Wednesday, 24 May 2017
Top UK Treasury official does not understand deficits.
Nick Macpherson was the top bureaucrat at the UK Treasury 2005-2016. Simon Wren-Lewis (Oxford economics prof) draws attention to the fact that Macpherson claimed in a Tweet that the “Tory pledge to balance budget by 2025 is a disappointment to anybody who wants to break the cycle of deficits, debt and devaluation.” Macpherson then claims in subsequent tweet that, “running a structural current deficit when economy is at full employment is poor economics and poor public finances stewardship.”
I don’t have any big disagreements with Wren-Lewis’s criticisms of Macpherson’s thinking. I’ll set out my own criticisms below which I think are slightly better than Wren-Lewis’s. This is a bit technical: only suitable for people with a serious interest in economics. Here goes.
I’ve actually pointed out the flaw in Macpherson type thinking several times on this blog over the years. But I’ll run thru it yet again.
Assume inflation averages 2% pa over the years. I.e. let’s assume that while inflation may be a bit above 2% in some years, it is below 2% in other years: more or less what has happened in the real world in recent years. Also assume that growth averages about 1% pa in real terms: again, an entirely reasonable assumption – 1% is approximately the actual rate of growth for the UK economy over the last 20 years or so.
The “Macpherson theory” is that in that scenario there should be no deficit over the medium / long term. In fact a deficit is inevitable on the above assumptions and for the following reasons.
The 2% inflation and 1% growth mean that the national debt and monetary base will shrink in REAL TERMS relative to GDP. So on the entirely reasonable assumption that those two will need to remain CONSTANT relative to GDP, then they’ll have to be topped up regularly. And that can only be done via a deficit!
The assumption that the debt and base will remain constant relative to GDP in the long term, or perhaps I should say “very long term” is what has actually happened in the UK over the last 200 years. That is, while the debt has risen to dramatic levels on some occasions, e.g. after WWII, it has on average hovered around the 50% to 70% of GDP level.
Notice that the sum of the debt and base are what MMTers sometimes refer to as “private sector net financial assets”. PSNFA is an important quantity. It equals or amounts to private sector net financial savings. And it seems (to repeat) that desired PSNFA over the very long term has remained roughly constant.
So, given that a constant deficit is needed, how big will it need to be? Well that’s easy. On the above assumptions, it will need to be (2+1)x50%=1.5% of GDP.!! Macpherson eat your heart out.
The argument put by Wren-Lewis in the above mentioned article is that zero is too low a rate of interest because it means the rate cannot be cut come a recession. Ergo at the zero bound, fiscal stimulus and an increased debt is needed to get the rate of interest up.
Well the slight flaw in that argument is that having got the debt and rate of interest up, the debt will shrink again because of the above mentioned 2% inflation and 1% growth. So Wren-Lewis would need to repeat his “fiscal stimulus so as to get the rate of interest up” process all over again after a few years.
In contrast, I’m advocating a PERMANENT deficit so that the latter “repetition” is not needed. I claim my “model” (for want of a better term) is a bit better.
Artificial interest rates.
Another weakness in the Wren-Lewis model is that under that model, interest rates seem to be simply a device for adjusting aggregate demand. In fact the rate of interest (e.g. for a zero risk loan) is the price of borrowed money, and it is reasonable to assume that GDP is maximised when interest rates are at free market prices, in the same way as it is normally assumed in economics that GDP is maximised when the price of anything else is at free market prices (except where it can be shown that there are good social arguments for the price being artificially low (as is the case with kid’s education) or artificially high (taxes on alcoholic drinks).
I.e. there is merit in the idea that interest rates should be left to find their own level, an idea promoted by Positive Money among others. The only possible flaw in the latter “Positive Money” strategy is that interest rate adjustments might work more quickly than fiscal adjustments. However, it’s far from clear that that is the case.
There is a Bank of England article which claims interest rate adjustments take a year to have their full effect. Plus there is no need to wait for politicians to have lengthy debates on the matter before adjusting fiscal stimulus: an element of variability can easily be built into tax and public spending which DOES NOT require lengthy debates. For example the UK adjusted VAT downwards and then up again during the recent crisis without the say so of politicians (apart from the UK’s finance minister, of course, who implemented those VAT changes.)