In the UK, a loose knit collection of left-wing academics, NGO heads, journalists and others is currently discussing a left alternative to Osborne’s increasingly disastrous Plan A. While all are agreed that Osborne has got it terribly wrong, there is less agreement about the nature of a truly different Plan B. Should one argue for slowing the pace of fiscal contraction, but at a pace which will not frighten the financial markets – a sort of Darling-lite budget – or should one press ahead full-steam for growth, arguing that this alone will restore budgetary health?
Since many of those involved in the debate are economists, the argument is at times tediously technical. Broadly speaking, it goes as follows. A government deficit has two components: the ‘cyclical’ component – which results from the growing spread between falling receipts (tax revenue) and growing expenditure (unemployment benefit) caused by an economic downturn – and the ‘structural’ component, the gap which may still exist when the economy returns to full capacity production. If there is still a large structural component when full capacity output is restored, some economists argue, then some form of fiscal consolidation will still be required – albeit, far milder than Osborne (or even Darling) anticipated. In the absence of such consolidation, financial markets might still attack Britain.
The reader will recall that the size of the structural deficit has changed over time: two years ago London’s Institute of Fiscal Studies (IFS) thought it might be just over £50bn, but today they think it’s at least twice that size. The alleged reason the structural deficit has widened is because the ‘output gap’ – ie, the gap between current output and full-employment output – has narrowed. The UK Treasury thinks the output gap is small (2.2% of GDP) because, they would argue, much of the UK’s previous production capacity is no longer available, or to put it a slightly different way, the trend line for potential output has been pulled downward by a recession.
The IFS Green budget (Feb 2011) thought the output gap was higher – but less than 4% – while the European Commission (Nov 2010) thought it to be 5%. (There is a long technical discussion of measurement problems at: http://www.ifs.org.uk/budgets/gb2011/gb2011.pdf – indeed, on one IFS measure, there’s no gap at all.) The Office for Budget Responsibility in its March 2011 report thought it was 3%. The National Institute for Social and Economic Research (January 2011) thought the output gap was probably higher than 4%, as indeed did the OECD.
Since a larger output gap implies a smaller structural deficit, technical arguments about how best to estimate the output gap may have important implications for policy. The phrase ‘may have’ is used deliberately. Some economists on the left believe, firstly, that the very notion of the output gap is highly problematical, and that, secondly, a go-for-growth strategy need not be constrained by a structural deficit.
Regarding the first problem, besides the considerable measurement difficulties raised in trying to forecast the output gap, the concept itself rests on the notion that any attempt to push growth past the full-capacity mark would set off accelerating inflation. In orthodox economists’ jargon, there is some ‘natural rate’ of employment and output at which inflation doesn’t accelerate -NAIRU (the non accelerating inflation rate of unemployment). Others argue that this ‘natural rate’ cannot be defined, or to use a phrase made famous by Joan Robinson, NAIRU is a ‘metaphysical’ concept. For that matter, they would argue that so too is the aggregate production function approach to estimating the output gap, an approach ridiculed in the famous ‘Cambridge debate’ some 40 years ago.2
If you’re feeling a bit confused at this point, it may be comforting to know that so too is much of the economics profession. But what of the second proposition – that a go-for-growth strategy need not be constrained by the structural deficit? Here the more left-wing would argue that, providing a growth strategy is investment-based and increases Britain’s capacity to produce for the home and overseas markets – as well as targeting sustainable energy, modern infrastructure and affordable housing – the structural deficit can be reduced to near-zero. With weak trade unions, there is negligible pressure for wages to rise faster than productivity, thus minimising the problem of domestically generated inflation.
Moreover, it can be argued that financial markets are highly unlikely to be panicked by a go-for-growth strategy for at least four reasons. First of all, Britain (which has never defaulted on its debt) has the longest average debt maturity of any OECD country.3 Secondly, given the current situation in Greece and Ireland, financial markets are beginning to recognise that Osborne-style fiscal consolidation is not the road to growth. Thirdly, Britain has a flexible exchange rate. Finally, suppose that as public investment expands, financial markets for whatever reason raise Britain’s borrowing costs outrageously. Under present conditions, we could simply resort to more quantitative easing (monetisation).
That’s the bare bones of the Plan B debate about the importance of the structural deficit. Over to you, the reader.
_______________
[1] In speeches made in the final quarter of 2010, Adam Posen suggested that output was at least 3% below potential and probably more than 4% below, and Martin Weale estimated that output was 4-6½% below potential; a full discussion appears at: http://www.publications.parliament.uk/pa/cm201011/ cmselect/cmtreasy/897/89704.htm
[2] See for example G Harcourt, Some Cambridge Controversies in the Theory of Capital, 1972
[3] See Duncan Weldon, http://duncanseconomicblog.wordpress.com/2011/04/13/debt-maturity-macroeconomic-trade-offs/
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<span class="topsy_trackback_comment"><span class="topsy_twitter_username"><span class="topsy_trackback_content">RT @SocialEurope: New blogpost: "A layman’s guide to the #left’s economic debate" by George Irvin http://goo.gl/fb/ybZDo #blogs</span></span>
<span class="topsy_trackback_comment"><span class="topsy_twitter_username"><span class="topsy_trackback_content">SEJ: "A Layman’s Guide to the Left’s Economic debate" by George Irvin http://bit.ly/dVh4lF #SocioTweets</span></span>
George, I think your post sums up the structural deficit (SD) debate very accurately. My own view is that we cant ignore the SD entirely, while remaining very sceptical about any estimate. At least in the medium term potential output is highly dependent on the actual output trajectory (although there may be rude awakening in the long run, as has arguably happened in the case of the UK and others – i.e. in the past they were growing faster than was actually sustainable). This implies that faster actual growth would reduce the SD (although by construction it should not). At the same time, financial markets are very short term. The fact that public investment may yield a positive return over its life-time (thus raising longer run potential output) may not convince them if, in the short run, deficits and deficit ratios keep rising.
OK, that's the economics. We need also to think about perceptions of deficit, among brokers and bondholders, also the politics of deficit perception, which carries us into the way public and political confidence is shaped by the newspaper press and other media. How would the dominant media treat a dash for growth? The Daily Mail's response is predictable; there's a body of historical evidence about how Labour governments' financial decisions have been treated. So, a precondition of dash for growth isn't just political will but a kind of anticipatory fire-proofing against the media onslaught.
So. The international financial markets are driven by the Daily Mail? Don't be so silly.
For us laymen it is hard to believe that a "ahead full-steam for growth" formula can be the answer unless the queastion is "How can we make things worse?" That's the Blair/Brown/Balls strategy, fuelled by a credit explosion, that got us into this mess in the first place. A managed economic contraction to enable debt and savings to get into balance, supported by sensible immigration and tax policies, would be a hard sell but would make more sense and be less dangerous in the long run.
Blair/Brown/Balls, didn't get us into this mess, and debt despite popular belief is smaller now as a % Of GDP than it has been for 200 of the last 250 years, and guess what a lot of those years were under Labour, the price of borrowing is 30% cheaper now than it was in 1998 so not only did we keep our AAA rating under them we reduced the debt and did it all on the back of successive deficits creating jobs and health services, pensions, and benefits.
Of course I am not saying they got it al right, I would have done a lot different, and regulating the banks was one of them and by the way Brown was debating doing so until he was assured by various different groups Including the Conservatives and the Liberals the dangers of doing so.
The cuts scenario unless its trimming at waste is harmful, proof being under this current government debt is expected to balloon and the deficit is not expected to shrink all that much, some reports say it will actually grow, cutting means slower than trend growth and that mean more unemployment and more benefits payments, and the self demand will not keep up, lower taxes on those with the highest MPC is the way in which we should be bolstering demand not by forcing people out of jobs and on to benefits, because that shifts the PPF(GDP) LRAS to the left and when demand is contractual as well its a downward spiral not the way we should be heading and is not how we solve the debt problem if indeed it really is a problem.
"Blair/Brown/Balls, didn’t get us into this mess, " Yes, they did. Brown created the structural deficit. Greece, Portugal and Spain do not have the international banking sector that the UK does, and look at the mess they are in.
"and debt despite popular belief is smaller now as a % Of GDP than it has been for 200 of the last 250 years, and guess what a lot of those years were under Labour, the price of borrowing is 30% cheaper now than it was in 1998 so not only did we keep our AAA rating under them we reduced the debt and did it all on the back of successive deficits creating jobs and health services, pensions, and benefits."
During the period after 1945,the percentage of debt to GDP decreased. This was achieved by inflating away the debt. Frankly, such a solution is no longer possible, as we saw by the mid 1970's.
"Moreover, it can be argued that financial markets are highly unlikely to be panicked by a go-for-growth strategy for at least four reasons. First of all, Britain (which has never defaulted on its debt) has the longest average debt maturity of any OECD country." But as the cost of borrowing rises, the future becomes more uncertain, and the terms become shorter to keep rates down. Sooner or later, excessive borrowing catches up. This is exactly what is happening in Greece.
"Secondly, given the current situation in Greece and Ireland, financial markets are beginning to recognise that Osborne-style fiscal consolidation is not the road to growth." The markets are realising that the constraints of the Euro have made matters far worse. True, fiscal consolidation is a major constraint on economic activity, but continued borrowing will inevitably lead to bankruptcy.
"Thirdly, Britain has a flexible exchange rate." Thank goodness for that. But to rely on a falling exchange rate leads to inflation, and the arbitrary reallocation of wealth.
"Finally, suppose that as public investment expands, financial markets for whatever reason raise Britain’s borrowing costs outrageously. Under present conditions, we could simply resort to more quantitative easing (monetisation)." …which will inevitably lead to inflation.
If this is Plan B for Britain, then we had better stick with Plan A.
"Here the more left-wing would argue that, providing a growth strategy is investment-based and increases Britain’s capacity to produce for the home and overseas markets – as well as targeting sustainable energy, modern infrastructure and affordable housing – the structural deficit can be reduced to near-zero. "
Then the more left-wing would be showing their ignorance. Sustainable energy (ie more costly) actually reduces growth, as it is less efficient than the alternatives. Affordable housing will not alter long-term growth,it will just distort the market. Improved ifrastructure may improve growth,but not by the several percentage points required to outrun the galloping cyclical deficit.
@Nick
The only thing I would qualify in my piece is that my 'go-for-growth' strategy is better described as a public-ibvestment driven 'return to full employment' strategy.
Perhaps before prattle on with your ToryBoy comments, you could best learn some economics.
It was predicted that we would have had £164bn more in tax than we currently do before the 50p tax rate was introduced, and any other increases their has and would have been, this in without closing in on the tax gap of £121bn which is ironically exactly the same as the whole of the deficit (including the structural deficit: Which is disputed between companies and politician's alike) This is without even taking into account the increase in benefits claimants and all other increased problems with unemployment( more dependency on health increased crime etc. So if this is not proof that in full employment that we wouldn't have a surplus or a near balanced books even this year then what is. If you are wondering where I got the figures from it was from a government website.