Tuesday, July 10, 2007

More about knzn fiscal policy

Thanks to Mark Thoma for picking up my last post. I think I could fill my blog for a month with daily posts responding to Mark’s comment, the comments on my blog, and the comments on Mark's blog. For today, anyhow, I’m just going to address one issue. As Mark notes:
…there are two separate issues here, one is stabilization policy and for that part of fiscal policy I have no problem with requiring that the budget be balanced over the business cycle. The other is investments in, say, human and physical capital…
I’ll certainly agree there are (at least) two issues, and maybe in the future I will comment on how the two interact. For now, I want to address the first issue.

From a pure stabilization point of view, I don’t think that balancing the budget over the business cycle is a good idea, in part for reasons already discussed in my previous post, and in part because I’m not even sure I believe in the whole concept of a “business cycle” per se. Business, and the macroeconomy, unquestionably has its ups and downs, but so does, for example, the stock market. We don’t normally speak of a “stock market cycle” (although some people do). There are recessions, and there are depressions, and there are inflationary booms, and there are non-inflationary booms. Recessions are limited by definition, but depressions can persist for many years. Inflationary booms are self-limiting, but the jury is still out on non-inflationary booms. Even if recessions and inflationary booms were the only phenomena, they can’t necessarily be expected to alternate: you could have 3 recessions in a row, separated by incomplete recoveries, and followed by 2 inflationary booms in a row, separated by a “soft landing.” The word “cycle” suggests a symmetry which is not, in general, present.

On the purely semantic point, I can accept the use of the word “cycle” for want of a better term, but the argument to balance the budget over the business cycle seems to rest on a substantive presumption of symmetry. It presumes that the stimulus needed during times of economic weakness will be exactly compensated by the excess revenue available during times of economic strength.

You might argue this symmetry must apply in the very long run, because the government has to satisfy an intertemporal budget constraint. Even that point is debatable: in the very long run, the government’s budget constraint applies only if the interest rate is at least as high as the growth rate. Otherwise, if you look out far enough into the future, there will always eventually be enough revenue to pay off any debt the government might accumulate over any finite stretch of time. Some have argued that, empirically, the government typically has faced an interest rate that is less than the growth rate.

But that’s not really my point. I’m cognizant of Keynes’ famous warning about excessive concern with the long run. And a single “business cycle” isn’t much of a long run, anyhow. Conventional business cycle theory might argue for a certain symmetry based on the characteristics of the Phllips curve, under the assumptions that the curve is linear in the short run and vertical in the long run. Under those assumptions, deviations from the NAIRU in one direction are always compensated – let’s say in the medium run – by deviations in the other direction. For the sake of argument I’m willing to accept the vertical long-run Phillips curve, but the linear short-run curve seems to me to be more an econometric convenience than a credible assertion about reality. Back when people believed in static Phillips curves, they used to plot the curves. I’ve seen reproductions of such plots, I can’t remember ever seeing one that looked like a straight line.

Even if (counterfactually) the business cycle is symmetric, it isn’t well-defined, at least not until after the fact. The NBER can’t make the government retroactively balance the budget once it decides what the business cycle dates were. Even if our goal is to balance the budget over one “cycle,” there is no obvious policy that would result in such a balance. The closest we could come is perhaps to require the budget be balanced over, say, 5 calendar years, but that strikes me as a very bad policy: during the first 3 years, we won’t know in advance whether the next 2 are going to be stronger or weaker economically, so we won’t know whether to run a deficit or a surplus. Knowing Congress, I expect the tendency would be to declare the first 3 years a recession and run deficits, which would then require surpluses during the last 2 years and result in an actual recession.

So here’s my alternative proposal: pick a set of interest rates and make fiscal rules contingent on those interest rates. For example, when the 10-year Treasury yield rises above 4%, a deficit ceiling goes into effect; when it rises above 5%, pay-go rules go into effect; when it rises above 6%, a surtax and specific spending restraints go into effect; and so on. We can quibble about the details, and in any case they can be adjusted later if necessary. But this policy makes a lot more sense to me than some attempt to handicap a vague business cycle (or for that matter a vague “trend” in the debt-to-GDP ratio, which can also be hard to identify without benefit of hindsight).

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Blogger Daniel said...

Hi Knzn,

Your argument depends pretty crucially on the ability of the central bank to influence the economy. (Or, in Paul Krugman's words, on the notion that "the unemployment rate will be whatever Alan Greenspan wants it to be.") And for right now, that seems like a pretty good assumption. But Keynes was mistrustful of that notion; as he wrote, "there's many a slip 'twixt the cup and the lip," meaning a lot has to go right for the purchase of bonds to influence the economy. The success of fiscal policy depends on much less.

Wed Jul 11, 09:14:00 AM EDT  
Blogger knzn said...

Daniel, I don’t think my argument depends on the central bank’s ability to influence the economy. It does depend on the central bank’s willingness to make wholehearted efforts to influence the economy, and (if, as in my example, we use a long-term interest rate to calibrate fiscal policy) on the bond market’s ability to anticipate those efforts. But if the central bank’s efforts fail (or are anticipated to fail), fiscal policy kicks in more or less automatically, because it is responding to interest rates, which are an index of the central bank’s unsuccessful efforts.

Wed Jul 11, 11:16:00 AM EDT  
Blogger happyjuggler0 said...

So basically you are saying the US government should short bonds when interest rates are low and then buy them when interest rates are high. A lucrative choice if you can pull it off.

My question is how you choose to create budget deficits. Do you cut tax rates or increase spending? If this were permanent it wouldn't be an issue (excepting normative biases), but basically you are implying a reversion to old policies once interest rates are high again.

If you raise spending, how do you do it in such a way that you also cut it again later? Do you cut the same programs that are labeled "temporary", or is it a rent seeking free-for-all? Is it even possible to not make it a rent seeking free-for-all?

If you cut tax rates, you have similar problems. You basically have to label them as temporary, and then fend off rent seekers who want it to be otherwise. Which taxes do you cut to start with? If they favor "the rich" you will get serious howls on the Left, while if you cut rates on "the working class", then you are going to have to raise those tax rates again while not raising rates on "the rich". How believable is it that that will happen in the real world of politics?

Ideally policies ought to be as stable as possible for maximum growth. I'd guess that uncertainty creates some serious deadweight loss that tends to counterbalance (or do worse) your stabilization policies focused on "shorting" low interest bonds.

P.S. Note that "the rich" is in quotes because income and wealth are not necessarily belonging to the same people. Nevertheless this is how high incomes are treated in common parlance.

Wed Jul 11, 12:44:00 PM EDT  
Anonymous breathless jogger said...

Budget deficits and surpluses 'create themselves' as a result of economic downturns and booms when tax rates are fixed and transfer payments are triggered by unemployment. In order to balance the budget in the long run, you would forecast the tax base over time and unemployment insurance and welfare usage (etc.) and set the tax rates and program entitlements so that they would balance in the long run. Of course you have to have good forecasters and people who can budget, but I'm pretty sure those people exist (economists? finance departments?).
Tax rates and program entitlements are not stable largely because of politics.
Of course, balancing assumes some sort of stable state. For instance, your ideal 'balanced budget' could be set such that government debt represents a certain proportion of GDP, tying it to growth. The government could then act like the central bank does with monetary policy and inflation, and adjust its fiscal policy, in the long run, so that it aims for this particular debt to GDP ratio.
But basically, the government should allow automatic stabilizers to do their jobs and should probably limit their other fiscal interventions and should instead focus their economist human capital on regulation and dealing with externalities.
As for the debt rule, a more complicated one could tie government debt to GDP per capita in a non-linear fashion. But I'm not sure that such a rule would be invented because of its long horizon, politically I mean (but maybe an economist already has come up with such a rule).
However, it does not really matter if economists come up with really sensible debt rules, or other nifty instruments like carbon taxes, if politicians decide they don't like them.

Wed Jul 11, 09:59:00 PM EDT  
Anonymous student said...

Breathless jogger (Sorry to butt in knzn)
Are you available for the week-end of August 4th for a lecture on fiscal policy? That should give you time to catch your breath.

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Anonymous breathless jogger said...

Sounds good to me! Well, sort of... Are you sure you want a lecture? I'd prefer taking a break from lecturing and relax instead.
I'm not sure that this is the right place for discussing these things though. Wanna take this somewhere else?

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