Japan and the burden of government debt

I don’t write enough about Japan, and now that some of my posts are very kindly being translated into Japanese I should try to remedy that. In fact there is currently a very good reason to write about the Japanese economy, and that is a very strong 2017 Q2 performance. Annualised growth was 4%, compared to 1.2% in the UK. What is particularly heartening about recent Japanese growth is that it is led by domestic demand rather than trade. In the past Japan seemed to have the opposite of the UK’s problem: growth was often led by trade, while domestic demand was weak.

This recent growth is not just making up for poor past performance compared to other countries. Comparisons of GDP growth are misleading for Japan because (unlike the UK and US) it has relatively little inward migration, so it is better to use GDP per head for such comparisons. (As Noah Smith points out, even this my bias comparisons against Japan because its population is aging.) Between 2006 and 2016, Japan increased GDP per head by a total of about 5.5%, compared to around 5% in the US and about 3% for the UK. Good compared to other countries, but all these countries should have had stronger recoveries from the recession.

Strong growth is good news because inflation is so low (around 0.5%): way below the 2% inflation target. The government is trying to stimulate growth using a modest fiscal stimulus and large scale quantitative easing (short and long interest rates are exactly zero) as well as implementing various structural reforms. But the striking thing about all this is that their net government debt to GDP ratio is 125% and rising (OECD Economic Outlook measure). This is higher than any other OECD country except Greece and Italy.

Does the conjunction of relatively strong growth and high government debt confound economic theory, as Bill Mitchell suggests? Like high powered money and inflation, any relationship between government debt and growth just does not work when interest rates are stuck at zero. High government debt could crowd out private investment (although some dispute this), but not when real long term rates are zero and inflation is near zero. Servicing high debt could discourage labour supply, but again not when interest rates are zero. Nor is debt a burden on future generations when the real rate of interest is well below the growth rate.

Of course most people think such high debt levels are a real concern because of ‘the markets’. But the markets will only stop buying this debt if they expect default or rampant inflation, and there is no way a government with its own currency can be forced to default. There is also no way it will choose to default with interest rates so low. This is the basic truth that our leaders in the UK choose not to tell us (and pretend otherwise).

But what happens when growth finally raises inflation, and interest rates rise. Will debt not be a problem then? Maybe, but only in the long term, so the government will have plenty of time to fix that roof when the sun shines. [1] Right now Japan does worry about its high levels of government debt, but it rightly worries about the combination of low growth and low inflation much more. In that sense it sets a good example to other countries.

[1] Fixing the roof while the sun shines is one of the Cameron/Osborne little homilies I approve of. The problem when they used it was the UK economy was actually in pretty poor shape, as we could tell because interest rates were so low.    

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.

Multipliers from Eurozone periphery austerity

For macroeconomists

We often see graphs relating fiscal consolidation to output growth since the Great Recession. Despite such scatter plots being very weak evidence, they appear to show that fiscal multipliers in the periphery countries like Greece have been very large indeed. At first sight this is not difficult to explain. These countries do not have their own monetary policies, and to the extent that fiscal consolidation reduces local inflation, real interest rates will rise, which increases the fiscal multiplier.

Unfortunately the basic New Keynesian (NK) model suggests this reasoning is incorrect, as Farhi and Werning show for temporary changes in government spending. While real rates might rise in the short run following a negative government spending shock, being in a monetary union ties down the long run price level in these economies. So, other things being equal, a negative government spending shock that reduces inflation now will be followed by higher inflation (compared to the no shock case) later, as the real exchange rate self-corrects. That in turn means that fiscal consolidation in the form of temporary cuts to government spending will produce a small rise in consumption for a period after the shock. (Consumption depends on the forward sum of future real interest rates, so as time progresses lower future rates dominate this sum.)

Of course that may simply mean that the basic NK model is incorrect or incomplete. As Farhi and Werning show in the same paper, with some credit constrained consumers we can get back to positive short term consumption multipliers, and therefore output multipliers greater than one. But it occurred to me, just before I was about to discuss this paper in an advanced macro graduate class, that the basic NK model could still give us what appeared to be large multipliers without such additions.

What we had in periphery countries was not just a government spending shock. In Ireland and Greece at least, that spending shock was preceded by a government debt shock. Either the government admitted to borrowing more than the official data suggested, or it had to bail out the banks. We can think of at least two types of response to a pure government debt shock. It could lead to a short sharp contraction in spending, in which case the analysis of Farhi and Werning would apply. Alternatively the government accepts that its debt will be permanently higher, and it only plans to cut spending or raise taxes to pay the interest on that additional debt.

In the latter case, assume that a significant proportion of that extra debt was owned overseas. We would have a permanent transfer from domestic to overseas citizens, and that would require a permanent depreciation in the real exchange rate. An increase in competitiveness is needed to make up for the permanently lower level of domestic demand that these transfers would produce. That in itself produces a terms of trade loss that impacts on consumption. But in addition in a monetary union, that depreciation would have to come about through a period of lower inflation, which would lead to a period in which real interest rates were higher. That in turn would decrease consumption, with the peak effect when the debt shock happened.

This is probably already written down somewhere, but it does explain why you could get apparently large multipliers in Greece and Ireland even if the simple NK model was broadly correct. What we had was a combination of a negative government spending shock and a positive government debt shock, and the latter could have led to significant falls in consumption. For these economies at least, true government spending multipliers may not be as large as they appear.

There I go again, choosing my economics to get the answer I want. Oh, wait ….

Confidence as a political device

Some technical references but the key point does not need them

This is a contribution to the discussion about models started by Krugman, DeLong and Summers, and in particular to the use of confidence. (Martin Sandbu has an excellent summary, although as you will see I think he is missing something.) The idea that confidence can on occasion be important, and that it can be modelled, is not (in my view) in dispute. For example the very existence of banks depends on confidence (that depositors can withdraw their money when they wish), and when that confidence disappears you get a bank run.

But the leap from the statement that ‘in some circumstances confidence matters’ to ‘we should worry about bond market confidence in an economy with its own central bank in the middle of a depression’ is a huge one, and I think Tony Yates and others are in danger of making that leap without justification. Yes, there are circumstances when it may be optimal for a country with its own central bank to default, and Corsetti and Dedola (in a paper I discussed here) show how that can lead to multiple equilibria.

But just as Krugman wanted to emulate Woody Allen, I want to as well but this time pull Dani Rodrik from behind the sign. In his excellent new book (which I have almost finished reading) Rodrik talks about the fact that in economics there are usually many models, and the key question is their applicability. So you have to ask, for the US and UK in 2009, was there the slightest chance that either government wanted to default? The question is not would they be forced to default, because with their own central bank they would not be, but would they choose to default. And the answer has to be a categorical no. Why would they, with interest rates so low and debt easy to sell.

The argument goes that if the market suddenly gets spooked and stops buying debt, printing money will cause inflation, and in those circumstances the government might choose to default. But we were in the midst of the biggest recession since the 1930s. Any money creation would have had no immediate impact on inflation. Of course their central banks had just begun printing lots of money as part of Quantitative Easing, and even 5 years later where is the inflation! So once again there would be no chance that the government would choose to default: the Corsetti and Dedola paper is not applicable. (Robert makes a similar point about the Blanchard paper. I will not deal with the exchange rate collapse idea because Paul already has. A technical aside: Martin raises a point about UK banks overseas currency activity, which I will try to get back to in a later post.)

Ah, but what if the market remains spooked for so long that eventually inflation rises. The markets stop buying US or UK debt because they think that the government will choose to default, and even after 5 or 10 years and still no default the markets continue to think that, even though they are desperate for safe assets!? In Corsetti and Dedola agents are rational, so we have left that paper way behind. We have entered, I’m afraid, the land of pure make believe.

So there is no applicable model that could justify the confidence effects that might have made us cautious in 2009 about issuing more debt. There are models about an acute shortage of safe assets on the other hand, which seem to be ignored by those arguing against fiscal stimulus. Nor is there the slightest bit of evidence that the markets were ever even thinking about being spooked in this way.

Martin makes the point that just because something has not yet been formally modelled does not mean it does not happen. Of course, and indeed if he means by model a fully microfounded DSGE model I have made this point many times myself. But you can also use the term model in a much more general sense, as a set of mutually consistent arguments. It is in that sense that I mean no applicable model.

Now to the additional point I really wanted to make. When people invoke the idea of confidence, other people (particularly economists) should be automatically suspicious. The reason is that it frequently allows those who represent the group whose confidence is being invoked to further their own self interest. The financial markets are represented by City or Wall Street economists, and you invariably see market confidence being invoked to support a policy position they have some economic or political interest in. Bond market economists never saw a fiscal consolidation they did not like, so the saying goes, so of course market confidence is used to argue against fiscal expansion. Employers drum up the importance of maintaining their confidence whenever taxes on profits (or high incomes) are involved. As I argue in this paper, there is a generic reason why financial market economists play up the importance of market confidence, so they can act as high priests. (Did these same economists go on about the dangers of rising leverage when confidence really mattered, before the global financial crisis?)

The general lesson I would draw is this. If the economics point towards a conclusion, and people argue against it based on ‘confidence’, you should be very, very suspicious. You should ask where is the model (or at least a mutually consistent set of arguments), and where is the evidence that this model or set of arguments is applicable to this case? Policy makers who go with confidence based arguments that fail these tests because it accords with their instincts are, perhaps knowingly, following the political agenda of someone else.     

Default panic and other tall stories

People still say to me that the UK or the US had to embark on austerity, because otherwise the markets would have taken fright at the ‘simply huge’ budget deficit. How do they know this? Because people ‘close to the market’ keep telling them so.

What can I do to show that this is wrong? The most obvious point is that interest rates on UK or US government debt have been falling since 2008, but the response I sometimes get is that rates have only stayed low because of austerity policies. So how about looking at one very short period, around the UK general election of 2010. The election itself was on 6th May, but Gordon Brown only resigned on 10th May, and the coalition agreement was published on 12th May.

Labour were proposing a more gradual reduction in the deficit than the Conservatives, but the Liberal Democrats (the eventual coalition partners) were during the election closer to Labour. So if there was any default premium implicit in yields on UK government debt, it should have fallen between 5th May and 13th May, either because Labour were defeated, or because the LibDems capitulated on the deficit. Now you may say that the markets were anticipating a Conservative victory, but even if that is true, on 5th May there was some doubt about that, which should have been reflected in the price. The coalition agreement published on 12th May clearly states a commitment to “a significantly accelerated reduction in the structural deficit”, so that doubt should have disappeared by then. If there was a default premium in rates before 6th May, it should have fallen by 13th May.

Yield on 10 year UK government debt: source Bank of England

As you can see, rates were higher on 13th May compared to 5th May. More to the point, there was no noticeable decline in rates because fiscal consolidation was going to be greater. Now of course other things may have happened over these few days to offset any default premium effect, and you can always spin stories about how markets were concerned about a coalition government so maybe the accelerated deficit reduction was not going to happen, etc. But they are stories: in terms of the data, there is no obvious effect.

The more sophisticated defence of austerity, as here from the Permanent Secretary at the UK Treasury in reviewing William Keegan’s new book, is that there exists a ‘tipping point’ somewhere: some level of the deficit at which the markets will take fright. It is then suggested, with reference to the Eurozone crisis, once you reach that point it is very hard to return, because a vicious circle sets in. Interest rates rise, making any new debt more expensive to service, which raises the deficit itself, making default even more likely. As we do not know where that tipping point is, it is best to stay well away from it by taking precautionary action before it is reached. The problem with this argument is that having your own central bank makes a key difference, not just to the chance of a funding crisis, but to its dynamics as well.

Having your own central bank does not rule out the possibility of default. As Corsetti and Dedola explain, the costs of inflation created by monetising the debt may exceed the costs of default. Markets know that, so they may still at some point begin to suspect that default could happen. It therefore follows that the markets could get it wrong: they may begin to suspect default even when there is absolutely no intention within government to let this happen.

Suppose this fate had befallen the UK or US governments in 2010. The markets suddenly panic that the government may default, even though the government has no intention of doing so. Interest rates start rising on government debt. But both governments have a Quantitative Easing programme, which is designed to keep long term interest rates low, so their central banks respond by buying more government debt. The cost of servicing government debt does not rise, because additional money is created, so there is no vicious circle. There is plenty of time for the government to take whatever action it wishes to take to reassure the markets. And unlike the model of Corsetti and Dedola, because there is a recession and a liquidity trap, the extra money created does not immediately lead to inflation. [1]

Having your own central bank, which is already undertaking Quantitative Easing, does not just make a funding crisis a lot less likely, it also crucially changes the dynamics. If a crisis occurs, the government is not trapped in a vicious circle. This in turn means that there is no obvious reason to act in a precautionary way. So why did no one make this point nearer the time? The answer of course is that they did.

[1] If you think that in these circumstances a foreign exchange crisis will get you, you need to explain why Paul Krugman’s analysis is wrong. 

The burden of government debt, again

Here is an attempt to clear up some of the confusion that still exists on this issue.

1) Government debt can be used to redistribute income to current generations from future generations, even if the aggregate level of consumption in each period remains the same. Proof by example: see here (or many similar proofs from Nick Rowe - his latest post on this is here).

Note: I think people get confused because although the first part of the proposition seems intuitive (if the government cuts taxes and pays for this by borrowing, surely those receiving the tax cut could spend it on themselves and be better off as a result), the ‘even if’ part seems wrong (if we are taking from the future to give to the present, current consumption must rise and future consumption fall). Those who have worked with OLG models, like Roger Farmer, find it easier to work through the logic as to how this is possible.

2) The size of government debt is not a good indicator of any burden. It is possible that government debt is positive, but there has been no attempt at intergenerational transfer. Proof 1: taxes on the young are cut, and the young save all the tax cut by holding the extra debt. Proof 2: borrowing for a capital project that benefits current and all future generations equally.

Note: This is important, as Noah Smith notes in this post. The size of government debt is not equal to the ‘burden’ on future generations. Indeed, positive debt is compatible with there being no burden at all.

3) There are probably much more important mechanisms going on right now that are transferring consumption from the future to the present: in some countries rising house prices, and climate change. No proof, just an opinion.

Note: despite this, if you think your grandchildren will have such a wonderful life compared to yours because of technological progress, you might not be too bothered. It is also worth remarking how potentially inconsistent it is to argue that we have to reduce debt now for the sake of future generations, and at the same time argue that it is too costly to take action now to mitigate climate change. 

4) Even if no intergenerational transfer is involved, high government debt could reduce future consumption for two quite plausible reasons: productive capital may be crowded out, and the tax required to pay the interest on the debt is distortionary (i.e. reduces output below optimal level). Proof: countless papers in the literature.

Note: I think it is wrong to describe both mechanisms as model specific, because you have to make quite extreme assumptions to avoid them. It is for this reason that I worry about high government debt in the long term. I have not heard anything to convince me that either mechanism is unimportant, or of any countervailing mechanism. (The need for safe assets could argue for high gross government debt, but not net debt, where the difference could be a large sovereign wealth fund.)

5) None of these arguments justify austerity at the Zero Lower Bound. Proof: countless posts by various people, including myself.

Note: For example, crowding out happens through high real interest rates, which are hardly a current problem. Nor is scarcity of labour arising from tax distortions.

Final thought. Think about government debt as a way of providing intergenerational insurance against negative demand shocks. When those shocks happen, the state pays out by cutting taxes (say) and increasing its debt. In normal times taxes rise again and the debt is gradually reduced. In this case allowing debt to rise following one of these shocks is no burden.  

That £170 billion bombshell

Paul Johnson of the IFS has written that under Labour “national debt [could be] around £170 billion higher (in today’s terms) by the end of the 2020s than would be achieved through a balanced budget.” That was all that certain newspapers needed to start talking about a borrowing bombshell under Labour.

£170 billion is a meaningless number, and the end of the 2020s is a meaningless date. First, we should put everything as shares of GDP. £170 billion is about 10% of GDP, and debt is currently around 80% of GDP. However it would be completely wrong to infer that under Labour debt to GDP would be 90% of GDP by 2030. If they achieved current balance by financial year 2017/18, then my excel spreadsheet says that with nominal GDP growth of 4% a year, by 2030 debt to GDP would be around 65% of GDP. (A few points below 65% if investment remained at 1.5% of GDP, a few points above it became 2% of GDP.) If the Conservatives balanced the overall deficit each year debt to GDP would be about 47% of GDP by 2030.

So a £170 billion bombshell actually means debt to GDP would have been reduced from 80% of GDP to around 65% of GDP. So the correct headline should have been “debt to GDP cut by a fifth in 2030 under Labour’s plans”. That is debt, which is much more difficult to reduce than the deficit. To say this is a ‘different interpretation’ is too polite – newspaper reports got it completely wrong. Who should you blame for this: Paul Johnson, innumerate journalists, biased newspapers? I’ll leave that to you.

There remains a real question of how quickly debt to GDP should be reduced. In terms of the analysis I did here and here, Labour’s plans - if it did achieve current balance by 2017/18 - are tougher than the path I described as ‘fast’ debt reduction, although not nearly as tough as Osborne’s plans. (This analysis was done before the Autumn Statement, but to pretend that the analysis needs to be revised on that account gives these numbers spurious precision.) However my ‘fast’ path did not keep to current balance after 2020, but had some further deficit reduction over the next five years. (As a result, debt to GDP was below 60% by 2030 under this fast path.) I have not seen Labour commit to sticking to current balance until the end of the 2020s. So in that sense as well the £170 billion number is meaningless.

What you should conclude from this is simple. First, as Paul Johnson and many others have pointed out, both Labour and Conservatives are aiming for tight fiscal policies (tighter than I and others think sensible given the macroeconomic situation), but the Conservatives’ plans involve substantially more cuts than Labour. Both involve reducing debt to GDP quite rapidly, so there is no question that both plans would not trouble the markets. So the only reason for going for Osborne’s plan, now apparently involving budget surpluses, is if you expect another financial crisis in the 2030s, and want debt to GDP to be something like it was before the last one. [1] Or, as a headline writer might put it (but somehow I doubt many would): “budget surpluses and austerity so we can afford to bail out the banks again soon”.

   

[1] For those who are really into fiscal rules, there is a technical question about whether it is better to have a target for the overall deficit or the current balance. As George Osborne has moved from the latter to the former, it may be best to read his detailed analysis of the issue. Cannot find anything? Well maybe, as I note here, he is simply following the discussion in Portes and Wren-Lewis (2014), which argues for deficit targets but a separate target for the public investment to GDP ratio.

Bond market fairy tales part 1

In a recent post I argued that the days when budget deficits mattered because of concerns about default are over. In 2010 it briefly looked as if deficits could be so large that default was a real possibility, but we now know that was never true for the US and UK, and within the Eurozone it was only true for Greece, and since then austerity has (unfortunately) brought deficits down substantially. In most countries deficits are now around sustainable levels, by which I mean that they can be financed and sustained at close to current tax rates and spending regimes. 

Which raises the question, why isn’t this common knowledge? Why in mediamacro do people act as if we were still in 2010? In this respect BBC journalist Robert Peston has an interesting post. Robert Peston is no fool, and his coverage of banking issues in particular is rightly famous in the UK. In his post, he notes correctly that there is a huge gap between the amount of austerity planned by Conservative and Labour after 2015. Let me quote what he says next.

“And here, of course, is where we need to ask Mr Market what he thinks of all this….The Tory view is that those [low] interest rates can only be locked in if the government continues in remorseless fashion to shrink the state and net debt. What Labour would point out is that countries in a bit of a fiscal and economic mess and currently refusing to wear the hairshirt that the European Commission thinks necessary, such as Italy and France, are also borrowing remarkably cheaply."

So what Mr. Market should tell Robert Peston at this point is that France can borrow more cheaply than the UK not because the French government is more credible and less likely to default - these are no longer important issues. The reason is that expected future short rates in France are lower as a result of the Eurozone recession. This means that because the Conservatives will cut back on spending more (than Labour), this will tend to reduce demand and output more, which in turn will mean expected future short rates will be a little lower under the Conservatives than Labour (as monetary policy tries to undo the impact of greater austerity). What Mr. Market actually told Robert Peston is as follows:

"And here is where Mr Market may be capricious, according to my pals in the bond market. They say the UK's creditors would probably be forgiving and tolerant of George Osborne borrowing more than he currently says he wishes to do, in that his record of reducing Whitehall spending by £35bn since taking office in 2010 has earned him his austerity proficiency badge. But Ed Balls has never been chancellor, although he was the power behind Gordon Brown when he ran the Treasury and much of the country, both in the lean years from 1997 to 2000 and the big spending Labour years thereafter.

So Mr Balls has yet to prove, investors say, that he can shrink as well as grow the apparatus of the state.”

What Robert Peston's pals in the bond market seem to be telling him (assuming that nothing was lost in translation) is that it is all about Labour's lack of credibility at being able to shrink the state. My immediate reaction: ?!?!? I have two problems.

1) Why the talk about credibility? Talking about credibility makes sense if we are worrying about default, but there is no chance Ed Balls is going to choose to default. You might worry that Labour will not cut the deficit by as much as they plan, which will intensify the mechanism working through monetary policy that I outlined earlier. If that is what his pals meant, why didn't they say this, and why does that involve the markets being capricious?

2) What is this about shrinking the apparatus of the state? Shrinking the deficit yes. But in what world does the return on bonds depend on the size of the state?

So it seems that my understanding of how the bond markets work is worlds apart from the understanding of Robert Peston's pals. I suspect that for mediamacro there really is no choice here: why would you believe an academic economist in their little old ivory tower rather than the guys who are directly in touch with the markets you are trying to understand. The fact the explanation they give you could have been drafted by someone in No.11 Downing Street (the UK Chancellor's residence) just suggests that George Osborne is in tune with financial realities.

Part 2 of this post will be why this logic is wrong.

Government debt, financial markets and dead parrots

Following the Autumn Statement, more commentators are noting the similarity between the macroeconomic choices facing electors next year to the choice they faced in 2010. Jeremy Warner even uses the phrase ‘déjà vu’ which I used in the title to this post in August. However what he neglects to mention is the big difference between 2010 and 2015 that I highlighted in that post, which is the absence today of any financing crisis for government debt. For Warner that is understandable - for him, and I suspect a few others, it was always about reducing the size of the state. However for most people in 2010 austerity was sold because of the fear that we would ‘become like Greece’.

This idea that the financial markets are hanging on every short term movement in the government’s budget deficit persists in much of macromedia. It is a myth. It is like the parrot in Monty Python’s famous sketch: it may have lived gloriously once, but now it is well and truly dead, and has been for some time.

You do not need to understand much about financial markets to see why. The market for UK government debt does not exist in isolation, but is instead connected to markets for a whole range of other financial assets. So a small change in the supply of government debt (because of a change in the budget deficit) will have a negligible impact on the interest rate required to sell that debt. [1] The most important determinate of interest rates on UK debt, which is a long term financial asset, is expectations about current and future short term UK interest rates. That is why UK rates on 10 year government bonds are currently around 2%, but for France just 1%: the ECB is expected to keep short rates lower for longer than the Bank of England.

This arbitrage between financial assets assumes that markets believe they will get their money back. The moment the market thinks this might not happen, they will demand a ‘default premium’: a higher interest rate to compensate them for the chance of default. This default premium is our parrot - it is what seemed to swoop up and down day after day during the Eurozone crisis from 2010 to 2012. But this parrot thrived in the Eurozone during that time for a very particular reason. The climate there has now changed, which means it is not what it once was, but it chances of living outside that region were always pretty small, and are today negligible. If anyone tries to sell you one, it will be dead.

If you are thinking about buying government debt and are concerned about possible default, you need to worry about two things. First, you need to ask whether the government will choose to default. It might do so if the political costs of raising taxes or cutting spending become too large compared to the costs of no longer being able to borrow money following default. Second, you need to worry about forced default, where the government is unable to ‘roll over’ (refinance) its existing debt, because the market will no longer lend to it. The two are related, but are not identical. The second risk admits the possibility of a self-fulfilling crisis: default occurs because the market believes default will happen, even if the government actually has no intention to default and can continue to pay the interest on its debt.

This is where your own central bank is very useful. It eliminates this second type of risk, because it acts like a lender of last resort, buying any debt the government cannot refinance through the markets. This is what the ECB refused to do until its OMT programme in September 2012. Until that point, markets were worried that governments in Ireland, Portugal and Spain would not be able to refinance their debt, and so would be forced to default. With OMT the ECB changed its mind, which brought the crisis to an end. The Eurozone parrot was not completely wiped out, because the ECB still made its support conditional, and because the possibility of voluntary default by some governments still remains, but it is not the bird it once was.

The parrot probably never flew in countries like the UK, US or Japan because these countries had their own central banks. Of course many people claim to have seen it, but it seemed to disappear as quickly as it came. The idea that it could survive in the UK or US today is just silly. In 2010 deficits in the UK and US were large, and debt was rising rapidly. It might just have been conceivable (although with a lot of imagination) that the UK or US governments might have chosen to default. Today deficits are near a sustainable level, which means that debt to GDP ratios are relatively stable. If someone tells you they have seen this parrot today, or that it is just resting and will wake if this or that policy is pursued, please respond as John Cleese did:

“'E's not pinin'! 'E's passed on! This parrot is no more! He has ceased to be! 'E's expired and gone to meet 'is maker! 'E's a stiff! Bereft of life, 'e rests in peace! If you hadn't nailed 'im to the perch 'e'd be pushing up the daisies! 'Is metabolic processes are now 'istory! 'E's off the twig! 'E's kicked the bucket, 'e's shuffled off 'is mortal coil, run down the curtain and joined the bleedin' choir invisible!! THIS IS AN EX-PARROT!!”

[1] There may at the margins be some market segmentation, and it is a margin that central banks have tried to exploit through Quantitative Easing (QE). However this involved buying huge quantities of government debt to influence it, and we are still not entirely sure that they succeeded in doing so. Besides that, a few billions on the deficit this year and next is a drop in the ocean.

Redistribution between generations

I ought to start a series on common macroeconomic misunderstandings. (I do not watch zombie films.) One would be that the central bank’s balance sheet normally matters, although this nice comment on my last post does the job pretty well. Here is one that crops up fairly regularly - that government debt does not involve redistribution between generations. The misunderstanding here is obvious once you see that generations overlap.

Take a really simple example. Suppose the amount of goods produced each period in the economy is always 100. Now if each period was the life of a generation, and generations did not overlap, then obviously each generation gets 100, and there can be no redistribution between them. But in real life generations do overlap.

So instead let each period involve two generations: the old and young. Suppose each produced 50 goods. But in one period, call it period T, the government decides that the young should pay 10 goods into a pension scheme, and the old should get that pension at T, even though they contributed nothing when young. In other words, the young pay the old. A fanciful idea? No, it is called an unfunded pension scheme, and it is how the state pension works in the UK. As a result of the scheme, the old at T get 60 goods, and the young only 40, of the 100 produced in period T. The old at T are clear winners. Who loses? Not the young at T if the scheme continues, because they get 60 when old (and assume for simplicity that people do not care when they get goods). The losers are the generation who are old in the period the scheme stops. Say that is period T+10, when the young get to keep their 50, but the old who only got 40 when young only get 50 when old. So we have a clear redistribution from the old in period T+10 to the old in period T. Yet output in period T and T+10 is unchanged at 100.

That example did not involve any debt, but I started with it because it shows so clearly how you can have redistribution between generations even if output is unchanged. To bring in debt, suppose government taxes both the old and young by 10 each period, and transforms this 20 into public goods. So each generation has a lifetime consumption of 80 of private goods.

Now in period T the government says that the young need pay no taxes, but will instead give 10 goods in exchange for a paper asset - government debt - that can be redeemed next period for 10 goods. In period T nothing changes, except that the young now have this asset. In period T+1 this allows them (the now old) to consume 50 private goods rather than 40: the 40 it produces less tax and the 10 it now gets from the government by selling the debt. Their total consumption of private goods has increased from 80 to 90. How does the government obtain these 10 to give the now old? It says to the young: either you pay 20 rather than 10 in taxes, or you can buy this government debt for 10. As people only care about their total consumption, the young obviously buy the debt. They now consume 30 in private goods in T+1, but 50 in T+2 when they sell their debt, which gets us back to the original 80 in total lifetime consumption.

This process continues until period T+10, say, when the government refuses to give the young the choice of buying debt, and just raises an extra 10 in taxes on the young. So the debt disappears, but the young are worse off, as they only have 30 of private goods to consume this period. Their total lifetime consumption of private goods is 70. We have a clear redistribution of 10 from the young in period T+10 to the young in period T enacted by the government issuing debt in period T.

If you are thinking that these redistributions need not occur if the debt is never repaid or the pension scheme never wound up, then we need to get a bit more realistic and bring in interest rates and growth (and the famous r<>g relationship), which these posts of mine (and these at least as good posts from Nick Rowe) discuss. But the idea with this post is to get across in a very simple way how redistribution between generations can work because generations overlap.

Unfunded pension schemes and intergenerational equity

Government debt and the burden on future generations

The Burden of Government Debt

Nick Rowe

How time travel is possible,

The burden of the (bad monetary policy) on future generations

The mythical debt crisis

A constant refrain, from both the Conservative and LibDem party conferences, is how the current government saved the country from a crisis. Here is Osborne: “Four years ago, our economy was in crisis, our country was on the floor.” Or LibDem Danny Alexander: “We’ve seen the economy through its darkest hour ..” Now someone from outside the UK would immediately think Osborne and Alexander had got their counting wrong: the Great Recession was in 2009, which was five not four years ago. But of course they do not mean that little old crisis - they are talking about the Great Government Debt crisis. The only problem is that this debt crisis is as mythical as the unicorn.

The real crisis was the Great Recession. And if any politicians can claim to have saved the country from that crisis, it is Labour's Gordon Brown and Alistair Darling. They introduced stimulus measures (opposed by Conservatives) that helped arrest the decline in GDP. By 2010, which is when Osborne took over, the economy was growing by nearly 2%.

But surely there was a debt crisis in 2010? Indeed there was, in other countries. Crucially, these were countries that could not print their own currencies. This became apparent when interest rates on Greek debt went through the roof. Interest rates on UK and US government debt after the recession stayed well below levels observed before the recession. UK and US governments never had any problems raising money, for the simple reason that there was never any chance they would default.

So wrong time, wrong country, but also maybe wrong people. Consumers and firms in the US and UK did feel they had borrowed too much, or wanted to save more, as a result of the financial crisis. The personal savings ratio in both countries rose substantially, and stayed high for a number of years. But people need something to save, like government debt. Which is one reason why interest rates on UK and US government debt stayed low: although the supply of that debt increased, the demand for it was increasing even faster.

So why do we not hear Labour claiming that they saved us from a crisis - at least their crisis was real! Why do claims that the current government saved us from an entirely mythical crisis generally go unchallenged? Such claims are the equivalent to the Republican Congress claiming they saved the US economy. Welcome to the strange world of mediamacro. What the media should be doing, the next time this government claims it saved us from the Great Government Debt crisis, is to borrow a phrase from Jim Royle: crisis my arse!   

Privatisation and government debt

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

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

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

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

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

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

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

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

Central bank advice on austerity

As I wrote recently, the economic debate on the impact on austerity is over bar the details. Fiscal contraction when interest rates are at their zero lower bound is likely to have a significant negative impact on output. Of course the popular debate goes on, because of absurd claims that recovering from austerity somehow validates it. Next time you get a cold, celebrate, because you will feel good when it is over! Which means more articles like this will have to be written.

An interesting question for an economist then becomes why austerity happened. There are some groups who have a clear self interest in promoting austerity: those who would like a smaller state, for example. While arguments for ‘less government’ are commonplace among the more affluent in the US, in Europe there is much less natural antagonism to government. As a result, as Jeremy Warner said, you can only really make serious inroads into the size of the state during an economic crisis. Large banks also have a direct interest in austerity, because they need low debt to make future bank bailouts credible, enabling them to carry on paying large bonuses from the implicit state subsidy that this creates. So, from a cynical point of view, for this and other reasons those close to finance will always talk up the danger of a debt funding crisis just around the corner.

However there is a large middle ground who genuinely believes austerity was required to prevent the chance of a funding crisis, particularly after Greece. Yet Quantitative Easing (QE) fundamentally changes this. If the central bank makes it known that QE drastically reduces the chance of a debt funding panic, and anyway they have the means to offset its impact if it occurred, any contrary advice from the financial sector might be defused. The middle ground might be persuaded that fiscal stimulus is possible after all.

Now this was never going to happen at the ECB. It takes every opportunity to promote austerity. It took two years of continuing crisis to get it to introduce OMT. I do not follow the US closely enough to know what, if anything, the Fed said about the impact of QE on the prospect of a bond market panic, but I do know Bernanke was not afraid to warn of the dangers of excessive austerity in his final days in charge of the Fed. Which brings us to the UK, and the coalition agreement of 2010. The Conservatives may well have advocated their austerity programme whatever the Bank of England had said: it was a golden opportunity to reduce the size of the state. However their coalition partners, the LibDems, had campaigned on a more gradual deficit reduction plan similar to Labour. Mervyn King’s advice during this period is often credited with helping persuade the LibDems to accept the Conservatives’ proposals. (See, for example, Neil Irwin, or for more detail Andrew Lydon).

So why did King advocate austerity, rather than telling politicians that with QE in place, a funding crisis was both much less likely and less damaging. We may get a clue from something recently published by the Bank, as part of its stress test scenario for UK banks (HT Britmouse). The application is to 2014 rather than 2010, but it may still indicate what the Bank’s thinking might have been four years earlier. It talks about “concerns over the sustainability of debt positions” leading to a “sharp depreciation in sterling and a build-up of inflationary pressures in the UK.” As a result, monetary policy is tightened and long term interest rates rise - presumably because QE stops.

In one of my first blog posts two and a half years ago I wrote that “austerity is not even a sensible precautionary policy when we have QE”. Does this scenario give me cause to doubt that verdict? It does not, for two reasons. First, what makes a funding crisis so scary when you cannot print your own currency is that it is a bit like being blown off a cliff. Once interest rates start rising because of fears of default, this in itself makes default more likely. We have a clear nonlinearity, such that it may become too late to retrieve the situation once the process begins, as periphery Eurozone countries found out. Depreciation in the exchange rate when rates are floating is not like that. The further the exchange rate falls, the more attractive the currency becomes, because trade in goods ties down the medium term level of the currency.

The second reason why a loss of confidence in a currency is not like a debt financing crisis is that the former cannot force default, whereas the latter can. That makes all the difference. Without QE the markets have to worry about what others in the market think. The government may not intend to default, but if they cannot roll over their debt, they do not get that choice. With QE the government cannot run out of money, so the markets no longer need to worry about a self-fulfilling market imposed default. All that matters is what the government will do, and there was never any serious chance that the UK would default on its debt whoever won the election.

However it is possible to see why the Bank might still have worried in 2010. Output had only just stabilised after the worst recession since WWII. They wanted to keep interest rates as low as possible to help a recovery. Yet inflation was more than 1% above target, partly as a result of the depreciation of 2008. The MPC believed their remit was to target 2% inflation two years ahead. If sterling had fallen further, they would have found it very difficult not to raise rates. Yet Mervyn King would not have wanted to go down in history as the Governor who raised rates during the depths of a recession.

I think this says a lot about whether we had the appropriate monetary policy framework. (For further discussion of the economics see this post and links therein.) But my main point is this. It is all speculation, because as far as I am aware the Bank said very little officially. The Governor let his views be known in private, and publicly endorsed the government’s austerity plan after the election (much to the annoyance of some MPC members), but there was no open debate about the issues. The Bank could have initiated this debate, but chose not to.

So when the next recession hits, and interest rates go to zero and budget deficits increase, will anything be different? The central bank is in a position to make it clear what the risks of a market panic really are when QE is in place - indeed you could say that it has a responsibility to do that. Or instead it can publically argue that it still has all the tools it needs to manage the economy, and advocate austerity in private. Mervyn King once said (pdf) “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.” Is this always going to be the case? 

Pareto, Inequality and Government Debt

Or is economics inherently right wing?

I noted in passing in an earlier post that Pareto efficiency was obviously not a value free criteria. So those who argue that economists should only look for Pareto improvements – changes where no one is made worse off – are making a value judgement. One, and only one, of its implicit normative assumptions is that inequality does not matter. For others see, for example, Elizabeth Anderson (pdf, HT Anon). Now you could argue that an assumption that inequality does not matter intrinsically is at least internally consistent with the conventional assumption that personal utility depends only on personal variables. However as that assumption is clearly incorrect, this is a rather weak defence.

(You could also reasonably argue that Pareto improving increases in inequality could have a negative impact on the personal variables of others that conventional economic analysis ignores. So, for example, rising incomes of the 1% - even if this initially comes from just increasing the size of the pie - allows that 1% greater political power, which they will subsequently use to redistribute income away from the 99%.)

This is hardly a new point. For just two recent examples of other posts saying the same thing: Richard Serlin here, and Ingrid Robeyns here. It only has to keep being said because too many students are taught that economists like the Pareto criteria because it is value free. One of the comments to that second post says that the task should not be to “import liberal or left-wing moral philosophy into economics. It’s to scrub right-wing, libertarian moral philosophy out of it.” Well, in my usual moderate manner, I’d say we should at least expose it.

A more sophisticated defence of Pareto optimality is the second welfare theorem, which says that we can separate issues of distribution from issues of allocative efficiency. So, if some Pareto improving measure only makes the 1% better off, we can go ahead with it and deal with any reduction in social welfare generated by additional inequality using lump sum transfers. One obvious problem with this idea is that there are no lump sum transfers. Another is that we do not as a society decide at some date every year what the optimal distribution of income to implement is. In practice the only chance of reversing any inequality created by a Pareto improving measure is to use compensation alongside that measure, but then agents will recognise this connection which in turn will influence incentives.

The only possibly original point I wanted to make here is that the absurdity of restricting policies to Pareto improvements becomes immediately apparent if we think about government debt. Measures to reduce currently high levels of debt will almost certainly make current generations worse off, because they will have to pay the taxes (or whatever) to get debt down. Yet I do not often hear people arguing that we have to let debt stay high because the government can only implement Pareto improvements. If you think about it for a second, restricting government debt policy to Pareto improvements would be a sure fire recipe for deficit bias.

While this may be obvious, textbooks still make a big deal of dynamic inefficiency. This is the idea that the amount of productive capital in society can be too high, so that too much output is going to preserving that level of capital (replacement investment to offset depreciation etc), and not enough to consumption. If that is true, then if the current generation saves less, everyone can be made better off. Government intervention to discouraging saving would be a Pareto improvement: the current generation consumes more because they save less, but future generations consume more because less output needs to go to replacement investment.

The symmetrical case is where there is too little capital, which also reduces long run consumption compared to what could be achieved. Yet the implication in many textbooks is that this case is not one we should worry about, because to change it (by raising saving) would make the current generation worse off and is therefore not a Pareto improvement. The discussion in Romer, for example, is all about whether economies are dynamically inefficient rather than sub-optimally small. We don’t think this way about government debt, so why should we when it comes to productive capital?

Why is there this emphasis on only looking at Pareto improvements? I think you would have to work quite hard to argue that it was intrinsic to economic theory - it would be, and is, quite possible to do economics without it. (Many economists use social welfare functions.) But one thing that is intrinsic to economic theory is the diminishing marginal utility of consumption. Couple that with the idea of representative agents that macro uses all the time (who share the same preferences), and you have a natural bias towards equality. Focusing just on Pareto improvements neutralises that possibility. Now I mention this not to imply that the emphasis put on Pareto improvements in textbooks and elsewhere is a right wing plot - I do not know enough to argue that. But it should make those (mainstream or heterodox) who believe that economics is inherently conservative pause for thought.    

Time inconsistency and debt

For macroeconomists

In recent posts I’ve talked about empirical work I did a decade ago on exchange rates, a non-technical piece on policy I wrote a few years ago, and some recent microfounded analysis undertaken by others. So for completeness, here is something on a pretty technical, thoroughly microfounded article that I wrote with Campbell Leith that recently came out in the JMCB.

The place to start is a result that is relatively familiar. When governments can commit and follow an optimal policy, steady state debt follows a random walk. If we start out from a position where the debt stock is at its optimal level, and then there is a shock that causes debt to rise, the optimal response is to let debt stay permanently higher. This is essentially a variant of the tax smoothing idea. Taxes could rise to bring debt back down to its pre-shock level, but that incurs current costs (higher distortionary taxes) for future benefits (less debt, therefore less debt interest, therefore lower taxes). If the real interest rate equals the rate of time preference, then tax smoothing implies it is better to smooth taxes, which in turn implies it is better to let debt stay higher.

I discussed this result in this post based an earlier EJ article written with Tatiana Kirsanova. That paper focused on simple fiscal rules combined with optimal monetary policy. This JMCB paper just looks at optimal policy, where the government jointly controls monetary and fiscal instruments, in a very conventional New Keynesian model.

In this kind of model the description above of the optimal response to a debt shock is not quite complete. In the initial period, governments will act to reduce debt by a small amount. It is optimal to engineer a small burst of surprise inflation to reduce debt. This only occurs in the initial period, and it has a hardly noticeable impact on debt. However once that period has passed, the same incentive exists to generate a bit of surprise inflation in the new current period to further reduce debt. So the policy is time inconsistent for this reason.

The time inconsistency problem is similar to the familiar inflation bias case for monetary policy. There, the optimal policy would be to achieve the inflation target, but if the natural rate of output is inefficiently low there is an incentive to generate an initial burst of surprise inflation. The only way of removing this temptation in future periods is to run inflation well above target, which is inflation bias.

So how do we remove the incentive to keep cutting debt a little bit? The answer is obvious once you state it, but it is unfortunately non-trivial to prove, which is what the paper does. The incentive to initiate a small amount of surprise inflation to reduce excess debt exists as long as there is excess debt. To remove the incentive to cut debt by a little, you have to cut debt by a lot. The discretionary, time consistent response to a positive shock to debt is to bring debt very quickly back to the pre-shock level.

 

So the first best policy, if the government can commit, is to let debt stay higher. The inferior policy that results from a lack of commitment is that debt is brought back down very quickly. If this result seems strange, it may be because we have in the back of our minds the real world problem of deficit bias and potential default. However neither is present in this model: the government is benevolent, and there is nothing in the model to make high levels of debt problematic. 

The paper calculates welfare in both the commitment and discretionary cases. The welfare costs of any shock to the public finances are much greater under discretion, as you might guess for a policy that immediately brings debt back down to its original level. Finally the paper looks at ‘quasi-commitment’, which puts some probability on plans being revised.

The paper takes an idealised set-up (benevolent governments) in a simple, idealised model (e.g. agents live forever), so it is a long way from practical policy concerns. (If you want something along those lines, see this paper I wrote with Lars Calmfors.) However what this paper does show is that there is no necessary linkage between the problem of time inconsistency and the lack of debt control. In a simple New Keynesian model lack of credibility can lead to excessive control of debt.