Tories against balanced budget multipliers

Simon Wren-Lewis says the idea of a balanced budget multiplier - the notion that a rise in public spending paid for by higher taxes will increase aggregate demand - is “a pretty robust bit of macroeconomic theory.”

Not so robust, it would seem, as to convince Tories. This week Liam Fox and Tim Montgomerie have called for the exact opposite - cuts in taxes financed by cuts in government spending. From a balanced budget multiplier perspective, this combination would depress demand. This is simply because £100 of extra public spending is £100 of higher aggregate demand, whilst £100 of tax cuts are a smaller boost to aggregate demand to the extent that some of the cuts are saved. Net, then, aggregate demand falls.

So, how can Simon be wrong and Tim & Liam right? I can think of two possibilities, both of which in effect leverage up the tax cuts to give a marginal propensity to spend out of them of more than one:

- Households will see tax cuts now as a promise of more cuts to come. They might therefore borrow against higher expected future incomes.

- If tax cuts incentivize businesses to expand, they might borrow to invest, and so aggregate demand would rise by more than the amount of the tax cut.

Both these mechanisms would be doubtful at the best of times. And these are not the best of times. With banks reluctant to lend, it’s surely less likely now than ever before that tax cuts could be leveraged up in these ways. There’s not much point giving people incentives to expand their businesses if attempts to do so are met with a “no” from the bank.

From an economists point of view, then, today is the wrong time to be fighting against the balanced budget multiplier.

But are Tim and Liam thinking as economists? I suspect not. They’re thinking as politicians. They seem to want to shrink the state for reasons other than likely short-run macroeconomic effects. And I guess they’re betting that - given popular (or at least media) hostility to the public sector - tax and spending cuts would be popular.

Maybe they’re right on both counts. But please remember that macroeconomic orthodoxy and political expediency are different things.

Comments

[Luis Enrique]

far be it for me to usurp your "top blogging" selections, but FR's latest on a related theme (Tory economic policy) is a tour de force:

http://flyingrodent.blogspot.com/2012/02/crimefare.html

[Luis Enrique]

but why is Ed Balls advocating tax cuts?

[Account Deleted]

Luis, Ed Balls is recommending a cut in VAT on the grounds that this will effectively deliver cash to low income groups. They are more likely to spend the lot and not save any, so the multiplier will be closer to 1 in comparison to a reduction in income tax rates or an increase in tax-free allowances.

[Luis Enrique]

AtoE

thanks. quibble: "They are more likely to spend the lot and not save any" - these are the same low income households crushed under the burden of debt, as we are told? Maybe they will (should?) save not spend.

[Account Deleted]

Luis, the bulk of personal debt is to be found in the middle of the income range. Those at the bottom often struggle to get credit, while the well-off tend to need it less due to savings.

[EdS]

I might be wrong, but doesn’t the balanced budget multiplier depend on there being a pool of unemployed resources to draw on?

In Simon’s article he seems to suggest the additional spending should be directed at infrastructure. Unless I’m missing something (quite possible) the UK output figures for infrastructure are as high as they’ve been for the last thirty years. That doesn’t suggest to me that there’ll be a huge amount of spare capacity.

[JustAnotherTaxpayer]

VAT cut incurs costs for supply-side and also depends on supply-side downward pricing pressure for pass-through. Given weak demand growth in 2011, where was that pricing pressure? We had to wait until Q4 to really see it (c.f. Tesco), and we were then on the edge of recession. That's not good.

I will buy the Liam/Tim position, supply-side magic needed plz.

Good to see ye olde "£100 increase in G" => "£100 increase in Y" argument where we totally ignore monetary policy etc is still getting rolled out.

[Blissex]

«And I guess they’re betting that - given popular (or at least media) hostility to the public sector - tax and spending cuts would be popular.»

The propaganda effort to deflect resentment towards the "real" exploitative parasites, that is the poor, disabled, and unemployed, rather than high earning low taxed insiders, has been entirely successful.

Two quotes, one from the UK and one from the USA:

The Times, 2011-09-17, Janice Turner:
«The C2 women who voted Conservative last time did so because they, in low to middling-paid roles such as nurses, secretaries and carers, believed welfare had grown too generous, that benefits rewarded the do-nothings while they toiled. They hoped the Tories would crack down.»

http://www.nybooks.com/articles/archives/2011/aug/18/what-were-they-thinking/
«It all goes back to the “shellacking” Obama took in the 2010 elections. The President’s political advisers studied the numbers and concluded that the voters wanted the government to spend less. This was an arguable interpretation.
Nevertheless, the political advisers believed that elections are decided by middle-of-the-road independent voters, and this group became the target for determining the policies of the next two years.
That explains a lot about the course the President has been taking this year. The political team’s reading of these voters was that to them, a dollar spent by government to create a job is a dollar wasted.
The only thing that carries weight with such swing voters, they decided — in another arguable proposition — is cutting spending.»

Note that these quotes are recent: middle class voters full of resentment demanded cuts in the middle of a ferocious recession, anything to punish the strapping young bucks and the welfare queens who don't want to take any of the many jobs on offer for every applicant :-).

[BenP]

"robust bit of macroeconomic theory"

Woodford benchmarks...

"Consider an economy made up of a large number of identical, infinite-lived households, each of which seeks to maximize..."

[BenP]

http://www.voxeu.org/index.php?q=node/7616

[Ralph Musgrave]

If the objective is stimulus, what in GOD’S NAME is the point of spending an extra £100 and then collecting an extra £100 in tax? Tax has a DEFLATIONARY effect: the opposite of the desired effect. It’s completely LUNATIC. I.e. why not just print £100 and spend it?

To be more accurate, printing and spending £100 would have a bigger stimulatory / inflationary effect than collecting £100 in tax and spending £100. The get the same effect as the latter it might only be necessary to print and spend £10.

As to the possibility that the extra money proves inflationary in a couple of years, that can be dealt with by raising interest rates and/or raising taxes and “unprinting” the money collected.

Keynes and Milton Friedman tumbled to the above point. Advocates of Modern Monetary Theory have worked it out. But apparantly no one else in 2012 gets it. I’m baffled.

[Keith]

I am baffled like Mr. Musgrave firstly by why Chris bothered to waste his time with Tory twaddle. As he pointed out this has no connection with economic theory. The demand effect of spending more financed by tax rises is well established and not in dispute. It works and the more you do it the more it works. As to why no one wants to spend more by creating demand via monetary expansion that is the result of the ideological choice to allow only private banks to create money. The problem with Modern monetary theory is that to work as a long term policy private banks and institutions would be less important and politicians don't want to miss out on the revolving door of cushy jobs in the private sector. The uniform unwillingness of politicians to actually try to effect the real economy using the many different tools which exist has no other rational explanation. I cannot think of one and if anyone can, do let me know, I am curious to understand. In the same way the euro problems as Prof. Krugman has shown are directly caused by huge private sector capital flows between states. The focus on public spending cuts is equally baffling; the role of such capital flows in producing currency and banking calamity is very long standing. Every period of asymmetrical flows is followed by a melt down. Governments never seem to do anything about it, and then bang!

[George Hallam]

"The problem with Modern monetary theory is that to work as a long term policy private banks and institutions would be less important and politicians don't want to miss out on the revolving door of cushy jobs in the private sector. The uniform unwillingness of politicians to actually try to effect the real economy using the many different tools which exist has no other rational explanation. I cannot think of one and if anyone can, do let me know, I am curious to understand."

These days politicians lack an independent popular base. They depend, not on local activists, but on the mass media to present themselves and win votes. They fear losing the confidence of the powers that be (how carry a lot of weight with the media) - hence their compliance.

We don't need to think just in terms of direct, personal corruption to explain the power of finance.

This is just a taster, lack of time and space means I haven't developed the full case.

[Ralph Musgrave]

On second thoughts I was being illogical above. Wren-Lewis’s point was that ASSUMING one wants a balanced budget, then raising taxes and public spending by £100 will raise demand. I answered that by saying that balanced budgets are a nonsense – which misses the point.

The REAL flaw in the “£100” argument is that ALL the additional employment is in the public sector, which is a big weakness in the idea because the OBJECT OF THE EXERCISE is simply to raise demand and employment – period. I.e. any system for raising employment ought to be able to do so while at the same time raising OR REDUCING public spending realtive to GDP, or indeed leaving it UNCHANGED relative to GDP.

Keith,

I don’t see why under Modern Monetary Theory (MMT) “private banks and institutions would be less important”. MMT is pretty close to Keynes. And under both an MMT and Keynsian regime government / central bank tries to control aggregate demand.

[Dipper]

There you economists go again. More ideas about how you can save the world by taking/borrowing money from person X and giving it to person Y.

There's no need to stimulate demand. There's lots and lots of demand. From the BRICS. We are just crap at making things they like because of decades of neglect of technology and engineering.

Economists are like racing drivers. Take this corner like this, accelerate up here like that. But sometimes its not about how you drive. Its about the engine. This government seems to understand this a lot better than any one I can remember