Wednesday, March 7, 2012

Killing Keynes

There have been some suggestions recently that the revised fiscal rules which all 27 EU members have already agreed to as part of the revised Stability and Growth Pact and which 25 of the 27 are proceeding to “transpose the ‘balanced budget rule’ into their national legal systems, through binding, permanent and preferably constitutional provisions” via the  Treaty on Stability, Coordination and Governance is the death of Keynesian-style fiscal policies in the EU.  That is not the case.

Keynesianism, as it is typically described now, is a counter-cyclical policy that allows governments to run deficits in bad times is respond to downturns with “sufficiently large” surpluses run in the good times to fund these deficits.  Virtually all countries are very good at achieving the former, but very few accommodate the latter.  Rather than outlawing counter-cyclical policy the fiscal rules are actually an attempt to formalise it as is said in the SGP.
Member States should achieve a more symmetrical approach to fiscal policy over the cycle through enhanced budgetary discipline in periods of economic recovery, with the objective to avoid pro-cyclical policies and to gradually reach their medium-term budgetary objective, thus creating the necessary room to accommodate economic downturns and reduce government debt at a satisfactory pace, thereby contributing to the long-term sustainability of public finances.
Of course, this is not to suggest that Lord Keynes himself would be a devout advocate of this approach to fiscal policy.  Keynes did favour a counter-cyclical pattern of expenditure but his emphasis was on the confidence effects that increased government capital expenditure can offer in a downturn, rather than current expenditure which has become the emphasis of government expenditure.
In one of his more whimsical moments in the GT Keynes wrote:
"If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez faire to dig the notes up again . . . there need be no more unemployment. . . . It would indeed be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing."
Although the government is essentially giving away the money it is doing so in a manner to stimulate private-sector investment in order to obtain the money.  Anyway, away from Keynes and back to Keynesians.  Here is a table which shows how the proposed ‘balanced budget rule’ incorporating a 0.5% of GDP limit on the structural deficit is counter-cyclical.
Counter-cyclical balances
The first column is the output gap: the difference between the forecast actual GDP and the estimated potential GDP.  We will not go into the difficulties of determining this here.  The next column is the sensitivity of the budget balance to the output gap.  The figure used here is 0.5 which is not too different from the EU15 figure of 0.49 used by the European Commission.  The figure for Ireland is 0.40.  All the current sensitivity estimates can be seen here.

Multiplying the first number by the second gives the cyclical-component of the budget balance, i.e. the impact of the economic cycle of the budget.  For example, if the economy is growing above its potential rate and has an output gap of 2% of GDP this is forecast to lead to an improvement in the budget balance of 1% of GDP.
If a country has a debt of greater than 60% of GDP the allowed structural balance is 0.5% of GDP.  Adding the two together gives the overall balance the country should be aiming for at different stages of the economic cycle.

If should be clear that the allowed overall balances are counter-cyclical. When the economy is growing above its potential it is required to run overall surpluses, and in a downturn it is allowed to run deficits.  In the case of a very large output gap of –4% of GDP it can be seen that the rule allows a deficit of 2.5% of GDP. 
Counter-cyclical government spending has not been outlawed.  The intention is to try and ensure “sufficiently large” surpluses in the good times.  There is no guarantee of that but this is not the attempt to kill Keynes, or more specifically Keynesianism, that some have been claiming. 

For those who are making this claim it would be useful if they could provide references to their calls for fiscal restraint and a reigning in of government expenditure during the good times.

9 comments:

  1. Where did Keynes talk about the "saving up for a rainy day fund"?

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    1. Anonymous,

      Keynes returned to the bottle analogy in Chapter 16:

      "'To dig holes in the ground', paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services. It is not reasonable, however, that a sensible community should be content to remain dependent on such fortuitous and often wasteful mitigations when once we understand the influences upon which effective demand depends."

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  2. @Seamus
    ""'To dig holes in the ground', paid for out of savings, will increase, not only employment, but ..."

    Could that be interpreted to deduce that using a proportion of private sector pension funds to finish all the unfinished houses and commercial buildings in the country, would pay a national dividend and thus a reasonable dividend for both the pension funds and the country?

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  3. Seamus - where do you find the 'rule' that budgets must be in cyclical surplus during a period of positive output gap? The EU Commission states that the 'balanced budget rule' is met if the structural deficit does not exceed 0.5 percent (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/128454.pdf). It would seem, therefore, that if this criterion were met, cyclical deficits would be allowed consistent with the general 3 percent rule and within the context of any application of the 1/20th debt reduction rule. Is this a function of the rule that expenditure growth should reference potential GDP growth rate? Or an implied MTO path given Ireland's current situation?

    The only reference I can find to a 'good times' situation in the revised SGP, where the structural deficit rule is being complied with, is that member states "should in particular avoid pro-cyclical fiscal policies in ‘good times’". What I can't find is a rule or formula whereby such member-states in good times are required to run cyclical or general balances - and if they don't, they will be subject to action by the EU Commission. There's disciplinary action aplenty for violations of the structural deficit rule.

    Thanks.

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  4. Hi Michael,

    It is not a 'rule' that budgets must be in cyclical surplus when the output gap is positive. When the output gap is positive the cyclical effect of the business cycle on the budget balance is positive. It is not possible to "run" a cyclical deficit. A cyclical deficit occurs only because the output gap is negative.

    Consider a country with a deficit of 2% of GDP. Assume that 1% of GDP of the deficit is due to a downturn and a negative output gap (the cyclical element) and 1% of GDP of the deficit is due to previous political decisions (the structural element).

    Further assume that the economy improves eliminating the output gap in the next year. The improvement will lead to an increase in tax revenue and a reduction in (unemployment-related) transfer payments. This improvement eliminates the cyclical element of the deficit. In a no-policy change scenario the deficit would be about 1% of GDP as the structural (political) component would remain.

    If the government was to decide to target a 3% of GDP deficit, in light of the economic improvement, this could only be done through political decisions to increase expenditure and/or reduce taxes. Thus in the second year, the cyclical component of the balance is zero and the structural deficit would have increased to 3% of GDP. This pro-cyclical policy would not be allowed under the proposed rule.

    There is no rule on the cyclical component of the budget balance. This is just something that can be measured rather than targetted. The proposed rule is to try and take out the influence of the economic cycle on the budget balance and focus on the element of the balance that is influenced by policy - the structural deficit.

    It is far from perfect but that is what it is trying to achieve.

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    1. Thanks for that, Seamus. There’s no doubting the mechanical relationship between cyclical and structural. However, the management of that relationship goes to the very core of your post – whether Keynes ‘lives’. A country with a positive gap may be in a more advantageous position under the Compact to engage in fiscal activism that over, the period of a MTO, does not lead them to degrade their structural deficit – namely, through boosting potential GDP. This flexibility is underscored by their manoeuvrability within the general deficit rule and cyclically boosted tax revenues. However, a country with a negative gap and issues with both deficit rules would, almost by definition, not be allowed this fiscal activism even though they are much more in need of it for short and long-term reasons. Therefore, such countries will fall further behind.

      Even leaving fiscal activism out of it, a country with a positive gap has a better chance of managing ‘the rules’ without harming potential GDP; a country with a negative gap and deficit issues could only manage the rules by doing significant harm to potential GDP. This would have, in turn, a depressing effect on the structural deficit itself.

      In this respect the rules will differ - for while one part may potentially veer towards the counter-cyclical (the country with the positive gap) with room for manoeuvre, it will create pro-cyclical pressures for countries with a negative gap deficit rule issues. And it is the latter at which significant parts of the rules were targeted (e.g. no ESM funding without adherence to the rules).

      This is shown in your table – an economy with a considerable negative gap is highly restricted by the deficit rules and would be forced into pro-cyclical policies. There are noteworthy caveats whereby the EU Commission may allow deviations from the MTO of any particular country due to shocks. I accept that such caveats cannot be formalised in any formula; we have to rely on common sense. However, what is currently expected of EU countries suggests we shouldn’t rely on this too much. After all, the Eurozone has returned to recession and the average output gap of Eurozone countries excluding Germany exceeds -2.5 percent. Yet the ‘deficit rules’ rule, regardless of pro-cyclicality.

      And this is before we even get to the issue of whether any of this can be the subject of robust and agreed measurement.

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  5. Hi Michael,

    I think one of the objectives of the rules is to try and eliminate 'fiscal activism'. The rules are designed with the concept of a balanced budget at their core and it is envisaged that deficits will only be generated by cyclical automatic stabilisers. The notion of an active fiscal policy, outside of cyclical developments, is all but being killed.

    Even in good times there are limits on fiscal policy. The deficit, structural deficit and debt rules would have had no impact in a booming economy like Ireland in the 2000s but the 'government expenditure rule' could have limited the increases in expenditure that took place in the run-up to the crisis. This rule has a substantial get-out clause for countries that have achieved their MTO so it's effect is hard to quantify.

    But all times the aim is to try and curb fiscal policy, either by limiting expenditure increases that are unmatched by discretionary tax increases in the good times and limiting the deficits that can be run in the bad.

    The rules may be able to achieve some counter-cyclicality for countries that are in an upturn of the business cycle (though this is not guaranteed) but it seems likely, as you suggest, that rigid adherence to the 3% benchmark will continue to result in pro-cyclical fiscal interventions in a downturn. The common sense you are looking for may be in short supply.

    I think it is worth pointing out that these rules are already in via the revised Stability and Growth Pact. The Fiscal Stability Treaty does not offer any significant amendment to the rules, though there are changes elsewhere. This will all boil down to application and whether this will actually be implement.

    The original SGP was rudderless by the end of 2002. Do we believe them we they say "we really mean it this time"?

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  6. I'm a month late, but...

    My main concern lies with the leeway this rule leaves to fight slumps. And in my view, it just isn't enough. I look at the US, with a 10% budget deficit and an estimated gap at 6% (http://research.stlouisfed.org/fred2/graph/?g=6tD), and it still has a sluggish performance with a very accommodating monetary policy.

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  7. What implications will these changes have for Ireland over the next few years?

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