Or what Policy Exchange were going to call their latest piece of research, until a last minute change of heart.
UPDATE: I would want to point out that anyone reading Andrew Lilico’s excellent submission to the SMPC can tell that he can produce interesting empirical stuff.
As readers of this blog will know, there are Keynesian effects and Non Keynesian effects. Sometimes, the government increasing its demand increases the size of the economy. An obvious example would be during a deep depression, when the problem is a lack of spending, not supply constraints being hit. At other times, an increase in government spending can operate through various constraints to ‘crowd out’ other resources.
Imagine a 1970s-style government, hogging the financial resources (available borrowing); taxing and directing spending into favoured sectors; taking the brightest staff; bidding up wages so that firms cannot compete; imposing taxes that take away profits.
You don’t have to imagine: it actually happened that way. By 1974 British firms were in a crisis of profitability, while workers’ wages took an ever greater slice of the pie. The government could not borrow at home or abroad and had to force the banks to take its debt, inflating the money supply. Read Caincross and Burke on this.
So far, I doubt I have made anyone fall off their seats in surprise. This is basic stuff. I hear you saying: We all know this can happen, oh FreeThinkingEconomist. Thanks for the history lesson. What about what is actually going on now? Which situation are we in now? you ask, plaintively.
Policy Exchange had an opportunity to join this debate, but instead in their paper they have insisted on simply repeating generalities gained from scouring past papers on how economies in general have behaved during the post War period, and then used this to apply specific advice to our current situation. Their paper is useful as a treasure trove of references for past fiscal consolidations that may or may not have the slightest relevance to the current situation. It does very little to actually look at the current situation (the best for this is Lombard Street Research, in my view. Or David Smith’s blog)
Let us look at one specific instance of how this ‘regress and policy advise to the average technique’ works in practise in this paper.
. We might expect that the interest rate penalty increases in a non linear way. In other words, moving from a 1% deficit to a 2% deficit is not likely to raise interest rates by as much as a shift from an 11% to a 12% deficit.
No, this has not happened. Look at the evolution of the UK’s 2010-11 deficit as understood by the market. Here are the figures taking 4 Budgets/PBR’s as observations:
|2010-11 borrowing||Yield on 2017 gilt|
The deficit for that year shoots up. The gilt yield goes down. Why? Here, take a deep breath, go off and read Scott Sumner for a few weeks, and come back having realised with a big light bulb over your head, this dramatic discovery:
The rate of interest is a function of ‘supply’ and ‘demand’
When businesses lose the appetite to invest, interest rates can fall even though the government starts asking for more from savers. Look at how much Fixed Investment was expected to contribute to 2010 demand in 2008 , and then go look at the latest budget estimates. The figure moves from 248 billion to 195 billion. (You will notice that general government consumption raced up by just 20 billion, hmm what splurge …)
Also, when private savings rates move up from zilch to 8-10%, and corporate cash balances shoot up, the supply of funds holds down interest rates. Supply. Demand. Look at both.
This is why their claim that the 12% deficit has caused rates to be 2% higher than they need be – hence generating the alarmist headline in ‘Banking Times’ about mortgages shooting up a grand a year – needs such a careful look at.
Could the UK achieve 2% long term rates if it cut its deficit to 0% now? Yup, it sure could. How? Well, by creating deflation. If the markets want a 1% real return, you they can get it with 2% long term mortgages if inflation expectations are crushed by 2-3% from where they are. Oh please sir, I really want to do that. How? Well, you just withdraw demand rapidly from the economy. Take 100 billion from demand via the government deficit, inflation expectations would dive and you bet you would get expectations of 1% inflation, and 2% nominal rates. Just like Japan. But this would not be because you have freed up the supply of funds from the overweening grabby government. It would be because you have cratered all DEMAND for the funds. Like Japan. Clever.
This is not rocket science. It does not involve the carefully search of thousands of academic papers trying to regress variable X against outcome Y. And adding another hundred papers to the pile showing – quite correctly, quite respectfully – that cutting the government can boost the economy adds no weight whatsoever to the argument that it is a good idea now. Look, I’m an economic liberal! I believe this! I am just also an empiricist! And the only empirical stuff in PX’s paper is to put the UK as an XY dot on a graph showing its deficit against its spread over Bunds.
Policy Exchange have done the equivalent of advising people how to dress according to what the average weather is for the season, without glancing outside of the window to see what it is actually doing right now.
The way to go about economic-fiscal advice now should be 10% theory – because the theory is really not that hard – and 90% a careful awareness of current economic conditions. It takes 10 minutes to explain theories of insufficient demand on the one side, and crowding out on the other. It is much more frustrating examining actual economic data out there to work out which forces have precedence at any time. But there are all perfectly available.
- How are average wages doing? Stagnant.
- How are bond yields? Despite the end of QE, still at near-lows.
- Are big corporates crowded out of borrowing markets? No they are sitting on cash.
Another absolute howler is this one: to equate the size of the fiscal deficit with the size of the fiscal stimulus. Read this and gnash:
It is the scale of the deficit that, on the Keynesian story, provides the “injection” into the economy, boosting demand in the short term. So even on our proposal, there would be more “injection” than in any previous peacetime event.
Another deep breath: a loss of income is not necessarily a stimulus! So you cannot naively take the deficit and say “this is how much stimulus we are giving!”. *
Imagine a country that received a subsidy of 4% of GDP from some external source. Then that subsidy was suddenly cut off. Its deficit grows by 4% of GDP. Is that stimulus? No. Of course not. Failing to collect £110bn of revenue that you thought you could collect is not all stimulative, as it would be if in pre-Crisis Britain you had lowered Income Tax or VAT to the tune of £110bn. Collapsing GDP incomes producing collapsing revenues does not equal a 10% of GDP stimulus, for pity’s sake!
A glance at tables 1.12 (ex post and here ex ante) show that government consumption has not provided a big incremental increase to demand. If PX are really keen to know how much fiscal stimulus was actually applied, this IMF document may help them. Their understanding of what LOOSE means might be updated with a glance at Slide 14 of this from those duffers the IFS. Or see this post. The government is taking demand from the economy in the next year!
*I appreciate that Brown misused this characterization at the G20 April 2009 in calling what they did a trillion dollars of support.