The claim often made
for fiscal consolidations (cuts in public spending or increases in
taxes) is that they are required to reduce the ratio of public sector
debt to GDP. But while fiscal consolidations are likely to reduce
public sector debt, they are also likely to reduce GDP, so the impact
on the debt to GDP ratio is unclear. Research just
published by the IMF suggests that, based on past
evidence, the average effect of fiscal consolidations on the debt to
GDP ratio is negligible (i.e. virtually zero).
Looking at the study
in more detail, the results are even worse for proponents of
austerity. By austerity I don’t mean fiscal consolidation in the
form of spending cuts, but any fiscal consolidation undertaken when
output is below trend. Here is a figure from the study.
On the left hand
axis is the probability that a fiscal consolidation will reduce the
debt to GDP ratio, where the average probability is 51%. The first
column shows that a positive output gap (GDP is above trend i.e. a
boom period) turns that probability into 57%. The second column shows
that if the world economy is above trend that ratio goes from 51% to
60%. The final column shows that if private credit is high relative
to GDP, the probability that a fiscal consolidation will reduce the
debt to GDP ratio falls to 42%.
In 2010, all
economies were recovering from recession (so the domestic and world
output gaps were negative) and private credit was high relative to
GDP (although falling rapidly following the financial crisis). So
2010 austerity was significantly more likely to increase the debt to
GDP ratio than to reduce it. As many of us said at the time, 2010 was
exactly the wrong time (indeed, probably the worst time) to embark on
fiscal consolidation, because not only would austerity lower GDP, but
it would raise debt to GDP because lower GDP would more than offset
lower debt. Which is exactly what National Institute modelling, among
others, said
would happen back in 2011.
Some have suggested
that while that lesson might have been relevant in an environment of
low interest rates (where rates can easily hit their lower bound),
that era has recently come to an end. This is where a second
piece of IMF research, in the same WEO, becomes very
relevant. It looks at historical trends in real interest rates, tries
to explain them in terms of key drivers, and then assesses where they
might go in the future.
The bottom line is
that we have not entered a new era. Instead real interest rates are
likely to go back to the same low levels that we saw before the
pandemic. One reason for this, demographics, is relatively
predictable. Another is the global slowdown in productivity growth.
Productivity growth is less predictable, but with no pick up in sight
continuing modest productivity growth seems like a good assumption.
Unless there is something big that is missing from the analysis, the
age of low real interest rates (what economists call secular
stagnation) is still with us.
In practical terms
this means that the trend level of nominal interest rates in the
advanced economies, the level that would neither stimulate or depress
activity in the medium term and where inflation is at target, is
between 1% and 3%. That means that as inflation falls, so will
current interest rates. We have not left the era when an economic
downturn could easily put interest rates at their lower bound. As a
result, it will remain the case that while monetary policy is the
first choice for controlling (excess) inflation, it is fiscal policy
that needs to be the
first choice for
avoiding recessions and boosting recoveries.
The message of this
evidence is familiar to anyone who understood macroeconomic theory
well before 2010: leave fiscal consolidation for the good times. Yet
this is a lesson politicians, and those that advise them, find it
very difficult to learn.
So why are so many
politicians, and much of the media, so resistant to accepting that
fiscal consolidations – if necessary – should be reserved for good
times and never undertaken in bad times. A large part of the answer
is that, for most politicians on the right, fiscal consolidations are
not primarily about reducing the debt to GDP ratio, but instead an
excuse to cut public spending and reduce the size of the state. It is
what I have called ‘deficit deceit’. No wonder that in the UK
over the last 13 years the government’s fiscal rules seem to change
very few years, because they are typically chosen to squeeze public
spending rather than enhance macroeconomic management.
However I don’t
think that is all. The cyclical nature of the government’s deficit
(rising in bad times, falling in good) encourages politicians to do
fiscal consolidation at the wrong time and discourage them from doing
fiscal consolidation at the right time. [1] They do this because
deficit targets treat governments like cash-constrained individuals,
who if they are short of money have to spend less and if they are
flush with money they have to spend more.
In theory this need
not happen if credible governments ditch debt targets, and ensure
deficit targets are medium term, like a 5 year rolling deficit
target. It shouldn’t happen if credible governments ensure this
medium term deficit target excludes public investment, allowing
public investment to reflect social returns, government missions and
the cost of borrowing. It shouldn’t happen if these medium term
deficit targets are chosen intelligently, allowing debt/GDP to rise
when it makes sense to do so. And finally it shouldn’t happen if
these medium term deficit targets are ignored if fiscal policy is
needed to avoid a recession, or to stimulate the recovery from one.
That is how sensible
fiscal policy would work. If it did, fiscal consolidation would only
occur in good times, and it would be effective in reducing debt/GDP.
Fiscal consolidation would not happen in bad times, allowing fiscal
stimulus to end bad times, and consolidation would only happen in
good times if that made economic sense.
But small state
politicians are not the only reason why this doesn’t happen. The
other reason is the media. Not just the right wing media, that wants
a small state, but also the media that likes to think of itself as
non-partisan. As I explained
here, in the world of mediamacro meeting deficit
targets are indicators of ‘government responsibility’, and
rolling targets that never arrive just don’t wash. We have a medium
term rolling deficit target today, but the media still gives us
monthly (!) commentary on the latest numbers for the deficit, with
predictable and endless speculation of tax cuts or spending cuts.
This isn’t because
most journalists in the media have the wrong model of how economic
policy should work, but rather they have no model at all. As a recent
BBC report implied, the main feature of much
journalism about economic issues is economic ignorance. That is why,
for example, ministers can keep asserting that giving doctors or
nurses more money would raise inflation without such statements being
challenged. (Higher pay for NHS staff or teachers does not put
pressure on prices, so it is not surprising that the evidence
shows no link to inflation.) If all journalists think
they know is government deficits or debt are ‘a bad thing’, then
this creates what I have
called mediamacro.
Politicians work in
a media environment, so many find it hard to combat mediamacro. If
the media wildly inflate the importance of deficit targets, and fail
to understand why these targets are much more long term than
inflation targets, then politicians will be tempted to act as if the
media’s view is correct. For this reason deficit targets encourage
politicians to do exactly the wrong thing with fiscal policy,
consolidating when the economy is weak and the deficit is rising, and
undertaking fiscal expansion when the economy is strong and the
deficit is falling (or in surplus). [2]
How do you
counteract both deficit deceit from the right and mainstream media
ignorance? The obvious answer, as Chris
Dillow suggests, is to give knowledge an institutional
voice, which in this case means enhancing an independent fiscal
council. Our own, the OBR, was set up by George Osborne to play a
much more limited role. The Treasury farmed out its fiscal
forecasting, but none of its macroeconomic analysis. That split makes
little economic sense, and it needs to change.
An OBR that was able
to provide fiscal policy analysis alongside its forecasts could
enhance public discussion of fiscal policy options, and give space
for politicians who want to promote good policy to counter media
ignorance. That advice could range from acting as a watchdog to stop
the government fiddling
the process to more general advice about the form of
fiscal policy rules. As long as it took its lead from the academic
literature and remained independent, this enhanced OBR would improve
public debate about fiscal policy, which in turn should help improve
policy itself.
[1] Basing targets
on cyclically adjusted deficits does not work, because cyclical
adjustment is too uncertain.
[2] The example that
always springs to my mind here is Spain
after the creation of the Euro. Spain should have been
running a more restrictive fiscal policy because its inflation rate
was above the Euro average, but because the budget was in surplus and
because of the centrality of deficit targets in the EZ, the
political/media just couldn’t cope with the idea of even larger
surpluses.
