Aggregate fiscal policy under the Coalition

In this article Simon Wren-Lewis considers the fiscal policy innovations under the Coalition before discussing the choice of austerity. He argues that that choice was a policy mistake which is difficult to explain and has had significant costs for the UK. [A link to Wren-Lewis’s earlier paper on the fiscal policy of the last Labour government, free to view until the election, can be found on the Labour government page .]

When the Labour government came to power in 1997, it made the Bank of England independent, and introduced a new framework for aggregate fiscal policy. Most academic macroeconomists would view both changes as progressive, and in Wren-Lewis (2013) I argue that Labour’s fiscal rules and the transparency that went with them came close to best practice at the time. When the Coalition government came to power in 2010, it also introduced an important institutional reform: creating the Office of Budget Responsibility (OBR). It too introduced a new framework for aggregate fiscal policy: their primary and secondary ‘fiscal mandates’. I would argue that, as with Labour, both changes can be seen as largely progressive.

There is a third similarity between 1997 and 2010. Both governments started with a tight fiscal policy. Labour promised to be more prudent than its predecessor, and the Coalition promised to reduce the deficit faster than Labour. However there was a key difference in the environment in which these pledges were made. In 1997 the economy was growing reasonably well, and interest rates were above 6%. In 2010 the recovery from the largest recession since WWII had only just begun, and interest rates were at their ‘Zero Lower Bound’ (ZLB): 0.5%.

This difference was crucial. The Coalition government’s policy of sharp fiscal consolidation reduced demand at a time when monetary policy could not reliably counteract this deflationary force, and as a result the recovery was delayed. Although fiscal austerity was to some extent put on hold in 2012, the damage had been done. A conservative estimate is that around 5% of GDP was lost forever as a result of this mistake, and it produced the slowest UK recovery on record. It is difficult to understand why this mistake was made and even more perplexing why the major party in the coalition is planning to make the same mistake again after 2015.

  1. The Office of Budget Responsibility

In my study of the Labour government’s fiscal policy record (Wren-Lewis, 2013), I noted that the years before the recession were characterised by over-optimistic fiscal forecasts. This, combined with fiscal rules that with hindsight were not ambitious enough, led to fiscal policy being a little too lax before the recession, although the impact on the deficit was dwarfed by the consequences of the subsequent recession . This over-optimism was an important motivation behind the Conservative plan to create a fiscal council for the UK: the OBR. Under the Coalition, fiscal forecasts were contracted out to the OBR, which would be independent of any political pressure to be over-optimistic.

Fiscal councils have become increasingly popular over the last ten years, but their role and form differ substantially from country to country (Calmfors and Wren-Lewis, 2011). A key question in setting up the OBR was whether it could be independent of government, even though it relied to a considerable extent on government departments for parts of its forecast. The OBR has inevitably made forecasting errors – all macro forecasters do – but there is no evidence that these errors have resulted from manipulation or pressure by government. In that sense the OBR has provided proof of concept.

In political terms the OBR also appears to have been a success, as both parties are talking about the possibility of extending its role. The opposition Labour Party wanted it to cost its post-election plans, and although the government has refused this particular request it has not ruled out this possibility for the future. George Osborne’s long term plans for fiscal policy also hint at a stronger role for the OBR. 

  1. Fiscal rules

The Coalition government introduced two fiscal rules to govern its decisions about aggregate fiscal policy. The primary fiscal mandate aimed to achieve cyclically adjusted current balance within five years, but where that target was rolling (i.e. the next year the target was still 5 years ahead). The secondary mandate was to have debt to GDP falling in 2015. This secondary mandate makes little sense in either theoretical or practical terms, and was abandoned. The primary mandate is more interesting.

Portes and Wren-Lewis (2014) argue that for a country like the UK where deficit bias is not endemic, and where there is an independent fiscal institution like the OBR, a rolling target for some measure of the deficit represents a good compromise between flexibility and effectiveness. It is flexible because it allows fiscal policy to respond gradually to shocks, but it is effective in achieving longer term goals for the debt to GDP ratio and allowing scrutiny by independent organisations. So the principles behind the Coalition’s primary fiscal mandate would have been sound if it had been implemented in normal times. The tragedy for the Coalition, and the UK economy, was that it was applied at the one time it should not have been: when interest rates were stuck at their ZLB.

Before discussing that point, we should make two additional points about the Coalition’s primary fiscal mandate. First, it targeted the current balance rather than the deficit, so it excluded public investment. (This may have been one of the reasons for the addition of a secondary mandate.) This gave the Coalition the option of keeping public investment high to support the recovery, an option which they did not take up: instead public investment was cut quite sharply. Second, the target was for the cyclically adjusted current balance 5 years ahead. While the 5 year period makes sense, it would be normal over such a long time horizon to assume that monetary policy would have returned the output gap to zero, making cyclical adjustment unnecessary.

  1. Austerity

In a speech delivered to the RSA in April 2009, George Osborne gave a short account of some history of macroeconomic thought, in which he said that the New Keynesian (NK) model underpinned his whole macroeconomic policy framework. In the basic NK model, monetary policy loses effectiveness when nominal interest rates hit zero, because nominal rates cannot fall further. In the UK they hit the ZLB at about the time he made that speech. In addition the same model says that if interest rates have hit their ZLB, a decrease in government spending will reduce demand and output with a multiplier greater than one.

Thus according to the model that underpinned George Osborne’s policy, fiscal austerity when interest rates are at their ZLB will substantially reduce output. So the Coalition, by introducing a more ambitious fiscal retrenchment than had been planned, was knowingly taking a large risk with the recovery. If the forecast outlined by the OBR in June 2010 proved too optimistic (and all macro forecasts are always subject to wide margins of error), then monetary policy would have to rely on the unconventional and untested tool of Quantitative Easing (QE) to put the recovery back on track.

As we now know, those downside risks came to pass. The OBR estimate that fiscal austerity reduced GDP growth by 1% in both 2010-11 and 2011-12. That means that by 2012 GDP was 2% lower than it could have been. Even if we make the extremely optimistic assumption that all of that lost growth was recovered in 2013, this means that during the first three years of the Coalition government 5% of GDP, or nearly £1,500 for each adult and child, was lost forever as a result of the austerity programme.

A counterargument sometimes made is that without austerity, any positive impact on GDP would have been offset by the MPC raising interest rates, because inflation rose sharply in 2011. This point does not excuse the policy mistake – high inflation was not anticipated in 2010 – but it could influence estimates of the cost of that mistake. I argue in Wren-Lewis (2015) that interest rates were unlikely to have been raised in 2010-11, and in addition that the OBR numbers already incorporate some monetary policy offset.

A cumulated GDP loss of 5% is probably a lower bound for the amount of resources wasted as a result of austerity. The OBR estimates assume multipliers that are based on past evidence, which includes periods where monetary policy was able to offset the impact of any fiscal change. Over this period interest rates were stuck at their lower bound, so monetary policy had to rely on the much more uncertain tool of QE. In this situation, multipliers are likely to be higher than any historic average, and for changes in public consumption and investment could easily exceed one.

If we apply a multiplier of 1.5 to the deviation from longer term trends in public consumption and investment over the first two years of the Coalition, the impact on GDP by the beginning of 2012 could be nearer 4% rather than the 2% estimated by the OBR. If we make the further assumption that this output loss has not been recouped subsequently (which at the ZLB also makes sense), then the cumulated output cost of austerity by the beginning of 2014 could be closer to 14% rather than 5% of GDP (Wren-Lewis, 2015b).

It is tempting to ascribe this policy mistake to a misreading of the Eurozone crisis of 2010, and the view of some at the time that austerity was required to avoid suffering the fate of the Eurozone periphery. (Subsequent events, and particularly the end of the crisis following the ECB’s introduction of OMT in September 2012, suggest the source of the crisis was the failure of the ECB to act as a sovereign lender of last resort.) A recent IMF evaluation (IMF, 2014) reaches exactly that conclusion about its own policy recommendations. However this view appears not to apply to George Osborne for three reasons.

First, unlike the IMF in 2009, he opposed fiscal stimulus when it was undertaken under the previous government. Second, public investment was cut back sharply in the first two years of the Coalition government, even though there was no requirement to do so coming from the Coalition’s own fiscal rules. Third, the Chancellor is proposing a further period of fiscal austerity after 2015, even though interest rates are still at the ZLB.

While it is difficult to find any economic rationale for why the fiscal austerity mistake was made, the consequences for the UK economy are not difficult to discern. In the 13 years of the Labour administration, GDP per head grew at an average rate of over 1.6%: the red line in the chart below. This was below the longer term average growth rate of 2.25% simply because this period includes the Great Recession. In the four years under the Coalition, growth in GDP per head has averaged just less than 1%. As the earlier calculations suggest, this exceptionally slow recovery is at least in part a result of fiscal austerity.

Chart 1 Growth in GDP per head (quarter on previous year’s quarter)

wrenlewiscoal1The original fiscal plan outlined in 2010 was to achieve cyclically adjusted current balance by 2015. No doubt as a response to the faltering recovery, this plan was abandoned in 2012, when the pace of deficit reduction slowed substantially. That the Chancellor was able to do this while still observing his primary mandate illustrates the flexibility of that mandate. 2012 and 2013 also saw the introduction of two schemes designed to stimulate the economy which are at the interface between monetary and fiscal policy: the Funding for Lending scheme, and the Help to Buy scheme. These may have contributed to a sustained recovery in GDP that began in 2013, such that GDP per head in 2014 probably grew at a rate close to its historic average.

  1. Conclusion

The Coalition government introduced two important fiscal policy innovations in 2010 that should be viewed as progressive: establishing the OBR, and adopting a primary fiscal mandate which would have been a good framework in normal times.

The tragedy for the Coalition, and the UK economy, was that the mandate was applied to implement a sharp fiscal contraction at the one time it should not have been, when interest rates were stuck at their ZLB. This was a decision that appeared to fly in the face of mainstream macroeconomic analysis, and – for the majority party in the Coalition at least – does not seem to be explained by unwarranted panic following the Eurozone crisis.

Unfortunately the impact of this mistake on the UK economy has been quite predictable, and helped create an unprecedentedly slow recovery from the Great Recession.

References

Calmfors, L and Wren‐Lewis, S (2011) ‘What should fiscal councils do?’, Economic Policy, CEPR;CES;MSH, vol. 26(68), pages 649-695, October.

IMF (2014) ‘IMF response to the financial and economic crisis’, Independent Evaluation Office, International Monetary Fund, Washington DC.

Portes, J and Wren-Lewis, S (2014)Issues in the Design of Fiscal Policy Rules’, Economics Series Working Papers 704, University of Oxford, Department of Economics.

Wren-Lewis (2013) ‘Aggregate fiscal policy under the Labour government, 1997–2010’, Oxford Review of Economic Policy, Oxford University Press, vol. 29(1), pages 25-46, SPRING.

Wren-Lewis (2015) ‘The Macroeconomic Record of the Coalition Government’, National Institute Economic Review, National Institute of Economic and Social Research, vol. 231(1), pages R5-R16, February.

Wren-Lewis (2015b) ‘The size of the recent macro policy failure’, Mainly macro blog post , 15th February: http://mainlymacro.blogspot.co.uk/2015/02/the-size-of-recent-macro-policy-failure.html

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