Home > Fiscal Policy, Monetary Policy > All That Matters is Nominal GDP, Fiscal Policy Edition

All That Matters is Nominal GDP, Fiscal Policy Edition

Was UK government spending “unsustainable” in 2008?  Is UK government spending “unsustainable” in 2013?  Is fiscal austerity “necessary”?

When I watch the neverending debate about fiscal austerity in the UK there is always something missing.  The closest economists come to answering the above questions is usually the dreaded “cyclically-adjusted budget deficit”, and that is little better than pulling numbers out of a hat.

I think you can only answer these questions if you consider the expected path of nominal GDP.  (You knew I’d say that, right?)

If you expect that UK nominal GDP is going to rise 8% every year for the next five years, then your answer to whether we “need” austerity right now is probably “no”.  Planning for Total Managed Expenditure rising 5% a year should not be too much of a problem at all.  In fact, it would be a breeze; the deficit will fall sharply as tax receipts rise in-line with NGDP, as is perfectly normal.

But if you expect that UK nominal GDP will be at the same level in 2018 as it was in 2008 – roughly what happened in Japan post 1991 – you’d want to make very different plans for TME.

The decision between “austerity” or “no austerity” seems like a false dichotomy.  We “need” austerity only to the extent that we have really bad monetary policy.  I see a simpler choice:

Plan A: We accept the current macro policy framework, and hence accept whatever path of NGDP the Bank of England decides to deliver.  Under the inflation target over the last five years, annual NGDP growth has varied between -3% and 5%; 2% on average.  The expected path of NGDP is very unclear.

Plan B: We change the macro policy framework to ensure the Bank of England provides growth of NGDP along the desired path.  Then set fiscal policy given that forecast path of NGDP.

Darling in his final 2010 Budget, and Osborne since, have both used some variation of “Plan A”; Ed Miliband and Balls offer no alternative.  Whether or not you do “fiscal stimulus” is highly unlikely to change the Bank’s desired path of NGDP; that if anything is the lesson of Japan (and I’d argue of 2008-2013 in the UK).

“Real” fiscal conservatives should not be content to stick with any variant of “Plan A”.  If you claim “Plan A has failed”, I’d agree with you; but you must realise that “more capital spending, maybe some tax cuts, and don’ t worry, I’m sure the Bank will do the right thing” is merely another variation of “Plan A”.  “Plan B” must be “better monetary policy”.

I do not wish to imply that we should change the macro policy framework because it makes fiscal policy “easier”, or because it will cut the deficit faster.  That would be a very bad way to set macro policy.  But I think it’s important to understand that fiscal policy has been “difficult” for the last few years for the same reason that the labour market has been “difficult”: nominal GDP fell sharply below the path that was expected in 2008, and has remained well below that path.

Those who cry that fiscal policy was “unsustainable” in 2008 are really making an absurd claim based on the presumption that the observed path of NGDP was the only possible path we could have followed.  That’s wrong.  Brown/Darling fiscal spending plans were neither cause of the crisis, nor the cause of the deficit (at least its unusual magnitude).  The pattern in this graph should be familiar:

UK Central Government Tax Receipts vs Trend.  Source:  ONS Series ANBV.

UK Central Government Tax Receipts vs Trend. Source: ONS Series ANBV.

Every Budget since (and including) March 2010 has accepted an ever-larger “NGDP gap”, a greater deviation from the old trend growth path.  Adjusting the fiscal stance to a much lower path of NGDP is always going to be very difficult; you can’t easily knock 15% off your spending if your income happens to come in 15% below expectations.  Nominal shocks matter, and wage contracts (among others) are sticky in nominal terms.

Alistair Darling was (rather bravely, I thought) telling people to expect “cuts worse than Thacher” before the 2010 election because he accepted a lower trend path of NGDP (and hence tax receipts), not because he was ideologically opposed to public sector spending.  Much the same applies to George Osborne.

If anybody is pleasantly surprised to read such a view of New Labour fiscal policy on this blog, there’s a kicker: everything I’ve said above about the public sector applies equally to the private sector.  It will always be possible for aggregate private sector borrowing, hiring, or investment to appear ex post “unsustainable” if nominal GDP falls below well below the expected path.

Had the private sector taken on, in aggregate, “too much debt” in 2007?  That question is as misguided as asking whether fiscal austerity is “necessary” in 2013.  It all depends on the path of NGDP.

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