For a delayed fiscal tightening

Our perceptions of the economy are shaped not just by current reality but also by the past. For example, Ulrike Malmendier and Stefan Nagel have shown (pdf) that people who experienced recessions in their formative years are more risk-averse than others even decades later; workers in the 1950s accepted low wage rises despite a tight labour market because they were cowed by memories of the Great Depression; and I struggled to believe that inflation could stay low in the 90s because my views were shaped by memories of the high inflation of the 1970s.

I suspect a similar motive lies behind the notion that the government must reduce its borrowing soon. Such a view makes sense if you think highish real interest rates are normal – as they were in our formative years. But it’s not so sensible when rates are negative.

20 year index-linked gilt yields are now minus 1.6 per cent. This means that if the government borrows £100 now it will have to repay only £72 in real terms. Which of course means that debt can shrink even if the government runs a deficit today. The maths of debt sustainability tells us that we can stabilize the current ratio of government debt to GDP even if the government runs a primary deficit (borrowing excluding interest payments) of around 2.9% of GDP. Its deficit this year will be only 1.1%, according to the OBR.

Richard Murphy is therefore right: there is no need for the government to balance its budget and no need for the forthcoming austerity described by the IFS.

Two counter-arguments to this won’t do.

One is that I’ve assumed gilts yields stay low, which they mightn’t do.

True, yields could rise – as the IFS says. But the government has to a large extent locked in lowish rates because it has borrowed long; the average maturity of government debt is 18 years. This means higher yields won’t immediately gravely raise debt interest payments. Also, yields are most likely to rise if the global economy proves stronger than expected. But the same stronger activity that raises yields would quite probably also raise tax revenues.

A second argument is that higher government borrowing would raise inflation by strengthening the economy. This, though, is a feature not a bug. We want to get interest rates away from their zero bound, so that conventional monetary policy can act as a cushion when the next downturn comes. Higher inflation is a way to achieve this. There is a strongish case for the macroeconomic policy mix shifting to looser fiscal and tighter monetary policy.

None of this is to say that fiscal policy should never tighten. It should, when real interest rates are at more “normal” levels. When this is the case, there’ll be a case for budget surpluses both to stabilize the debt-GDP ratio and to prevent a tightening of monetary policy that pushes rates very high.

Obviously, we are not yet at this stage. Fiscal tightening should thus be delayed.

Such a delay should be used wisely. We should regard it as a chance to better organize the public finances – to ask what sort of tax base we want; what should be the mix of tax rises and spending cuts; and how to find genuine efficiency savings in the public sector – a question which of course requires a knowledge of ground truth which only workers themselves can provide. If such a debate helps to legitimate austerity, it would also help make it more credible and sustainable.

If we had an intelligent politics – which is a big if – a delayed fiscal tightening would be a better tightening.

Comments

[Bob]

"None of this is to say that fiscal policy should never tighten. It should, when real interest rates are at more “normal” levels."

Or you just leave interest rates at zero and tighten bank lending on the asset side (loans that do not meet criteria for public purpose become a gift.) Adjusting via interest rates is silly and positive interest rates is giving away free money to rich people.

The mainstream is basically saying, control demand through interest rates and try to manage public debt-servicing requirements through fiscal policy.

This amounts to saying, government should try to boost demand (i.e. total spending) by doing anything other than actually spend. And it should try to minimize any inflation risk associated with the interest owed on public debt by means other than tailoring interest-rate settings to that purpose.

Functional finance is a “radical” reversal of this logic.

It amounts to saying, the surest way to boost demand (spending) is for government actually to spend. And the best way to ensure that interest payments on public debt pose no inflation risk is through the appropriate setting of interest rates.

[Bob]

"so that conventional monetary policy can act as a cushion when the next downturn comes."

Why not boost the auto stabilisers?

[Ralph Musgrave]

“We want to get interest rates away from their zero bound..” says Chris. Where does he get that idea from? Ideally interest rates should be at their free market level. At least it’s widely accepted in economics that prices (including the price of borrowed money) should be at free market levels, except where the free market has clearly gone wrong (“market failure” as it is called by economists).

An obvious and flawed objection to the latter point is that the mere fact of a recession or excess unemployment is evidence that interest rate declines have not gone far enough. In fact there is no obvious obstruction to interest rates falling in a recession. In contrast, there is a very obvious obstruction to the market’s other (and I would suggest main) cure for recessions, namely the Pigou effect. (That’s the fact that given a recession in a perfectly free market, wages and prices would fall, which raises the real value of money, which in turn encourages spending. The obstruction is Keynes’s “sticky downwards” phenomenon: the fact that it is plain impossible to cut wages at least in unionised sectors.

In short, interest rate adjustments are daft: the best cure for a recession (as advocated by MMTers and Positive Money) is simply to create new base money and spend it, and/or cut taxes, while leaving interest rates to market forces.

[aragon]

Jeremy Corbyns pick as a replacement (apparently) Rebecca Long-Bailey supports budget surpluses, but could not name a country that runs a budget surplus when asked on the Daily Politics.

Another thirty years of Austerity!

Budget surpluses are followed by recessions.

Inflation risk comes from zero bound interest rates, as there is no cost to borrowing for speculation.

Please don't mention the Philips Curve.

When will the madness end?