Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
Some time ago I started a theme “When you’ve got friends like this” which focuses on how limiting the so-called progressive policy input has become in the modern debate about deficits and public debt. Today is a continuation of that theme. The earlier blogs – When you’ve got friends like this – Part 0 – Part 1 – Part 2 and Part 3 – serve as background. The theme indicates that what goes for progressive argument these days is really a softer edged neo-liberalism. The main thing I find problematic about these “progressive agendas” is that they are based on faulty understandings of the way the monetary system operates and the opportunities that a sovereign government has to advance well-being. Progressives today seem to be falling for the myth that the financial markets are now the de facto governments of our nations and what they want they should get. It becomes a self-reinforcing perspective and will only deepen the malaise facing the world.
One of the authors I consider today is associated with the New Political Economy Network and I considered that organisation’s input into the policy debate in this blog – A new progressive agenda?. This blog could have easily been Part 4 in this series.
There was an article in the UK Guardian (March 18, 2011) – Osborne must change tack, or risk being blown off course – which sounded, on face value, that is was probably going to be on-track.
Before I read it I clicked on the links attached to the author’s names to see what their affiliation was.
One of the authors, Adam Lent is the “programme director” at the RSA which is the Royal Society for the encouragement of Arts, Manufactures and Commerce. The RSA describes itself in this way:
… has been a cradle of enlightenment thinking and a force for social progress. Our approach is multi-disciplinary, politically independent and combines cutting edge research and policy development with practical action.
Okay, sounds progressive. My initial thinking about the title was probably going to be right and I could just skim the article and move on.
The other author, Tony Dolphin is a senior economist at the Institute for Public Policy Research (ippr).
The IPPR describes itself in this way:
Independent, radical, progressive
ippr has established itself as one of the most influential think tanks in British politics. Our research and policy ideas have helped shape the progressive thinking that is now the political centre ground since 1988. Our work has always been driven by a belief in the importance of fairness, democracy and sustainability. And now, at a time of economic and political crisis, we are using radical thinking to take this agenda forward.
Whoa … that is definitely progressive sounding and radical too.
Dolphin says his “areas of expertise include macroeconomic policy, the structure of the UK economy, Taxation and households’ saving and borrowing”. So he should know a thing or two about sectoral balances, monetary systems and the opportunities that being a monopoly-issuer of a currency bestows on a government such as in the UK.
I imagined that they were going to tell their readers that spending is essential for economic growth and that with private spending faltering (from a very flat position) in the UK and net exports still subtracting from growth the the austerity plans to cut spending would be devastating for the British economy.
I expected them to debunk the notion that consumers and firms are not spending in the UK at present because they are so scared of future tax increases to “pay back the deficits” that they are saving up to pay for them. This has been a central claim of the austerity proponents.
I expected them to tell their readers that the multiplied response from the public cutbacks would reduce growth (perhaps even push the UK economy back below the zero growth line) and increase unemployment. Last week’s labour force data showed unemployment to be rising again in Britain and the cuts have not even began to be felt.
I expected them to tell their readers about automatic stabilisers will probably undermine the British government’s plans to cut its deficit anyway because as economic growth falters, tax revenue will fall and welfare payments (even with the cuts) will rise automatically and push the budget into further deficit (and therefore offset the cuts in net spending).
I expected them to tell their readers about the sectoral balances – that is, debunking the myth that the government and non-government sector can simultaneously reduce their debt levels (under current arrangements).
And given that they were both associated with radical thinking (Lent is also associated with the IPPR) I wouldn’t have been surprised if they developed a narrative about how ridiculous it is that governments claim they operate at the behest of the “bond markets” which has been a central theme of the UK government as they tried to justify the unjustifiable – cut public spending in a weak economy with rising unemployment.
All those expectations ran through my mind as I began to read the article.
You can be wrong occasionally. If this article is what goes for progressive thought in the UK these days GXX help us!.
The Guardian article is a shortened version of a paper – Deficit Reduction Averaging A Plan B for fiscal tightening – put out by the IPPR this month under the author’s names.
The basic idea is that they think the British economy is still weak and vulnerable to further damage if the Government’s deficit reduction plan continues.
They claim that the Government’s deficit reduction plan has to legitimately balance two competing sensitivities:
First, it would need to maintain market credibility by convincing those holding or purchasing gilts that the government still has a credible medium-term plan to reduce the deficit in a transparent and methodical fashion (and not by inflating it away).
Second, it would, nevertheless, need to incorporate some degree of flexibility to allow the process of deficit reduction to be slowed, or even halted, while the economy remained weak but then speeded up when output and job creation recovered.
If the word “dove” coming into mind as you read this … deficit doves.
Deficit doves think deficits are fine as long as you wind them back over the cycle (and offset them with surpluses to average out to zero) and keep the debt ratio in line with the ratio of the real interest rate to output growth. Torturous formulas are provided to students on all of this under the presumption that the government does have a financing constraint but as long as it is cautious things will be fine.
Deficit doves are within the same species as the “deficit hawks” in that they believe that the long-term deficits pose serious risks although short-term deficits might be necessary during a recession. A standard aspiration for a deficit dove is thus to propose the government runs a “balanced budget” over the business cycle which is clearly dim-witted as a stand-alone goal and un-progressive in philosophy.
From the dove viewpoint, public borrowing is constructed as a way to finance capital expenditures. Since government invests a lot in infrastructure and other public works, those investments should at least allow for a deficit. This was already recognised by the classical economists as a golden rule of public finance.
The problem that deficit doves ignore is that the budget outcome is not autonomous – that is, a deterministic balance that is controlled by the government. The budget outcome in a modern monetary economy is endogenous and determined, ultimately by the non-government saving desires. While the government can try to reduce its deficit by cutting net spending if this runs, for example, against the desires of the private domestic sector to increase their saving ratio (assuming, say a current account deficit) then the government’s aspirations will be thwarted.
The fiscal drag will combine with the spending withdrawal of the private domestic sector (and the leakage from net exports) and the economy will contract further pushing the deficit back up via the automatic stabilisers.
It is impossible for a government in a fiat monetary system to guarantee a budget deficit outcome if it is working against the behaviour of the non-government sector.
Context is everything. The reason that the deficit dove position is unsound at the national level is because they ignore the context. For example, if a government is facing an external deficit and the private domestic sector are net saving (spending less than they are earning) then to maintain economic growth the government has to be running a budget deficit.
So unless a nation can generate significant current account surpluses, then the balanced-budget over the cycle rule that deficit doves hold out will be equivalent to aiming for the private domestic sector to be dis-saving and becoming increasingly indebted over the same cycle (to the extent that the external account is in deficit).
The average extent of this private domestic sector deficit position would mirror the average current account deficit (if a budget balance was achieved). This would be tantamount to returning to the unsustainable growth path where the private domestic sector accumulates ever increasing levels of debt. That is total idiocy and reflects a lack of understanding of the way the monetary system and the aggregate relationships between the government and non-government sector work. –
In my view, deficit doves actually make the political case for full employment harder to make because they are held out as the “left wing” of the debate. So regression towards to mean takes us further to the right. Centrist positions now are out there a fair distance to the right and a long way from what we used to call the centre!
The authors want to develop a deficit reduction strategy that balances what they call “market and economic sensitivity in a simple and transparent fashion”.
The economic sensitivity is the impact of the deficit reduction on the level of activity. It will be negative – so any reduction strategy must think that a negative public contribution over the next several years is warranted. I come back to that point.
But their blind observance to the market sensitivity is what really amazed me. They say in the Guardian article that:
Osborne would counter that his most important task is to keep the markets calm by convincing them he is serious about cutting the UK’s sovereign debt. Any wavering risks higher interest rates which in itself would bring economic turmoil and hardship. He is not wrong in this but the measure of a good deficit reduction plan is its ability not simply to hold down bond traders’ blood pressure but to do so in a way that allows for a flexible response to economic uncertainty.
In their extended Report they go one step further and say it is:
… important to recognise that bond investors would be wary of any plan that lacked detail and might be more susceptible to deviation for political gain. There would, therefore, be an important role for the independent Office for Budget Responsibility (OBR), which would be charged with establishing the economic outlook and determining the appropriate pace of deficit reduction in the short-term. It would also ensure that the government’s medium-term plans remain on course to achieve the ultimate target of eliminating the structural deficit by the specified date.
Where is the evidence that the bond markets are not calm? Answer: there is none.
Further, who cares about the bond markets. The UK government has all the power. It can simply ignore the bond markets if they get uppity. In fact a truly progressive position is to advocate the merger of the treasury and the central bank and stop issuing public debt altogher.
Please read my blog – Who is in charge? – for more discussion on this point.
But it gets worse doesn’t it? The OBR is an unelected institution made of of mainstream fiscal conservatives. What right should they have to determine “the appropriate pace of deficit reduction in the short-term”. These so-called “independent” fiscal watchdogs are a neo-liberal stunt to impose political pressure on governments to adopt conservative fiscal strategies and entrench excessive unemployment as a result.
In a democracy, the government is elected and takes the responsibility for its decisions. If we don’t like them we vote them out at the next election. We cannot vote out the OBR!
How can a progressive advocate an elected government relinquishing these important fiscal decisions and putting them into the hands of such a body as the OBR? This is neo-liberalana personified!
Lent and Dolphin typify how progressive now means right.
They say that:
To save the British economy, the chancellor should commit to an average annual reduction in the deficit, rather than set targets …
To be cute, the authors propose a Plan B – “Deficit reduction averaging”.
How does it work?
Under this plan, the government would commit to eliminating the structural deficit by a particular financial year through a mixture of spending cuts and tax increases, with the pain initially planned to be spread evenly over the life of the deficit reduction plan. Then, in each subsequent year, the required annual reduction would be recalculated, based on the actual deficit in the latest fiscal year.
In addition, should the outlook for the economy deteriorate, the government could reduce the pace of deficit reduction until economic conditions improve, at which time the pace would be speeded up in order to return the plan to target. This ensures economic sensitivity.
In effect, the Treasury would set an overall target to eliminate the deficit by a set date by achieving an average reduction in the size of the deficit each year. Because the goal for each year is an average of the remaining reduction required, rather than a pre-determined annual target (as in the current government’s plans), there is greater opportunity to change the pace and depth of consolidation in response to short-term economic fluctuations.
This approach would still require the government to establish clear spending and tax plans designed to meet each year’s fiscal target, together with an overall plan for medium-term deficit reduction. But the pace of reduction would be varied in response to different outcomes for the economy.
So that is Plan B.
What should we make of it? Answer: it is a neo-liberal ploy with softer edges and fails to address the fundamental issue – why would the British government want to eliminate the structural budget deficit?
It is taken for granted that this is an appropriate aim.
Brief refresher – what is a structural deficit?
In his New York Times article (January 6, 2011) – The Texas Omen – Krugman said that the structural budget deficit is “a deficit that persists even when the economy is doing well”.
You are led to think that when the economy is doing well there should not be a deficit. This is the standard deficit dove line that most progressive tout – thinking it sets them apart from the deficit terrorists who advocate balanced budgets or surpluses irrespective of the context.
The term “structural deficit” is being increasingly used in the public debate as the weak recovery ensues and the talk has turned to credible “exit” plans for fiscal policy. The mainstream economics position that budgets should be balanced or in surplus (and that the deficits being experienced at present will need to be “paid” for by offsetting surpluses then leads commentators to conclude that any estimated structural deficit is a problem.
A structural deficit is the component of the actual budget outcome that reflects the chosen (discretionary) fiscal stance of the government independent of cyclical factors.
The cyclical factors refer to the automatic stabilisers which operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.
In times of economic decline, the automatic stabilisers work in the opposite direction and push the budget balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).
The problem for economists is to determine whether the chosen discretionary fiscal stance is adding to demand (expansionary) or reducing demand (contractionary). It is a problem because a government could be run a contractionary policy by choice but the automatic stabilisers are so strong that the budget goes into deficit which might lead people to think the “government” is expanding the economy.
So just because the budget goes into deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.
To overcome this ambiguity, economists decided to measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the budget balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.
As a result, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. As I have noted in previous blogs, the change in nomenclature here is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation.
The Full Employment Budget Balance was a hypothetical version of the budget balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the budget position (and the underlying budget parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.
This framework allowed economists to decompose the actual budget balance into (in modern terminology) the structural (discretionary) and cyclical budget balances with these unseen budget components being adjusted to what they would be at the potential or full capacity level of output.
The difference between the actual budget outcome and the structural component is then considered to be the cyclical budget outcome and it arises because the economy is deviating from its potential.
So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the budget balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.
If the budget is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual budget outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual budget outcome is presently.
So you could have a downturn which drives the budget into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.
The question then relates to how the “potential” or benchmark level of output is to be measured. The calculation of the structural deficit spawned a bit of an industry among the profession raising lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.
Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s. I considered that controversy in the blogs cited above.
The outcome is that the mainstream employ a biased measure of full employment (the NAIRU) to serve as the benchmark which means that any estimate of the structural deficit will always suggest that the discretionary fiscal position is “too expansionary” when in fact it is too contractionary. This reflects the bias towards higher unemployment than is necessary which is built-in to the mainstream approach.
So measurement issues aside, why should the structural deficit be zero at full employment? Answer: there is no logic to that aspiration.
It all depends on the what is going on in the economy.
it is crucial that people start to understand how the sectors that comprise the macroeconomy interact. You cannot understand statements about public sector aims – that is, whether they are appropriate or not – unless you also know what the context is.
The context is that there is no real prospect of a strong external contribution (the current account deficit widened towards the end of the year) in the UK any time soon and a highly indebted private sector suffering widespread negative equity in their housing assets. The household saving ratio has risen in recent years as they try to reduce their debt exposure. Private investment is very weak.
So under these conditions the only way that growth can continue (and expand) is that the public sector run deficits commensurate with the spending gap left by the private domestic saving and the external deficits. Given that growth has faltered in the UK and is not strong enough to prevent unemployment from rising these conditions mean that the public deficit has to expand.
Any notion of a “deficit reduction” strategy is simply irresponsible and committing the nation to rising unemployment and stagnant economic activity.
Even at full employment, if there is an external deficit and the private domestic sector desires to save overall (spend less than they earn) then the budget has to be in “structural” deficit. If from that position, the government tries to eliminate the deficit it will quickly force the economy to shed jobs and the maintenance of full employment would be impossible.
Given that the British economy is nowhere close to being at full employment and is heading away from that goal at present there is a need to widen the structural deficit.
What is clear – no progressive should entertain any notion of deficit reduction at present.
Is the deficit reduction averaging approach any different to a fiscal rule?
Here is a graph I created to compare the current Osborne deficit reduction plan which plans to deliver a structural deficit as a per cent of GDP of -0.9 (that is a surplus) by 2015-16 to the “progressive” deficit reduction averaging approach which plans to deliver an even larger surplus (2 per cent of GDP) two years later by 2017-18.
The latter approach takes a more gradual approach by starting less severely and then taking the difference between the end goal (which is just an imposed fiscal rule) – 2 per cent surplus – and the current budget position and dividing it by how many years are left in the deterministically-imposed adjustment path to compute how much deficit reduction occurs in each of the following years.
So it is just one fiscal rule being replaced by another. If all hell breaks loose they both fail and the automatic stabilisers will wipe them out.
You might also be wondering about why they are not only proposing to eliminate the structural deficit but actually drive it into surplus.
In the Report the authors say:
We believe that the government is right to aim for a surplus on the current budget …
Why is that an appropriate aim?
There is no further discussion which might have outlined a strong export-led strategy whereby the external sector would drive such surpluses that the private sector’s desire to net save overall would be satisfied and the government sector would have to run surpluses to take the heat out of the economy.
On all their simulated growth estimates I do not see an overheating economy envisaged.
I also don’t see any discussion about external surpluses nor a heavily debt-burdened private sector. All these realities which are intertwined with the government’s budget outcome and economic are ignored in the Report.
Is that an important oversight? Answer: definitely. Refer above to my discussion about the sectoral balances.
These characters are drawing up deficit reduction strategies without any coherent reference to the other major macroeconomic aggregates.
So if the external sector remains in deficit (and it will likely do so), their fiscal reduction plan will drive the private domestic sector into deficit (and increasing indebtedness) slightly more slowly than the Osborne plan will.
One of the major problems facing Britain at present is that indebtedness of the private domestic sector. That sector has to reduce its debt exposure. It will not be able to do that under either deficit reduction plan.
The “progressive” Report is silent on that issue which suggests to me that they haven’t even considered it. But then given at least one of them is self-proclaimed expert in “macroeconomic policy, the structure of the UK economy, Taxation and households’ saving and borrowing” it would be astonishing if they didn’t.
Which means their plan is crazy rather than just ill-informed.
Total aside – that only Australians will get
Our Prime Minister was interviewed yesterday and the press report today (March 21, 2011) that she admitted to being:
… a cultural traditionalist, indicating she will oppose moves by the Greens for euthanasia and gay marriage laws and that she believes it is important for people to understand the Bible- despite the fact she is an atheist.
I saw this photo today and wondered whether The Greens had kidnapped her and forced her undergo the “Green Treatment”.
Further, research reveals that we were not so lucky, she was visiting a laser laboratory at the ANU.
During the interview she also said that The Greens:
… did not have an economic philosophy about “reform or about growth”
That is true. Our progressive hopes are thoroughly neo-liberal when it comes to macroeconomics – that is, the big questions regarding fiscal policy.
Please read my blog – Neo-liberals invade The Greens! – for more discussion on this point.
Stay tuned for Part 5 in the series. The self-proclaimed “progressives” are trying to be relevant in the debate but really just hand over the debate to the conservatives. It is very disappointing.
That is enough for today!