fiscal policy

Happy Christmas from the Office of Budget Responsibility

Image reproduced from here

The sectoral balances approach to economic forecasting has come under scrutiny recently. It is certainly the case that when used carelessly, projections based on accounting identities have the potential to be either meaningless or misleading. This will be the case if accounting identities are mistakenly taken to imply causal relationships, if projections are presented without a clear statement of the assumptions about what drives the system or if changes taking place in ‘invisible’ variables such as the rate of growth of GDP are not identified (balances are usually presented as percentages of GDP).

Used with care, however (or luck, depending on your perspective), the approach is not without its merits – as I have argued previously. If nothing else, the impossibility of escaping from the fact that in a closed system lending must equal borrowing imposes logical restrictions on the projections that can be made about the future paths of borrowing in a ‘closed’ macroeconomic system.

Which brings us to the Chancellor’s Autumn Statement and the OBR’s rather helpful projections. As Duncan Weldon notes, the OBR are likely to receive a rather warmly written card from the Chancellor’s office this Christmas. While true that the OBR have, in the past, been less than helpful to the Chancellor, one can’t help but wonder about the justification for announcing the OBR projections at the same time as the Chancellors’ statements. Why are the OBR projections not made known to the public at the same time that they are made available to the Chancellor?

But back to sectoral balances. The model used by the OBR produces projections which comply with sectoral balance accounting identities. Four are used: those of the public sector, the household sector, the corporate sector and the rest of the world. The most closely watched is of course the public sector balance. The headline result of the OBR forecasts is that the public sector will run a surplus by 2019. What has so far received less attention (at least since Frances Coppola examined the projections from the March 2015 OBR forecasts) is the implication of this for the other three balances. The most recent OBR projections are shown below.

Fig-1-November-2015

Since the government is projected to run a small surplus from mid-2019, the other three sectors must collectively run a deficit of equal size. The OBR projects that the current account deficit will fall from its current level of around five per cent of GDP to around two per cent of GDP. The UK private sector must be in deficit. Interesting details lie in both the distribution of this deficit between the household and corporate sectors, and in the changes in figures since the last OBR reports in March and July.

In order to show how the numbers have changed since the previous forecasts, I have collected the data series from all three releases into individual charts.

The OBR series from these three releases for the public sector financial balance are shown below. Other than postponing the date at which the government achieves a surplus (and some revisions to the historical data) there is little difference between the three releases.

Fig-2-Public

Changes to the projections for the current account deficit are more significant. The latest projections include improvements in the projected deficit of between 0.5% and 1% of GDP, compared with the July predictions. With the current account deficit at record levels in excess of 5% of GDP, I think it is fair to say the projections look optimistic. I note that in each of the three OBR series, the deficit starts to close in the first projected quarter. Put another way, the inflection point has been postponed three times out of three.

Fig-3-ROW

Things start to get interesting when we turn to the corporate sector. Here the projections have changed rather more significantly. Whereas the previous two data series showed the corporate sector reversing its decade-long surplus in 2014 and finally returning to where many think the corporate sector should be – borrowing to invest – the new series contains significant revisions to the historical data. As it turns out, the corporate sector has remained in surplus, lending one per cent of GDP in Q2 2015. The corporate sector is not now projected to return to deficit until Q3 2018.

Fig-4-Corporate

Since the net financial balance for any sector is the difference between ex post saving – profits in the case of the corporate sector – and investment, these revisions imply either falling corporate investment, rising profits, or both.

The data series for corporate investment are shown below. The historical data have been revised down significantly. Investment in Q2 2015 is 1% of GDP lower than previously recorded. (This is hard to square with Osborne’s statement that ‘business investment has grown more than twice as fast as consumption’.) The reduction compared to previous forecasts widens in the projection out to 2020. Nonetheless, it is hard to escape the conclusion that the projections are extremely optimistic. By 2020, business investment is expected to reach twelve per cent of GDP, higher than any year back to 1980.

Fig-5.Investment

What of business profits? These are shown in the table below, taken from the OBR report. It seems that corporate profit grew at 10% year-on-year in 2014-15, despite GDP growth of around 2.5%. While projected growth rates decline, corporate profit is expected to grow at over 4% annually in every year of the projection out to 2021 (in a context of steady 2.5% GDP growth). There is not much sign of GoodhartNangle in these projections.

Fig-6-Profits

So, to recap: by 2020 we have government running a surplus just under 1% of GDP, a current account deficit of 2% of GDP and a corporate sector deficit around 1% of GDP. Those with a facility for mental arithmetic will have already arrived at the punchline – the household sector will be running a deficit of around 2% of GDP. In fact, given data revisions, the household sector appears to be already running a deficit close to 2% of GDP – a deficit which is projected to remain until 2021 (see figure below).

Fig-7-HHAs a comparison, note that in the period preceding the 2008 crisis, the household sector ran a deficit of not much over 1% of GDP, and for a shorter period than currently projected.

The OBR has this to say on its projections:

Recent data revisions have increased the size of the household deficit in 2014 and we expect little change in the household net position over the forecast period, with gradual increases in household saving offset by ongoing growth of household investment. Available historical data suggest that this persistent and relatively large household deficit would be unprecedented. This may be consistent with the unprecedented scale of the ongoing fiscal consolidation and market expectations for monetary policy to remain extremely accommodative over the next five years, but it also illustrates how the adjustment to fiscal consolidation assumed in our central forecast is subject to considerable uncertainty.  (p. 81)

Perhaps there is something to the sectoral balances approach approach after all. One can only wonder what Godley would make of all this.

Jo Michell

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Corbyn and the Peoples’ Bank of England

Jeremy Corbyn’s proposal for ‘Peoples’ Quantitative Easing’ – public investment paid for using money printed by the Bank of England – has provoked criticism, including an intervention by Labour’s shadow Chancellor Chris Leslie. It seems the anti-Corbyn wing of the Labour party has finally decided to engage with Corbyn’s policy agenda after several weeks of simply dismissing him out of hand.

Critics of the plan make two main points: that the policy will be inflationary and that it dissolves the boundary between fiscal policy and monetary policy. It would therefore, they claim, fatally undermine the independence of the Bank of England.

The first point is inevitably followed by the observation that inflation and the policy response to inflation – interest rate hikes and recession – hurts the poor. As ever, the first line of attack on economic policies proposed by the left is to claim they will hurt the very people they aim to help. Leslie falls back on the old trope that the state must `live within its means’. It is well-known that this government-as-household analogy is nonsense. But what of the monetary argument?

Inflation is not caused by printing money per se. It is instead the result of a combination of factors: wage increases, supply not keeping pace with demand, and shortages of commodities, many of which are imported.

By these measures, inflationary pressure is currently low – official CPI is around zero. Since this measure tends to over-estimate true inflation, the UK is probably in deflation. There is finally evidence of rising wages – but this comes after both a sharp drop in wages due to the financial crisis and an extended period in which wages have grown at a slower rate than output. The pound is strong, reducing price pressure from imports.

More importantly, the purpose of investment is to increase productive capacity and raise labour productivity. Discussion of monetary policy usually revolves around the ‘output gap’ – the difference between the demand for goods and services and the potential supply. Putting to one side the problems with this immeasurable metric, the point is that investment spending increases potential output as well as stimulating demand, so the medium-run effect on the output gap cannot be determined a priori.

The issue of central bank independence is more subtle – certainly more subtle than the binary choice presented by Corbyn’s critics. That central banks should be free from the malign influence of democratically elected policy-makers has been an article of faith since 1997 when the Labour government granted the Bank of England operational independence. But, as Frances Coppola has argued, central bank independence is an illusion. The Bank’s mandate and inflation target are set by the government. In extremis, the government can choose to revoke ‘independence’.

More relevant to the current debate is the fact that the post-crisis period has already seen significant blurring of the distinction between monetary and fiscal policy. In using its balance sheet to purchase £375bn of securities – mostly government bonds – the Bank of England has, to all intents and purposes, funded the government deficit. The assertion that the barrier is maintained by allowing debt to be purchased only in the secondary market is sleight of hand: while the government was selling new bonds to private financial institutions the Bank was simultanously buying previously issued government bonds from much the same financial institutions.

At this point, critics will object that the Bank was operating within its mandate: QE was enacted in an attempt to hit the inflation target. This is most likely true, although during the inflation spike in 2011, there were suggestions the Bank was deliberately under-forecasting inflation in order to be able to run looser policy; as it turned out, the Banks’ forecasts over-estimated inflation.

None of this alters the fact that quantitative easing both increases the ability of the government to finance deficit spending and has distributional consequences; QE reduced the interest rate on government bonds while increasing the wealth of the already wealthy. Crucially, there won’t be a return to ‘conventional’ monetary policy any time soon. At a panel discussion at the FT’s Alphaville conference on ‘Central Banking After the Crisis’ featuring George Magnus and Claudio Borio among others, there was consensus that we have entered a new era in which the distinction between monetary and fiscal policy holds little relevance; there will be no return to the ‘haven of familiar monetary practice‘ in which steering of short-term interest rates is the primary mechanism of macroeconomic control.

The issue which has triggered this debate is the long-term decline in UK capital expenditure – both public and private. An increase in investment is desperately needed. Corbyn isn’t the first to suggest ‘QE for the people’ – a number of respectable economic commentators have recently called for such measures in letters to the Financial Times and Guardian. Martin Wolf, chief economics commentator at the FT, recently argued that ‘the case for using the state’s power to create credit and money in support of public spending is strong’. Former Chairman of the Financial Services Authority, Adair Turner, has made similar proposals.

I agree, however, with the view that it makes more sense to fund public investment the old-fashioned way – using bonds issued by the Treasury. Where I disagree with Corbyn’s critics is on the sanctity of `independent’ monetary policy; the Bank should stand ready to ensure that these bonds can be issued at an affordable rate of interest.

Why has Corbyn – supposedly a throwback to the 1980s – proposed this new-fangled monetary mechanism? Rather than some sort of populist gesture, I suspect this reflects a status quo which has elevated the status of monetary policy while downgrading fiscal policy. This, in turn, reflects the belief that the government can’t be trusted to make decisions about the direction of the economy; only the private sector has the correct incentive structures in place to guide us to an optimal equilibrium. Monetary policy is the macroeconomic tool of choice because it respects the primacy of the market.

Given that the boundary between fiscal and monetary policy has broken down at least semi-permanently, that status quo no longer holds. It is now time for a serious discussion about the correct approach to macroeconomic stabilisation, the state’s role in directing and financing investment and the distributional implications of monetary policy. It is to Corbyn’s credit that these issues are at last being debated.