Some Thoughts on Fiscal Policy
(I’ve been promising Paul some thoughts on Modern Monetary Theory ( MMT) for about a week now, I started writing it up this weekend and realised I was actually writing about two different things – MMT and fiscal policy, so I’ve split the post into two – this is on fiscal policy and more specifically on MMT will follow).
In a comment over at Don Paskini’s last week, Paul wrote that we should focus on “enlightened fiscal policy (post-Keynesian) and leave monetary policy as the sideshow that it is”.
That kind of comment makes me a little uneasy, because as much as I think cutting the deficit now will be unproductive and dangerous – I don’t have that much faith in fiscal policy as a tool alone.
What really worries me about MMT is comments such as this from Warren Mosler, a doyen of MMT, (emphasis all mine):
UK News – GDP Stronger than Expected
As expected, boom time for now as the massive deficit spending raised savings and incomes, recharging consumer batteries, and supply the financial equity to fuel the subsequent expansion.
Look for rate hikes to add gasoline to the fire as well.
The risk of slowing from fiscal tightening is way down the road.
In fact, it’s usually the automatic stabilizers that tighten things sufficiently to throw the economy into reverse.
Again, years down the road.
I’d bet all the money in my wallet (a grand total of £13.45p it seems), that now is not “boom time” for the UK economy. Leaving aside that most of the “massive deficit spending” was actually a fall in tax revenues (much of it related to property and finance) rather than a stimulus as such and leave aside that Osborne is planning to try and close this deficit anyway – on what level does this analysis actually work?
Is any deficit large enough likely to bring about “boom time”?
I think at this point we need start considering multipliers and the power of fiscal policy.
Simply put the fiscal multiplier is the relationship between changes in government spending and taxes and changes in economic output.
This long-ish post from Chris Giles over at the FT, runs through the issues in a good amount of detail.
If the multiplier was zero then changes in taxes and spending would have no effect on the economy, if the multiplier was negative then less government spending will lead to faster growth.
The FT summarised the different possible assumptions as follows (my emphasis):
Zero: This is the cop out assumption that fiscal policy has no effect on the economy. It means the growth forecast will be unaltered whatever you do to taxation and public spending. It is not necessarily wrong, as is evident in this rather nice and simple academic paper on the VoxEU.org website. But to say the multiplier is zero at a time of significant impairment of monetary policy and weakness in Britain’s main export market is a strong assumption.
Negative: This is the assumption that sorting out Britain’s fiscal mess will so improve confidence in the economy that growth will be faster than previously thought and borrowing even lower as a result. If the OBR choose a negative multiplier, the Office will give George Osborne the perfect honeymoon gift. In a rather cynical Britain, the OBR would need some quite powerful evidence if it were to go down this route, as it would smack of the OBR having been captured by its political master in its first outing.
Between zero and one: Here we are in “crowding out” territory. Fiscal tightening does impede growth, but cutting £1 of spending reduces gross domestic product by less than £1. This zone would be viewed as a pretty normal assumption for Britain, an open economy with a flexible exchange rate. It is where many economists would implicitly put themselves because they are very prone to talk about the fiscal headwinds to growth.
One: Assuming a multiple of one suggests that taking £1 of public spending out of the economy reduces GDP also by £1. Such fiscal tightening would have quite a marked effect on growth and significant second round effects, implying more spending cuts and tax increases.
Greater than one: If we are in this zone, cutting the deficit is amplified into lower output and at some point a high multiplier implies that deficit reduction so damages growth as to worsen the budget deficit. This was Labour’s argument in the general election that did not convince the public. It was based on the assumption that the economy was too fragile now to take deficit reduction, not that the multiplier is always greater than one. Were Sir Alan Budd’s new OBR to take this assumption, it would represent a declaration of war on the Treasury and the new government. I think we can rule it out, but given that makes the OBR’s decision highly political.
The OBR in the budget set out the multipliers as follows:
Table C8: Estimates of fiscal multipliers
Change in VAT rate 0.35
Changes in the personal tax allowance and National Insurance Contributions (NICs) 0.3
AME welfare measures 0.6
Implied Resource Departmental Expenditure Limits (RDEL) 0.6
Implied Capital Departmental Expenditure Limits (CDEL) 1.0
To give this context the IMF (page 35 of this) in March 2009 gave its multiplier assumptions as:
The range of growth estimates reflects different assumptions on fiscal multipliers. The low set of multipliers included a multiplier of 0.3 on revenue, 0.5 on capital spending and 0.3 on other spending.
The high set of multipliers included a multiplier of 0.6 on revenue, 1.8 on capital spending and 1 for other spending.
In the US Moodys estimated (page 3 of this) multipliers as follows:
Nonrefundable Lump-Sum Tax Rebate 1.02
Refundable Lump-Sum Tax Rebate 1.26
Temporary Tax Cuts
Payroll Tax Holiday 1.29
Across the Board Tax Cut 1.03
Accelerated Depreciation 0.27
Permanent Tax Cuts
Extend Alternative Minimum Tax Patch 0.48
Make Bush Income Tax Cuts Permanent 0.29
Make Dividend and Capital Gains Tax Cuts Permanent 0.37
Cut Corporate Tax Rate 0.30
Extend Unemployment Insurance Benefits 1.64
Temporarily Increase Food Stamps 1.73
Issue General Aid to State Governments 1.36
Increase Infrastructure Spending 1.59
As can been seen, above there are a range of estimates of different multipliers, to take two examples:
Capital spending: The OBR estimated the UK capital spending multiplier at 1.0. But in the US Moody’s estimated it as 1.59. The IMF suggests a range running from 0.5 to 1.8.
Welfare spending: The OBR estimates this multiplier 0.6. In the US estimates of similar measures were 1.64 and 1.73. The IMF suggests 0.3 to 1.0.
One thing leaps out – no matter which set of numbers one uses (IMF, OBR, Moodys) capital spending and transfers to those most in need (AME Welfare in the UK, food stamps, unemployment insurance, etc in the States) – have the highest multipliers.
Now, for what it’s worth I think the OBR multiplier numbers all look a little on the low side but I don’t think they are massively off. UK fiscal policy multipliers are lower than US numbers as we are a more open economy. Put more money in people’s hands (either through a tax cut or a benefit increase) and they’ll spend more of it on imports (which subtract from growth).
The overall lesson of this is – fiscal policy is not a panacea that can fix the economy. Cutting spending now will lead to lower growth and increase the risk of a double dip but this doesn’t mean fiscal policy can solve all of our problems, in the long run – especially in an open economy like the UK, monetary policy is far more important. As are other tools – industrial policy, skills policy, regional policy.
So Labour should be setting an economic policy that moves the debate well beyond the size of the deficit.