Sunday, 10 March 2013

Believing in "miracles"? Self-defeating austerity and self-financing stimulus

The Prime Minister's speech on the economy on Thursday was, leaving the policy aside, notable for some of its analytical claims.  Simon Wren-Lewis's dissection is thorough and comprehensive; Danny Blanchflower and Adam Posen have a lengthy discussion here . In particular, much has already been written about the Prime Minister's misinterpretation of the OBR's position on the impact of fiscal consolidation on growth; for a thorough explanation, see Duncan Weldon.

But I wanted to focus on another specific passage of his speech, since it seems directed at, among others, us here at NIESR, and where the Prime Minister cites the work not of the OBR but of the IFS to put the counterargument. The Prime Minister argued:
"So those who think we can afford to slow down the rate of fiscal consolidation by borrowing and spending more are jeopardising the nation’s finances. Labour’s central argument is exactly that.  They say that by borrowing more they would miraculously end up borrowing less.  Let me just say that again: they think borrowing more money would mean borrowing less.Yes, it really is as incredible as that.The Institute of Fiscal Studies has completely demolished this argument.They say that if we had stuck to Labour’s plans we would be borrowing an extra £200 billion.."
I am not sure whether the Prime Minister is correct in his description of Labour's policy, but in any event he is of course perfectly entitled to critique it.  But the argument that we can afford to slow fiscal consolidation, and that under some circumstances that might have little or indeed no impact on borrowing, is made by numerous economists, including us here at NIESR.  And the assertion that the IFS has "demolished" it is false.  In fact, quite the opposite; as I discuss below, the macroeconomic analysis presented in the IFS' most recent Green Budget argued explicitly that "slowing the rate of fiscal consolidation" would be "appropriate", and that doing so would not "jeopardise the nation's finances." 

But first, let's examine the mechanisms by which changes to tax and spending affect borrowing. Obviously, the direct impact of tax increases and spending cuts is to increase revenues and reduce spending, and hence to reduce borrowing. But there are also indirect impacts: tax rises and spending cuts reduce growth, which in turn increases borrowing. 

Now, most of the time, these indirect impacts will not offset the direct ones.  Putting up taxes cuts the deficit, as you'd expect. But we are not in normal times. In current circumstances - with output well below capacity, long-term real interest rates exceptionally low, and monetary policy apparently ineffective - fiscal consolidation is much more likely to damage growth, and hence reduce revenues, than in normal times, as I explain here.   

As Simon says, the arithmetic of this was set out by Brad Delong and Larry Summers, the former US Treasury Secretary, here.  Whether higher borrowing in the short term leads to lower borrowing over the medium to long term depends on a number of factors; the level of real interest rates, the impact of the extra borrowing on growth,  the responsiveness of tax receipts and spending to growth, and the extent to which a short-term growth shortfall does long-term damage to the economy.  All of these are empirical questions, to which the answers may change over time. Their conclusion:
"Indeed, under what we defend as plausible assumptions, temporary expansionary fiscal policies may well reduce long-run debt-financing burdens. These conclusions derive from even modest assumptions about impact multipliers, 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."
In other words, under current circumstances, it's quite plausible that borrowing more could lead to borrowing less (over the longer term). As I wrote at the time:
"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."
Similar reasoning has led IMF economists to come to a very similar conclusion, in a paper published just last week, which:
 "provides empirical evidence supporting the hypothesis that fiscal consolidation can raise the debt ratio in the short-term".  
Paul Krugman discusses this paper at greater length here. But what about the IFS?  Has it indeed, as the Prime Minister implies, engaged in vigorous debate with Delong and Summers, the IMF, not to mention me, about our assumptions and arguments, and "completely demolished" them? No, of course not; macroeconomic analysis is not the IFS' specialism. The IFS analysis to which the Prime Minister refers predates the Delong and Summers paper and that of the IMF.  More importantly, it does not address the arguments they and I make at all, because it is not about the macroeconomic impacts of fiscal loosening (on growth, interest rates, revenues and spending) at all.

The Prime Minister is correct in his subsequent sentence: that the IFS said that if the government had continued with "Labour's plans" (that is, not introduced extra tax rises and spending cuts in June 2010) then £200 billion more borrowing would have been required.  But, because the IFS did not estimate the impact of those tax rises and borrowing on growth - they assumed everything else stayed the same - that's a statement of arithmetic, not a macroeconomic analysis. If you assume that tax rises and spending cuts don't impact growth, then of course they reduce the need for borrowing; the IFS was simply quantifying that.  The IFS did say:
"Of course, there are uncertainties around any estimates of the impact of policy changes on overall borrowing and it is possible that some of the weaker outlook for the economy has actually been caused by a detrimental impact of the additional fiscal consolidation announced by the coalition government that is not captured in the official estimates of the measures’ impact on revenues and spending. However, the error in estimating the size of the policy impact would have to be implausibly large to lead one to conclude that borrowing would actually have been lower in the absence of the additional tax rises and spending cuts that have been announced since May 2010."
So it was clearly the IFS view at the time that the additional tax rises and spending cuts had reduced borrowing; but this was not based on any substantive analysis, nor quantified; the £200 billion figure does not take account of the growth or other indirect impacts. Nor, importantly, was it a statement about the general principle of whether slowing fiscal consolidation would lead to higher or lower borrowing, but rather specifically about the measures introduced in 2010, not about the impact of more borrowing now.

So what does a proper macroeconomic analysis tell us?  Can austerity be "self-defeating", even on its own terms?  In a more recent analysis, Dawn Holland and I examine this question, not just for the UK but for the EU as a whole. We found that the UK's fiscal consolidation strategy has reduced growth quite significantly, and that in turn means that the reduction in borrowing has been much less than might have been expected.  But it doesn't mean that we've actually borrowed more. 

So we agree that the government's tax rises and spending cuts have indeed, as the IFS says, reduced borrowing, although not by nearly as much as the government hoped - one reason, albeit not the only one, that they have had to abandon their fiscal targets.  However, when you look at the EU (including the UK) as a whole - that is, when you take account of the negative impact of fiscal tightening not just in individual countries, but across the EU - the picture changes dramatically: 
"in current circumstances, fiscal consolidation is indeed likely to be "self-defeating" for the EU collectively.  As a result of the fiscal consolidation plans currently in train, debt ratios will be higher in 2013 in the EU as a whole rather than lower.  This will also be true in almost all individual members states (including the UK, but with the exception of Ireland).   Coordinated austerity in a depression is indeed self-defeating."
In other words, for the EU (including the UK) collectively, "borrowing less" has in fact meant "borrowing more", as this chart shows. 



But of course the Prime Minister's speech - note the present tense in the paragraph above -  is much less about the past than about what should happen now, and in particular in the upcoming Budget.  His real target is "those who think we can afford to slow down the rate of fiscal consolidation by borrowing and spending more."  By that he presumably means those like NIESR, Martin Wolf, the Economist, the IMF, and so on, who support extra government borrowing now, in particular to finance public sector investment.  For example, the Economist called last week for an extra £28 billion of public investment, while I argued last year for £30 billion. 

So would borrowing more to spend more on investment - the proposition actually on the table - lead over the medium term to more or less borrowing? Well, the Prime Minister may not have noticed, but the IFS did actually have something to say about this in their Green Budget a few weeks ago. Oxford Economics (OE), who do the macro analysis underpinning the Green Budget,  analysed the impact of £10 billion extra debt-financed capital spending in each of the next two financial years. 


Their conclusion - and OE's macroeconomic model is quite similar in structure to those used by both NIESR and the OBR - is that it would boost growth by 0.5% this year and next (with some of the impact reversing in the following year). Assuming, conservatively, that output returns to the base case scenario in 2016, the cumulative increase in output over the 2013-15 period is a little over 2 percent.  Their conclusion: 

"it would have been possible to boost short-term growth prospects through higher capital spending..with stronger growth yielding higher tax receipts, the [short-term] impact on the deficit would have been relatively small. We feel this would be an appropriate level of stimulus." 
So we can add OE to the long list of "those who think we can afford to slow down the rate of fiscal consolidation by borrowing and spending more", and who the Prime Minister thinks are "jeopardising the nation's finances."

OE don't directly quantify the impact of this extra growth on borrowing over the medium term. But, usefully, the Treasury do, in their paper here. They conclude a "1 per cent increase in output relative to trend after two years is estimated to reduce the ratio of public sector net borrowing to GDP by just under ¾ percentage point."   So the impact of this extra output on borrowing will be, just by simple arithmetic, be a cumulative 1.5% of GDP - or somewhat more than the £20 billion extra up-front borrowing.  In other words, if you believe the Green Budget analysis, and the Treasury's own calculations - both of which are very much mainstream macroeconomic modelling exercises - borrowing to invest now is indeed essentially free.  

In short, slowing down the rate of fiscal consolidation would not jeopardise the nation's finances; if anything, done sensibly, the opposite.  This claim is neither incredible nor miraculous, but endorsed by those economists who've looked carefully at the theory and at the empirical evidence.  And far from "demolishing" this argument, the last IFS Green Budget provided yet another piece of analysis that reinforces it.  What was always "incredible" was the  government's claim that rapid fiscal consolidation would not significantly reduce growth, and hence make it harder to repair the public finances; sadly, we have not been afforded any miracles.  

15 comments:

  1. You wrote: 'I am not sure whether the Prime Minister is correct in his description of Labour's policy'
    yet maintain you are not politically biased. Interesting.
    Next, you write; 'In other words, under current circumstances, it's quite plausible that borrowing more could lead to borrowing less (over the longer term)' based on research from Wren lewis, itself based on numbers crunched by Larry Summers. Now, at this point, I felt compelled to put down my cup of Earl grey. Larry Summers??!?!?
    So to sum up, we should borrow more now because the US has shown that their extra borrowing in the past has led to lesser borrowing currently.
    Interesting.
    Perhaps in your coming pieces we may hear your thoughts on the US fiscal cliff and potential impacts on the UK?

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    1. I wrote that sentence because I wanted to make it clear that I'm not endorsing "Labour policy", since I'm genuinely not sure whether the PM's description of it is accurate. Are you?

      Your "summing up" is, as I'm sure you're aware, nonsense; I refer specifically to UK-specific quantitative modelling by both NIESR and Oxford Economics. Did you not read that far?

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    2. Out of interest Robert, what is so wrong with Larry Summers' (and Brad DeLong's) figures?

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    3. Mr Portes, you wrote: 'In other words, under current circumstances, it's quite plausible that borrowing more could lead to borrowing less (over the longer term)' as summing up Summers and Delong, whose work in turn you used as justification for, your words:
      'But we are not in normal times. In current circumstances - ... fiscal consolidation is much more likely to damage growth'
      I merely pointed out that this dosen't seem to have worked in the US, so am wondering why it should work here (both Anglo-saxon models.
      Simon
      I wonder what sort of cataclysm it would take for you to question someone's number crunching ability? Politely, Summers has always, quite clearly and obviously, had VERY strong vested interests e.g. his thoughts on taxation. His multipliers were always overly optimistic, I wonder why?

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    4. That's a direct admission you didn't bother reading to the end, since you say you are "wondering why it should work here", but I present quantitative analysis from both NIESR and OE explaining exactly that. Do your homework. Then, if you dispute the analysis, explain why. But so far you haven't made a substantive argument.

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    5. A characteristically rude, presumptious response yet again Robert. Why do you presume I don't question data used in macro models? I was genuinely hoping you could direct me to a weblink/paper illustrating the incorrectness of Summers' numbers in this paper, and by association Brad DeLong's, as they co-wrote it. Judging by the response above, instead it appears Summers' main problem is his views and 'thoughts on taxation' are highly questionable or plain wrong simply because they don't fit your own, (in much the same way as Portes is wrong).

      You did read the paper didn't you? It appears that his (and DeLong's) "overly optimistic multipliers" as you claim, are, in reality, anything but overly optimistic.

      In their highly detailed consideration of multipliers, they note that other scholars identify a range of 0.8-1.5, and even of 0.5-2.0 for the multiplier. Importantly noting that deficit financed spending "undertaken during a severe recession, the estimates are likely to be at the *upper bound of this range*". (p.17).
      Bearing this in mind, guess what multiplier value they use in their study?
      "A baseline-case multiplier of 1.0" (p.24)
      Which they note, referring to wider empirical evidence "...is likely to be an underestimate, and perhaps a substantial underestimate, of the policy-relevant multiplier in an economy which is, like the U.S. today, at the zero nominal lower bound on safe short-term interest rates".
      So, instead of perhaps being somewhere between 1.5 - 2.0, the multiplier Summers uses is a gargantuan 1.0!
      They conclude that "if the short run multiplier is even *moderate* (like theirs is) and if there are even modest hysteresis effects, then temporary expansionary fiscal policy will not impose future fiscal burdens...".
      Importantly they note other independent studies, namely Denes et al.(2012) and Cottarelli (2012), who conclude likewise that "stimulative deficit spending is self-financing, and fiscal austerity is self-defeating".
      The sheer weight of evidence which runs contrary to and disproves your misplaced views and understanding must be overwhelming, and perhaps shows in your often unecessarily aggressive narrative. You are allowed to self-reflect and amend your views when the facts don't fit them, as the Master himself alluded to.

      The sort of cataclysm which forces me to question someone's number crunching would definately be the catastrophic austerity policy being designed and presided over by Messrs Cameron and Osborne, and Rehn & Merkel in Europe.




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    6. In their paper 'In search of the Multiplier for Federal Spending in the States During the New Deal”, economists Price Fishback and Valentina Kachanovskaya look at the impact of federal stimulus programs during the Great Depression on a state-by-state basis. The National Bureau of economic research summarized thus:
      'The multiplier for wages and salaries was substantially less than one, as was the multiplier for retail sales. Furthermore, the researchers find that the impact of the federal spending on employment was negligible and may have been negative.'
      Negative sir, negative. On the 2009 stimulus package,Fishback and Kachanovskaya concluded that;
      ' the current multiplier in the states would be around one or less for personal income, which includes transfer payments, and SMALLER for other measure of income'
      More?
      NBER on a paper ' How big (Small) are fiscla multipliers?' in which data from 44 countries was analysed (I do hope that the size of the population sample has made an impression)over a period from 1960 to 2007, concluded that;
      that fiscal multipliers are smaller in open economies than in closed economies, and are zero in high-debt countries.' and
      'We have found that the effect of government consumption is very small on impact, with estimates clustered close to zero... In contrast, in economies open to trade or operating under ‡flexible exchange rates, a …fiscal expansion leads to no significant output gains. Further, …fiscal stimulus may be counterproductive in highly-indebted countries; in countries with debt levels as low as 60 percent of GDP, government consumption shocks may have strong negative effects on output.'
      Negative, Simon...negative.
      So, there seem to be arguments against what Mr Portes claims in general.
      If I appear rude it is perhaps because some economists and commentators appear very one sided in their 'evidence' based views, and I am sick, as a very patriotic type, I am sick of watching Englishmen tear the country apart over arguments that are based on such one sided views- the intellectual dishonesty in the last decade has never been so prevalent i.e. never have so many academics proffered so much 'evidence' to support their theories, when in fact, as I was discussing only last night with a first in economics from Cambridege, when in fact so many economists are so poorly educated mathematically that they don't even understand what a model is.


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    7. So Simon, have you considered why Lawrence's multipliers may have always been so optimistic? If indeed they are , of course... perhaps in coming to your decision it's worth considering political philosophy as mother to the so called 'science' they call economics. I am not rude by nature, but in such uncertain times where moronic decisions really will cost many people their jobs, the politics MUST be taken out of economics, unless it is to determine a one off national goal e.g. full employment. After that, no more sub-optimal decison making based on one sided factually evident blah blah flim flam.
      Back to the cup of tea...

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    8. Very bizarre. You started by asking why US evidence was relevant to the UK; I pointed out that you clearly hadn't bothered to read the blog, which cited recent UK-specific studies. Now you refer to US evidence from the New Deal. You also refer to a cross-country study 1960-2007; but of course the entire point of Delong/Summers, as well as Wren-Lewis's writings and recent NIESR work, is to explain why multipliers are very different now. So all this really shows is that you haven't bothered to engage with the arguments.

      Finally, while I don't like to censor comments unless absolutely necessary, could you please try to make them vaguely coherent/grammatical, and leave out the stuff about patriotism please.

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    9. This comment has been removed by the author.

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    10. Hi Robert
      In addition to Jonathan's points above, unfortunately your response, specifically regarding multipliers is incoherent, characterised by false comparisons and does nothing to discredit or refute the multiplier values of DeLong & Summers or the points I raised.

      You strongly complain about intellectual dishonesty later on in your post, but cite multipliers from the Fishback & Kachanovskaya study of "substantially less than one" and of "one or less...or smaller" when illustrating how 'wrong' I was.
      However, reading the actual article, whilst they do say this, they also say in the very same paragraph "the multiplier ranges from 0.91 for a combination of government grants and loans to 1.39 when only grants are considered. The personal income multiplier for public works and relief was around 1.67". So they also note multipliers significantly greater than one, but you didn’t tell us!
      Anyone can cherry-pick data to suit their needs Robert, but don’t then talk about how sick you are of "very one-sided evidence based views" and the "intellectual dishonesty" of economists and commentators!
      Recall also that in my previous post the multiplier values I quoted of 0.8-1.5, and even of 0.5-2.0 for the multiplier relating to deficit financed spending "undertaken during a severe recession, the estimates are likely to be at the *upper bound of this range*". (p.17). These are taken from numerous surveys of multipliers for these specific economic conditions, not just one paper as with Fishback & Kachanovskaya. For reliability the size of the population sample is surely very important isn’t it, rather than relying on one scholarly paper for estimates of the multiplier?

      Using the NBER paper you unfortunately make a massive false comparison by using cross country data from 1960-2007, because the multiplier under consideration is (quoting DeLong & Summers) that which is relevant "in an economy which is, like the U.S. today, AT THE ZERO NOMINAL LOWER BOUND on safe short-term interest rates".
      Those 44 countries and time periods you tried to use to disprove my argument (which have low multipliers and thus "negative Simon, negative" impacts on output) cannot possibly be used as a comparator because the economic circumstances of the 1960-2007 period were not relevant as they were so very different to those of today. Your comparison would have been valid and would have disproved the large multipliers argument had most of those 40 countries you refer to been:
      i) in recession, and
      ii)at the zero nominal lower bound
      And for most of the 47 year period!
      Then you would have been comparing like for like economic circumstances.
      But these were not the prevailing economic circumstances relevant for 1960-2007, so logically no comparison can possibly be made, as DeLong & Summers are only considering multipliers of the very specific circumstances of economies in or recently in recession and ZLB conditions.

      I don't know if you were being dishonest. But there does seem to be fundamental errors and consistent incoherence in your arguments and attempts to demonstrate the incorrectness of my points. So I don't think you should really be talking about poorly educated economists with their one-sided views.
      Perhaps you ought to focus your frustrations and anger on those politicians in power whose policies right now are harming the economy and impoverishing millions of people, rather than at economists who suggest alternative policies (which rightly or wrongly you don’t agree with) which are not in place, and so are not the cause of the massive hardship we are seeing in the UK and especially so in Europe.

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    11. Correction: Regarding my NBER commments above, I should have said "And in many of those countries during the 47 year period."
      Not only that, whilst the selective comments you have quoted from the NBER paper are true, you somehow also neglected to include another quite important part which is really the most relevant when making comparisons to DeLong & Summers' multiplier...
      "our results are related to the notion that monetary accommodation plays an important role in determining the expansionary effect of fiscal policy...Coenenet al(2010) show that monetary accommodation is an important determinant of the size of fiscal multipliers in seven different structural models used in policymaking institutions.This result also relates indirectly to the theoretical studies of Christiano, Eichenbaum, and
      Rebelo (2009) and Erceg and LindÈ (2010) showing that ***fiscal multipliers are larger when the central bank's policy interest rate is at the zero lower bound***.
      We thus find that differences in monetary accommodation are the main cause for differences in the magnitude of fiscal multipliers across exchange rate regime". (my *** added above).
      Lets leave it there as I prefer coherent discourse, rather than spending time correcting erroneous arguments supported by selective data.

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  2. Jonathan

    As you say (in reply to Robert), both the Green Budget by the IFS and the Treasury concur with the findings of the NIESR, Wren-Lewis and DeLong & Summers.
    So, is there any reason why the IFS or indeed the Treasury have not yet publicly pointed out David Cameron's latest example of...how can I say it...applying austerity to the truth, in a similar way that Robert Chote at the OBR did on Friday?
    Or is it because the OBR need to 'be seen' to be independent, and did so by the quick rebuke on Friday?
    In any case, since there appears no supporting evidence in his favour,I expect similar 'innaccuracies' from Cameron over time as he needs to say whatever it takes to continue(justify)his policies, which ought to be more publicly recognized as being the means of achieving their ultimate, ideological goal of shrinking the state; irrespective of evidence, facts and economic hardship caused.

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    1. The IFS will have to speak for themselves I'm afraid! On the Treasury, since they don't do forecasting any more it's really down to the OBR: and (as Simon Wren-Lewis points out in his post on Stephanie Flanders)they are explicitly prohibited from modelling alternative policy scenarios, although it seems highly likely their model would give a very similar result to that of Oxford Economics.

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    2. Thanks Jonathan,
      I think for the sake of not only political and economic accountability, but also accurate,improved economic discourse, Robert Chote's rebuke was important and highly necessary; the IFS really need to do likewise.
      For many (all?) economists, these are extraordinary times proving very difficult to analyse and comprehend. So for the vast majority of the electorate, understanding what is really going on in the economy is nigh on impossible. Since the electorate is influenced by and sometimes base their views on what the Prime Minister/Chancellor says, it is very unhelpful and complicates things even further if the highest office in the land is so cavalier in misusing and misrepresenting data and the views of institutions.
      Particularly so when peoples livelihoods, finances, future prospects and even peoples'lives are at stake; resting on policy decisions which have been publicly justified through misrepresentation and distortion of facts.
      People deserve better, so the OBR's letter on Friday was one small step in the right direction, as is your own and the NIESR's in pointing out the inaccuracies and deception. I only hope the IFS do likewise.
      Keep up the great work.



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