(Non) lessons of the fiasco

All of us tend to interpret political events as confirming our prior beliefs. We must, however, resist this temptation when thinking about the now-reversed Kwarteng/Truss Budget. There are two interpretations of this fiasco which are not as robust as you might think.

The first one is that it shows that small state conservatism is impossible. I don't think this inference is warranted.

Imagine that Budget had been announced at a time of recession when inflation was below target and both short and long-term interest rates near zero. In such circumstances, I suspect markets would applaud: looser fiscal policy is the right thing to do then - as many of us were saying in 2010-12. Yes, bond yields would rise - but that's natural and desirable as a consequence of escaping recession, and it's possible that gilt losses would be accompanied by share price rises.

Of course, we would quibble with the redistributive impact of cuts to top taxes, and we'd argue that spending rises would be better at reflating the economy than tax cuts. But in macroeconomic terms, the Kwarteng-Truss Budget would have been acceptable.

And a few years after the Budget, Kwarteng/Truss could claim not only that they had averted recession, but also that subsequent growth had been good. Yes, orthodox economists would reply that this was due more to standard accelerator effects and diminished uncertainty than to supply-side effects of tax cuts. But that's the point: we would be debating whether tax cuts had worked. We wouldn't be claiming that the Kwarteng/Truss approach had been refuted.

This counterfactual tells us that the fatal flaw in the Kwarteng/Truss Budget was its macroeconomic judgement, not its supply-side measures.

Let's try another counterfactual. Imagine their Budget had been announced after a positive supply shock - something that had both boosted growth and reduced inflation. Tax cuts would then look "affordable", because the stronger economy had reduced government borrowing. Nobody would panic. The way to shrink the state, remember, is to have a strong economy.

What would such a supply shock be? One candidate would be sharp reversal of this year's oil and gas price rises. The right, however, might add another candidate: non-fiscal supply-side measures such as planning reform. On that view, the Kwarteng/Truss error has been to do policy in the wrong order: tax cuts should have followed other supply-side policies, not preceded them.

Now, personally I am of course very sceptical that cuts to top tax rates would greatly stimulate the supply-side. But this scepticism is not enhanced by the Tories' latest fiasco. What this proves is that their macroeconomic and market judgement is atrocious. It does not prove that rightist supply-side measures are always doomed to fail. To establish that, you need other evidence.

There is another hypothesis which I think is unproven by recent events. This is that, contrary to the claim of modern monetary theory, bond markets are in themselves a constraint on government borrowing.

My problem with this idea is that we've seen bonds sell off at a time of high inflation. It is possible that what gilt markets are worried about, therefore, is not a flood of issuance but simply that tax cuts will further add to inflation. On this view, MMTers are right. It is indeed inflation that is the constraint upon government borrowing. Bond markets are merely a mechanism through which this constraint becomes obvious to government.

Of course, something would refute MMT - if we were seeing bonds sell off at a time of low inflation. But this is not what's happening.

There is, however, a wrinkle here. What we've seen since the summer is not just a rise in nominal gilt yields but also a sharp rise in real ones too. You might think this consistent with the market fearing a glut of debt, not just inflation - that markets are, in Paul Krugman's words, pricing in a "moron risk premium."

Possibly, but not certainly.

For one thing, this risk premium might reflect not the quantity of debt but rather the manner of conducting policy: in sacking Sir Tom Scholar and sidelining the OBR, Kwarteng/Truss signalled that they were heedless of dissonant voices. That's just bad policy-making.

For another, higher real yields are themselves a sign the markets fear inflation. Real yields are higher because markets expect higher real short-term interest rates. Which is just what should happen as the Bank tries to reduce inflation.

And for a third thing, even now real yields are well below their 1990s levels. In a longer-term context the bond market vigilantes are still softies.

This issue matters for how the left should think about fiscal policy. If the problem is indeed too much borrowing then there might be a case for wealth taxes merely to raise revenue. If, however, the problem is inflation then wealth taxes are a less good solution: insofar as the rich don't spend their wealth, such taxes won't much reduce inflation.

My point here is to try to lean against the old habit of seeing our prejudices confirmed everywhere. Macroeconomics and politics are often afflicted with the Duhem-Quine problem, that hypotheses can never be tested in isolation. Recent events do not prove that small-state supply-side policies are impossible, and nor do they prove that the bond market and not inflation is the constraint upon borrowing. Maybe they are, maybe not - but this fiasco does not establish so much.

Instead, it proves just one thing - that the Tory reputation for economic competence was not justified. And perhaps it never was.

Comments

[James Charles]

" . . . how the left should think about fiscal policy."?
“ . . . whereby the coefficient for ∆g is expected to be close to –1. In other words, given the amount of credit creation produced by the banking system and the central bank, an autonomous increase in government expenditure g must result in an equal reduction in private demand. If the government issues bonds to fund fiscal expenditure, private sector investors (such as life insurance companies) that purchase the bonds must withdraw purchasing power elsewhere from the economy. The same applies (more visibly) to tax-financed government spending. With unchanged credit creation, every yen in additional government spending reduces private sector activity by one yen. . . .
“Equation (22) indicates that the change in government expenditure ∆g is countered by a change in private sector expenditure of equal size and opposite sign, as long as credit creation remains unaltered. In this framework, just as proposed in classical economics and by the early quantity theory literature, fiscal policy cannot affect nominal GDP growth, if it is not linked to the monetary side of the economy: an increase in credit creation is necessary (and sufficient) for nominal growth.
Notice that this conclusion is not dependent on the classical assumption of full employment. Instead of the employment constraint that was deployed by classical or monetarist economists, we observe that the economy can be held back by a lack of credit creation (see above). Fiscal policy can crowd out private demand even when there is less than full employment. Furthermore, our finding is in line with Fisher’s and Friedman’s argument that such crowding out does not occur via higher interest rates (which do not appear in our model). It is quantity crowding out due to a lack of money used for transactions (credit creation). Thus record fiscal stimulation in the Japan of the 1990s failed to trigger a significant or lasting recovery, while interest rates continued to decline. ”
http://eprints.soton.ac.uk/339271/1/Werner_IRFA_QTC_2012.pdf

[Nanikore]

The fundamental cause has been liquidity being drawn back ias US quantitative easing is reigned back. This is creating turbulence in the global capital markets. In such conditions interest rates and the dollar rise, particularly as it is a safe haven currency, the world's reserve currency.

Even before this budget, a number of prominent City analysts were saying that the uK was showing characteristics normally seen in emerging markets -an extraordinary, but telling, remark. Emerging markets lack hard currencies,and have to be cautious about trade deficits so that they can afford the dollars needed to purchase vital, domestically unsubstitutable, imports. A risk premium is added to bonds denominated in their currency. Such countries have to be cautious about running large unfunded government deficits. The link between external deficits and budget deficits is not an obvious one, and it applies more in some countries than others.

When the US was flooding global markets with liquidity it hid a lot of problems in weaker countries. Now those problems are out in the open (Deutsche Bank identified low productivity and an historically high trade deficit as problems). The Kwarteng budget was a bad budget at the worst of times. While not the underlying cause of the crisis, it was the spark.

[Nanikore]

"unfunded deficits"- I mean unfunded tax cuts or spending.

Emerging markets also face limits to monetising their debts, and economies like the UK do as well.

Inflation is a factor, but it is not the critical one at the moment for the UK. By far the critical factor is the US' decision to start reversing its QE.

It is the balance of payments constraint that a few people had forgotten. Very important when we are talking about a small open economy dependent on foreign capital markets to finance that deficit.

It is important we do not use America-centric theories to talk about the UK. They are two very different economies. BOP deficits don't matter for places like the US as they do for Britain. Again, we don't have the USD's exorbitant privilege.

[Dr Zoltan Jorovic]

Economics is the art of making wrong forecasts based on impossible assumptions using inaccurate data and disguising it in excess mathematical detail. Unsurprisingly no Economists agree, and no formula for consistently running an economy successfully has ever been developed. It has provided a good living for many, and ample opportunity for argument. All heat, and little light.

[shoreline view]

Wouldn't a wealth tax control asset price inflation? The very rich run around, buying up properties purely as wealth stores, inflating the housing market, creating asset bubbles in general, destabilizing the stock market. Tax them more and they'll be less careless and less likely to disrupt regular peoples' finances.