One reasonable response to arguments that the UK, or US, needs less austerity and more fiscal stimulus is ‘deficits are already large’. Now there is an obvious trap here, which is that deficits in a recession are large because of the automatic stabilisers. However it remains the case that in many countries budget deficits are large even when they are cyclically corrected. Cyclical correction is a non-trivial task, and involves making judgements about output gaps which are far from easy at present, but it is better to try than to ignore the issue. The chart below plots ‘underlying’ budget deficits as calculated by the OECD in their end November 2011 Economic Outlook. (More accurately, they are the financial balance of general government as a percent of GDP corrected for the cycle and ‘one-offs’.)
|Underlying budget deficits, OECD Economic Outlook Nov. 2011|
Cyclical adjustment takes a bit more than 2% of GDP off the 2010 deficit for the UK and the US, reflecting a view that the output gap was around 3.5% that year. So in 2010 cyclically adjusted budget deficits were still very large in both countries, reflecting in part a deliberate policy of fiscal stimulus. The chart also shows the underlying deficit projected for 2013. (Projected changes over these three years are smooth enough not to make the choice of particular years important.) In terms of withdrawing stimulus, or instituting austerity, the Euro area is expected to do more than the UK, and the US less than the UK. This raises a simple question: in judging the direction of policy, should we be looking at levels or changes?
The first thing to say is that we have to be careful relating budget deficits to the stance of fiscal policy because of forward looking behaviour. Suppose the government permanently increases spending, and finances this initially through debt, but Ricardian Equivalence holds. In that case we would get a budget deficit, which generates a matching private sector surplus because consumption falls, and there is no stimulus to aggregate demand. Perhaps a more relevant example in the current situation might be that the government promises to gradually reduce spending, making the current level of taxes eventually sustainable, but the private sector does not believe this, and instead expects taxes to be raised in the future. In this case consumers would save more to help pay for the expected increase in taxes. Once again there is no stimulus, this time because the government is not believed.
For the sake of argument let’s put those concerns to one side, and assume in the case of the UK that long term plans to reduce spending without raising taxes are credible. We have a large private sector surplus not because consumers are saving to pay for future tax increases, but because they are increasing their precautionary saving, or because those that want to borrow cannot do so because banks are restricting lending. In that case, the question about levels or changes in deficits depends on what is likely to happen to private sector demand. If the private sector is expected to continue to save in this way, then we have the same demand gap, but less of it is filled by the public sector, so aggregate demand and output fall. In that sense fiscal policy is restrictive because deficits are falling. However if the increase in private saving is expected to come to an end, which it should at some point, then it is appropriate that the public deficit also declines at some point.
It is all a question of timing, which of course is uncertain. However this uncertainty gives us a very strong argument for not reducing the size of public sector deficits too quickly. If high levels of private savings continue in the short term, then the appropriate policy is to maintain large deficits. But what if the private sector starts spending again? Will that not mean we have too much demand? Two points here. First, when there is a large degree of spare capacity, we can probably tolerate quite rapid growth in demand for a time, without this being inflationary. In fact it is a good thing, because we get rid of unutilised resources sooner. Second, if demand growth is too rapid and inflation rises (and we cannot cut government spending quickly enough because of well known institutional and implementation lags), then we can use monetary policy to cool things down.
We have an asymmetry of risks. If fiscal policy is too expansionary, we have monetary policy as a fall back. However, because of the zero bound for interest rates and uncertainty over the effectiveness of Quantitative Easing, we do not have a similar insurance policy if fiscal policy is tightened too quickly.
This is why I think the speed of fiscal tightening implied by the chart above is too rapid. In the UK in 2010, for example, there was a clear risk that private sector demand would not pick up in 2011. The risk coming from the Eurozone was also apparent. In these circumstances, the prudent policy option was not to scale back public spending too rapidly, because there was no insurance policy in place if these risks materialised. They did materialise, and UK growth stalled. The Eurozone is making exactly the same mistake, in perhaps a bigger way.
Now I have not mentioned the risks associated with rising debt, which is something I’ve discussed elsewhere. However one simple point is worth making again and again. If the recession reflects additional net saving by the private sector, they want to hold more assets. Furthermore, given the character of the recession, they want to hold relatively safe assets. There is a literature on the current shortage of safe assets. Budget deficits provide those assets, but still interest rates on debt are falling outside the Eurozone because there are not enough of them. This too points to budget deficits being cut too quickly.