The persistence of fiscal stupidity

Stupidity lives. This is the message of yesterday’s Spring Statement. Philip Hammond said:

If, in the Autumn, the public finances continue to reflect the improvements that today’s report hints at then, in accordance with our balanced approach, and using the flexibility provided by the fiscal rules I would have capacity to enable further increases in public spending and investment in the years ahead.

You shouldn’t need me to tell you this is daft. Government spending should not be constrained by the state of the public finances.

You don’t need to believe in MMT to see this. Bog-standard orthodox economics tells us the same. For one thing, when real interest rates are negative – as they have been since 2011 – governments can borrow a lot and still see its debt-GDP ratio fall over time. And for another, when interest rates are at rock-bottom, governments should relax fiscal policy to raise interest rates to give the Bank of England room for conventional monetary policy to work when the next slowdown hits.

Instead, the constraint upon government spending is inflation. If the government employs enough people, or raises their wages or spends enough on goods such as building materials, wages and prices will rise and that will push up interest and squeeze private spending.

It’s in this context that delaying public spending increases until the public finances improve is counter-productive. The best time to spend is when the public finances are poor because that is when the economy is depressed and inflation therefore not a problem. If you wait until government borrowing falls, you are more likely to increase spending when the economy is doing well and when capacity constraints are emerging. That’s when public spending is potentially inflationary.

Now, it’s unclear whether this is an argument against higher public spending soon. It might be that the very idea of aggregate spare capacity is mistaken, or perhaps capacity constraints (especially in a small open economy) don’t lead to much additional inflation. And there might well be a case for shifting the policy mix towards looser fiscal and tighter monetary policy. 

What is very clear, though, is that the case for increases in public spending was greater a few years ago than it will be next year, unless we get a major surprise.

If the fiscal stance is determined by the state of the public finances, we’ll get exactly the wrong policy – too much tightness when the economy is slack, and too much looseness in a boom.

Government finances are not like household finances, simply because public spending is so big that it affects the rest of the economy – something which is not true of households.

This, of course, should be known by any first-year student. Hammond, however, went out of his way to explicitly state his error:

That is how responsible people Budget. First you work out what you can afford. Then you decide what your priorities are. And then you allocate between them.

That may be true for a household. But it’s plain false for a sensible government.

My story here, though, is not about economics: all this should be too obvious to need saying.

Instead, it’s about politics. The persistence of the household fallacy shows that wrong ideas are not driven out of public life and debate doesn’t raise the quality of policy. Quite the opposite. As long as they hurt the poor whilst cossetting the rich, governments can get away with anything.

Comments

[TickyW]

For those who know very little about economics, i.e., most of the population, Hammond's household fallacy resonates though, and voters are likely to vote for it.

[Blissex]

«the constraint upon government spending is inflation»

Even "inflation", whatever that is, may not be a constraint, if the losers from "inflation" cannot form a political majority and elect a different government. The real constraint is the balance of trade, because the government cannot force foreign suppliers to accept payment in a depreciating currency -- foreign suppliers demand to be paid in "hard" currencies.

As to "inflation", clever Economists define it in such a way that it effectively means the cost labour to business and property owners. For most people it is instead their cost of living, and a large part of it is the cost of housing.
Because the tories, whether New Labour or Conservatives, have been running a fantastically loose debt policy with a tight fiscal policy, housing cost inflation in the parts of the country where the jobs have been concentrated has been very, very high, hitting the living standards of workers quite badly.

But since workers have not been able to elect a pro-worker government, the "inflation" constraint has been inoperative, because those whom "inflation" enriches are in government.

This will end when either foreigners will stop financing the big trade deficit or when workers manage to elect a government that is against housing "inflation".

[Schofield]

"For those who know very little about economics, i.e., most of the population, Hammond's household fallacy resonates though, and voters are likely to vote for it." All the more reason there should be an economic and monetary system literacy test before you're allowed to vote!

[Jim]

Is there any point in the last 30 years where you reckon, given hindsight, that the UK should have been running a budget surplus, or a balanced budget? Or is this just one of those 'More government spending regardless' rants?

[J. Edgar Mihelic]

I'm having fun mapping out the UK's indifference curves in my mind.

[chris]

@ Jim - not at all. Maybe policy was too loose in the early-mid 90s.
And this is not about the size of govt. I'm more sympathetic to the idea we should shrink the state than I am to austerity.

[Dipper]

This is an example of The Second Crisis of Management. This is when you are in charge of someone and you have absolutely no idea what they are doing, (e.g. a marketing manager in charge of scientists).

Under those circumstances you have two options; get someone else with specific knowledge and who you trust o make the decision for you as to whether they are any good; or else use your own instincts to judge the risk-reward.

Unsurprisingly, when given the choice between people who say "we're going to print lots of money and give it to people; don''t worry, this is all going to work just fine" and people who say" we will live within our means" lots of people will go for the person who says we will Iive within our means.

The first crisis of management? That's for another time.

[Blissex]

«given hindsight, that the UK should have been running a budget surplus, or a balanced budget?»

Well, that's a bit of a trick question, because many Economists are really keen to pretend that the extremely expansive monetary policy of the past 30 years can be entirely ignored, or that it is entirely independent of fiscal policy.

But asking about a "budget surplus, or a balanced budget" really makes no sense by itself, what matters is the overall stance and purpose and effects (including on the balance of trade) of economic policy as a whole, as pithily summarised by G Osborne (usual quotes):

«A credible fiscal plan allows you to have a looser monetary policy than would otherwise be the case. My approach is to be fiscally conservative but monetarily active.»
«“Hopefully we will get a little housing boom and everyone will be happy as property values go up”»

[Jim]

"I'm more sympathetic to the idea we should shrink the state than I am to austerity."

And how exactly do you shrink the State while spending more money?

[JW]

But the left-wing never tells that story, of how and when they *won't* spend more and what the limits to its spending actually are. So it looks like there is no theoretical limit to what they will spend in any circumstances. When they explain that story - and stick to it - then the household fallacy might fall. Just saying "the government budget isn't like a household budget you know" doesn't really help that much.

[Noah Carl]

"For one thing, when real interest rates are negative – as they have been since 2011 – governments can borrow a lot and still see its debt-GDP ratio fall over time."

Surely one of the reasons why interest rates are low is that the government has committed to reducing the deficit?

When it was revealed that there were "severe irregularities" in Greek accounting procedures, and the deficit was a lot higher than people had realised, interest rates went through the roof.

[reason]

"And there might well be a case for shifting the policy mix towards looser fiscal and tighter monetary policy. "

WOW! Somebody gets it. That was the big mistake, thinking that encouraging more private debt was the best to way towards sustainable development. It seems almost nobody understood "Between Debt and the Devil". What a waste. Maybe it will be discovered in 10 years.

[reason]

"Is there any point in the last 30 years where you reckon, given hindsight, that the UK should have been running a budget surplus,"

Actually the standard is not a balanced budget - the standard is the rate of growth. We want the money supply to grow but not the private debt/GDP ratio.

[reason]

"And this is not about the size of govt. I'm more sympathetic to the idea we should shrink the state than I am to austerity."

Isn't the real question what does "the size of govt." actually mean. Do you count tranfers as part of the "size of govt." or only the resources actually used by government. I'm of the view that redistribution is not only desirable but also necessarily.

[Ralph Musgrave]

Nice article, except that Chris says “…when interest rates are at rock-bottom, governments should relax fiscal policy to raise interest rates to give the Bank of England room for conventional monetary policy to work when the next slowdown hits.”

That amounts to saying “Interest rates should be artificially raised, with every mortgagor paying more interest on their debt than they need, just so that the BoE can cut rates come the next recession.”

Given that any amount of stimulus can be imparted simply by having the BoE and government print money and spend it (and/or cut taxes), why bother with artificially high interest rates?

Warren Mosler (founder of MMT) and Milton Friedman advocated a permanent zero rate on government debt: i.e. they argued that governments should pay no interest to anyone on their liabilities. I think M&F were right.

[Blissex]

«It might be that the very idea of aggregate spare capacity is mistaken»

Unlikely, but the pre-neoliberal idea was that there are two very different cases: a "general glut" and a "partial glut" with very different capacity constraints and policies.

«or perhaps capacity constraints especially in a small open economy) don’t lead to much additional inflation.»

Well, for example the capacity constraints (with respect to job opportunities) of housing in the south-east and London have resulted in galloping inflation, and vice-versa excess capacity with respect to job opportunities) of housing in other region has resulted in significant deflation.
Similarly for the inflation (or deflation) of the cost of labour where affected by entry of women or northeners or foreigners in the southern labour force.

Again the distinction between "global glut" and "partial glut" (sectoral or geographical) matters a great deal.

[Blissex]

«distinction between "global glut"»

Correction: the more correct technical term is "general glut", as used previously.
As to that, how many of those reading this have ever seen mentioned the difference between "general glut" and "partial glut" and how critical it is to both classical, neoclassical and JM Keynes' theories of the political economy? And in recent times?

[Keith]

The quote from Osbourne of course implies without directly saying so that his aim to "rebalance the economy", was a fraud all along. Increasing house price inflation and raising share values, by massive QE, means increasing consumption by the well off and more imports. So no rebalancing towards production or investment. Hardly a new policy for the UK, just a continuation of the policies which junked the manufacturing and industrial sectors.

I note our tory trolls provide no actual reasons as to why your claims about the fiscal stance are mistaken. More economics education is certainly a good idea methinks....

[reason]

Something must be wrong with my reading comprehension. I find that I (almost) agree with Ralph Musgrave. (My guess is that we should be running higher real interest rates to discourage private debt and that printing money might also have the effect of increasing nominal interest rates via inflationary expectations. But of course, if we are no longer so dependent on monetary policy for cyclical stabilization, yes we don't need to keep the "ammunition dry".)

[Robert Mitchell]

"That is how responsible people Budget. First you work out what you can afford. Then you decide what your priorities are. And then you allocate between them."

Janet Yellen recently interviewed on CSPAN told a story of a private equity firm drawing up their dream financing plan, fully hedged against market or economy downturns, and presenting it to a bank with no expectation of acceptance. But the bank was eager to expand its balance sheet so the PE firm got its self-funding perfectly hedged initial loan.

The point being, finance firms don't behave like households. They create trillions in credit that exchanges near par for central bank issued money.

[Robert Mitchell]

@ Dipper

"when given the choice between people who say "we're going to print lots of money and give it to people; don''t worry, this is all going to work just fine" and people who say" we will live within our means" lots of people will go for the person who says we will Iive within our means."

Point out that the people creating money as credit in the private sector get to define their own extravagant means. They also claim divine right to impose arbitrary scarcity on access to vast persistent surplus, by telling fables about money running out.

Their myths cherry-pick stories about temporary scarcities (oil), and ignore vast overproduction which is by far the norm. Private finance manufactures money on demand for their friends, who pay extractors to be ruthless. Instead of recycling, market pressures favor new extraction and more environmental disruption. Scarcity of money, because ideology, should not be accepted as a valid excuse not to fund a basic income, say.

[JW]

@Robert Mitchell,

Your post defines the problem perfectly. Here you seem to want people to think of creating credit in the private sector as a bad thing but then say that it would be fine for governments to do it. It also does not specify any limits at all for what that creation of credit should be.

You need to have a better story, explain your policy idea better.

[Robert Mitchell]

@ JW

I say let bankers be bankers. Expose their willful, wanton money creation explicitly, then ask: why can't we use the same tool of money creation to fund a basic income at no taxpayer cost?

[JW]

Why would we want to if it is wilful and wanton? Is there a downside to doing this, or not? Is there a limit to how high the basic income should be, and if so, what is it?

[Robert Mitchell]

@ JW

My story says that bankers will be willful and wanton with money creation because it is in their nature. Any regulations will only reinforce their will to get around them. In my story, there is a double standard between public money creation to support bank-created credit (allowable), and public money creation to support individuals in their daily financial crises (inflationary and therefore unacceptable).

Inflation is often cited as the downside to public money creation, but the private sector has shown us that the money supply rises much faster than inflation. (I took a screenshot of a St. Louis Fed graph showing that M2 has risen 5 times faster than CPI since 1959: http://subbot.org/coursera/money2/m2_vs_cpi_index.png .) The private sector deals with inflation by creating money much faster than prices rise.

We can enact public policies to implement an explicit indexation scheme: raise everyone's incomes as prices rise, thus maintaining real income purchasing power. Inflation's unwanted effects are therefore neutralized. (Israel used indexation successfully for decades; if they had the technology we have today, they would not have had to abandon it in the early 1980s.)

I would set basic income at the average income level for the country in question.

The idea is that given a choice, many individuals will be able to forego the way of the bankers and choose to live irrational (according to rational expectation theory) lives where they consume less as they learn more. When bankers see with their own eyes how much happier such individuals are, they too may voluntarily choose to become irrational (according to mainstream economic theory).