Conservative lack of fiscal caution

I’ve been struck by the activities of the Conservative Party Twitter rebuttal machine on economics, ‘Tory Treasury‘ on Twitter, who Danny Blanchflower calls ‘aka Rupert Harrison’.  (He being Osborne’s chief of staff).

One theme today was portraying the Labour fiscal plans as incautious.  Tory plans to target a falling debt to GDP ratio were cautious because this would provide room for a subsequent, repeat fiscal expansion to counter another crisis.  I find this somewhat ironic, because their plans also fail to establish that reduction in the actual deficit will be contingent on the economy lifting off from the zero bound, so that we can be confident monetary policy has room to compensate.  One might regard that as being oblivious to risk too.

The Autumn 2014 updated Fiscal Charter which the two parties are agreeing to implement and arguing about at the same time, stipulates that ‘The Treasury’s objectives for fiscal policy..’ include the obligation to ‘support and improve the effectiveness of monetary policy in stabilising economic fluctuations’.

Both parties should take note of this.  If that is an objective of fiscal policy, then it cannot be the case that deficit reduction proceeds come what may, or proceeds at all right now.  With interest rates at their natural floor, further forward guidance likely of limited impact, quantitative and credit easing of questionable impact so far, and some regarding QE at least as close to the point where costs exceed benefits, there may be no scope to compensate for the contraction in aggregate demand that fiscal consolidation would entail.  Theoretical analysis, and ungenerous readings of recent Japanese history suggest that there is the chance to get trapped at the zero bound.  Attempting now to contract the fiscal stimulus, with headline CPI inflation at least heading in the wrong direction, is hazardous.

The card that both parties are playing is the worry about long-term fiscal credibility.  But it is not credible to promise to do something that is obviously not in our interests, and, judging by the stalling in deficit reduction that happened in this Parliament, likely not to happen anyway.  And concerns about credibility are hardly consistent with not specifying how these plans will be met.

Deficit-reduction-come-what-may has resulted from a strange kind of pernicious electioneering, under the spotlight of media commentary that also, so far, has not broached the likely reality of fiscal policy in the next two or three years.  I suggest that this lends weight to arguments that the role of fiscal stimulus, particularly at the zero bound, should be codified further in the direction of Wren-Lewis style fiscal councils.  We used to think that fiscal independence was necessary to stop pre-election booms and post-election busts.  But right now we need fiscal independence to protect the economy against the opposite problem: populist austerianism.

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5 Responses to Conservative lack of fiscal caution

  1. Blenheim says:

    Hi Tony – on Twitter, you ask “Tory Treasury” to explain how continued deficit reduction at the ZLB is consistent with believing in the analysis offered by New Keynesian models.

    However, if you literally believe in New Keynesian models, my (limited) understanding is that Forward Guidance is very powerful. Couldn’t this substitute for fiscal policy (just in these models, I understand that in the real world things could be different). thanks!

    • Tony Yates says:

      In principle, it could. However, in reality, I think the scope for significant further forward guidance is limited. I also think that relying on results that are true under rational expectations is rash, too. There may not be anyone listening to the guidance as keenly as the RE brand of NK models says. FYI there’s a really interesting new paper by Nakamura, Mackay and someone, showing how the effect of forward guidance is much weaker in heterogeneous agent versions of the NK model. More familiar results on FG derive from Eggertson and Woodford’s representative agent version, and this feature is inherited by the BoE COMPASS model. As a practical matter, I think that the BoE completely messed up forward guidance, as I wrote about before. In particular, they fudged whether it constituted more stimulus or not, [Carney probably wanted more stimulus, and went on to describe it as something to ‘secure the recovery’, implying that it was, but other MPC members probably did not want more stimulus, which left Carney in a tricky spot in front of Treasury Committee].
      You can make a similar argument that QE is available too. But this is still of uncertain impact. Some argue that the costs outweigh the benefits, or may do now with stocks of QE already so high.
      But good point

      • Blenheim says:

        Thanks a lot for your reply Tony.

        I did wonder about this, as I’ve seen a number of people claim (not in papers, but on blogs/in the press) that the “standard” NK models at the ZLB imply monetary policy is impotent and so you need to use fiscal policy. This confused me as Woodford’s Jackson Hole speech seemed to suggest that “Odyssean” FG could ensure that monetary policy worked (though I think he was skeptical about QE). Thanks a lot for clearing this up!

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