Monday, 1 April 2013

In defence of 'plogs'

It is fair to say that I would not have imagined myself writing a post in defence of the Office for Budget Responsibility. Nevertheless, here I find myself (sort of).

That is not to say I intend to offer any excuses for the OBR’s worryingly poor forecasting record for UK economic output, which have been used all too frequently as a fig-leaf to cover a litany of equally poor policy decisions. Instead I want to defend Robert Chote and his team from a particular charge levelled at them by the FT’s Chris Giles last week.

In an article entitled “How to ‘plog’ the hole in our awful public finances” Giles writes:

“Had the OBR assumed significant spare capacity now alongside extremely weak growth in the economy’s potential output, it could combine a lacklustre forecast for output growth without the assumption that spare capacity would still exist in 2017-18.

The benefit would be a logical and consistent forecast, but the assumptions would come at a cost: the OBR would have been forced to tell the chancellor he needed to raise taxes or cut spending further now. In this world, more of the government’s borrowing would be deemed structural rather than cyclical – meaning it would not disappear automatically when growth resumed.”

Given the OBR’s track record, I can understand Giles’ cynicism over the latest forecasts (even though they have become much more conservative since December). The problem is that the assumption of “extremely weak growth in the economy’s potential output” relies on an extrapolation of the UK’s prospects based on current policy. That is, if we continue to go down the current path the government may ultimately have to cut much deeper in order to hit its own targets.

And here, I think, is the mistake. Current policy has undeniably failed to deliver the recovery expected by the OBR to date. With no meaningful changes to the policy mix it remains difficult to see where the drivers of growth will come from that will allow the economy to grow 1.8% next year and 2.3% in 2015.

Yet I see it as no less of a heroic assumption to claim that there has been permanent output destruction than it is for those on the other side of the debate to suggest that the large output gap can be bridged through better policy. Moreover, as Japan has demonstrated over the past two decades, the sustainability of government finances cannot simply be measured by a country’s net sovereign debt to GDP but in its ability to service it.

Giles suggests that if the OBR had factored in a shallower recovery it might have necessitated  “telling the chancellor he needed more austerity now”. This logic, however, sits uncomfortably with a recent paper released by the IMF on the challenge of debt reduction during fiscal consolidation.

In what could be seen as a shot across the bows for governments trying to cut their way to fiscal sustainability the author’s write:

“[Debt] targeting could be self-defeating: if authorities focus on the short-term behavior of the nominal debt ratio, they may engage in repeated rounds of tightening in an effort to get the debt ratio to converge to the official target, undermining confidence, and setting off a vicious circle of slow growth, deflation, and further tightening.”

The implication is that bringing in new rounds of fiscal consolidation to chase arbitrary targets can damage short-term growth causing the targets to be missed again and necessitating further rounds of cuts. Sure, if the UK’s output capacity has been permanently impaired then reducing the rate of spending may be necessary over the medium term, but establishing how much of the deficit is “structural” and how much “cyclical” seems to me just as impossible a debate to resolve as establishing a consensus for the size of the Output Gap has proven.

Giles claims that the implicit assumption of the OBR’s forecast is that the Bank of England is effectively impotent as it is “unable to eliminate spare capacity in the economy until about 2021”. In effect he goes on to dismiss this idea by suggesting that the reason the output gap cannot be bridged through monetary policy is that some output has been permanently lost, therefore is “structural”.

There is, however, another plausible option. With monetary policy already bumping up against the zero lower bound and most of the extraordinary measures brought in (such as quantitative easing) limited in their impact by a damaged financial sector the idea of constraints on monetary policy is far from fanciful.

If the transmission mechanisms of monetary policy are impaired, then the impact on the real economy is likely to be muted. Yet one effect that the BoE’s asset purchase programme has had is in reducing the cost of government borrowing and, through its de facto guarantee to act as buyer of last resort, has also helped to invert the impact of economic weakness on government bond yields.

This has left a potential avenue of central bank policy into the real economy – government investment. Unfortunately it was precisely the assumption that fiscal policy could do nothing to aid Britain’s growth prospects that lead to the Coalition’s austerity policies and appears the tacit position in Giles’ thinking.

Yet as Brad DeLong wrote in a Brookings paper last year:

“[In] a depressed economy, with short-term safe nominal interest rates at their zero lower bound and with monetary authorities committed to keeping them there for a considerable period of time, the policy-relevant [fiscal] multiplier is likely to be larger than econometric estimates based on times when the zero nominal lower bound does not hold would suggest.”

As DeLong’s paper suggests one of the best ways to ensure that the damage from an economic crisis becomes permanent is to allow cyclical unemployment to become structural. If the lesson policymakers take from deteriorating OBR forecasts is that they should do more of current policy then we may have lots to fear indeed.

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