Fiscal policy: the cognitive biases

The fact that government borrowing has risen so far this year reminds us of a key truth about the public finances - that they are less amenable to government control than generally thought. This is because government borrowing is the counterpart of private sector lending. Borrowing will fall when and only when private sector investment rises and savings fall. And this is not happening yet.

This poses a question. Given this, Why do so many people pretend that governments can easily control borrowing? I suspect it is because of a number of cognitive biases:

1.The fundamental attribution error. We tend to attribute outcomes to agency more than to situational factors. This causes us to over-estimate the extent to which the Chancellor determines borrowing and to under-estimate the extent to which that borrowing depends upon millions of private decisions to save or invest.

2. The representative heuristic. We tend to think that outcomes must somehow resemble causes, so we think that government spending and tax decisions must determine borrowing when in fact they (largely) determine the level of GDP instead. This heuristic leads us to underplay the extent to which policies other fiscal policy affect borrowing. A solution to the euro crisis, and/or effective policies to get banks lending again, would be more effective deficit reduction policies than fiscal restraint.

3. The illusion of control.People over-estimate the extent to which they are in charge of events. This might be even more true of politicians than other people because of...

4. The optimism bias. People tend to enter politics if they think they "can make a difference". This means politicians are selected for the optimism bias, the belief that they can affect events for the better.And this predisposes them to believe they can control government borrowing.

We shouldn't just blame politicians, though. These biases exist in the media as well. The Chancellor who told the truth - that he can't easily control public borrowing because private sector net lending depends upon things out if his control such as the euro crisis, banking system and dearth of investment opportunities - would be committing career suicide.

There's more. It's hard to fight against these biases in part because of the social proof effect; when so many people seem to believe something, it is tempting to go along with them.

And even if you conquer the social proof effect, there's another problem - the Overton window. When the dominant discourse is that governments control borrowing, the person who denies this becomes a crank, an extremist, and is ignored, at least by non-economists. Those who understand the public finances thus make excessive compromises to mainstream opinion, for example, by telling stories in which fiscal policy does affect government borrowing by affecting the private sector's financial balance.

Such stories will often be true - though they don't seem to have been so in the last 12 months. But they don't change the fact that the government's financial balance is merely the counterpart of the private sector's.

It was Bismarck who said that politics is the art of the possible. He should have said that it is the art of the application of cognitive biases.

Comments

[Joe Otten]

Just to clarify are you saying the government could double public spending without increasing taxation and this wouldn't affect borrowing?

Your formula

(T - G) = (I – S) + (X –M)

doesn't necessarily imply the RHS causes the LHS. We could rearrange it to

(X-M) = (T-G) - (I-S)

RHS causes LHS seems more plausible here.

Another interpretation of your position would be that the supply-siders are right and we could halve tax rates without losing revenue.

[Jackart]

Your point (2) stated "we think that government spending and tax decisions must determine borrowing when in fact they (largely) determine the level of GDP instead" as fact, when it's controversial.

Cause and effect could be reveresed: low private investment over the Brown years to now could be as a result of crowding out by a massive state spending-spree.

[Luis Enrique]

Joe

some clues on how to say what causes what, here:

http://blogs.ft.com/martin-wolf-exchange/#axzz21SCYQhVf

[Joe Otten]

Oh yes I would agree that governments are passive in practise. Big changes in tax rates or spending are rare. Current austerity is non-existent, at least according to those who actually want to cut public spending.

So if the analysis is that governments generally do nothing fiscally significant and external/private sector factors drive changes in the balances, I would agree.

But that is not to say that you cannot increase the deficit by cutting taxes.

[Zorblog]

You may say that a deficit is only possible if there is a willingness to lend from the private sector (either domestic or foreign).
But that willingness alone is not sufficient for causing the deficit. Savings will go to other assets if there's no deficit, until nominal rates of return on every asset reaches zero (or a return that does not pay for the risk), in which case savings will go under the mattress.
It looks to me that this is exactly what we are seeing right now.
I'm a bit surprised about that post, but maybe I missed the point.

[chris]

@ Zorblog - remember that a willingness to lend affects the govt deficit via GDP. If the private sector want to lend, then it cuts investment and saves more. But this drop in aggregate demand depresses tax revenues and so causes a govt deficit.
@ Jackart - through want mechanism did state spending crowd out private investment? Interest rates were trending down throughout the 00s, so it wasn't the interest rate channel.
And real wage growth was pretty modest, so it's unlikely to be the case that state spending greatly bid up the price of labour.
It could be that the spedning led to expectations of higher taxes. But if this were so, we'd expect households to have saved more, not just companies.
So, what mechanism had you in mind?

[sewa mobil jakarta]

Nice article, thanks for the inforation.

[Neilwilson]

"remember that a willingness to lend affects the govt deficit via GDP"

It's not willingness to lend that's the driver in a country with its own currency. What else are they going to do with the money at that point? Spend it? (in which case it goes to the government for free in taxation via the additional transactions).

Or they swap it with somebody else who is going to spend it. (Same result - increase in taxation).

Or it ends up in the default saving place - an account at the central bank.

All Treasury is doing is offering a savings bond (Gilts) for the money that would otherwise be left in the current account (Reserve account at the Bank of England). That is a matter of policy and is not required. There is no earthly reason why the BoE itself couldn't set an appropriate interest rate for government borrowing.

The underlying cognitive mistake is to believe that the government is pulling money away from the private sector. Yet the austerity measures implemented over the last few years have proven beyond a shadow of a doubt that cannot be the case.

The causality is the non-government sector wanting to save and pushing money at the government and the central bank. The theory that low interest rates would stem that flow has failed - the savings market does not clear automatically at a given level of output; it requires an active pump to recycle spare money (or a depression causing mass bankruptcies - which eliminates the excess savings 'naturally').

To repeat: the non-government sector is *saving*. That excess saving is not cleared via interest rate movements. That leads to a paradox of thrift situation which must be resolved via active fiscal intervention to prevent a depression and mass bankruptcies.

The pre-existing auto-stabilisers are just about stopping the economy declining at the moment, but aren't strong enough to restart the private sector engine.

Without a change of policy stagnation is the best we can hope for.

[Neilwilson]

"Savings will go to other assets if there's no deficit, until nominal rates of return on every asset reaches zero "

Only if the central bank, and where it exists National Savings, drop their interest rate to zero. Otherwise the floor is the remuneration rate on those central bank accounts.

The ECB is currently the 'mattress' in the Eurozone for example, via the German Bundesbank.

The natural interest rate is zero, and there has to be active intervention to keep the policy rate above that.

[Neilwilson]

"Current austerity is non-existent, at least according to those who actually want to cut public spending."

It does exist. The elements of government spending that are discretionary, eg government investment spending, have been cut markedly.

But that didn't cause a private sector spending spree. Saving continued at the same high level as before. So tax take started to fall due to reduced activity and benefit payments went up (I suspect via tax credits and increased State pension payments).

When you hear John Redwood talking about government spending going up, he is implying that was a discretionary decision.

It wasn't. The discretionary bit went down and the auto-stabiliser bit went up by more. So overall government spending went up.

[Widz]

Please address these pontis.1) The powers that be think that the limiting factor in the great depression was to let the system breakdown (losing businesses, means losing jobs, which means losing businesses). So, they print money and have the govt take on toxic debt to fix the structural problem."Problem solved" some might say.2) Oh sure, one might say "That helps the banks/corps, but the public is still up to it's ears in debt!". Yes it is. However, stopping foreclosure, forcing writedowns, keeping interest rates low, letting people "rent for free"... all magic tricks to keep people working, spending and the cycle continues...3) Angrily you say, "the rest of the world won't allow this!" Alas, what if per chance the rest of the world is in on it? What if they will allow some inflation, so long as they can go on a spending spree buying companies, oil, and the like...as the terms of repayment for the US dollars they surely have saved up. What if they rest of the world needs us to remain a strong consumer for their production houses? What if the rest of the world has been letting this go on for years already, so this isn't anything new. Haven't we exported inflation in nebulous forms such as polluted air (because we can't pollute here, so we don't make here), or depressed wages abroad, and cheap foreign currencies that keep the standard of living low over there to support us over here.

[Therisa]

Eric...excellent article. I agree with you 100%. When this raelbancing takes place do you think it will be a 50% unemployment figure, or do you think manufacturing and agriculture will increase?I, for one see a disintegration of employment and not a huge uptick in either manufacturing or agriculture. When the US Dollar and US Treasuries imlode,the USA will have no real capital to invest in either of these two sectors.This indeed, will be far worse than the Great Depression.Lastly, one more question. Many analysts are saying investors should be getting into farmland. I don't agree to a certain extent. Do you agree that USA farmland's value is tied to cheap energy and water? Both are declining rapidly making this a horrible investment in the future. The falling EROI- energy returned on invested is what is destroying the US suburban economy.