Dodging the debate

On December 3rd George Osborne, Britain’s chancellor, delivered the autumn statement, the country’s annual mini-budget. We are hosting a round-table discussion of the statement and the direction of British economic policy. Today’s contributor is Michael McMahon from Warwick University.

Is Britain’s fiscal plan on track? It depends how you define the plan. George Osborne has not achieved what he set out to do in 2010, when he aimed for a deficit of 1.9% of GDP and debt of 68.8% of GDP by 2014-15. According to Wednesday’s statement, those figures are now expected to be 5.5% and 80.4% respectively. But the major setbacks happened in the first two years of the government. By November 2012 the 2014-15 numbers were revised to 5.2% for the deficit and 79.0% for debt. So the fiscal plan has been largely on track since then.

But a more important question is: what is the correct track for fiscal policy? What amazes me about the politics of the autumn statement is how ingrained the objective of eliminating the deficit has become. The chancellor went to great lengths to emphasise that the government is going to “stay the course”. Ed Balls stressed that Labour wants to “get the balance into surplus as soon as possible”.

The other striking aspect of the political discussion is how fiscal policy is assumed to be the main cause of either economic woe or success. Each side draws on bits of evidence to support its view. The chancellor sezed on recent good news, especially high GDP growth compared to other major economieis and the fact that real earnings have at last started to grow, as evidence that “the economic plan is working”. The opposition imply that fiscal policy is the cause of low real wage growth.

The truth is that disentangling the effects of changes in fiscal policy from everything else going on in the economy is very difficult. Austerity directly lowers growth in the short term and also indirectly affects growth by altering incentives. But other developments are important too. Similarly, fiscal policy affects real earnings to different degrees for different people but it is not the sole determinant of nominal wage growth or inflation. British productivity—which determines wages in the long-run—is not a direct fiscal choice.

The problem is that we don’t know what would have happened under different policies, and theoretical estimates of the effects of fiscal policy depend on the model used. Even in the most basic Keynesian models, which admit a large role for fiscal policy and contain a constant multiplier, the ultimate change in GDP from deficit reduction depends on the split between spending cuts and tax rises, and on the response of monetary policy.

In any case, the political debate is somewhat misplaced. A zero deficit is neither necessary nor sufficient to stabilise or reduce the government debt-to-GDP ratio. Europe’s fiscal targets limit deficits to 3% of GDP and debt to 60% of GDP. But simple accounting analysis shows that the size of deficit that a country can sustain while keeping debt-to-GDP stable depends on the average interest rate charged on the debt and on nominal GDP growth. Faster growth and lower interest rates both allow countries to sustain higher deficits.

Another problem is that discussion tends to focus on government debt without looking at the whole balance sheet, as we would for companies or households. Borrowing for current spending is different to borrowing to acquire assets. And the biggest liability for most governments is the future pension and health spending stemming from aging populations. Our current fiscal accounting does not properly capture this.

By focusing on headline figures such as the deficit and debt and bickering about the extent to which government policies have influenced the economy, politicians miss the chance to have a real debate on the amount that we, as a society, want to spend and how we can pay for this.

Three basic facts should be the starting point of the debate. First, there are two broad reasons for government spending. One is the collective provision of goods and services such as defence, law and order, roads, education and health. The other is to redistribute income between individuals and across time; for example, this is the aim of state pensions, unemployment benefits and support for the ill. There is a certain minimum level of spending required for core services like national defence, law and order, and basic education. How much else the government spends is a political choice (and varies significantly across the OECD).

Second, paying for government spending requires taxes, either now or in the future to repay debts. When we discuss how and what to tax, there is a distinction between Pigouvian taxes, such as petrol taxes, which are designed to change behaviour, and Ramsey taxes, which try to raise necessary revenue in the least distortive way.

Third, we should not assume that big government is better or worse than small government. Bad government is bad. A small government can spend its money badly and a big government can spend money well and deliver public services that are highly valued.

The fiscal debate needs to change to incorporate these facts and elucidate the underlying reasons for policy changes. In the run up to the election, all parties need to stop political point-scoring and to engage in a candid discussion about the fiscal choices that now need to be made. According to the latest survey of economists by the Centre for Macroeconomics, there is amazing agreement—especially for economists—that that the scale of planned spending cuts is not credible. They would become more credible if there were a wholesale rethink of the role of the state. Which areas should be the focus of government spending? How should this spending be financed? How much scope is there to spend public money more efficiently?

The public needs to see the detail of each party’s answer to these questions, not simply high level commitments to reducing deficits or debt without plans for how those targets will be achieved. Only then will people know what they are voting for.

Source: The Economist Dec 9th 2014, 10:06 by MICHAEL MCMAHON | UNIVERSITY OF WARWICK

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