Sunday, 23 September 2012

Is it time to loosen fiscal policy?

The debate on the scope for looser fiscal policy just does not go away.  With every ONS release it seems, the cry for more action goes up.  But, unlike the popular media, I am not terribly interested in whether Keynes or Hayek are right or what they would have done.  Much to our, no doubt, great loss they are dead and so we must really work it out ourselves.   The key questions we have to ask are pretty obvious and yet is continually amazes me that the debate is so little illuminated by answers to these questions:

·         What is the level of public debt relative to income and is it on a sustainable path?
·         Relatedly, what is the financial market’s appetite for holding UK government debt – is the demand curve perfectly elastic or rather inelastic?
·         What is the likely level of spare capacity in the economy?

Your empirical answers to these questions will help frame your views on whether fiscal policy should be eased.  If you think that the level of debt is well characterised by net debt excluding financial interventions (66.2% at the end of the second quarter of 2012), that financial markets are willing to hold a lot more UK debt without asking for higher interest rates and there is a lot of spare capacity in the economy then I forecast that you will be asking for an end to fiscal consolidation and some activism.  On the other hand, is you think the total obligations of the public sector are large (around 165% on a gross basis at the end of 2011) relative to the financial market’s willingness to hold more debt and that there may not be very much spare capacity, the I forecast you will not be calling for a Fiscal Plan B.

The first chart below show the path of public to GDP under net and gross calculations including or excluding the obligations arising from assistance to the financial sector.  A nice stable path prior to 2007 is disrupted and shocked markedly upwards as the economy delivered a sequence of large negative growth rates and the banking sector required some recapitalisation.  My preferred measure of public debt  in normal times, gross debt (which accounts for all government debt issued and liabilities arising) has itself doubled since 2007.   When we add in financial interventions, it has quadrupled.  These kinds of debt numbers are unprecedented in peacetime in the UK and ought to warn us about any attempts to ease fiscal policy further.

It is said that the first round of QE (Bank of England-sponsored temporary purchases of bonds from the private sector over 2009 to 2010) knocked some 50 Bp off ten-year bonds yields (see Meaning and Zhu, 2012).  In other words by reducing the net supply of debt that has to be absorbed by the private sector, bond prices are higher than they would otherwise be and so yields correspondingly lower.  Although it is encouraging that these purchases had a significant impact on yields, the exact same net supply story also means that further debt issuance would actually raise yields unless accompanied by further QE operations.  I suppose it might possible to raise levels of public debt and keep interest rates low by ever larger quantities of QE but such a joint strategy really would amount to the monetary financing of fiscal deficits.  The basic idea of QE originally was to provide some direct impact on bond yields conditioned on the stance of fiscal policy not to allow the fiscal policy to issue more debt than they would otherwise have chosen.

Whether we want to issue a lot more debt might, apart from any nuances on monetary-fiscal interactions, really depend on our view of the amount of spare capacity in the economy, the output gap.  I have extended the most recent release for GDP (2012 q2) to the third quarter of 2015 using the most likely path of output from the Bank of England’s August Inflation Report.  And then run two very simple measures to de-trend: (i) a(n) (HP-)filter that allows the trend to vary over time and (ii) one that assumes the time trend is fixed.  Unsurprisingly the latter introduces significantly more variance into the cycle than the former.  The time trend suggests significant spare capacity whilst the filter suggests that the output gap has closed.  For comparison, I cross check these estimates against those of the OBR and find that their estimates are highly correlated with the filter but suggest on average a couple of percent more spare capacity.  If, in your view, more expansionary fiscal policy only affects demand and you do not believe in the time trend measure, then you also will not be inclined to argue for more expansionary fiscal policy.  

So rather than taking a high minded position on the philosophy of expansion and providing rhetoric on the need for growth, I would encourage economists to estimate some of these key parameters and so allow us to make a rational choice on the basis of the facts.  To the extent that we are uncertain of many key parameters, economics tends to advise policy to be employed in a cautious manner and that mean changing less rather than more.  It also means that the case for radical alternatives need to be fairly clear cut.  Now how about some analysis based on some numbers?