jamesz

Fiscal rules need an enforcer

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Since the Autumn Statement there has been a lot of discussion about fiscal rules. One of the most substantive comments has come from Simon Wren-Lewis, who is something of an expert on the subject of fiscal rules and fiscal councils. His conclusion is that

…the main problem with the UK government’s fiscal mandate has nothing to do with cyclical adjustment or any of the other things discussed above. It is just inappropriate for the situation we are now in.

There is a lot of good stuff there, so head over and read it, but I’m not convinced by this conclusion. To understand why, let’s go back to the reason for a fiscal rule. The idea is that we need rules to commit the Government to a sustainable debt path because the political incentives don’t necessarily push them in that direction. That means the rules need to constrain the government’s actions in times when it is inconvenient for them to exercise prudence. It is certainly not enough for the rules to be kept only when it is politically convenient.

Wren-Lewis is saying that there will be times when even the best rules must be broken. However, if the Government is given the task of deciding when to break the rules then they may as well be discarded. Rules that bind the Government only when it feels like being bound will never do the job that they were designed for. To be effective, fiscal rules must be resilient to external shocks so that they can force governments to do the prudent thing when it not in their political interests to do so. Anything else compromises the credibility of the rules beyond saving.

That is not to say I disagree with Wren-Lewis that there are circumstances in which you might want to breach the rules, whatever they are. It’s just that you can’t let the Government decide when such circumstances have arisen. This is a strong argument for having an independent body to enforce the fiscal rules, and to decide on circumstances in which they might be legitimately ‘bent’. Rules are usually used in tandem with an independent council who can both enforce the rules and credibly legitimise departures from them. In Sweden, for example, the independent fiscal council recommended that the government run bigger deficits during the financial crisis.

Wren-Lewis may be right that the UK’s current rules are too inflexible to deal with the present situation, but a government can’t expect to break its own rules and retain credibility. Either another mechanism must be found or the fiscal rules become a paper tiger.

jamesz

UK fiscal rules and the Autumn Statement

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The big news out of George Osborne’s Autumn Statement last week was the abandonment of his fiscal rules. But the real story for economists was in the OBR’s forecasts. There were two rules:

  1. The cyclically adjusted budget deficit must be eliminated within five years (a rolling window); and,
  2. Debt must be falling as a percentage of nominal GDP by 2015-16.

What’s notable about both of these rules is that they are about a future balance, so whether they have been met is presently a matter of judgement for the official forecaster. That forecaster is the Office of Budget Responsibility, an independent body that is incredibly transparent about its models, methods, and judgment. In this Autumn Statement its forecasts predicted that the Chancellor will breach his debt target. He is forecast to meet the deficit target, but only by a small margin.

Before getting worked up about Osborne failing to meet his target let’s remember that meeting fiscal targets is not inherently noble. It is a means to and end, and that end is long-term fiscal sustainability. It is ensuring that the country’s debt is manageable in the long run. So the real question is whether Osborne’s targets have much relation to that objective. Read more

jamesz

Housing politics in the UK vs NZ

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Housing is expensive in NZ so the government commissioned a report into why that is. It said the problem was (largely) zoning restrictions constraining supply. The authorities were unimpressed.

Housing is expensive in the UK so the government suggested opening up more land to housing. The papers are unimpressed.

I doubt that the populations of Auckland and the UK are all that different in their views, so what is causing the divergence of political views? I’m sure there’s some inference to be made here about the politicians’ constituencies based on public choice ideas, so let me know in the comments if you can join the dots!

jamesz

Will macroprudential regulation succeed?

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It is common to hear politicians and financiers these days saying that things are different now. That lessons have been learned. That changes to regulation will ensure that this sort of thing is unlikely to happen again in future. Of course, people say these things after every crisis. Now Vox reports a study that attempts to estimate whether learning actually takes place after a crisis and whether the institutional changes reduce the risk of future crises.

…past occurrence of a banking crisis, on average, does not reduce and may even increase the probability of future crises. … we find no evidence that the history of previous exposure of the banking sector to systemic crisis episodes seem to matter.
…
A possible explanation for our failure to detect a learning process from past banking crises is that regulators and policymakers are learning, but at a speed that does not catch up with the dynamic evolution of modern banking. The regulator is frequently preparing to prevent the last crisis, and not the future one.

This hypothesis reminds me a lot of Bruce Schneier’s writing on airline security in the US:

If we spend billions defending our subways, and the terrorists bomb a bus, we’ve wasted our money. To be sure, defending the subways makes commuting safer. But focusing on subways also has the effect of shifting attacks toward less-defended targets, and the result is that we’re no safer overall.

Regulation of some financial products may make them more stable, but the regulation will push people to develop new, more profitable products that evade the rules. Have we then made the system any safer? I haven’t followed macroprudential regulation closely enough to know if that’s a problem, but we can only hope that history doesn’t repeat in this case.

Matt Nolan

Defending inflation targeting

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After seeing David Parker claim that inflation targeting was dead, I felt obliged to chip in with my two cents – which Rates Blog kindly allowed me to do.

In the article I looks at the critique of RBNZ policy based on “imported price spikes” and “credit flows” and point out how the RBNZ framework for this does makes sense – and does not need a change.

My conclusion shifts the blame for any perceived imbalances:

The determination to change what the Reserve Bank does is surprising to me. Our central bank helped to guide New Zealand through one of the largest global shocks imaginable, helped to keep our core banking system together, and by all but the strictest measures they have achieved their monetary policy mandate.

A clear target for monetary policy, a respect for their role in financial stability, and their credibility with the public were the things that helped them achieve this. It makes no sense to turn around and change what the Reserve Bank is doing after such a success.

Instead, those in government should be looking at themselves.

Policies to favour investment in residential property (through tax status and other regulatory focuses) helped to drive the “imbalances” New Zealand faces.

A failure to take into account population aging is making the government fiscal situation look increasingly unsustainable.

Transfers to the middle classes, which we may feel are fair, still come with a cost – bidding up house prices, and reducing capital investment.

If we want to explain the “imbalances” in the country, and what should be done, we need to look at government policy, and the interventionist policies taking place overseas – the monetary policy of the RBNZ is an unrelated scapegoat.

Governments aren’t honest about the costs of their policies.  The decision to introduce working for familes, and generally increase targeted spending, reduces inequality – but it reduces economic activity and “competitiveness”.  We may believe these transfers are fair, that is fine, but no amount of blaming the RBNZ will change the trade-off we face.

Politicians are either lying or are naive about the trade-offs – either way, their bleating is giving you the wrong information, and it threatening to disestablish the institutions that have helped New Zealand do relatively well in the last 20 years.

jamesz

Behavioural economics and policy

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Stephen Gordon applies the Lucas critique to behavioural economics and nudges:

A key insight of behavioural economics is that people don’t always and everywhere re-optimise whenever their environments change. Instead, they will often – or even usually – make use of various rules of thumb and/or passively accept the default option. …This the idea behind ‘nudges’: you can alter people’s behaviour by making minor changes to the frames in which people operate…

But this only works if the change is subtle enough to not attact the full, direct attention of the decision-maker. If the change is big enough, people will haul out the full artillery of their rational selves in order to try figure out what optimal decision is. This means that behavioural economics is unlikely to be of much use in policy-making.

What he’s saying is a policy that takes advantage of people’s rules of thumb relies on them using the rules of thumb. If the policy is a big enough change in the circumstances they face then they might change their rule of thumb, which changes the effect of the policy. Unless you know how people form their heuristic, you can’t target it with policy.

For example, setting organ donation schemes to be opt-in by default may increase the level of donation because people don’t have a strong preference over whether they donate after death. If you applied the same reasoning to a decision that people care deeply about then it might have no effect because people will make the effort to choose their preferred option.

It’s an interesting point but I think Gordon goes too far by suggesting that it invalidates the targeting of behavioural heuristics. Read more