Are Deficits “Good” or “Bad”?
I should probably steer clear of this well-trodden path, but it’s hard to resist. The fiscal deficit dominates UK politics and economics. Yet I find the economics becomes murkier as time passes.
I can understand a world in which monetary policy determines
the size of the sun the level of nominal GDP. I can understand a world in which fiscal policy affects lots of things, including the velocity of money. I struggle to understand a world in which fiscal policy determines the level of nominal GDP. And nominal GDP is what we really care about in terms of demand management. Everybody is signed up to that, right? But let’s pretend we can ignore monetary policy for the moment.
The defining narrative of our times was that the Coalition government is cutting the deficit “too far, too fast”. The implication is that running deficits is “good”, and contributes positively to aggregate demand (NGDP). Running smaller deficits will “hurt growth”. We can interpret those claims in terms of the effect on the level, or growth rate, of nominal GDP.
(Economists do themselves no favours by talking exclusively about real not nominal aggregates when discussing demand management. It’s a shoddy trick, because supply-side changes get mixed in with demand-side changes.)
But this is the Guardian in November 2011:
Britain will borrow a “staggering” £158bn more than the government planned a year ago, Ed Balls claimed on Tuesday as he accused George Osborne of presiding over a “truly colossal failure” in his economic plans.
And here the narrative shifts, or at least becomes murky. Can it still be that deficits are “good” per se? Ed Balls thinks that running large(r) deficits is a sign of failure!
For almost the entire period since March 2007, and particularly since March 2010, the US has run a looser overall fiscal stance – a more stimulative fiscal policy – than the UK, even taking the full operation of the larger automatic stabilizers in the UK into account. Cumulatively, since 2007Q1, the difference has amounted to 3% of GDP.
This is from a paragraph talking about deficits, measured as a percentage of GDP. So here is more support for use of the deficit (% of GDP) as a “measure” of how fiscal stance affects aggregate demand.
Even if the deficit did tell us the “correct” measure of the fiscal stance… which deficit? The ONS inconveniently give us two for the UK: one including the effects of financial interventions, one which doesn’t. Similarly, US deficits are “flattered” (reduced) by the regular return of coupons paid on Treasury bonds held by the Federal Reserve – a reasonably chunky number due to the large purchase of bonds under QE. The Bank of England is not doing the same. (Simon Ward has suggested the BoE return the accumulated profits from QE to HM Treasury as a one-off improvement to the deficit. I wonder if this idea might be revisited this year in light of gloomy projections for the fiscal position?)
Then we can head over to Brad DeLong on “self-financing fiscal expansion“, or Simon Wren-Lewis for a discussion of the “Balanced Budget Multiplier”. The latter is the idea that an increase in fiscal spending and taxation by £x will increase aggregate demand by £m*x but hold the deficit fixed. If the deficit is held constant in nominal terms, but nominal GDP is rising, that means the deficit is falling as a percentage of GDP. So… we can have “fiscal stimulus” and “falling deficits”? Now I’m really confused.
Should we instead talk about the level of fiscal spending as the measure of the fiscal stance? OK, but then Mr Posen’s comparison of deficits is totally meaningless. And we need a more nuanced take on the fiscal policy of “Slasher Osborne”, who has always planned to increase the level of total fiscal spending (Total Managed Expenditure rising from £696.8bn in 2010-11 to £757.5bn 2015-16, in the June 2010 Budget). That’s a slightly slower rate of increase than planned under Labour, but it’s still an increase. Yes, we could add in the multiplier fairy, and say that increases in current spending will not offset cuts to capital spending. But it all requires some pretty heroic assumptions.
And if Osborne is increasing spending, and increasing taxes (in 2011 at least), how exactly does that differ from a “self-financing fiscal expansion”?
I’m left more confused than enlighted by the whole debate.