Friday, February 19, 2010


Darling storm-tossed but unflappable.
More than 60 leading economists have backed Alistair Darling’s wish to delay spending cuts until 2011 (subject of course to the general election outcome), creating a dividing line within the profession on the crucial issue of how to reduce the UK’s public debt. Two letters in today’s FT warn of the risks of damaging Britain’s fragile recovery by “reckless” early cuts. They are a direct riposte to 20 economists who wrote to The Sunday Times at the weekend supporting the Conservative party’s argument that fiscal tightening should start sooner or soonest. Of course, it seems unfair to cut public spending when it is not to blame for credit crunch or recession, and anyway where to cut with least economic damage? In my opinion the answer is certainly not in labour-intensive services. There is a lot of cant about the budget deficit and the national debt. The media is casual in its unthinking description of public finances in 'a mess', 'in disarray', 'unsustainable', and other horror-fuelled characterisations. The opposite is true. Actually, no-one is claiming that high deficits and national debt are sustainable long term; he question is how sustainable it is in the short to medium term. But even in the short term it makes no sense to look only at one side of any balance sheet. And, sadly, I have to say that all 80+ economists are remiss in this also. It is pointless to look at the budget deficit and national debt gross, not net. Over the past year while the debt grew towards £1 trillion and the deficit to £140 billions (or 8.8-12.8% ratio to GDP depending on what is currently the most credible view of total GDP?) there has also been a growth of that proportion of debt internal to government, not least buying in up to £200bn of gilts using off-balance sheet funding, and the gaining of substantial assets in bank shareholdings without resource to the general government budget. Looked at in this light the net position is neutral to positive, hence the case for spending cuts is vacuous as well as dangerous, and indeed it may be argued that both deficit and debt should be i gross terms higher to deliver adequate deficit-spending growth impulse to the economy! We are getting a lesson in the politicians' and general public's inability to look at matters in double-entry balance sheet terms, a myopia that opportunistic politicians and their economist allies are not slow to egregiously (irresponsibly) exploit! In the medium term I calculate that the profits to be realised from the governments' bail-out of the banks will actually pay for 40% of projected UK budget deficits, though there is some question how much of that may be foregone by exiting bank support schemes early to attract institutional investors back into buying banks' shares?
There is also a critique to be offered about many economists and commntators on the subject that they have an exaggerated idea of the size of government in the economy, look too much at consumption expenditure explanation for GDP/GNP ignoring income side of the account: and worst of all assume a fixed cake in which the more flows through public sector (government) the less is available for private sector to freely enjoy and keep, which is only a short term truth, mainly at micro-level, but a medium term falsehood at macro-level i.e. insofar as government can finance recovery more painlessly and cost-effectively than relying on private sector impetus, which is understandably lacking in courage and weak by being atomistically self-serving, a realistic as opposed to a false economy we must rely far more on government in recession years than the private sector to proceed in the right direction.
All that aside, what are the economists saying?
Letter 1
From Prof Lord Layard and others.
Sir, Last Sunday 20 fellow economists wrote to The Sunday Times advocating a more rapid reduction of Britain’s budget deficit than is currently planned in the Pre-Budget Report. “There is a compelling case”, they said “for the first measures beginning to take effect in the 2010-11 fiscal year.”
We disagree.
First, while unemployment is still high, it would be dangerous to reduce the government’s contribution to aggregate demand beyond the cuts already planned for 2010-11 (which amount to 1 per cent of gross domestic product). Further immediate cuts – even supposing they are practicable – would not produce an offsetting increase in private sector aggregate demand, and could easily reduce it. History is littered with examples of premature withdrawal of the government stimulus, from the US in 1937 to Japan in 1997. With people’s livelihoods at stake, a responsible government should avoid reckless actions.
Second, Britain’s level of government debt is not out of control. The net debt relative to GDP is lower than the Group of Seven average, and on present government plans it will peak at 78 per cent of annual GDP in 2014-15, and then fall. Even at its peak, the debt ratio will be lower than in the majority of peacetime years since 1815. Moreover British debt has a longer maturity than most other countries, and current interest rates on government debt at 4 per cent are also low by recent standards.
Third, since the crisis began, private households and businesses have had to increase their saving in order to reduce their debts. It is this saving that finances the government deficit. If the government did not take up the slack, there would be a deeper recession. But fortunately, wise counsel has prevailed so far, and public spending has been maintained as an offset to reduced spending by the private sector.
Of course there needs to be a clear plan for reducing the government deficit. But the existing one for next year appears sensible. What is needed then is much more detail for the following years, and a radical plan for the medium term. That is what the debate should be about.
A sharp shock now would not remove the need for a sustained medium-term programme of deficit reduction. But it would be positively dangerous. If next year the government spent less and saved more than it currently plans, this would not “make a sustainable recovery more likely”. The weight of evidence points in the opposite direction. Letter 1 is signed by: Lord Layard,Emeritus Professor of Economics, LSE; founder of the LSE Centre for Economic Performance; Chris Allsopp, Reader in Economic Policy, University of Oxford and former member of the MPC; Alan Blinder, Gordon S. Rentschler Memorial Professor of Economics and Public Affairs, Princeton University, and former Vice Chairman of the Board of Governors of the Federal Reserve; Sir David Hendry,Professor of Economics, University of Oxford; Sir Andrew Large,Former Deputy Governor of the Bank of England and former member of the MPC; Rachel Lomax,Former Deputy Governor of the Bank of England and former member of the MPC; Robert Solow,Nobel Laureate and Emeritus Institute Professor of Economics, MIT; David Vines; Professor of Economics, University of Oxford, and Fellow of Balliol College; Sushil Wadhwani,CEO, Wadhwani Asset Management and former member of the MPC.

To clarify a couple of points: the writers are not saying that households will invest in government debt directly from their savings. In fact, the purchases will be almost wholly by UK banks less that bought by foreignors to finance the UK's trade deficit. The banks are under so much pressure to buy Gilts for their capital reserves the puchase will come from funds hitherto applied to banks' proprietary trading. The deficit is worth about one seventh of UK banks' capital and will reduce the banks' speculative exposures and funding gaps indirectly and help the quality of their solvency. The effect is not to productively absorb higher surplus household savings - these are reducing banks' funding gap borrowings. The main point missed is that the deficit opened up because of lower tax revenues in the recession in order to maintain public spending on services and other matters, but is also tivial in macro-economic terms compared to how pivate sector borrowings and financial and property firms' debt got into disarray to several times GDP compared to the Government's debt/GDP ratio of an expected peak o only 78%. The panic concern about government finances is a blind; it is private sector finances that need fixing.
Letter 2 From Lord Skidelsky and others.
Sir, In their letter to The Sunday Times of February 14, Professor Tim Besley and 19 co-signatories called for an accelerated programme of fiscal consolidation. We believe they are wrong.
They argue that the UK entered the recession with a large structural deficit and that “as a result the UK’s deficit is now the largest in our peacetime history”. What they fail to point out is that the current deficit reflects the deepest and longest global recession since the war, with extraordinary public sector fiscal and financial support needed to prevent the UK economy falling off a cliff. They omit to say that the contraction in UK output since September 2008 has been more than 6 per cent, that unemployment has risen by almost 2 percentage points and that the economy is not yet on a secure recovery path.
There is no disagreement that fiscal consolidation will be necessary to put UK public finances back on a sustainable basis. But the timing of the measures should depend on the strength of the recovery. The Treasury has committed itself to more than halving the budget deficit by 2013-14, with most of the consolidation taking place when recovery is firmly established. In urging a faster pace of deficit reduction to reassure the financial markets, the signatories of the Sunday Times letter implicitly accept as binding the views of the same financial markets whose mistakes precipitated the crisis in the first place!
They seek to frighten us with the present level of the deficit but mention neither the automatic reduction that will be achieved as and when growth is resumed nor the effects of growth on investor confidence. How do the letter’s signatories imagine foreign creditors will react if implementing fierce spending cuts tips the economy back into recession? To ask – as they do – for independent appraisal of fiscal policy forecasts is sensible. But for the good of the British people – and for fiscal sustainability – the first priority must be to restore robust economic growth. The wealth of the nation lies in what its citizens can produce. Letter 2 is signed by: Lord Skidelsky,Emeritus Professor of Political Economy, University of Warwick, UK; Marcus Miller,Professor of Economics, University of Warwick, UK; David Blanchflower,Bruce V. Rauner Professor of Economics, Dartmouth College, US and University of Stirling, UK; Kern Alexander,Professor of Law and Economics, University of Zurich, Switzerland; Martyn Andrews,Professor of Econometrics, University of Manchester, UK; David Bell,Professor of Economics, University of Stirling, UK; William Brown,Montague Burton Professor of Industrial Relations, University of Cambridge, UK; Mustafa Caglayan,Professor of Economics, University of Sheffield, UK; Victoria Chick,Emeritus Professor of Economics, University College London, UK; Christopher Cramer,Professor of Economics, SOAS, London, UK; Paul De Grauwe,Professor of Economics, K. U. Leuven, Belgium; Brad DeLong,Professor of Economics, U.C. Berkeley, US; Marina Della Giusta,Senior Lecturer in Economics, University of Reading, UK; Andy Dickerson,Professor in Economics, University of Sheffield, UK; John Driffill,Professor of Economics, Birkbeck College London, UK; Ciaran Driver, Professor of Economics, Imperial College London, UK; Sheila Dow,Emeritus Professor of Economics, University of Stirling, UK; Chris Edwards,Senior Fellow, Economics, University of East Anglia, UK; Peter Elias,Professor of Economics, University of Warwick, UK; Bob Elliot,Professor of Economics, University of Aberdeen, UK; Jean-Paul Fitoussi,Professor of Economics, Sciences-po, Paris, France; Giuseppe Fontana,Professor of Monetary Economics, University of Leeds, UK; Richard Freeman,Herbert Ascherman Chair in Economics, Harvard University, US;Francis Green,Professor of Economics, University of Kent, UK; G.C. Harcourt,Emeritus Reader, University of Cambridge, and Professor Emeritus, University of Adelaide, Australia; Peter Hammond, Marie Curie Professor, Department of Economics, University of Warwick, UK; Mark Hayes, Fellow in Economics, University of Cambridge, UK; David Held, Graham Wallas Professor of Political Science, LSE, UK; Jerome de Henau,Lecturer in Economics, Open University, UK; Susan Himmelweit,Professor of Economics, Open University, UK; Geoffrey Hodgson,Research Professor of Business Studies, University of Hertfordshire, UK; Jane Humphries,Professor of Economic History, University of Oxford, UK; Grazia Ietto-Gillies,Emeritus Professor of Economics, London South Bank University, UK; George Irvin,Professor of Economics, SOAS London, UK; Geraint Johnes,Professor of Economics and Dean of Graduate Studies, Lancaster University, UK; Mary Kaldor,Professor of Global Governance, LSE, UK; Alan Kirman,Professor Emeritus Universite Paul Cezanne, Ecole des Hautes Etudes en Sciences Sociales, Institut Universitaire de France; Dennis Leech,Professor of Economics, Warwick University, UK; Robert MacCulloch,Professor of Economics, Imperial College London, UK; Stephen Machin,Professor of Economics, University College London, UK; George Magnus, Senior Economic Adviser to UBS Investment Bank; Alan Manning,Professor of Economics, LSE, UK; Ron Martin, Professor of Economic Geography, University of Cambridge, UK; Simon Mohun, Professor of Political Economy, QML, UK; Phil Murphy, Professor of Economics, University of Swansea, UK; Robin Naylor, Professor of Economics, University of Warwick, UK; Alberto Paloni, Senior Lecturer in Economics, University of Glasgow, UK; Rick van der Ploeg,Professor of Economics, University of Oxford, UK; Lord Peston, Emeritus Professor of Economics, QML, London, UK; Robert Rowthorn,Emeritus Professor of Economics, University of Cambridge, UK; Malcolm Sawyer, Professor of Economics, University of Leeds, UK; Richard Smith,Professor of Econometric Theory and Economic Statistics, University of Cambridge, UK; Frances Stewart, Professor of Development Economics, University of Oxford, UK; Joseph Stiglitz,University Professor, Columbia University, US; Andrew Trigg,Senior Lecturer in Economics, Open University, UK; John Van Reenen,Professor of Economics, LSE, UK; Roberto Veneziani,Senior Lecturer in Economics, QML, UK; John Weeks,Professor Emeritus Professor of Economics, SOAS, London, UK.
Many hundreds of other economists would sign this letter if asked. It is signed by many friends especially those from my Cambridge years. But I notice that few are macro-economic modelers; nearly all are theoreticians albeit of an empirical bent i.e. sceptical of abstract long run theory. They usefully point out that just as the deficit is automatically generated by the long deep recession it will also be automatically reduced by recovery. What may be less appreciated or not thought to be a vital point, when higher savings in the economy are required and when banks and institutional investors (in all countries)are forced for stability and solvency reasons to invest more heavily in government bonds there needs to be a healthy domestic supply, not least after £200bn of QE, otherwise they have to buy substantial foreign treasury bonds with worse consequences for the external trade balance. There is in fact a level of government borrowing always required below which it should not fall. This, most economists generally have ignored.
What the economists are responding to is party politics in the lead-up to a general election. Opposition parties are, like the Irish, averse to letting the truth stand in the way of a good story. New Labour gave The Conservative government a similarly totally unrealistic kicking in the 1997 election by claiming public finances were in a mess. At that time, mysteriously, Chancellor Ken Clarke, perhaps resigned to losing, did not riposte with the obvious question to New Labour "what would you have done differently to get the economy out of recession (in '91 & '92)?" This time, while we are still in a recession, not the case in '97, Chancellor Darling is defending his wicket and has the above economists supporting him.60 economists are less than the "350 economists from across the world" who recently wrote to G20 leaders calling on them to introduce a financial transactions tax on speculative dealings in foreign currencies, shares and other securities. It is less than the 365 economists who (in vain) wrote in 1981 to The Times calling on the 'Thatcher' government to alter its economic policy to end the current recession.
What did the 20 economists who support the Conservative Party's policy state? They said:
IT IS now clear that the UK economy entered the recession with a large structural budget deficit. As a result the UK’s budget deficit is now the largest in our peacetime history and among the largest in the developed world.
In these circumstances a credible medium-term fiscal consolidation plan would make a sustainable recovery more likely.
In the absence of a credible plan, there is a risk that a loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability, which could undermine the recovery.
In order to minimise this risk and support a sustainable recovery, the next government should set out a detailed plan to reduce the structural budget deficit more quickly than set out in the 2009 pre-budget report.
The exact timing of measures should be sensitive to developments in the economy, particularly the fragility of the recovery. However, in order to be credible, the government’s goal should be to eliminate the structural current budget deficit over the course of a parliament, and there is a compelling case, all else being equal, for the first measures beginning to take effect in the 2010-11 fiscal year.
The bulk of this fiscal consolidation should be borne by reductions in government spending, but that process should be mindful of its impact on society’s more vulnerable groups. Tax increases should be broad-based and minimise damaging increases in marginal tax rates on employment and investment.
In order to restore trust in the fiscal framework, the government should also introduce more independence into the generation of fiscal forecasts and the scrutiny of the government’s performance against its stated fiscal goals. letter is signed by: Tim Besley, Sir Howard Davies, Charles Goodhart, Albert Marcet, Christopher Pissarides and Danny Quah, all of London School of Economics; Meghnad Desai and Andrew Turnbull, House of Lords; Orazio Attanasio and Costas Meghir, University College London; Sir John Vickers, Oxford University; John Muellbauer, Nuffield College, Oxford; David Newbery and Hashem Pesaran, Cambridge University;
Ken Rogoff, Harvard University; Thomas Sargent, New York University; Anne Sibert, Birkbeck College, University of London; Michael Wickens, University of York and Cardiff Business School; Roger Bootle, Capital Economics; Bridget Rosewell, GLA and Volterra Consulting.
The 20 economists' letter might imply there is no deficit and debt reduction plan. It, however, uses the word 'credible' without offering a reason why the government's medium term plan is not credible? My analysis suggests the government is being very modest and over-cautious in not targeting how much profitable gain there will be from its bank bailout measures and how quickly tax revenues will increase without higher tax rates. 'Credibility' can here mean appearance more than substance. The 20 say they worry about 'loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability' . The higher interest rate argument is really pathetic because all should know that 'crowding out' theory never found empirical proof - it's just a theory, and a very poor one. Higher interest rates to defend the currency is more credible, but this is such a contextually complex matter that my opinion is that the 20 lack a realistic perspective and sense of proportion. What has been happening across the FX exhagnge market continues not to be driven by relative economic performance and interest rates at all, but by all banks reducing their cross-border assets and liabilities, and in this respect the UK with £4 trillions of such positions after about £400 billions of deleveraging that sank the pound (usefully perhaps) what the 20 are talking about is inconsequential.
What we have here are 20 highly reputable economists who are insufficiently versed in what is going on in the financial markets and banks and the scale of thei balance sheet changes and how these impact the economy - they are living in an economics from pre-financial globalisation. This should not be true of Goodhart, long term colleague at the LSE of Mervyn King, but, no offence intended, his academic focus on the theoretical trees of financial markets interpreted in reductionist maths models I always felt blinded his research group from seeing the whole wood.
The 20 economists do advise sensitivety to economic circumstances, but I fear they do not have the applied macroeconomic modeller's understanding of timing. As noted by the 60 economists, the timetable for starting spending cuts is too soon to be sure of the robustness of recovery, just as, I may add too, we do not yet know how much of the government's budget revenue shortfall in 2009 will be recovered later as corporations' and others' tax provisions are realised, just as we do not know if banks will recover 30% or 50% of credit losses or have to eventually realise more than 10% of credit crunch writedowns.
In pointing up the high budget deficit it should be understood that much uncertainty remains that as in all previous experience will narrow that gaps we see nominally today - there is a difference between cash-flow borrowing and eventual outturn for the year seen in hindsight of 1-2 years hence. Output, inflation and even trade statistics are all severely revisable for up to 2 years.
Of the signatories, I am shocked at seeing among them Pesaran, Desai, Muellbauer, and Newbery, maybe not Newbery given his field is the most opaque mathematical economics, not empirical or applied, and not policy modeling. Roger Bootle is constantly a disappointment to me in his avowel (professional positioning) of almost neo-liberal economics since he can at least claim to have a macroeconomic model to operate, however flawed in medium term forecasting. Costas Meghir is also at the Institute for Fiscal Studies that I believe has in recent years taken an over-prudent view of borrowing over the cycle. Its stated view is "Whoever forms the next Government should put in place a fiscal tightening more ambitious over the next Parliament than that set out in the PBR, but without putting the recovery at undue risk with significant extra tax increases or public spending cuts in the coming year" - and in this respect at least does not favour cuts this year. But, in any case, it lacks an adequate model to sustain macro-economic views. Wickens is a general equilibrium theorist in closed economy models. Rogoff was at one time classified (by Stieglitz) as a market fundamentalist, and while this may be harsh it is the case that his analyses of crises begin and end with public sector indebtedness and monetary-driven inflation. It is disappointing that a first class logician remins bounded by partially-sighted theory. I wish he would retrain his focus to look at private sector debt and illiquid one-way markets.I could make similar superior judgements of others but would be unfair and conceited.
My main objection to the 20 remains however that they have a blinkered mindset when focusing on problems to treat context as "all else being equal" i.e. context-free. This is perhaps permissable for theory but not for applied prescriptions. Rogoff, for example, has the integrity of self-doubt, his only accusation against Stiegltiz is the presumption of certainty of showing no self-doubt or self-criticism. Henec, I'm surprised that he sides with the 20 in being certain that earlier spending cuts and higher tax rates are needed. Others agree with Martin Wolf of the FT, and I would have expected Howard Davies to agree too, that it is better to overshoot in ensuring recovery than try to economise on deficit spending to do merely the optimally minimal and risk failure, which is I think the best comment to end on.

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