Kocherlakota’s argument for fiscal expansion in the US

Is there a macroeconomic case for tax cuts in the United States right now? Paul Krugman and I say no, using the following logic. The Fed thinks we are close to full employment, if we use the term to denote the level of employment that keeps inflation constant. Generalised tax cuts (rather than just tax cuts to the very rich) will tend to raise aggregate demand, which will lead inflation to increase. The Fed will therefore raise interest raise rates further to offset this increase in demand before it happens. As a result, the tax cuts will have no impact on demand, but simply make funding investment more expense.

There are clear grounds for saying that the Fed is wrong about the economy being close to full employment, and therefore any increase in aggregate demand from any source would not raise inflation. But a central bank that acts in the textbook manner will not wait for the higher inflation to materialise, but will anticipate it because it takes time for interest rates to influence demand and inflation. As a result, tax cuts will lead to higher interest rates and there will be no net impact on demand.

Narayana Kocherlakota, who used to be on the committee that sets US interest rates, presents another possible reason why an increase in demand will not raise inflation. He argues that aggregate supply has been suppressed by low demand, and that rising demand might itself stimulate supply. For example, a lot of technical innovations might have been shelved while demand was depressed, but would be brought into production if demand looked like expanding rapidly. As these technical innovations would expand the capacity of firms to produce more, they would not raise prices as a result of any increase in demand. As these innovations would produce more from the existing labour force, there would be no inflation pressure coming from wages either.

If this sounds like wishful thinking, remember than the US economy, like most, is still way below the level of output that pre-recession trends would have suggested were likely. Did research into new and better production techniques really slow down substantially during the recession years, or did the research still take place to be implemented at some later date?

Even if this argument is plausible, and I think it is, it would still be irrelevant if the Fed didn’t make any allowance for it. They would still believe that tax cuts would raise demand and inflation, and so they would raise interest rates and crowd out any increase in demand. Indeed, if the Fed believed this ‘endogenous supply’ argument, they surely wouldn’t have raised rates in 2016.

What Kocherlakota wants the Fed to do is follow an approach put forward by Federal Reserve Bank of Chicago President Charles Evans. He puts the case in this speech. Essentially the Fed should depart from the usual policy approach of targeting expected inflation, and wait for inflation to actually rise above target before it raises rates. This would mean that it ignored any fiscal stimulus (whether it be tax cuts or additional public investment), and focused simply on the actual inflation rate. If we were in fact below full employment, or if demand created its own supply, the fiscal expansion would raise output and welfare.

An important point that Kocherlakota makes, and I have made in the past, is that you do not need to believe with certainty that we are below full employment or that demand will create its own supply. All you have to do is give it some significant probability of being true. You then look at the costs and benefits of pursuing an Evans type monetary policy weighted by this probability. A key point here is that the costs of a short term overshoot of the 2% target are likely to be a lot smaller than the cost of missing out on a percent or two of national output for potentially some time.

Does this change my views on a prospective Trump stimulus package? Not really. There is a very strong case for more public sector investment on numerous grounds. But that investment should go to where it is most needed and where it will be of most social benefit, and I think it is very unlikely (along with I suspect most economists) that a Trump Presidency and a Republican House can deliver that. That extra public investment will give the economy the stimulus that could work with an Evans type monetary policy. From a macroeconomic viewpoint there seems no point in doubling up on stimulus through tax cuts, and in terms of how the Fed reacts it may even be counterproductive.

Reactionary Keynesianism

Under Donald Trump we might get what some have called Reactionary Keynesianism. But a stimulus is a stimulus, right, and for those of us who think most OECD economies should be ‘run hot’ to try and make up some of the ground still lost from the Great Recession any fiscal stimulus should be welcomed? So Martin Sandbu writes

“it is hypocritical of anyone to warn that Trump’s promised tax cuts will endanger the public finances if they called for fiscal stimulus under Obama and his putative Democratic successor. …. While the composition of tax cuts and spending increases may matter, the overall size of any deficit increase matters at least as much.”

If by this he means don’t worry too much about the composition, the overall size of the deficit is more important, I think this is terrible macroeconomics. It is foolish to believe that anything that raises the deficit will stimulate.

We know that a part of any Trump stimulus will be large tax breaks for the very rich. The very rich will almost certainly consume virtually none of this tax break in the short term. It is the one part of the population where Ricardian Equivalence almost holds. You might think that therefore it does at least do no harm to short term aggregate demand. But this could be wrong, because the logic of the intertemporal budget constraint still operates. Those tax cuts will not be paid for by higher activity in the short term, so they may mean higher taxes down the road. Now if people who are not very rich think that these might be their taxes that are increased down the road, they will reduce their consumption today. The net effect could be a drop in demand.

You may think that consumers may not be so foresighted, so demand will not actually fall. But the logic of the intertemporal budget constraint still holds. If tax cuts for the rich just raise the deficit with almost no short run demand boost, then that is a transfer to the rich today from the non-rich tomorrow. If tax cuts for the rich were paid for by tax increases on everyone else today many politicians would be up in arms. Delaying the tax increase on everyone else by borrowing is a trick that should be seen straight through.

Yet I fear this is still not the case, and talking about tax cuts for the rich as part of a stimulus just helps confuse politicians. Those on the right understand this: tax cuts for the rich are nearly always part of a general stimulus: when Nigel Lawson did this it helped bust the UK economy. We should just repeat again and again: tax cuts for the rich paid for by borrowing are really tax increases for everyone else.

The example of tax cuts for the rich is the example that refutes the general proposition that the composition of any fiscal stimulus matters less than the overall size of any increase in the deficit.

Trump has also said he wants more investment in public infrastructure. That is something the US desperately needs, but remember that Trump will usher in an era of crony capitalism and politics like never before. The infrastructure that you might get could be far from the infrastructure the US actually needs, and instead may be whatever buys votes or other kinds of deals that help a Trump administration. Now if that infrastructure was produced entirely by those who otherwise would be out of the workforce but would like the jobs involved, then aggregate welfare would still increase: it is Keynes’s famous digging holes example. But in practice that seems unlikely to be completely or even mainly true, and so these white elephants may in practice crowd out better projects. In that case US citizens would not be better off in the short term as a result of this fiscal stimulus, even if GDP did rise. And the stimulus would not pay for itself, so once again other people should worry about the government’s intertemporal budget constraint.

If the economics of Reactionary Keynesian is bad, I think the politics is even worse. Quite simply, by achieving very little beyond redistributing to the rich and unworthy, it gives Keynesian policy a bad name. But we can avoid that, when we can, by not calling every increase in the deficit a stimulus. And by saying tax cuts for the rich paid for by borrowing are really tax increases for everyone else.

Tax cuts vs spending vs helicopters

Some people still seem unable, or maybe unwilling, to understand the basic New Keynesian (NK) model. Should it be surprising in this model that cutting taxes on wages at the Zero Lower Bound (i.e. when nominal interest rates are fixed) are contractionary? Of course not. The basic NK model contains an intertemporal consumption function that implies Ricardian Equivalence holds, so consumers save all of the extra income they get from a tax cut. But cutting taxes increases the incentive to work, thereby increasing labour supply, which through a Phillips curve decreases inflation. With a fixed nominal interest rate that implies higher real rates, which are contractionary. QED.

Now the main thing not to like here is the consumption function and Ricardian Equivalence. Empirical evidence points strongly to a significant income effect, with a marginal propensity to consume around a third rather than zero. There are good theoretical reasons why you might get this result, even with totally rational consumers. But the implication that cutting taxes will lead to some increase in labour supply seems reasonable, and that will put some downward pressure on inflation. This is why pushing ‘structural reforms’ that expand the supply side in a liquidity trap can be counterproductive in the short term. (Things are more complex when you have a fixed exchange rate.)

Now you may quite reasonably believe that in the real world a positive income effect from a tax cut will raise demand by more than any increase in supply, so inflation will rise and real rates will fall. But it remains the case that as a stimulus measure directly raising demand through higher government spending does not generate this supply side offset. That the NK model has this feature seems like a virtue to me. The only point I have to add is that because helicopter money, as traditionally envisaged, is a lump sum transfer (everyone gets an equal amount, so it is independent of wages), you do not get this offsetting supply side effect. So for that reason helicopter money is more effective as a stimulus instrument in a liquidity trap than cutting taxes on wages.

Has Cameron blown the austerity cover?

What I had expected to happen was that the Conservatives would keep to the line that spending had to be reduced because debt and the deficit were too high. The need for austerity because you have borrowed too much was a simple message that everyone understood, even if it didn’t make much sense when applied to a government during a recession. There would be appropriate nudges and winks that, once elected, this tough fiscal line might be modified to make room for tax cuts, but the official line would be ‘debt implies austerity’.

Those who are better informed about the macroeconomics, whether on the right or left, have always understood that this was cover for a desire to shrink the size of the state. However this perspective hardly ever saw the light of day in the media. It is tempting to lapse into conspiracy mode at this point - to believe that the rules of mediamacro are whatever suits a particular set of interests. I suspect this is too simple. For myths to work well they have to be based on half-truths, and they have to obey some internal logic.

So when John Snow berated Ed Miliband for forgetting to talk about the deficit, I think he actually believed that the deficit was this all important constraint that was driving austerity. People understand that when they borrow too much, hard times have to follow. That cornerstone can support many other beliefs. The bank manager who says you must reduce your spending is not popular, but you know he is being responsible. I suspect a great deal of the advantage that the Conservatives enjoy in terms of economic competence in the polls simply comes from this idea (and associating Labour with creating the debt problem). It is difficult to see where else it comes from, with deficit targets missed and stagnant real wages and productivity.

Now that Cameron has promised large tax cuts, does this blow away the cover? Nice if it happened, but unlikely. The Conservative line that only they were prepared to take the debt problem seriously still works. For every person who, as a result of the promised tax cuts, begins to question whether the size of the deficit really was such a major problem, there will be many more that continue to believe it is and will scold the Conservatives for not being responsible enough (but still vote for them).

As a result, I do not think it will change how voters see the past. Looking to the future, on the other hand, it is will be very difficult for Osborne to argue that his future austerity is a painful necessity, and the plans of others dangerously profligate. The retort ‘how come there is room for large tax cuts’ is too strong. If they have any sense Labour will turn the tables. Whereas they have costed all their new commitments, Cameron’s tax cuts are to be paid for by yet unspecified spending cuts (the ‘magic asterisk’). The political danger of the magic asterisk is that it is left to the voter’s imagination to fill them in. If Labour are clever (which may be a big if) they will make appropriate suggestions depending on the audience. Furthermore, interviewers with any self respect will press the Conservatives to outline exactly where ‘the money will come from’ to pay for the tax cuts.

It also lets Labour free of all those questions about the commitments they do have, and whether the country can really afford them. The choice becomes should we spend money on the NHS or on tax cuts, and that I think is ground Labour should be happy to fight on. (There is also the danger that these tax cuts, which mainly benefit the better off, will be viewed in the same way as the cut in the 50p rate.) It is also a more honest debate. Hopefully Labour will spell out exactly how they will achieve their fiscal targets, so that the contrast between their fully costed plans and the Conservative’s uncosted plans will be crystal clear. Add to this the uncertainty created by the proposed EU referendum (see Roger Liddle here reinforcing some of my own thoughts), and perhaps the Conservatives will no longer be seen as the safer pair of hands. (For an example of this train of thought, see these remarks about UK credit ratings.)

For these reasons, I do not think that announcing large tax breaks was always part of the Conservative’s plan. Of course offering tax cuts will gain some votes, but it puts at risk one of their main political assets, which is the perception of future economic responsibility. This in turn may suggest that the Conservatives are far from confident about winning in 2015, as the polls so far have not shown the hoped for pre-election drift to the governing party. Whatever happens, watching how mediamacro develops just got more interesting.   

Why uncosted tax cuts are apparently a problem for Labour

Just a short addition to today’s post. I had assumed that the Conservatives’ macroeconomic pitch for the next election was going to be based on prudence and ‘responsibility’. Only we will achieve a budget surplus by 2020, because only we recognise how dangerously high the current level of government debt is. We will achieve this, because unlike the other parties we do not go around making unfunded spending commitments. Of course the Conservatives would plan targeted tax breaks for the (very) well off, like the one on pensions announced earlier this week and well described by the Economist here, but these would be sufficiently specialised that they would not dent the public image.

I was wrong, as Cameron revealed today with commitments to large tax cuts mainly for middle and high income earners by 2020 whatever. These commitments are totally unfunded, in the sense that we are not told how they would be paid for (except that it will not be by additional borrowing). So the pretence that government spending had to be cut to get debt down has gone - we now have lower government spending (which, given existing commitments, has to mean additional money from the working poor and disabled) in order to cut taxes.

I mentioned last week the drubbing the supposedly left leaning Channel 4 news gave Ed Miliband because he forgot to mention the deficit. As anticipated, John Snow’s interview with Cameron was an altogether more friendly affair. But today their economics editor Paul Mason, whose journalism can be very good, was forced to acknowledge that this unfunded tax give away broke from the recent tradition where particular fiscal pledges were fully costed. But no fear, even Mr. Mason lives in mediamacro land. His final thought on this unfunded tax pledge - it puts Labour in a very difficult position!?! Unbelievable.