Tuesday, 27 March 2012

It's not too late to change course: Macbeth and fiscal policy

I appeared before the Treasury Committee today to discuss the Budget.  As usual, we were asked about the government's macroeconomic strategy, and the case for a change of course. Two of my fellow witnesses, Jens Larsen and Roger Bootle, said that while they thought that there was a strong case that the government's fiscal consolidation programme was too aggressive - that is that we would be better off now had the scale of fiscal tightening in the first year or two been less - that the risks of changing course now outweighed the benefits.  [Note for the record: I hope I am paraphrasing them fairly; they are both excellent economists, and I agreed with most of what they said to the Committee]. 

I described this as the "Macbeth argument", from the following quote:
"I am in blood stepped in so far that should I wade no more, Returning were as tedious as go o'er."   [Act III, scene iv.]

In other words, since Macbeth has already killed Duncan and Banquo, it is better to carry on (and order the deaths of Macduff and his family) than to stop. So, although misguided policy has led to unnecessary economic damage, that damage is (returning to economist speak) a sunk cost; and the pain ahead is less then the pain that we would suffer if we changed course, as a consequence of the possible negative financial market reaction.

The Treasury also appears to subscribe to a variant of this argument.  When the original fiscal consolidation plan was welcomed by the rating agencies, that was a vote of confidence:  
"Standard & Poor's, the ratings agency, revised its outlook on Britain from negative to stable..The Chancellor said: ""That is .. a vote of confidence in the Coalition Government's economic policies.."  Telegraph, 26 October 2010
But when the same rating agencies realised the damage the plan was doing to growth, that made it even more necessary: 
"Fitch revised the outlook on the UK's rating to negative from stable...."A week from the Budget this is a reminder of why it is essential Britain sticks to its plans to deal with its debts," a Treasury spokesman said..."  Telegraph, 14 March 2012
Even leaving aside the obvious inconsistency here, I remain of the view that this argument is incorrect, for three reasons:
  • As I argued here, I don't think it's plausible to argue that markets have more confidence in governments that never adjust policy even when it is sensible to do so. Markets can be irrational. But there is neither a theoretical reason nor any empirical evidence to suggest that they are irrational in this particular way. Indeed, history suggests the opposite: that the real hit to credibility comes from sticking to unsustainable policies – think Argentina in 2001 or Britain in 1992.  Nor does the argument that if the government adjusts its strategy, markets will lose all faith in its ability to consolidate at all, carry much weight: Simon Wren-Lewis explains why here
  • the downside risks are hugely overstated, as I've argued consistently, and as the (non)-reaction to the moves by the rating agencies has demonstrated. 
  • most importantly, the negative consequences of continuing on the current course - the costs of inaction - are considerably understated.  According to the OBR's latest forecasts, the economy will still be producing well below potential even in 2015 - and, as a direct consequence, unemployment will remain well above the natural rate.  650,000 people who could and should be in jobs - if the economy was on track - won't be. 
And this in turn will do damage that will last not for years but for decades. As the research that we and others conducted for the ACEVO Commission on Youth Unemployment showed, the potential long-term economic and social damage that is likely to result from the current levels of unemployment, especially youth unemployment, is huge.

The implications of this for fiscal policy are set out in an exceptional - and exceptionally important - new paper by Brad Delong and Larry Summers. They analyse the impact not just of fiscal multipliers on short-term growth, but on the long-term implications that flow from hysteresis effects  - ie the long term damage done to an economy's productive capacity by restrictive fiscal policy in the short term.  They show that, when interest rates are very low, you only have to assume very modest hysteresis effects indeed to justify short-term fiscal expansion.  Their conclusion is worth quoting at length:  
Indeed, under what we defend as plausible assumptions of temporary expansionary fiscal policies may well reduce long-run debt-financing burdens. These conclusions derive from even modest assumptions about impact multiplier, hysteresis effects, the negative impact of expansionary fiscal policy on real interest rates, and from recognition of the impact of interest rates below growth rates on the evolution of debt-GDP ratios.  While our  analysis underscores the importance of governments pursuing sustainable long run fiscal policies, it suggests the need for considerable caution regarding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero bound. 
In other words, in economies like the US and UK, the case for rapid consolidation is exceptionally weak. Although multipliers in the UK are undoubtedly lower than in the US, the evidence for substantial hysteresis effects is probably rather stronger; the basic logic still holds. 

It is for this reason - the long-term economic, social and even fiscal damage being done by current policy - that I favour a change of course. Returning to Macbeth: of course, his argument was wrong.  Much more blood is shed after this scene than was before (including his own and that of Lady Macbeth).  Of course, we don't know what would have happened if he'd adopted an alternative strategy, but it seems highly probable that both the short and long-run outcomes would have been preferable. 

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