to his current plans, he would have less than a 50% chance of meeting his fiscal rules.

As a result, the Chancellor announced budget plans that implied an additional squeeze on spending, which is now extended to beyond the next general election. Now I have mixed feelings about this, because I think fiscal policy in the UK at the moment is way too deflationary. I also do not know if the OBR’s analysis on the output gap is correct, although I do know it is evidence based. (I find the disappearance of so much potential output so quickly something of a puzzle.) But it remains the case that the OBR made the Chancellor do something that he would not have wanted to do.

The real counterfactual is whether the same thing would have happened without the OBR. Treasury officials will have looked at the same evidence, and might have come to the same conclusions. But then the Chancellor might have asked ‘how sure are you that the output gap is not as big as you thought last year’, and the officials would have correctly replied ‘well it is all very uncertain’. In those circumstances it is all too easy for them collectively to conclude ‘let stick with the old numbers until things become clearer’. This is not meant to be a comment on individuals: this is just how government works. A key argument behind the conservative party’s proposals for the OBR is that it prevented politicians influencing the forecast, and that is exactly what it may have done on this occasion.

So 2011 was the year in which the OBR began to make a real difference. Now bias in forecasting is not the only thing that can go wrong with aggregate fiscal policy. Once it is has been going for a few years, I would like to see the OBR’s remit extended so that it can look at the implications of alternative policies. It would also be an obvious body to filter academic research on trying to improve fiscal rules. Until it does these things, it cannot hope to improve the policy goals that governments set themselves. In short, it has a long way to go before it can convince a government not to embark on misguided austerity. But this year the OBR made a start on making fiscal policy respond to evidence rather than political convenience.