The A, B, C of fiscal policy

You wouldn't guess from his performance yesterday, or from most of the mediamacro coverage of it, but there's one big fact about Osborne's Autumn Statement: it confirmed that austerity has failed in its own terms. Back in 2010, the OBR forecast that PSNB in 2014-15 would be just £37bn. It now expects it to be almost £84bn. Taking the last five years together, Osborne has borrowed £96.6bn more than he expected to in June 2010*.

To see why this should be, forget the fancy macroeconomics and think about a simple story.

Imagine there are only three people in the world: Adam, Bill and Charlie. They all buy and sell stuff from each other, but Adam's spending exceeds his income and so he's borrowing from Bill. Bill, in other words, is saving with Adam. Then, one morning Adam wakes up and decides to stop living beyond his means and so cuts the amount he spends with Bill by an amount equal to what he is borrowing. What happens?

There are three alternative categories of possibility.

In scenario one, Bill simply accepts his drop in income and stops saving. Adam has therefore succeeded in eliminating his borrowing.

In scenario two, Charlie is happy that Adam has reduced his spending and borrowing. He had been thinking of buying a new car. But because Bill was lending so much to Adam, he couldn't lend to Charlie. Now that Bill isn't lending to Adam, he can do so. And because Bill was working so much to provide Adam with stuff, he couldn't supply the parts for the car that Charlie wanted. Now that he's not working so much for Adam, he can supply Charlie. In this scenario, Adam's spending cut has unleashed new borrowing and higher spending by Charlie. And because some of Charlie's extra spending finds its way to Adam, Adam sees his income rise and his borrowing fall even more than he planned.

In scenario three, however, things are grimmer. Bill wants to continue to save - perhaps because he needs to prepare for his old age, or perhaps because he's frightened that Charlie will stop spending too. In this case, Bill reacts to Adam's spending cut by reducing his spending with Adam and Charlie. He thus continues to save and Adam and Charlie are also worse off. And because Adam's income has fallen, he continues to borrow.

It shouldn't take any imagination to translate these scenarios to the real world. Scenario one corresponds to a simple case where the Keynesian mulitiplier in one: total incomes fall by the amount of Adam's spending cut. Scenario two is expansionary fiscal contraction. Scenario three is one in which there are big Keynesian multipliers.

There are two points to this tale.

Point one is that one individual can only successfully reduce his borrowing if others want to reduce their saving or increase their borrowing. In scenario one Bill wanted to save less and in scenario two Charlie wanted to borrow more. In both, Adam was able to reduce his borrowing successfully. But in scenario three, Bill wanted to keep saving and so Adam couldn't reduce his borrowing. All that happened was that incomes fell. This tells us that the government is not in control of its finances. It can only borrow less if someone wants to lend less.

Point two is that in setting real-world fiscal policy, the government must asK: which of these three scenarios is most relevant to current circumstances? They've all been true at some time or other.

Herein lies why Osborne failed. Scenario three best describes the 2010-15 world. Foreigners have wanted to continue to save: to clean up balance sheets in the euro area, because oil exporters couldn't reinvest their windfalls domestically; and because Asian economies wanted to run current account surpluses. This meant that someone in the UK had to borrow. Because the private sector didn't want to, the public sector did.

The question for the next five years is: which of these three scenarios will apply? If UK businesses really do want to invest as much as the OBR expects, or if the euro area's balance sheet repair is almost over, we might be in scenarios one or two.

If so, then Osborne's planned austerity might just work better than his actual austerity.

Personally, though, I'm way of this. I think his fiscal plans are like Twisty the Clown: scary, but fictitious.     

* Strictly speaking, the figures aren't wholly comparable, as the out-turns use the new national accounting methods. But this doesn't make much difference.

Comments

[cjcjc]

I'm being a bit thick, but has there therefore been "austerity" or not?

[Seb]

Could you add monetary and policy and the zero lower bound in please.

[paulc156]

cjcjc: "I'm being a bit thick, but has there therefore been "austerity" or not?"

Just less than intended: https://thenextrecession.files.wordpress.com/2014/12/austerity.png

[Luis Enrique]

This is the sort of thing that got me interested in economics in the first place - it's insightful, and important. Much as everybody loves to beat up economists, this post wouldn't likely not have been written by anybody else.

cjcjc I'd say you must distinguish between instrument and outcome. I'd reserve word austerity to refer to an instrument: the decision to tackle a deficit by cutting departmental spending. If that happened, austerity happened. If you then find tax receipts fall and welfare bills rise, and your deficit stays high, that's your outcome. This is why it makes sense to say austerity failed because the deficit did not fall.

[Rhys]

One thing I don't understand, if he has got it so wrong over the last 5 years consistently borrowing more than forecast, why should anyone believe his new forecasts?

[chris]

@ Luis - thanks
@ Seb - monetary policy and the ZLB are implicit in my stories.
One way to motivate scenario 2 is that the cut in Adam's borrowing reduces interest rates and (say) Charlie's spending is very interest-sensitive.
In scenario 3 maybe there is an interest rate so negative as to induce Charlie to borrow. But if we can't get to it because of the ZLB, he'll not borrow.
@ Rhys - there's tons of scepticism among City economists about his forecasts: many agree with Rick that his spending plans are unrealistic.

[Luke]

I'll second what Luis said. And also thanks to Luis for the outcome/instrument point. I was confused by austerity combined with higher borrowing.

[theOnlySanePersonOnPlanetEarth]

I take the polar opposite opinion to Luis, it is shit like this that makes me think economics is simply another form of masturbation.

Anyhow, they all buy and sell stuff from one another? They clearly also borrow from each other?

Where is Charlie in Scenario 1? On holiday? Why didn’t Charlie ask why Bill was lending to Adam but not him? And why is Bill the only lender? Are the other workshy in relation to Bill? Or does Bill produce things that take less time but fetch the same price? On that note, how are prices determined in this world? Does everything sell at its value? Are prices always stable no matter what?

Still in scenario 1, where does Bill get the power to decide whether Adam can spend more or less? Can’t Adam just say, I am spending less, tough shit Bill. Bill may reply, at least I can spend more time playing solitaire now I don’t have to produce the extra stuff for you. What is Bill doing with the extra income he gets from Adam? Clearly he is not buying more from either Adam or Charlie, is he?

I can’t be arsed with the other 2 scenarios.

And 3 possible scenarios? Yeah, whatever you say pal.

[Ben]

Surely the problem is that 3 people have a maximum output. So they start working. But one pulls forward demand artificially inflating the price of items through debt. So GDP is artificially high.

When the borrowing stops the money supply drops as we are no longer inflating prices with debt.

Then some economist comes along and says we are in recession because GDP has dropped.

Debt is asymmetric. The problem occurs *after* the thing that caused the problem. The two appear distinct. Like herpes.

If you don't want "incomes" to fall then don't pull them forward.

If you think output was up just because someone inflated prices by pulling their income forward then wow.

It doesn't take much imagination to apply the above to 2003.

[Luis Enrique]

this post explains very clearly how a decision to cut borrowing and spending by one party can lead different outcomes, each consistent with fundamental adding up constraints, depending on other savers/borrowers/spenders react.

it doesn't matter what Charlie was doing in case 1, or why Bill is only lender etc. the point holds.

There is a particular stripe of stupid-clever that sees a simple parable and immediately starts trying to pick holes, thereby failing to learn what the parable has to teach us.

There is something fundamental about economics here - when I started learning economics, I was forever saying but what about this, what about that. Later I realised that whilst it is vital to always be asking what the model may be missing and how conclusions would differ in different cases, you also need to take what is there to be taken from each case. Then you learn something. I reckon a hostility towards and misunderstanding of this form of reasoning explains a lot of the criticisms of economics.

here is a pretty weighty paper explaining case based reasoning

http://economics.sas.upenn.edu/pier/working-paper/2013/economic-models-analogies-third-version

here is an example of a critic of economics completely missing the point of what an economic model is for:

http://unlearningeconomics.wordpress.com/2014/04/10/how-not-to-do-macroeconomics/

here is another classic of that genre:

https://fixingtheeconomists.wordpress.com/2014/08/01/the-information-asymmetry-paradigm-is-vacuous/

[Ben]

I disagree. If we have a money supply of $100 divided amongst 5 people and ManA writes another zero on the end (which is allowed in our example as we also have realistic regulators who forgot to forbid this).

I'm not going to then have a conversation with you about why GDP hasn't gone up 100% again this week like last week. Nor am I going to suggest we should all get into the profession of ManA because he has over half the money supply no matter how unacceptable his path is.

It does matter how we got there.

[Ben]

Missed a bit - should read "another zero on the end of his share, $20. Anyhow you get the idea.

[gastro george]

@Ben Re your first post, a couple of points. Of course any sensible person would always look at inflation-adjusted GDP. And debt doesn't necessarily cause a rise in prices, as you might notice if you look around.

[Ben]

Debt does if it's available on a subset of items. For example: housing. But we are told this isn't part of the inflation figures.

And that's the beauty of it.

So we have a bullshit world 2000-2008 where we are told growth is real, no need to adjust for inflation in spite of a huge spike in the money supply by printing through housing.

Then the taps go off as we hit the wall.

The economists sit around talking about everything relative to 2007 which was of course simply pulling forward demand that didn't show up in inflation figures.

As my wife said to me today: how come women are now all working and we are worse off. The answer? It's all soaked up by housing costs. All references by the establishment to prices are made now as "multiple of household income" instead of "primary income".

With this last point and the non-inclusion of housing prices in inflation figures it's passed the whole of economics by.

[Ben]

So if it does matter how we got here, and that's how we got here (housing) then I'm calling the original example a pile of rubbish because it's pulling forward demand for growth that hasn't come (for a variety of reasons such as mature economies, mis-allocation of resources into finance etc).

The growth wasn't real so you can't work back from now to 2007 and wonder why we are doing so badly.

2003-2008 was an attempt by the west to fake growth as they got desperate. It was a confirmation that our economies were struggling as demographics shifted.

We pulled forward more than we were going to grow. Now we should make the boomers+ take a haircut on housing and pensions to fix that.

[gastro george]

@Ben I won't disagree with you about the existence of a housing bubble, and inflation will obviously be caused by the short-supply of housing. I was speaking more generically.

I also think that I share with you a concern for the housing market in the future. It's been notable that, with each crisis in the neo-classical/neo-liberal era, it's been necessary to reduce interest rates further, until they can now go no lower. One way of maintaining demand in the economy is to cheapen debt and, as you say, to bring purchases forward from the future. It's also notable that Osborne is forecasting personal debt to ride. That is unsustainable, and will only end in tears.

[Ben]

Gastro - it's *the* main component of the UK economy yet it's just hand-waved away by economists.

Where would the UK "economy" be without tripling (nominal) during the Blair years? In GDP terms worse but in reality far better.

The terms of the debate deliberately mis-represent. GDP is hopelessly misleading. The inflation figures are totally wrong from housing price inflation to shrinkflation to inclusion of electronics.

The entire debate around inflation totally wrong - the first thing any armchair economist trots out is deflation delays purchases.

None of the example on this page captures the printing-via-debt-via-houses then including it as "growth" then not having the growth. None of it captures the change in the support ratio and the effect on asset prices.

[Luis Enrique]

for interested readers, here are the 400 odd papers that ignore, sorry, cite an great paper by Ed Leamer, with the title "The business cycle IS the housing cycle"

http://scholar.google.co.uk/scholar?cites=9511130799026544947&as_sdt=2005&sciodt=0,5&hl=en

here's the Leamer paper
http://www.nber.org/papers/w13428

[Ben]

My favourite economics joke (not that one hears many), not telling it perfectly but whatever:

A farmer and two bankers are shipwrecked on an island. Two weeks later help finally arrives. The bankers greet their rescuer who remarks how well they look.

BankerA: "we realised the potential of the natural resources on this island were tremendous".

BankerB: "I created some fiat money, we divided it up. I lent BankerA ten times my share for a coconut farm startup, he invested ten times his share in an accountancy startup."

Rescuer: "well that's amazing, only where is it all, I don't see any produce - how did you actually survive?"

BankerA: "oh and we ate the farmer"

I like it because it illustrates how credit is created from nothing and then lent on an asset that is then worth that much because credit was created and extended on it. Both ways. Nothing achieved, looks good on paper and they ate the one guy who could have done some real work. Not perfect but rings true enough...

[Ben]

Nobody is saying some aren't Luis, we can all google away for whatever. It simply seeks to drown the other side in data. Easily done on the internet.

Fact is in the UK house price inflation is deliberately excluded from inflation figures to allow them to print through that channel without it showing up. Then all debate sticks slavishly to GDP which is inflation adjusted. Job done.

We are way poorer. Both parents working, all for the price of land.

The example in this blog post got nowhere near touching on these dynamics.

[Luis Enrique]

Ben

yes. This blog post does not touch on these dynamics, because it's about something else. You are criticising an apple for not being an orange.

yes we can all google - if you had, you might not have written housing is hand-waved away by economists. I wouldn't mind betting that a large majority of economists would say the housing market is very important to the UK economy, how monetary policy works etc.

plus I like that Leamer paper, and figured some of Chris' readers might too

[Ben]

I think it is very much related to the item because that wally in the example is pulling forward demand for growth that isn't coming.

The context was public borrowing suppressing demand. In the UK we've seen demand pick up (slightly) because Osborne started printing via housing again with help2buy. But all we hear is that govt spending was cut (a bit).

But of course it's not inflationary because it's not in the figures, plus the house is now "worth" $NNN because someone just lent them that much for it. And as prices are set at the margins every else's house is worth more. And so they re-mortgage. The multiplier effect is huge.

House price printing is never on the radar but it sets the beat.

Round and round we go with all productivity soaked up by land prices as sure as eggs are eggs. It's impoverishing us. The whole system is broken and economists are failing us.

[Ralph Musgrave]

Just one minor criticism of Chris’s article: it’s where he says “This meant that someone in the UK had to borrow. Because the private sector didn't want to, the public sector did.”

Actually, given a desire by the private sector to save more, there is no need to supply it with INTEREST YIELDING assets of any sort. That is, the private sector can be supplied with base money, i.e. central bank created money. And that normally yields no interest.

My point ties up with something Keynes said in the 1930s, namely that given a recession, government should spend more borrowed money or printed money. Personally I don’t see the point in the state borrowing money when it can print the stuff.

[cjcjc]

Thanks for the replies to my dumb question.

Nonetheless the deficit has fallen, though obviously not as much as promised.

Has anyone estimated what the deficit would have been without the cuts?

[Anders]

@Ben "UK house price inflation is deliberately excluded from inflation figures"

"Inflation" in the UK has been conceived as accelerating retail or consumer prices. CPI (without mortgage interest payments) and RPI (with) are both reported. This isn't some conspiracy since the housing bubble began in the 1980s. You can extend the term "inflation" to cover house prices if you like, but that isn't what "inflation" actually means.

"a huge spike in the money supply by printing through housing"

But why do you refer to the housing bubble as "printing"? This was a private sector monetary expansion - ie inside money; "printing" refers to an expansion in the monetary base. I do agree with you that housing costs are a problem, but I'm struggling to follow where you see agency in the housing market.

[Pension60]

Economists who gave us austerity just gave us killing off the poor of all ages as somehow solving economic woes, when all it does is making a naiton more in debt for as long as austerity is undertaken.

The ring fenced National Insurance Fund, not needing a top from tax for decades, is being morally stolen from people who only have the state pension as food and fuel money, even if stay in work, and disabled / chronic sick unable to work and losing benefit more and more, no other income or a tiny works pension not even 4 per cent lowest income level.
https://you.38degrees.org.uk/petitions/state-pension-at-60-now

As the poor are misrepresented, libelled and slandered by people who never known who the poor really are, then austerity kills.

And for all that, the nation's national debt rises.

The Greens would have paid off national debt and solved poverty and hunger but not widely advertising their 2015 manifesto pledges of:

- Replacing all benefit and so ending needing of the billions spent on benefits admin with:

- universal, automatic Citizen Income, non-withdrawable
to the level of the basic tax allowance

- Full State Pension to all citizens, irregardless of National Insurance contribution / credit history, mostly lost due to benefit rule changes and early retirement to mostly low waged under the massive austerity job cuts.

[Ben]

M0 to M2, whatever. When I say printing I don't mean physical notes. It is an expansion of M2 that bears no relation to fundamentals because there is no constraint on bank lending (other than demand).

The price of homes (rent/mortgages take up nearly 1/2 of wages) has rocketed way above wages. It's made working pointless. It's inflationary which is a hidden tax, mostly on workers as they can't afford assets.

[Anders]

@Ben

"When I say printing I don't mean physical notes"

I know; when Bernanke says printing he doesn't mean notes either - he means an increase in central bank reserve balances.

"[the housing-driven credit expansion of 2000-8 was] an expansion of M2 that bears no relation to fundamentals because there is no constraint on bank lending (other than demand"

Since when should an increase in the money supply be related to fundamentals? I didn't think anyone wanted to put caps on bank lending; wow.

What are fundamentals, in your sense, anyway? Should money / NGDP be fixed - and if so, how?

[Ben]

Anders - I guess you missed all the outrage over fiat. I want to put a cap on bank lending, they are controlling our lives by ramping asset prices which are set nearly exclusively by the ability to borrow. I guess I'd sooner see LVT limit the propensity to borrow to speculate.

Either way it needs fixing as it's *the* issue of our time.

Life for the young is made very hard due to high house prices.

[gastro george]

@Ben I understand your concerns, but you need to be more precise in your terminology. For example, IIUC, fiat is nothing to do with commercial bank lending. Sterling could be gold-backed but that wouldn't necessarily stop banks from "creating money". You're confusing apples and oranges.

[Anders]

Gastro - Ben sounds like a full reserve banking aficionado.

Ben - no one here would say that housing isn't an issue. But abusing terms - referring to house price growth as "inflation" and referring to normal bank lending as "printing" (as if it's done by the govt or central bank) - you are going to struggle to get your point across.

[Ben]

Hell I think house price "growth" should be counted into inflation. It has a huge impact on GDP. The whole debate is hamstrung by stuff like this by design. Disaster for the UK youth.

[Luis Enrique]

Ben
"has a huge impact on GDP" are you talking about nominal or real GDP? Sure, there are arguments for including asset prices in inflation, personally I see no reason not to look at various measures.