Osborne's idiotic idea

The FT reports that George Osborne wants to make unicorn farming compulsory:

The new fiscal mandate is expected to enshrine in law one area of common ground between the Tories and Lib Dems: that the cyclically adjusted current deficit should be eliminated by 2017-18.

This is imbecilic.

One problem is that the cyclically adjusted current deficit cannot be observed precisely. To calculate it, we must know how far away output is from its trend or potential level. But we cannot know this. As Paul Ormerod says, the idea of an output gap is just mumbo-jumbo. Comapnies don't know how much extra output they could squeeze out of their existing resources until they try to do so. And if companies can't know, nor can macroeconomists. In this sense, the idea of a structural or cyclically adjusted budget balance is a mythical concept. Targeting it is like unicorn farming.

Put it this way. Two years ago, the OBR expected (pdf) CPI inflation to be 2.2% at the end of 2014. It looks like being a full percentage point lower. What should we make of this undershoot?

One possibility is that there was more spare capacity in 2012 than the OBR thought, and this has pushed down inflation. This interpretation merely corrobates my claim that the output gap is unobservable and uncertain.

Another possibility is that inflation is low because of spare capacity in the world economy. But if this is the case, then perhaps the UK economy can continue to grow insofar as inflation won't choke off the recovery. If so, the UK's output gap is irrelevant.

Whichever it is, we shouldn't worry about the idea of a cyclically adjusted deficit.

Two other things make me think Osborne's idea is a daft one.

One arises from the basic national accounts identity that financial balances must sum to zero. The government can therefore only run a surplus if others are running a deficit.

But what if the ongoing Asian savings glut (evidenced for example by China's massive current account surplus) and balance sheet repair in the euro area cause the rest of the world to continue to run a financial surplus?* For the government to run a surplus would then require the domestic private sector to run a deficit. But as Richard says, this is far from certain. Latest figures show that business investment and mortgage approvals are falling, suggesting that households and firms are disinclined to go on the sort of spending spree that would take them into a financial deficit. If the government tries to cut spending when foreigners and the private sector want to run financial surpluses, the result can only be one thing - weaker economic activity.

My other gripe lies in the plan to eliminate the deficit by a given date.

The problem here is that recessions are pretty much wholly unforecastable. It's possible therefore that the economy could fall into recession then. If so, then a cyclically adjusted deficit would be wholly warranted in order to support demand. Legislating for a balance in 2017-18 thus tries to criminalize counter-cyclical policy. That's stupid.

Now, you might think that, in saying all this I'm merely being a Keynesian.

Wrong. In fact, I'm writing in a Hayekian spirit. Hayek famously and correctly argued that economic knowledge was inherently fragmentary and dispersed and so central agencies could not possibly know very much. I'm echoing him. I'm saying that the OBR cannot know enough about the productive potential of millions of firms to know what the output gap is. And it hasn't got enough knowledge of the future to predict recessions.

In presuming otherwise, Osborne is thus not only anti-Keynesian, but anti-Hayekian. I thus agree with Simon - that he is illiterate and plain dumb.   

* "The rest of the world's financial surplus" is just another name for the UK's current account deficit.

Comments

[Luis Enrique]

yep, I've been known to defend the concept of a cyclically adjusted deficit* but it's hard to argue with any of this. Sheer idiocy, let's hope he's underestimated voters. I fear he may not have done.

* because I think it just amounts to asking the question: what do we think the public finances will look like once things get back to normal, if policy stays as it is?

[SubtleBlade]

could we please have 'stupid' instead of'dumb'. Unfortunately the walking vacuum can actually speak.

Otherwise, spot on.

[Magnus Carlsen]

Luis is right. You can't have your 'spare capacity' cake without eating a (negative) output gap. At least conceptually.

But indeed meaningful contemporaneous measurement is not possible.

Basically Osborne doesn't give two hoots about the structurally adjusted deficit. He co-opts these words to attain credibility with 'mediamacro' and raise the issue salience of debt reduction. We know what his real agenda is.

[Keith]

At the risk of being boringly repetitive, is not the Tory party now a cult believing in irrational ideas immune from reality?

And what happened to the Lib Dems? The SDP partners have lost all social democratic credibility.

As an American judge famously asked in another context; are you on crack?

[rogerh]

The old poison pill defence. If you look like losing the election then implement the law and poison the well.

[Simon Reynolds]

As you say, Chris: "One problem is that the cyclically adjusted current deficit cannot be observed precisely. To calculate it, we must know how far away output is from its trend or potential level."

But surely, even if we think we know how far away output is from its potential level, the uncertainty in the measure of any structural deficit based on an output gap estimate is much greater than any uncertainty in the output gap estimate itself.

If forecast income is 97 and forecast expenditure is 100, then the forecast "deficit" is 3.

But, if actual income is 96 and actual expenditure is 100, then the "real" deficit is 4 -- that is, the "real" deficit is 33% higher than forecast, given just a 1% error in income forecast.

The difference between two large numbers varies vastly more than any variation in either or both of those two numbers.

Osborne's idea is definitely a daft one.

It is daft to base policy on the forecast difference between two (uncertain) large numbers.

[Colinrtalbot]

Excellent piece Chris.

The thing is tho, this - Osborne and Alexander's daft plan - has nothing to do with economics and everything to do with politics. It's about supposedly boxing in Labour and exposing their supposed lack of fiscal responsibility for not agreeing to a "balanced budget" bill.

I doubt they take this very seriously themselves as actual policy - Osborne has been happy to do a bit of ducking and diving over the past 4.5 years whilst all the while pretending to be sticking to his "long term economic plan" (a unicorn if there was one).
Prof. colin Talbot

[George Carty]

As I see it, George Osborne is completely obsessed with the wrong deficit.

We can't get the budget deficit down without getting the CURRENT ACCOUNT deficit down. Are our current economic ills an argument that should prevent Germany and the East Asian countries running a trade surplus against us by leaving the EU and heavily taxing (if not outlawing outright) imports from those countries?