fiscal policy

Robin Harding

The paper at this year’s US Monetary Policy Forum – where market economists get to present to central bankers – is called “Crunch Time: Fiscal Crisis and the Role of Monetary Policy“. It shows a new wrinkle on US fiscal problems: if there is any kind of debt sustainability crisis it could make the Fed’s exit from easy monetary policy a whole lot more painful.

This is the money chart. Black is the baseline for Fed profit and loss in the coming years. Red is what happens if a fiscal crunch pushes up long-term bond yields (and hence causes losses for the Fed on its portfolio). 

Robin Harding

It looks like Congress will not heed pleas from the Federal Reserve for a fiscal policy plan – see Bill Dudley’s speech last Thursday for another example – as we await confirmation that the ‘supercommittee’ has failed. This is very bad news for the coherence of US economic policy, something totally ignored by Congress, which seems to think it can have an extended philosophical argument about the correct size of government without any consequences.

As Mr Dudley noted (emphasis added):

“It would be greatly beneficial if the Administration and Congress could more effectively work together to craft a coherent fiscal policy. As I see it, this would consist of two elements—continued near-term fiscal support to underpin economic activity and long-term fiscal consolidation to ensure debt sustainability. Without action in Washington, fiscal policy will turn sharply restrictive in 2012—exerting a direct drag on real GDP growth of more than one percentage point. At the same time, the long-term path under current policy is unsustainable.”

 

Robin Harding

Although it seems like a world away, the main economic policy argument in the early summer of 2010 was about the effectiveness of fiscal stimulus, in the wake of the Obama administration’s $787bn American Recovery and Reinvestment Act.

Now that the administration is asking for a new $447bn stimulus that question should be back at the top of the agenda – and thanks to two excellent new NBER papers it is going to be a lot harder for people to distort the economic argument.

Most of the new evidence suggests that in today’s specific circumstances – where the zero lower limit means that monetary policy is not as loose as the Fed would like – then fiscal stimulus could be very effective indeed. 

Robin Harding

Macroadvisers have put out their estimates of the economic effect of passage of the House Republicans $61bn of FY11 spending cuts. They are lower than Goldman Sachs, higher than the Fed, and look pretty solid to me.

  • Our simulation analysis suggests this near-term fiscal drag would reduce annualized growth of real GDP during the second and third quarters of this year by ¾ percentage point, with smaller impacts for a few subsequent quarters.

 

Chris Giles

Giving evidence to the Treasury Select Committee this morning, George Osborne claimed the UK economy was back on track.

He added that it was pretty clear to him that the previous Labour government had overstated trend growth for much of its time in office and there had been a big “boom” in the economy for much of the decade.

Warming to this theme, the chancellor referred the Committee to his favourite chart of the June Budget, which shows what the output gap would have looked like if a more modest figure – and what Mr Osborne said was “more realistic” estimate for trend growth – had been assumed by the previous government. 

Chris Giles

When the FT reported that senior Bank of England staff including Monetary Policy Committee members thought Mervyn King, Bank governor, had overstepped the line separating monetary and fiscal policy, the governor was dismissive.

He rounded on my excellent colleague, Daniel Pimlott, who asked him whether he had the unanimous support of the MPC in endorsing the political decision on the speed and scale of the new government’s deficit reduction.

“And, just for the record, I’ve spoken far less on this than almost any other central bank governor around the world; less than Ben Bernanke, less than Jean-Claude Trichet, both of whom have given speeches in great length and regularly. I haven’t spoken on this except in response to direct questions at the Treasury Committee, and when asked by the Coalition. So perhaps we’ll move on to a serious question about the economy.”

 

Chris Giles

On Monday, the IMF cannot contain its enthusiasm the UK’s harsh austerity plans. On Thursday it releases research warning fiscal consolidation “will hurt” and “are likely to be more painful if they occur simultaneously across many countries, and if monetary policy is not in a position to offset them”.

The IMF finds that, “fiscal consolidation equal to 1 percent of GDP typically reduces real GDP by about 0.5 percent after two years”. Does the IMF left hand talk to its right hand?

Sadly for journalists, the answer is “yes”. Both IMF documents hype-up their conclusions to give the appearance of deep contradiction. They are, in fact, consistent.

How so? 

Chris Giles

The reporting  of the International Monetary Fund’s assessment of the British economy and the important speech by Adam Posen has given the impression that the Fund is optimistic about UK prospects while Mr Posen is pessimistic. That is the inevitable consequence of news reports focus on downside risks to policy (the IMF gushed while Posen fretted). In fact, the reverse is true.

The argument, once again, hinges on the assessment of the UK’s potential for growth.

  • The Treasury, the IMF, the Office for Budget Responsibility and most in the Bank of England are the pessimists. They believe one of the two following possibilities: either that lots of capacity was lost permanently in the recession, or that the economy was fundamentally unsustainable before the downturn, as shown in this graph. I understand the IMF’s latest estimate is that the output gap is only 3 per cent.
  • Mr Posen and Ed Balls, shadow schools secretary, are optimistic. They believe that output is fundamentally below potential and significant spare capacity exists, at least for now. That means growth can and should be higher.

What follows from this distinction?

Everything. In monetary policy, 

Chris Giles

The IMF tends to be a bit sniffy about countries’ economic policies in its annual report on countries’ economies. That often helps finance ministries in domestic political battles to do the right thing.

But with the new government adopting Fund-friendly fiscal policy, the Bank of England insisting it is ready to act either way on monetary policy and a strengthening of financial policies on the way, the Fund has been reduced to a schoolkid’s crush in its latest assessment of the UK economy. I understand from the Treasury that the chancellor is pleased.

Here are some highlights. On the immediate economic outlook:

“This progressive strengthening of private and external demand should underpin a moderate-paced recovery, even as the public sector retrenches.”

Even though the IMF said 

Chris Giles

On this blog, I have repeatedly noted with dismay how badly Britain is afflicted by structural deficits disease – the mistaken belief that you can measure the underlying budget deficit.

Various economists have sympathised with my campaign, but argued that governments need to set fiscal policy and to do so ministers need an estimate of the ‘size of the hole in the public finances’ or ‘the deficit which would remain once the economy got back to normal’.

Some Treasury officials have said that without a target path for the structural deficit, it would be impossible to follow a consolidation plan and have room for automatic stabilisers to work in the event that the economy is derailed.

Apart from the many other problems I have noted with these arguments, a new drawback of the Treasury’s position occurred to me this week. It is that the Treasury’s June Emergency Budget does not give one estimate of the hole in the public finances, but three. And they are not consistent. Take your pick, the hole is either £116bn, £128bn or £160bn.