When the present government was first formed, I expressed support for the fiscal strategy outlined by George Osborne, the new Chancellor, subject to the understanding that the pace of fiscal tightening would be scaled back in the event of outcomes for the real economy markedly worse than forecast. I continue to feel unease at the prospect of a new burst of fiscal expansion designed to reignite the economy, as is being widely advocated in professional circles. Why?
It is not that I doubt the truths of Keynesian economics, let alone the proposition that it is better to have big deficits when there is excess aggregate supply and to make up the lost revenue by raising taxes and/or reducing expenditure when the economy is in boom. Of course, the reluctance of many of the present Keynesians to support large fiscal surpluses during the last boom (in 2005-08) hardly gives them great credibility. (Similarly, most British economists refuse to acknowledge that fixing the sterling rate by joining the euro when it was first formed would have had the great virtue of ruling out as immediately inflationary the irresponsible fiscal policies of the pre-2007 years.) But all that is water under the bridge. The basic reason for concern at the prospect of renewed fiscal expansion is because this involves adding to debt. And high debt is a bad thing: because it involves transferring income to the present generation (which has already done quite nicely, thanks Jack) from future generations; because it involves lowering the potential growth rate (this has not been denied in the Rogoff-Reinhardt controversy); because it increases the chance of a currency collapse. And there can be no doubt that fiscal expansion would increase the level of debt, and the ratio of debt to potential GDP (the conceptually relevant measure), even though it is true enough that it is not certain that it would increase the ratio of debt to actual GDP, as many of the proponents of fiscal expansion have argued with great vehemence. No one sensible (i.e. someone who has absorbed Keynesian economics and not subsequently engaged in an intellectual abnegation called “rejecting Keynes”) denies that a reduction in fiscal expansion is likely to reduce the level of GDP in the short term. But the essence of economics is weighing off one good against another, and the question is whether this means that the lower debt is bought at too high a price. There seem to me to be two arguments as to why a lower debt may be worth sacrificing some current income. The first argument is that one cannot be sure that there will be the possibility of reversing the increase in debt while there is still time. It is all very well to proclaim, the principle that fiscal policy should be tightened when times are good, but this takes it for granted that times will improve. A danger in delaying action is that if recovery does not follow promptly even with fiscal expansion then it may become necessary to tighten policy at an even more inopportune time. Indeed, the present government has argued that it found itself in this situation: that if only there had been tighter policies in the past, there would be less need to tighten policy now. Admittedly the argument that there is no alternative but to tighten policy now is highly speculative: It is only true if a continuation of existing spending policies without a tax increase to pay for them (or a new stimulus, where that is what is being urged) threatens to tip the economy into crisis. But the counter-argument that because the government is currently able to borrow at low interest rates this danger can be ignored is unpersuasive: a few weeks before the Greek crisis started the Greek sovereign was able to borrow at only a few basis points more than Germany. In other words, one cannot predict how or when a crisis will emerge. All one can say with any confidence is that actions which violate the transversality conditions1 will sooner or later generate a crisis. Hence it is safer to avoid violating the transversality conditions, knowing that one cannot predict the next crisis. The other danger with delay is that the tightening may never happen, for political reasons. No politician will welcome the prospect of having his time in office remembered for the fiscal contraction undertaken, and there are countervailing arguments. They look phony enough to anyone with an economics education, but that does not mean that they do not have political appeal. Can’t you already hear it: You want to cut expenditure when we have the resources to afford it? Already the reduction in the budget deficit in the United States in recent weeks (written on May 18, 2013) is being cited as reducing the need to cut public expenditure. It is asking a lot to expect politicians to take actions that are contrary to common sense just because they are theoretically correct. So if one does not reduce spending (or raise taxes) when times are difficult, it may never get cut at all. So where does this lead me? To the same place as the IMF: Advocacy of less fiscal contraction in the short run than is currently planned, within a framework of regarding fiscal contraction as generally a good thing.