Whatever happened to the government debt doom spiral

A number of people, including the occasional economic journalist, are puzzled about why government debt at 90% of GDP seemed to cause our new Chancellor and the markets so little concern when his predecessor saw it as a portent of impending doom. I always argued that this aspect of austerity had a sell by date, so let me try to explain what is going on.

The 90% figure comes from a piece of empirical work which has been thoroughly examined, and found to be highly problematic. (Others have used rather more emphatic language.) Part of the problem is a lack of basic thinking. Why should the markets worry about buying government debt, beyond the normal assessment of relative returns. The answer is that they worry about not getting their money back because the government defaults.

If a government cannot create the currency that it borrows in, then the risk of default is very real. Typically a large amount of debt will periodically be rolled over (new debt sold to replace debt that is due to be paid back). If that debt cannot be rolled over, then the government will probably be forced to default. Knowing that, potential lenders will worry that other potential lenders will not lend, allowing self fulfilling beliefs to cause default even if the public finances are pretty sound.

The situation is completely different for governments that can create the currency that the debt they sell is denominated in. They will never be forced to default, because they can always pay back debt due with created money. That in turn means that lenders do not need to worry about forced defaults, or what other lenders may think, so this kind of self fulfilling default will not happen.

Of course a government can still choose to default. It may do so if the political costs of raising taxes or cutting spending is greater than the cost of defaulting. But for advanced economies there is an easier option if the burden of the public finances gets too much, which is to start monetising debt. That is what Japan may end up doing, and what others may also do if QE turns out to be permanent. But this is a very different type of concern than the threat of default. And it does not, in the current environment, lead to the emergence of large default premiums and market panics.

How can I be so sure? Because with QE we have had actual money creation, and it has not worried the markets at all. It seems hard to tell a story where markets panic today about the possibility of monetisation in the future, but are quite sanguine about actual monetisation today.

So for economies that issue debt in currency they can create, there is no obvious upper limit anywhere near to current debt/GDP ratios when economies are depressed and inflation is low. Japan shows us that, and we must stop treating Japan as some special case that has no lessons for the rest of us. (How often did we hear of their lost decade in the 1990s that it couldn’t happen anywhere else.)

It was good that the IFS suggested Hammond has a look at Labour’s fiscal rule. As I explained in this post, Hammond’s new ‘rule’ is pretty worthless. But one key part of Labour’s rule that keeps being ignored but is crucial in today's environment is the knockout if interest rates hit their zero lower bound. It is for the reasons described above that this knockout is there and is perfectly safe: when interest rate policy fails you can completely and safely forget the deficit and debt and use fiscal policy to ensure the recovery. It is the basic macro lesson of the last 6 years that is fairly well understood among academic economists but still remains to be learnt by most people who talk about these things. Whether senior economists in the UK Treasury need to learn it or just keep quiet about it for other reasons I do not know.

2016 Autumn Statement

Got back from a trip to London to give my lecture (pics above: thanks to everyone at SPERI and New Statesman, plus Beth Rigby for chairing and everyone else for coming) looking forward to not thinking about economics for the rest of the day, only to find the Chancellor had given an Autumn Statement. Luckily the whole thing appears to be a damp squib compared to the expectations raised beforehand, so here are just a few points. On helping the so-called just about managing, see the ever excellent Ben Chu.

Public investment

Remember all the talk beforehand about substantial increases in public investment? What we got is increases of 0.3% or 0.4% of GDP in each of the financial years from 2017 to 2020. These increases give us figures that are slightly above the numbers we saw from the Labour government in the years immediately before the financial crisis. We should be spending much, much more when interest rates are so low.

Fiscal rules

There was also much speculation that we might return to more sensible fiscal rules, now that Osborne’s had been busted. Instead the new Charter for Budget Responsibility is honestly not worth the paper it is written on. We have a target for the total cyclically adjusted deficit (including investment) for a fixed year. Whatever the number involved, this makes two mistakes: having a fixed rather than rolling date, and by including public investment in that target. It is a recipe for panic cuts in public investment a year or two before the target date.

There is also a target of a falling debt to GDP ratio by the same date. I’m at a loss to understand why you need a target for this as well as a target for the deficit. The change in the debt to GDP ratio is after all just the change in debt (which is the deficit) and the change in GDP. So targeting the change in the debt to GDP ratio just adds to the deficit target some things that you cannot control: GDP growth and your position in the business cycle. I knew there would be no zero lower bound knock out, because that would be a clear admission that 2010 austerity was a mistake. But I did hope for something more intelligent than this.

I fear George Osborne has totally discredited the idea of a fiscal rule. Remember that Labour stuck to its fiscal rules for 10 years, before they inevitably fell victim to the largest recession since the 1930s. Yes there was fiddling at the margin, but the important point was that they did have a strong influence on what the Chancellor did. I now suspect that, by breaking a whole series of rules within a shorter period of years, whatever a Conservative Chancellor says has become pretty worthless.

The fuel duty fiddle

There is this great chart in the OBR’s autumn statement document.

It shows how Conservative Chancellors keep postponing rises in fuel duty. One obvious question is why. But the OBR is also concerned about whether this makes a mockery of its forecasts. Each year they are obliged by parliament to continue to assume that in all subsequent years the government will raise fuel duty after each ‘one-off’ cut. And almost each time the Chancellor announces a ‘give away’ for motorists: they will postpone any increase ‘just for this year’. You can see why they do it: it allows the papers to write favourable headlines. But if they really are going to go on doing this, it means that really their policy is to have no increases in fuel duty. Fiscal forecasts based on the assumption that they will increase fuel duty will be much too optimistic. The government is fooling parliament and the public, but the OBR cannot do anything about it because of the restrictive rules it is forced to operate under.

The cost of Brexit

The big news was of course the higher levels of borrowing. As this table shows, a significant part of that is due to the fiscal costs of Brexit.

Surprise surprise - there will actually be less money available for the NHS and other public services after leaving, rather than more. It is as if that red Leave bus just crashed and rolled over so it is now upside down. The two big factors are lower productivity growth and lower immigration. The OBR has, unsurprisingly, followed their own previous analysis (immigration) and the consensus economist view (productivity growth).

I can almost guarantee that the Sun and Mail will make no mention of this - or if they do it will only be to rubbish the OBR. So, following the theme of my lecture, I really hope that the broadcasters’ nightly news programmes pick this up. Channel 4 news did do so, but I didn’t watch the others (let me know in comments).

The NHS and squeezing the public sector

Not a penny more for an NHS in crisis. Make no mistake, as this blog has shown before, the current crisis in the NHS is simply because it has been starved of resources for the last six years. I really wish Labour (it has to be them, because they are the only party who the media will take any notice of) would run a campaign that busted the myth of a ‘protected’ NHS. But what Hammond’s refusal to do anything about this shows is that this government is continuing the squeeze of the public sector begun by the Coalition. Here is the relevant chart from the OBR. 

Public investment and fiscal rules

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

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

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

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

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

Fiscal rules and MMT

What I call the ‘consensus assignment’ in modern macroeconomics is that monetary policy keeps output stable at a level that leaves inflation at target over the medium term, and fiscal policy stabilises the ratio of government debt to GDP. Most mainstream macroeconomists understand that assignment does not work at the Zero Lower Bound (ZLB), but a few disagree. To those that follow MMT fiscal rules that target the deficit are wrong because they think fiscal policy should do the job monetary policy is supposed to do in the consensus assignment, even outside the ZLB. They do not think monetary policy is predictable or reliable enough to do the job the consensus assignment gives it. That is a perfectly legitimate view, but one I and mainstream macro do not agree with. I discussed all this here in March.

Contrast this simple one paragraph explanation to this post, which takes 14 paragraphs to miss this basic point. Instead it says

1. I assume that output is constant (my italics)
   
   
2. I prefer models about how the world should work rather than how it works
   
   
3. I am “a static kind of man living in a dynamic world”
   
   
4. I am “a proponent of waste”
   
   
5. People should question my veracity when I make my arguments

The first three are mistakes I can understand, because for some reason he has failed to grasp the point about monetary policy and has tried to come up with other rationalisations. But the final mistake is going too far: just because you cannot understand another point of view does not mean the other person must be lying. Is this acceptable discourse within MMT?

Fiscal rules should target the deficit, not spending

This jointly authored VoxEU piece on making the EU more resilient after Brexit that came out nearly two months ago has already had some unfavourable comment: Paul Krugman calls it timid, and Brad Delong does not like it much either. I want to pick out one particular idea, which I think is simply wrong and dangerous, and which I find it extraordinary that so many economists signed up to. Here is the relevant passage, in a section about the public finances.

“In most countries, the level of [government] expenditure – rather than the deficit – is the main problem. High expenditure makes it difficult to raise taxes and balance the budget, leading to dangerous debt dynamics. Thus, a focus on expenditure rules, linking expenditure reduction to debt levels, appears to be one of the most promising routes.”

Now this sounds to me like saying two things. The first is that the size of the state is too large in most countries. [1] The second is that we can use the need to bring government debt down as a way to correct that. It sounds to me exactly the policy that I accuse US and UK governments of following, although in their case the linkage is generally concealed. In this article it is suggested it should be explicit.

Whatever your views about the size of the state (including having no a priori view), it seems obvious that this is an intensely political issue. In contrast questions about the appropriate long run size of government debt are not so political, but more importantly they involve a completely different set of issues to those involved with the size of the state.

That is why policies or fiscal rules that aim to stabilise or bring down government debt focus on the budget deficit. It keeps the issue separate from the appropriate size of the state, and hopefully takes a good deal of the politics out of that issue. Linking the two issues makes it very easy to fall into what I call deficit deceit: saying we must cut government spending because government debt is too high, rather than because the state is too large. Even if that is avoided, associating the two sets back the cause of sensible debt management by needlessly politicising it.

That is why sensible fiscal rules target the deficit in some form, and allow how that deficit is achieved to be a political choice. I know this may seem obvious to me because I have written a lot about fiscal rules, but I would have thought the point might have also occurred to one of the economist authors of that article. When heterodox economists argue that the mainstream is hopelessly embroiled in the neoliberal project, they will be able to cite this article as evidence.

[1] You might say that, perhaps with certain European countries in mind, this is just a recognition that there is too much inefficiency and needless bureaucracy within government, rather than being a deeper statement of what governments should and should not do. If that is the case the authors should say so, but even then the coupling with debt control is problematic.

Avoiding political discourse

When PoliticsHome interviewed me about what the Blanchflower review of monetary policy might come up with (which will not report for some time), I couldn’t help but end with a plea.

“My biggest fear is that some people may try and put their political spin on anything we recommend, even when those recommendations come from an analysis of the technical academic literature. When I accepted an invitation to be on Labour's Economic Advisory Council, one or two people did suggest that this would damage my reputation as an economist. Given that being a member placed no restrictions on what I could do or say in public, or any obligation to support party policy, I thought it was an extraordinary accusation to make. Can you imagine a medic being told that they had damaged their reputation by advising policy makers about medical research?”

I used the example of medical research for reasons outlined here, and because I like comparing economists to medics.

As the economist Paul Romer has noted (see also here), political discourse is not like scientific discourse, and it is a problem when academics sometimes adopt a political way of thinking in their day job. In political discourse it is critical whose side you are on. If you are on one side anything that favours or helps the other side is presumed wrong. So when I agreed to be on Labour's Economic Advisory Council (EAC), many of those that were opposed to Corbyn’s leadership naturally assumed that I must be a Corbyn supporter. When I said that if George Osborne set up an equivalent of the EAC and invited me I would agree, and that I had indeed given advice to his Treasury and his advisors, the accusations changed from being the enemy to aiding and abetting the enemy. [1]

We were aiding the enemy because I and other EAC members are ‘providing legitimacy’ to the new leadership: we are being used for our reputations. And sure enough, here is John McDonnell doing exactly that in a recent speech:

“We’ve enshrined these commitments in our Fiscal Credibility Rule, drawn up with help from the world-leading economists on our Economic Advisory Council.”

Except that is exactly what happened: I gave a paper at the first EAC on what I thought the fiscal rule should be, it was discussed there, McDonnell’s team then developed it internally, discussed their version of it with Labour’s shadow cabinet and the rule was made public.

Labour’s new fiscal rule, as far as I know, is the first fiscal rule that sensibly responds to the possibility that monetary policy can run out of reliable ammunition (QE is much less reliable than fiscal policy), and I hope that sets an example that others will follow. [2] I also think politicians should get credit for listening to economists and adopting sensible rules or creating useful institutions. That is exactly what Gordon Brown did in 1997/8, and what George Osborne did in 2010 in establishing the OBR.

In my view the EAC is a useful innovation in economic policy making, because the link between academic economics and policy has become weaker in recent years for various reasons. The EAC is unusual in part because it makes the politician who set it up vulnerable. Any member of the EAC can, if they wish, publicly criticise Labour policy and get additional media coverage as a result of EAC membership. And academics being ideas people rather than political people might be particularly prone to do that. That is a level of vulnerability that many politicians would avoid. (See this for example.) That is one reason why it is misguided to suggest that we should have given our advice in private rather than through a public body like the EAC.

Some who are enmeshed in political discourse say that policies are two a penny and can be put in place in an instant: it is only leadership and winning that matters. I suspect much the same is true for many (not all) political commentators, who often see policies as simply weapons to attract voters. As Gaby Hinsliff remarks, many political commentators have a bias to those they see as winners. But I don’t want a world where academics only give policy advice to politicians who they support or who they think will win. It politicises economics, and that can damage the credibility of the subject.

Because academic economists, or academics of any kind, give advice on their policy area to politicians should never have to mean that those academics support those politicians. People enmeshed in political discourse find it hard to understand that, but I refuse to accommodate them. My job is economic policy, and I while I will do what I can to try and get politicians to adopt policies based on sound economics, those means do not include adopting a political discourse.

[1] For the record, no one in the Labour Party from 2010 onwards asked me for my advice on any occasion. This was despite (or maybe because of) everything that I wrote opposing George Osborne’s austerity policies and defending the Labour government's fiscal policy on my blog (which started at the end of 2011). Had they done so, I would have gladly given it.

[2] Those who might be tempted to see the zero lower bound knockout as just a 'loophole', you just betray your mediamacro mindset. Those tempted to say anyone on the left would have adopted this type of rule, go read some MMT. 

Fiscal rule redux

Although this discussion is about the UK, the macroeconomic issues involved apply equally elsewhere.

Most of the media discussion of Labour’s new fiscal rule presented before the budget focused on the commitment to balance the current budget. The media did this because ‘the hook’’ was the similarity between this aspect of the rule and the rules proposed by Brown or Balls. As I noted at the time, no one in the media seemed to want to compare this goal to the Chancellor’s overall surplus objective, which remains rather extraordinary.

In some ways this element is the least interesting part of the rule. Two other key parts are that current balance is a rolling five year target, and the knockout if interest rates hit their zero lower bound (ZLB). Both are more difficult to explain quickly in a mediamacro world where the deficit is considered all important, although at least with the rolling 5 year target a quick response is that the coalition government adopted exactly that form of target. If they had adopted the less flexible target of current balance by 2015, the economy would have been even more screwed by austerity than it actually was.

The really new feature of the rule is the knock out. (This was described as a ‘loophole’ by one political reporter: mediamacro again.) The rule is deliberately suspended to allow for fiscal stimulus when interest rates hit their ZLB. How much stimulus? Whatever it takes to get interest rates to rise above the ZLB. In Portes and Wren-Lewis we suggest the Bank of England are the obvious people to advise on this (the size of stimulus, not its form in terms of spending increases or tax cuts). The focus of fiscal policy switches from deficit control to stabilising demand, but only because monetary policy can no longer do that job effectively.

If such a rule had been in operation during the Great Recession, we would have seen a continuation of the fiscal stimulus we saw in 2009 into later years. That would have meant, for sure, that government debt would have risen by more than it did, but it would also have meant, for sure, that output would have recovered more quickly. What would have happened to the debt to GDP ratio we cannot know for sure, but the important point is that this does not matter.

It is this last point which is the most difficult to convince people about in the mediamacro world. In this (imaginary) world, we have to worry about the deficit because if we do not there might be a financial panic, with interest rates on government debt rising and perhaps even an inability to sell that debt. The best response to this concern is it would not matter even if it happened, because the Bank of England would buy the debt and keep interest rates on that debt down. Of course the market panic scenario will not happen anyway, because there is zero chance that the government will default, but trying to convince people that the financial markets will behave rationally after the global crisis is hard.

Many non-economists think creating money to cover the deficit sounds outlandish, until you point out it is already happening with QE. The potential size of the QE programme is unlimited. The whole point of QE is to keep long term interest rates, like the interest rate on government debt, low. QE happens when short interest rates are at their ZLB. That it why, when rates are at the ZLB, fiscal policy can focus on stimulating the economy. [1]

There are some who think that any kind of fiscal rule represents appeasement of the austerity position. As I discussed in my post on MMT, I do not think that is very good economics, particularly for a party (like Labour) that is committed to maintaining an independent central bank that uses monetary policy to stabilise demand. In that regime, when you are not at the ZLB, deficit bias is a potential problem. I think intergenerational fairness is important, and we shouldn’t ignore it just because the argument is misused to support austerity. I am reminded of this every time I look at Norway, and recall how Mrs. Thatcher effectively used oil revenues to cut taxes rather than build up a sovereign wealth fund. There is a certain irony that George Osborne’s current policy of going for surplus, while totally wrong for today, would have been the right policy in the late 80s and 1990s.

Ellie Mae O'Hagan recalls how many on the left (in my recollection all shades of the left) argued that when austerity started to bite there would be a popular revolt against the policy. That did not happen, in part because of mediamacro, but also because there was not a clear alternative to unite behind. Labour tried to have it both ways, expressing worries about what austerity was doing but also agreeing that the deficit was a current concern. In Labour’s new fiscal rule we have a policy that sets out clearly how we should deal with any new crisis, and also how we should have dealt with the last one. It is a policy the left should unite behind, because overcoming mediamacro’s obsession with deficits will not be easy.

[1] You can only do this if the government controls the currency its debt is issued in. When that does not happen, as many developing countries have found to their cost, you do have to worry about the bond markets. That was exactly the problem that led to the Eurozone crisis, until the ECB came up with OMT.

A more elaborate argument for countries that do borrow in their own currencies is that a market panic over government debt would be accompanied by a run on the currency. Paul Krugman tackles this, but following discussions with the FTs Martin Sandbu I do plan to discuss this issue further at some point.  

The question that was not asked

I had the (mis)fortune to listen to the BBC’s World at One while returning home from a lecture yesterday. The second item (20 minutes in) was about the new fiscal rule proposed by Labour’s John McDonnell in a speech that morning. The item contained three segments. The first was from a BBC political reporter, the second an economist at the IFS, and the third from Labour’s 2015 election campaign director.

The reporter, Ross Hawkins, described the zero lower bound knockout as a ‘loophole’, and also talked about taxpayers money. He then described how the knockout would work (the MPC would decide), but went on to relate how a Labour press officer had described his questions as being from a Tory crib sheet and had walked away. The economist Carl Emmerson did a solid job of saying what the rule would mean post 2020, although he had to respond at least once that just because the ‘borrowing to invest’ idea was not new did not make it bad. Then came Spencer Livermore to say exactly that - as it was similar to Labour’s rule for the 2015 election, and as this had failed, Labour needed something new and radical. He did not say, and was not asked, what this new and radical fiscal policy might be.

It occurred to me afterwards that at no point did anyone ever ask whether this rule was better or worse than George Osborne’s fiscal charter. Carl Emmerson tried to contrast the two rules, but natural questions like ‘should we borrow to invest’ or ‘does it make economic sense to have a zero lower bound knockout’ were never asked. Just think about that: the opposition proposes a fiscal rule that is quite different from the government’s, and in 10 minutes of radio no one asks which is better.

Livermore was not asked what his new and radical fiscal rule might be because it was of no interest - all that was of interest to the interviewer was that he was criticising his own side. That was not an accident of the way the discussion went, but inherent in the way the segment as a whole was constructed. If listeners had been looking for any kind of discussion of the economic merits of the new rule they would have been disappointed.

Unfortunately this particular programme was not an isolated case. Channel 4 News took a similar line, interviewing Livermore again, with no economist in sight. I once saw a chart somewhere that looked at who talks about economics in the media, and less than 10% of the time it was economists. This matters, because it is how we end up with governments pursuing policies that sound good in soundbites, but cause considerable damage to our economies.

A (much) better fiscal rule

Today the Labour Shadow Chancellor John McDonnell will give a speech where he puts forward an alternative fiscal rule to George Osborne’s fiscal charter. It involves a rolling target for the government’s current balance: within 5 years taxes must cover current spending. It leaves the government free to borrow to invest. Investment cannot be unbounded, as there is a commitment to reduce debt relative to trend GDP over the course of a parliament.

No doubt we will hear the usual cries from the opponents of sensible fiscal rules: Labour plan to borrow billions more than George Osborne and they plan to go on borrowing forever. The simple response to that should be that it is right to borrow to invest in the country’s future, just as firms borrow to invest in capital and individuals borrow to invest in a house. Indeed, with so many good projects for the government to choose from, and with interest rates at virtually zero, it is absolute madness not to investment substantially in the coming years.

This part of the rule is similar to the main fiscal rule Osborne himself adopted under the Coalition, which in turn is not unlike previous rules adopted by Labour. What is new is that McDonnell’s rule involves what could be termed a ‘zero lower bound knockout’: if interest rates hit their lower bound following a recession, the focus of fiscal policy shifts from deficit targets to helping monetary policy support the economy. It reflects the knowledge we have gained since the global financial crisis.

Again critics will claim that the knockout would have meant building up even more debt after the last recession. But what matters with debt is its relationship to GDP, and it is far from clear whether more stimulus in 2009 and 2010 would have increased the debt to GDP ratio, because you are increasing GDP as well as debt. But even if debt to GDP did rise, this reflects the right choice. It means prioritising the real economy - jobs and wages - over an obsession with government debt.

We will no doubt be told by government supporters that this would have led to financial disaster, just as we are also told that the coalition saved us from disaster. We will be told this by some economists working in the financial sector - a sector that created the Great Recession. But there is no evidence for this impending disaster, and plenty of evidence that it is a complete myth. As Paul Krugman might say, in a country with its own central bank the bond vigilantes just keep failing to turn up.

Recessions come and go, you might respond, but higher debt will always be with us. That ignores two key points. First, prolonged and deep recessions cause lasting damage. UK GDP per head is currently over 15% below pre-recession trends. Does none of that have anything to do with the slowest UK recovery from a recession in centuries? Second using fiscal policy to end recessions quickly does not mean higher debt forever. The key point is that debt can be reduced once the recession is over and interest rates are safely above their lower bound. Doing that will be no cost to the economy as a whole, as monetary policy can offset the impact on demand. Obsessing about debt during a recession, by contrast, costs jobs and reduces incomes, as every economics student knows and as the OBR have shown.

The rule happens to mean that pretty well all of the additional austerity Osborne has detailed since the election is unnecessary. But that is a byproduct of adopting a sensible rule. If there is any ‘reverse engineering’ going on, it is with the fiscal charter, which some argue was adopted with the political purpose of making Labour look less prudent before the election. As McDonnell notes, no economist has attempted to defend Osborne’s fiscal charter.

Yet I know this point worries some Labour MPs and commentators. They say, quite rightly, that one of the main reasons the 2015 election was lost was because Labour were not trusted on fiscal policy. But the basic truth is that you do not enhance your fiscal credibility by signing up to a stupid fiscal rule. Apart from getting attacked for doing so by people like me, your collective heart is not really in it and it shows. You get trapped into proposing to shrink the state as Osborne is doing, or hitting the poor as Osborne is doing, or raising taxes which makes you unpopular. And if by chance it ever looks like you might be getting that trust back, Osborne or his successor will move the goalposts again.

The far more convincing way to get trust back is to adopt a fiscal rule that makes sense to both economists and the public (‘only borrowing to invest’), and actively talking about it. When the Conservatives accuse you of borrowing, you do not try and change the subject, but remind people that is what firms and consumers do. Borrowing is not a dirty word, particularly when it is on vital investment and you can do it for almost nothing! Indeed borrowing to invest shows you are optimistic about the future and are prepared to do things to make it better. In contrast those who would turn down these investment projects in order to reduce debt as fast as possible have a negative outlook that fears the future.

The Conservatives know they are vulnerable on public investment. Osborne tries to give the impression that he is doing a lot of it, but the figures do not lie. In the last five years of the Labour government the average share of net public investment in GDP was over 2.5%. During the coalition years it fell to 2.2%, and for the five years from 2015 it is planned to average just 1.6%. That is not building for the future, but putting it in jeopardy, as those whose homes have been flooded have found to their cost.[1]

[1] Besides cutting spending on flood prevention while part of the coalition, Damian Carrington revealed yesterday that UK funding for research on flooding has been cut by 62%! There can be no better indication of the madness of George Osborne’s deficit obsession.   

The fiscal charter media fiasco

The House of Commons passes into law a fiscal charter which enshrines in the short term another period of severe austerity, and thereafter commits the government to a crazy fiscal rule. The media (with one or two notable exceptions) focus on Labour U-turns and 20 odd abstentions. The Labour leadership have only themselves to blame of course. Which given the way the media operates is true. But does it have to be this way?

Behind the gimmick of a charter is a real policy that will impact on everyone. This policy is the reason the government will make substantial cuts to tax credits for millions of poorer working people, making their already difficult lives substantially harder. George Osborne said as much in his budget speech . Would these people really think that this was of less interest than endless discussion of Labour embarrassment? Who are television news programmes made for: ordinary people who receive tax credits or a Westminister bubble obsessed with political process?

The charter is all about macroeconomics: fiscal policy and fiscal rules. There is an academic literature on fiscal policy and fiscal rules. I have not come across a single non-partisan academic economist who supports this charter, and certainly not one who knows about this literature. For an academic discipline that is always accused of being hopelessly divided, that is saying something. The reasons are not that difficult to get across:

• The policy restricts public investment at just the time that public investment should be high because borrowing and labour are cheap. Its a near universal view among economists that now is the time for higher public investment.
  
  
• Targeting a surplus year in and year out is likely to lead to harmful volatility in tax rates or spending. All macro theory says the deficit in the short-term should be a shock absorber.
  
  
• If the charter is achieved, it will bring debt down ridiculously fast, penalising the current working generation.
  
  
• Fiscal austerity when interest rates are very low is never a good idea

Again with the exception of a few newspapers, I heard nothing of this in media reporting. Instead I heard misleading statements, like you needed surpluses to get debt down when what matters is the debt/GDP ratio. (2% deficits with normal growth will reduce the debt ratio.)

Even the ‘highbrow’ news programmes like Channel 4 news and Newsnight chose to spend most of its time talking about U-turns on either side. No mention of the complete lack of economic support for this charter. On an issue with such important consequences, is that fulfilling a duty to inform? We have millions of hardworking but poor families who will be made substantially worse off as a result of a fiscal rule which no academic economist has supported? Will these families ever find that out? What does that tell us about our media, and our democracy?

When economists play political games

I saw you talking to those people the other day. You really should think twice before being seen to talk to people like that.

Similar lines could be taken from countless novels about class, race or some other form of social exclusion. When I agreed to be part of a group that would occasionally advise the new Shadow Chancellor John McDonnell on economic policy, I must admit I hadn’t expected something like that to be said to me by economists I respect. Political hacks would say it for sure, but economists interested in promoting good policy?

Just to be clear, McDonnell’s group places no restrictions on what its members can say in public about policy. We are not required to support or endorse Labour policy. Indeed, to the extent that Labour does adopt a policy that any of its members disagree with, the group gives those members a slightly higher public profile if we make that disagreement public. As the media generally fails to distinguish good economic advice from political spin, a direct channel like this group seemed like a good idea, with no cost to its members except their time. Except ...

On Monday McDonnell announced a U-turn: he would no longer support Osborne’s new fiscal charter. The media focus, as ever, was on the ‘political shambles’ of a U-turn, with only the occasional suggestion that the charter itself was economic nonsense. (The body of this FT leader was an exception.) A few economists on twitter, however, suggested that this political shambles somehow reflected badly on the members of the advisory group. One described the members of the group being ‘branded’ by association. If other economists reading this sympathise with that view, you need to read on.

As this FT piece suggests, the new Labour position of not supporting the charter is likely to find general support among the advisory group. (We have not yet met.) Indeed, as I said to the FT, a huge majority of macroeconomists — particularly if they know something about fiscal policy — would recommend opposing the charter. I have no idea if the views of any of the group had any influence on this U-turn, but if it did that means the group is having some influence, which has to be a positive thing. Indeed, as I know some of those making this ‘guilt by association’ charge actually oppose Osborne’s charter, they should welcome the fact that we may have helped change Labour’s position. Instead they are saying his change of mind reflects badly on us!? It makes no logical sense, unless something else is going on here.

As I said in an earlier post, I am happy to give advice on macro policy to any of the mainstream political parties, whether I agree with their current macro or other policies or not. Over the past five or more years I have given public and private advice to Treasury officials working for the actual Chancellor. I feel strongly that governments should and can follow good macroeconomics whatever their political persuasion. For me to say I’m not going to talk to you because I do not like your policy on X would be as silly and childish as it sounds.

So what is going on with economists who would not blink an eye at me giving advice to a Chancellor whose policies I often (but not always) oppose, but suggest that when it comes to the Labour party there is some kind of guilt by association? It seems to me that they are, knowingly or not, part of a political game. The game is to give the current Labour leadership some kind of pariah status. If we were talking about a party like the BNP, that might make some sense, but for the main opposition party in which a radical leadership is going to have to reach a consensus with their less radical MPs it does not. Unless of course your primary interest is to support another party. Which is why the government and many journalists want to foster this pariah status frame of mind. It is a shame that some economists who are parroting this guilt by association line seem not to understand the political game they are inevitably playing.

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.