Beware the fair-weather fiscal friend

As I’ve discussed before, a change is in the air for fiscal policy. The FT has done a mea culpa and said “the aim of balancing the budget can, at least temporarily, be dropped.” This is good news for those who have waged the long and lonely war against the fiscal hawks, but I want to urge caution about over-interpreting the new shift in fiscal policy.

There are two ways ideas can shift. First, the assumptions and/or internal logic of an idea can be rejected wholesale; the idea’s core can be negated. Ptolemaic astronomy, which held the Earth was the center of the universe, is gone without reservation, caveat, or condition.

But ideas can also change in a more gentle fashion. The core remains, and where it fails to explain, special caveats, a long list of “buts” “ifs,” and asterisks, are appended. Circumstantial reasons are proposed for why the idea does not work; perhaps the idea only works in “normal times,” and today is not; perhaps it only works when people behave a certain way, and today they are not. At some point, it is presumed, reality will again dance to theory’s tune.

This second type of change is fragile and skin-deep. The special conditions and circumstances can be jettisoned to reveal the original core. If Ptolemaic astronomy were only wrong because we were temporarily passing through a heliocentric phase, we should not be surprised to see its advocates return once they deemed the phase over.

Much of the change in fiscal policy is of this second kind. Exceptionally low interest rates, overextended monetary policy, and a pandemic induced slump are special circumstances that temporarily waive the normal logic, but they do not challenge it. The logic of balanced budgets and restrained fiscal policy still holds in “normal times” (oh those halcyon days!), we are just living through a special period that allows us to temporarily deviate from the optimum.

This colors the attitude of new converts to other parts of the consensus. As the FT’s article makes clear, a temporary shift in circumstances is no reason to change other parts of the consensus, for example changes to central banks are out of the question – “The facts have changed, but not everything else should.”

The danger is these temporary changes can be reversed quickly, at which point the old logic lurking in the background will return in force.

We should not be naïve about these processes being purely fact-based. Facts do not speak for themselves, and interpretation is complex. The US fell below estimates of full employment in 2015, but it took another four years for the Fed to change its approach to unemployment. The FT made much about sensible people changing their minds with the facts, but as Robert Skidelsky’s letter makes clear, the facts haven’t changed, it is only the FT’s interpretation which has.

Low rates, low growth, and low inflation have relaxed many of the distributional and political tensions around macroeconomic policy, and made this entente possible. Subdued inflation has allowed the financial sector to acquiesce to expansionary policy, but do not expect that to last should it pick up again.

Take last week’s fiscal framework from Orszag, Rubin, and Stiglitz (here). While they agreed on what should be done now, they were divided about the post-recovery period – “once we’re at full employment” (never mind that no one knows where it is). Rubin trotted out the warning he has been telling for thirty years, about how out-of-control US debt will cause a crisis of confidence, and a massive currency crisis. Never mind that the opposite has happened. He sounded like the old Marxists, who, when asked why the forces of history had not yet delivered the inevitable revolution, would say “just wait.”

It is a good thing that fiscal policy is experiencing this renaissance, but we should remember that many of its new friends are fair-weather.

Another day, another fiscal policy framework

It’s an exciting time in fiscal policy. A new paper out features three unlikely bedfellows. Financiers cum public servants Peter Orszag and Robert Rubin, advocates of fiscal discipline and balanced budgets in the Clinton and Obama administrations, have published with Nobel Laureate Joseph Stiglitz, of “resigning from the World Bank in protest” fame.

Their core message is simple but profound: the world is uncertain, and policy makers have a poor track record predicting the future. The defining macroeconomic events of the last fifteen years, the GFC, Trump, Brexit, and Covid-19, surprised specialists and laypeople alike. Economists did not predict the years of stagnation across the developed world, or today’s era of low interest rates.

What does that mean for fiscal policy though?

It is as inadvisable to assume we are in a “new normal” of perpetually low interest rates as it was to assume in 2009 that we were on the verge of returning to an “old normal.”

Policy makers should eliminate normal from their vocabularies, or in their words: a cogent fiscal policy framework should account for this deep uncertainty and provide fiscal policymakers tools to manage it and its fiscal consequences

What does it mean in practice, what are the ‘tools’?

The familiar: expand automatic stabilisers, make infrastructure spending more automatic and less pro-cyclical, increase debt maturities, and index long-term entitlement spending.

The novelty is their call for fiscal discretion. Hard fiscal anchors like the 3% deficit limit, or the 60% debt/GDP ratio need to go. Alongside automatic stabilisers, governments need discretion to respond to the unique challenges thrown up by an uncertain world.

This is a big shift. As I’ve written about before, the goal for many decades was to limit government discretion as much as possible, whether by legislating spending limits, or policing from independent central banks. The closer government was to an algorithm, the better.

In practice, their proposals do not differ much from Summers and Furman’s recent policy paper, however, their caution against taking today’s low-interest rate environment as given is a good one.

Most importantly, placing true uncertainty – Knightian uncertainty – at the centre of their framework is a positive step forward.

As you might expect from such unlikely bedfellows, there were some interesting tensions on display which I’ll get into tomorrow.