Chancellor of Osb – First Mirrors, now up in Smoke
Impossible Dream: A balanced budget target
The successfully long-running Chancellor of Osb charade seems at last to have hit the buffers, over-burdened by banal rhetoric, missed targets, and ever-more blatant pandering to the rich. The justified outrage, even by Tory MPs, at the Chancellor’s trade of supporting the disabled for tax cuts for the few revealed the rotten core of his austerity project. This no very slight-of-hand and academy schools seem to outrage even his fellow Tory MPs.
Along with many others I demonstrated that expenditure cuts represent the least effective – as well as the most inequitable – method of reducing fiscal deficits. The Chancellor himself has proved this in practice. At the end of his first full year in office (April 2011) overall annual borrowing was £139 billion, compared to £80bn now, almost five years later. A little arithmetic reveals this as a monthly reduction of one billion. At that rate the deficit would close in September 2021, after over 11 years of Osbornite austerity should be mismanage the economy for that long.
A flaw deeper than tardiness in deficit reduction resides in the rhetorical obfuscation of the austerity propaganda – the belief that policies exist capable of maintaining a balanced budget over an extended period. Achieving this is at best improbable and trying diverts from the serious job of fiscal management.
Stuart Chase, an American journalist wrote in the 1930s that commonsense tells us the world is flat. In the same spirit most politicians and much of the public believe that commitment to match public revenue with public expenditure represents sensible, sound and achievable fiscal policy. This might be termed the Fiscal Balance Goal (FBG). Within the consensus in favour of this goal considerable disagreement exists over 1) when and how rapidly to achieve it, 2) what specific measure of the budget requires balancing, and 3) what policies the government should apply to bring the balance about.
We should not throw all FBG supporters fall into the same camp. On the contrary, obsession to the point of lunacy characterises the aggressive George Osborne version – all deficits are bad; they should be eliminated as quickly as possible; public revenue must cover total spending; and expenditure cuts, never tax increases are the appropriate method. Until recently the Chancellor’s repeated failures and inconsistencies seem not to have weakened the grip of this madhouse version of the FBG over the public mind and the media.
Even the putatively sensible Institute for Fiscal Studies focuses on the minutia of the Osborne fiscal outcomes rather than ringing the bell on the inherent madness of the policy. A reputable organization should not meticulously re-calculate the likely success of Osborne achieving his fiscal targets, but to label the attempt for what it is, nonsense.
The ideological absurdity of the Osborne FBG does not taint all versions. Gordon Brown’s “golden rule” -- that the government should borrow to invest but not for current expenditure -- has analytical basis. On even stronger analytical ground is the explicitly flexible version of shadow chancellor John McDonnell, borrow to invest and balance current spending with revenue over the economic cycle.
The Chancellor’s extreme version FBG has proved so ideologically successful, rather like a virus of the mind, that all politicians seem compelled to commit to some balancing rule. The shadow chancellor deserves credit for finding the most flexible and least ideological variation.
Fiscal Balancing in Practice
A basic problem with the FBG in all versions is the inherent improbability of achieving it. The improbability emerges clearly when we specify the conditions for its successful implementation.
Private and public spending determines the level of national income when the economy is at less than full potential. To keep the example very simple, I leave out foreign trade, treat private investment as constant, all public revenue is strictly proportional to national income (for example, at 35%), and current household disposable income determines current household consumption. Therefore, all changes result from adjustments in public expenditure.
Assume that the budget balance is negative and we have an Osbornite as chancellor, committed reduce the deficit quickly. In this simple case the chancellor can increase taxes or reduce expenditure. The Osbornite goes for expenditure cuts. The expenditure cuts reduce aggregate demand, causing a fall in national income and disposable income that result in a decline in tax revenue. As a result, public borrowing declines by less than the cuts themselves. To employ a canine metaphor, the expenditure cuts cause the deficit to chase its tail.
In this simple case in which private investment and exports do not change, to maintain orderly fiscal management and meet his specified targets the chancellor must have an accurate estimate of an interactive system in which the indirect or second round effect of a cut in expenditure is a fall in revenue. To assess this interaction the chancellor and advisers need to know the values of two key behavioural relationships – the marginal tax-to-GDP ratio and the margin consumption-to-income ratio for households (“marginal propensity to consume”).
As George Osborne’s repeated missed targets show, in the concrete conditions of the real world feedback effects prove extremely difficult to estimate. These concrete complications include the openness of the UK economy to foreign trade, variations in time of adjustment for revenue collection and private investment decisions, and the changes in employment and wages that result from the fiscal cuts.
Estimates can and will be made – that is the purpose of the statistics profession – but they come with a substantial marginal of error (“random variation”). When to the feedback interactions we add Osborne’s changes in tax rates, forecasts become uncertain to the point of unpredictable. The Chancellor has verified this unpredictability, finding it necessary to conjure external causes for the fiscal instability generated by his policies.
Fiscal Balance over the Economic Cycle
Far more complicated still is to balance expenditure and revenue in an economy with changing levels of output, “over the cycle”. By definition “the cycle” refers to a period of several years. Attempting to calculate the interactions and feedbacks among economic variables over several years when basic parameters change is only the most obvious problem.
Intractability begins with defining and measuring “the economic cycle”. Whatever the definition chosen, balancing over the cycle cannot be an ex ante commitment; that is, it only a fool or a knave follows Osborne’s lead and specifies a time period over which the public budget balances. This is because neither the beginning nor the end of a cycle is predictable even in principle.
If the commitment is retrospective, then achieving it becomes dependent on definition and measurement. Over 50 years of statistical studies of economic cycles have produced no generally agreed definition. One cycle ends when the next begins, but that tautology takes us nowhere analytically. Measurement and definition should not be tasks assigned either to the Treasury or the Office of Budget Responsibility. The former has a conflict of interest (and never wants to be wrong) and the latter’s objectively is dubious under any government.
More fundamental than definition and measurement is what a chancellor thinks causes “the economic cycle”. Osborne and the Cameron government view the cycle as a natural phenomenon that occurs independently of the actions of policy makers. It cannot be avoided; like with the weather the government can only prepare for its impact (“repair the roof while the sun shines” Osborne is fond of saying).
As a more analytical chancellor John McDonnell would view the economic cycle as manifesting the inherent instability of a market economy. Pragmatic and non-ideological use of fiscal policy provides a powerful method to reduce that instability. Though cycles cannot be eliminated, with active fiscal management the duration and amplitude are subject to policy influence.
Managing the economic cycle to minimize instability is simultaneously management of revenue and expenditure. Expenditure policies are themselves a major determinant of revenue flows. For George Osborne this fact of fiscal life is a curse, leading him into repeated policy failures. For an enlightened chancellor the expenditure-revenue interaction is a blessing. The balance between revenue and expenditure – “making ends meet” – becomes an outcome derivative from the primary task of a chancellor who knows his job, minimizing market instability at the aggregate level.
Constraint on Fiscal Management
This rational approach to fiscal management – in contrast to the illusion of deficit management – can under unusual circumstances encounter a constraint of debt sustainability. Understanding the nature of this constraint requires overcoming an ideological phobia as powerful as Osborne’s deficit obsession. Osborne seems to embrace the fallacy that some absolute or relative level or public indebtedness represents the borderline between sustainability and disaster.
The most obvious version of the debt sustainability fallacy is the Maastricht rule specifying that gross public debt should not exceed 60% of GDP. This rule starts with a technical error by measuring public debt as gross liabilities rather than net. The UK Treasury and almost very national government employ the net measure (gross debt less liquid assets such as central bank holdings of foreign currencies).
If 60% referred to the net debt it would be only slightly less absurd. As anyone with a mortgage knows, servicing cost determines the sustainability of a debt. For a household the borrowing rate and repayment period determine servicing cost. The International Monetary Fund has a standard formula for calculating the sustainable net debt to GDP ratio.
Three key numbers to calculate UK debt sustainability are the public sector fiscal balance without interest payments (primary balance), the interest rate for public borrowing, and the sustainable growth rate of the economy (find estimates of those numbers here). Applying the IMF formula yields a UK debt-to-GDP ratio almost double the current 83%. Despite what the Chancellor might allege, UK fiscal policy is not constrained by the public debt, nor likely to be in the foreseeable future.
The lessons from sound analysis are clear: should the opportunity arise, do not pay down the debt, use the revenue to build up the economy (as the shadow chancellor pledges). This approach implies an active fiscal policy in which public investment provides a strong driver for economic growth, and current expenditure rises and falls to maintain the economy close to the growth potential that investment, public and private, creates.