Euro shocks & fiscal policy

There's something George Osborne said today that I want to argue with. It's this:

If, for instance, lower growth was the result of the Government’s fiscal policy, [the OBR}would say so.
But they do not.
They say the economy has “performed less strongly” than they had expected.
They forecast growth this year of -0.1%, but in their view “the weaker than expected growth can be more than accounted for by over-optimism regarding net trade”.

True, the OBR does say this; par 2.8 of this pdf. However, if Mr Osborne thinks this justifies his fiscal stance, he is surely wrong.

First, the OBR's forecasts in March were based upon the view that tighter fiscal does hurt the economy. It assumed that cutting current public spending by 1% of GDP reduces GDP by 0.6% (par C54 of this pdf).Whilst this is a lower multiplier than many believe, it is not the negative one of expansionary fiscal contraction theory. The fact that GDP's shortfall from March's expectations can be blamed upon external factors does not mean austerity doesn't depress the economy. It just means the extent to which it does is not obviously greater than the OBR thought a few months ago*.

Secondly, the fact that the euro area economy is weaker than expected is itself a reason why we should have had a looser fiscal policy - to cushion us from that external shock.

You might reply that the government can't be blamed for not foreseeing the depth of the euro area's troubles.

True. But as I've said, shocks are an unavoidable fact of economics, and a policy that doesn't consider them isn't worth a damn.

Put it this way. Let's say fiscal policy has been looser this year, and we'd experienced the opposite shock, of stronger European growth. What would have happened?

Gilt yields would now be higher, mainly because stronger economic activity depresses demand for safe assets. That means higher government borrowing costs. But such costs would be a price of success, not a symptom of policy failure. And the extra borrowing generated by the looser policy could well be offset by lower borrowing arising from our stronger economy. It's unlikely markets would take fright at this; it's rare for western bond markets to suffer a serious loss of confidence when debt-GDP levels are lowish, the economy is growing and borrowing falling. And even if they did, the Chancellor could restore confidence by tightening now, against a background of a stronger economy.

My point is simple. The cost of a tight fiscal policy given an adverse demand shock from Europe is probably greater than the cost of a looser policy, given a positive shock. To the extent that this is the case, the fact that GDP has fallen this year because of the euro shock does not exonerate Osborne at all. It just shows that he failed to consider properly the high possibility of shocks.

* Actually, the fact that the OBR's forecast for domestic demand was right does not mean their belief in small multipliers is correct. It's quite possible the OBR assumed too small multipliers, but got their forecasts for domestic demand correct because they were overly optimistic about other things. 

Comments

[Metatone]

It's interesting how badly the OBR experiment has failed, in the sense that they couldn't find the independence to ever question Osbourne's assumptions.

[gastro george]

The clue to the OBR's "independence" is in the name ...

[Alex]

Well, the OBR has transitioned from being in the EFC/low output gap camp to being in the high output gap camp. But a major role of all these institutions is to provide a way to admit that facts are in some sense true, but also that the powerful are still right. Compare Leveson, Butler, Hutton.

Does anyone know if OBR has any offices, staff, or budget of its own now? Back in 2010 it consisted of Treasury secondees working out of offices in the Treasury, reporting to Dave Ramsden, the head of the Treasury forecasting division. And of course, it flexible-friended for Osborne literally as soon as it was set up. I think it's acquired some more substance since then, but it's still said to use a lot of Treasury civil servants.

[Luis Enrique]

off topic, I was listening to Robert Chote try to explain why economy was doing badly on Radio 4, and he did not once mention government fiscal policy (austerity). This is from somebody supposedly free of political interference.

[gastro george]

It's kind of ironic that the OBR website is at budgetresponsibility.independent.gov.uk - you would have thought they ought to have their own domain name ...

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