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Posts Tagged ‘deficit reduction policies’

Austerity: yes or no?

Here are a series of videos examining the case for and against austerity policy. Is such policy necessary to re-balance countries’ economies and retain or regain the confidence of investors? Or does such policy harm not just short-run growth but long-run growth too? Does it reduce investment and thereby aggregate supply?

These videos follow on from the news item Keynes versus the Classics: a new version of an old story. In the first video, Mark Blyth, author of Austerity: the History of a Dangerous Idea, argues that austerity policy has not worked and never can. George Osborne, by contrast, argues that although it has been a ‘hard road to recovery’, austerity policy is working.

International bodies take a more nuanced stand. The IMF, while supporting the objective of reducing the government deficit, argues that the pace of the cuts in the UK should be slowed until more robust growth returns. The OECD, in examining the global economy, is more supportive of countries maintaining the pace of deficit reduction, but argues that the ECB needs to take stronger monetary measures to boost bank lending in the eurozone.

With austerity having increasingly alarming effects on unemployment and social cohesion, especially within certain eurozone countries, such as Greece, Portugal and Spain, it is not surprising that there are growing demands for rethinking macroeconomic policy.

There is general agreement that more needs to be done to promote economic growth, and a growing consensus that an increase in infrastructure expenditure is desirable. But whether such expenditure should be financed by increased borrowing (with the extra deficit being reduced subsequently as a result of the extra growth), or whether it should be financed by reductions in expenditure elsewhere, is a continuing focus of debate.

Austerity: the History of a Dangerous Idea The Guardian, Mark Blyth (27/5/13) (see also)
IMF: UK austerity will be a ‘drag on growth’ BBC News. Hugh Pym (22/5/13)
George Osborne: ‘Hard road to recovery for UK economy’ BBC News (22/5/13)
Economy and austerity BBC News, Sajid Javid and Stephen Timms (1/5/13)
IMF’s Olivier Blanchard urges UK austerity rethink BBC News (16/4/13)
OECD ‘supportive of Osborne austerity plans’ BBC news (29/5/13)
Stimulus vs. austerity measures in EU CNN, Mohamed El-Erian (29/5/13)
‘No time to wobble’ on deficit reduction YouTube, Sir Roger Carr (CBI president) (16/5/13)
Deficit-Cutting: Not If, But When Wall Street Journal Live, David Wessel (8/5/13)

Questions

  1. What are the arguments for maintaining a policy of deficit reduction through tight fiscal policy?
  2. What are the three principles put forward by Mark Blyth for designing an appropriate macroeconomic policy?
  3. How does the fallacy of composition relate to the effects of all countries pursuing austerity policy simultaneously?
  4. Is the IMF for or against austerity? Explain.
  5. Assess the policies advocated by the OECD to stimulate economic growth in the eurozone.
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It could be you

An excellent learning exercise for students of economics is to take a journal article that uses data to model the economy and then try to replicate the authors’ results. You may well be given an assignment like this in future years of your degree.

One such exercise is used on the University of Massachusetts Amherst’s doctoral programme in economics. Thomas Herndon is a student on that degree and chose to examine a well-known and highly influential paper, Growth in a Time of Debt by Carmen Reinhart then of the University of Maryland and Kenneth Rogoff of Harvard University and former chief economist of the IMF. Professors Reinhart and Rogoff used new data on 44 countries spanning about 200 years.

A key finding of their paper, published in 2010 in the American Economic Review Papers and Proceedings, is that once a country’s government debt exceeds 90% of GDP, growth rates fall considerably: the median across countries by about 1% and the mean considerably more.

The paper has been hugely influential. It has been used to justify the austerity programmes being pursued in many countries, including the UK and the eurozone. Cutting the government deficit to GDP ratio, and ultimately the government debt to GDP ratio, has been seen as a way of achieving higher growth over the longer term, and justifies the adverse effect on short-term growth from the dampening of aggregate demand.

Well, this seemed an interesting paper for Thomas Herndon to examine, and he was keen to show just how Reinhart and Rogoff’s data led to their conclusions. But try as he might, he could not replicate their results. His initial reaction was to think he had made an error, but each time he checked he came back with the same conclusion: they must have made errors in their calculations.

His supervisor at Amherst, Professor Michael Ash, after Thomas had checked and checked again, realised that something was wrong. He encouraged Thomas to write to Reinhart and Rogoff to request sight of their dataset. They duly obliged and it was then that Thomas spotted various errors. These are explained in the articles below, but the overall effect was to alter the conclusion. Although high debt may undermine growth to some extent, the effect is much less than Reinhart and Rogoff concluded, and there are several exceptions to this rule.

On 15 April 2013, Thomas, along with his supervisor, Michael Ash and his colleague, Robert Pollin, published a response to the Reinhart and Rogoff paper. In the abstract to their paper, Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff they state that:

… coding errors, selective exclusion of available data, and unconventional weighting of summary statistics lead to serious errors that inaccurately represent the relationship between public debt and GDP growth among 20 advanced economies in the post-war period. They find that when properly calculated, the average real GDP growth rate for countries carrying a public-debt-to-GDP ratio of over 90 percent is actually 2.2 percent, not –0:1 percent as published in Reinhart and Rogoff. That is, contrary to RR, average GDP growth at public debt/GDP ratios over 90 percent is not dramatically different than when debt/GDP ratios are lower.

The authors also show how the relationship between public debt and GDP growth varies significantly by time period and country. Overall, the evidence we review contradicts Reinhart and Rogoff’s claim to have identified an important stylized fact, that public debt loads greater than 90 percent of GDP consistently reduce GDP growth.

So could this be you in the future? Will you take a famous paper and, by re-examining and reworking the data, find that its conclusions are wrong? Could you end up changing the world? Exciting stuff!

Podcasts
Austerity: A Spreadsheet Error? BBC, More or Less, Tim Harford (20/4/13)
Austerity justification study ‘inaccurate’ BBC Today Programme, Robert Pollin (18/4/13)

Articles
UMass Student Exposes Serious Flaws in Harvard Economists’ Influential Study The Atlantic Wire, J.K. Trotter (18/4/13)
Shocking Paper Claims That Microsoft Excel Coding Error Is Behind The Reinhart-Rogoff Study On Debt Business Insider, Mike Konczal (16/4/13)
How a student took on eminent economists on debt issue – and won Economic Times of India (19/4/13)
Meet the 28-Year-Old Grad Student Who Just Shook the Global Austerity Movement New York Magazine, Kevin Roose (19/4/13)
An economist’s mea culpa: I relied on Reinhart and Rogoff Confessions of a Supply-Side Liberal blog, Miles Kimball (22/4/13)
The Rogoff-Reinhart data scandal reminds us economists aren’t gods The Guardian, Heidi Moore (18/4/13)
Reinhart, Rogoff… and Herndon: The student who caught out the profs BBC News Magazine, Ruth Alexander (20/4/13)
George Osborne’s case for austerity has just started to wobble The Guardian, Polly Toynbee (18/4/13)
The error that could subvert George Osborne’s austerity programme The Guardian, Charles Arthur and Phillip Inman (18/4/13)
The Excel depression Sydney Morning Herald, Paul Krugman (19/4/13)
Europe: Retreat from austerity BBC News, Gavin Hewitt (23/4/13)

Guest post by Thomas Herndon
The Grad Student Who Took Down Reinhart And Rogoff Explains Why They’re Fundamentally Wrong Business Insider, Thomas Herndon (22/4/13)

Papers
Growth in a Time of Debt NBER working paper, Carmen M. Reinhart and Kenneth S. Rogoff (January 2010)
Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogo ff PERI Working Paper 322, Thomas Herndon, Michael Ash and Robert Pollin (April 2013)

Questions

  1. What were the particular errors made by Reinhart and Rogoff?
  2. How has their paper been used as a basis for the design of macroeconomic policy?
  3. What are the limitations of using even accurate time-series data as the basis for policy measures?
  4. How might the work of Herndon change the direction of future macroeconomic policy?
  5. In his guest post in Business Insider (see link above), Herndon wrote: ‘The implication for policy is that, under particular circumstances, public debt can play a key role in overcoming a recession.’ What might this role be?
  6. Why might we have to be cautious in drawing policy conclusions from Herndon’s work?
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Debating a possible mansion tax

There has been considerable discussion recently about whether the government should introduce a property tax on high value properties. The government, finding it difficult to reduce the public-sector deficit and yet determined to do so, is looking for additional measures to reduce government expenditure or raise tax revenue.

But would it favour a mansion tax as a means of raising additional revenue?

The imposition of such a tax is favoured by both Liberal Democrats and the Labour Party. It is strongly opposed, however, by Conservatives. But just what would such a tax look like and what are the arguments for and against it?

One alternative would be to impose a one-off tax on property valued over a certain amount, such as £2 million. Alternatively it could be levied only for as long as the government is seeking to make substantial inroads into the deficit.

Another would be to add one or more bands to council tax. At present, council tax in England is levied in 8 bands according to the value of a person’s property. The highest band is for property valued over £320,000 in 1991 prices, with the amount of tax due for each band varying from local authority to local authority. (Average UK house prices in 2012 are 135% higher than in 1991.) In Scotland the bands are lower with the top band being for property valued over £212,000 in 1991 prices. In Wales, there is an additional band for property valued over £424,000, but properties are valued in 2003 prices, not 1991 prices.

With low top bands for council tax, people in mansions end up paying the same as people in much more modest property. It would be relatively easy to add additional bands, with the top band applying only to property worth, say, over £1 million or more.

The arguments in favour of a mansion tax are that it is progressive, relatively easy to collect, hard to evade and with minimal disincentive effects. The arguments against are that it would make the tax system ‘too progressive’, would not necessarily be related to an individual’s ability to pay and could have substantial disincentive effects.

The progressiveness of the UK tax system is illustrated in the chart, which looks at the proportion of income paid in direct, indirect and all taxes by quintile groups of households – that is, households grouped into five equal sized groups ranked from lowest to highest gross income. (Click here for a PowerPoint of the chart.)

The following articles look at the debate as it has raged over the past few weeks. Try to unpick the genuine arguments from the political rhetoric!

Articles
Clegg Says U.K. Could Apply Mansion Tax ‘in Five Seconds’ Bloomberg, Robert Hutton (25/9/12)
Two thirds back mansion tax on £1m homes Metro, Tariq Tahir (8/10/12)
Mansion tax would ‘tackle inequality’ This is Tamworth (27/9/12)
Council tax: the easy way to make mansion-dwellers pay Guardian, Simon Jenkins (25/9/12)
Rich must pay fair share in tax BBC Andrew Marr Show, Nick Clegg (23/9/12)
We will get mansion tax on £2 million homes through next budget, promise Lib Dems The Telegraph, Rowena Mason (25/9/12)
Trying to tax the wealthy not worth the price The Scotsman, George Kerevan (31/8/12)
Tax on wealth is true to Tory principles Financial Times, Janan Ganesh (24/9/12)
How would Clegg’s emergency wealth tax work? Guardian, Hilary Osborne (29/8/12)
Labour considers mansion tax on wealthy Financial Times, George Parke (5/9/12)
Conservative conference: Cameron rules out ‘mansion tax’ BBC News (7/10/12)
Don’t make wealth tax a habit Financial Times, Howard Davies (29/8/12)
George Osborne blocks mansion tax, but insists wealthy will pay more The Telegraph, Robert Winnett (8/10/12)
Why George Osborne had to kill the mansion tax The Spectator, Matthew Sinclair (7/10/12)
David Cameron rules out mansion tax and plans further welfare cuts Guardian, Hélène Mulholland (7/10/12)
Viewpoint: Would a wealth tax work? BBC News, Mike Walker (29/8/12)
For all the claims made about wealth taxes, it’s not correct to say the rich are paying their fair share Independent, Jonathan Portes (2/10/12)

Data
House price data links Economics Network
The Effects of Taxes and Benefits on Household Income, 2010/2011 ONS (26/6/12) (see especially Tables 2 and 3 and Table 26 for historical data)

Questions

  1. Explain the distinction between direct and indirect taxes, and between progressive and regressive taxes. For what reasons do the poor pay a higher proportion of their income in indirect taxes than the rich?
  2. What forms can a tax on wealth take?
  3. How progressive are taxes in the UK (see the ONS site in the Data section above)?
  4. Assess the arguments in favour of a mansion tax.
  5. Assess the arguments against a mansion tax.
  6. What type of wealth tax would be hardest to evade?
  7. What are the likely income and substitution effects of a wealth tax?
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Calls grow for a Plan B

With all the concerns recently about Greek and Italian debt and about the whole future of the eurozone, you would be forgiven for thinking that the problems of the UK economy had gone away. This couldn’t be further from the truth. Problems are mounting and pessimism is growing.

First there is the problem of a contracting eurozone economy. This will directly impact on the UK as almost half of UK exports go to eurozone countries. Second there is the impact of the government expenditure cuts, most of which have still not taken effect yet. Third there is the fact that, with the combination of inflation over 5% and nominal pay typically rising by no more than 2%, real take-home pay is falling and hence too is the volume of consumer expenditure. Fourth, there is the increasingly pessimistic mood of consumers and business. The more pessimistic people become about the prospects for their jobs and incomes, the more people will rein in their spending; the more pessimistic businesses become, the more they will cut back on investment and economise on stock holding.

Forecasts for the UK economy have become considerably bleaker over the past few weeks. These include forecasts by the National Institute for Economic and Social Research (NIESR), the accountancy network BDO, Ernst & Young’s ITEM Club and the CBI in its SME Trends Survey and November Economic Forecast. The Treasury’s latest Forecasts for the UK Economy, which brings together forecasts by 29 different organisations, also shows a marked increase in pessimism from September to October.

So is it now time for the government to change course to prevent the economy slipping back into recession? Do we need a Plan B? Certainly, it’s something we’ve considered before on this news site (see Time for a Plan B?). The latest call has come from a group of 100 leading academic economists who have written to the Observer. In their letter they spell out what such a plan should contain. You’ll find a link to the letter below and to other articles considering the proposals.

The letter
We economists have a Plan B that will work, Mr Osborne Observer letters (29/10/11)

Articles
Plan B: the ideas designed to restart a stalled UK economy Observer, Daniel Boffey and Heather Stewart (29/10/11)
Plan B could have been even more aggressive, but it would definitely work Observer, Will Hutton (29/10/11)
The economy: we need Plan B and we need it now Observer editorial (30/10/11)
If tomorrow’s growth figures disappoint, Plan B will be a step closer, whatever David Cameron says The Telegraph, Daniel Knowles (31/10/11)
Plan B to escape the mess we are in Compass, John Weeks (7/11/11)

The report
Plan B; a good economy for a good society Compass, Edited by Howard Reed and Neal Lawson (31/10/11)

Questions

  1. What are the main proposals in Compass’s Plan B?
  2. How practical are these proposals?
  3. Without a Plan B, what is likely to happen to the UK economy over (a) the coming 12 months; (b) the next 3 years?
  4. Why might sticking to Plan A worsen the public-sector deficit – at least in the short term?
  5. What are the main arguments for sticking to Plan A and not easing up on deficit reduction?
  6. Find out what proportion of the UK’s debt is owed to non-UK residents? (See data published by the UK’s Debt Management Office (DMO).) How does this proportion and the average length of UK debt affect the arguments about the sustainability of this level of debt and the ease of servicing it?
  7. If you had to devise a Plan B, what would it look like and why? To what extent would it differ from Compass’s Plan B and from George Osborne’s “Plan A”?
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Time for a Plan B?

The government is sticking to its deficit reduction plan. But with worries about a lack of economic recovery, or even a double dip recession, some economists are calling for a Plan B. They back up their arguments by referring to the lack of consumer confidence, falling real incomes and rising commodity prices. Without a slowing down in cuts and tax rises, the lack of aggregate demand, they claim, will prevent a recovery.

The government maintains that sticking to the cuts and tax rises helps maintain international confidence and thereby helps to keep interest rates low. Also, it argues, if the economy does slow down, then automatic stabilisers will come into play. Finally, even though fiscal policy is tight, monetary policy is relatively loose, with historically low interest rates.

But will there be enough confidence to sustain a recovery? Economists are clearly divided. But at least the IMF seems to think so. In its latest assessment of the UK economy, although it has cut the growth forecast for 2011 from 2% to 1.5%, that is still a positive figure and thus represents a recovery, albeit a rather fragile one.

Articles
Coalition’s spending plans simply don’t add up Observer letters, 52 economists (5/6/11)
Is George Osborne losing his grip on Britain’s economic recovery? Guardian, Heather Stewart and Daniel Boffey (4/6/11)
George Osborne plan isn’t working, say top UK economists Guardian, Heather Stewart and Daniel Boffey (4/6/11)
How are the Coalition fixing the economy? The Telegraph, Tim Montgomerie (28/5/11)
Cameron’s new cuts narrative The Spectator, Fraser Nelson (27/5/11)
The changing narrative of Chancellor George Orborne Channel 4 News, Faisal Islam (17/5/11)
The UK could be leading with a new economic approach, instead we follow Guardian, Will Hutton (4/6/11)
The coalition’s strategy is courting disaster Observer, (5/6/11)
Government faces fresh calls for a Plan B BBC News (5/6/11)
‘Serious debate’ needed on economy BBC Today Programme, Stephanie Flanders (6/6/11)
IMF cuts UK growth forecast for 2011 BBC News, John Lipsky (Deputy Director of the IMF) (6/6/11)
IMF says hope for best, plan for worst BBC News, Stephanie Flanders (6/6/11)
IMF set out a ‘Plan B’ for George Osborne BBC News, Paul Mason (6/6/11)
How to rebalance our economy Independent, Sean O’Grady (6/6/11)
IMF maps out a Plan B for the UK economy The Telegraph, Jeremy Warner (6/6/11)
A long and hard road lies ahead for the British economy Financial Times, Martin Wolf (6/6/11)

IMF Report
United Kingdom – 2011 Article IV Consultation Concluding Statement of the Mission (6/6/11)

Forecasts
OECD Economic Outlook 89 Annex Tables (June 2011): see especially Annex Table 1
Output, prices and jobs The Economist

Questions

  1. Explain what is likely to happen to each of the components of aggregate demand.
  2. Is monetary policy loose enough? How could it be made looser, given that Bank rate is at the historically low level of 0.5% and could barely go any lower?
  3. What are automatic fiscal stablisers and how are they likely to affect aggregate demand if growth falters? What impact would this have on the public-sector deficit?
  4. What is meant by the ‘inventory cycle’? How did this impact on growth in 2010 and the first part of 2011?
  5. What is likely to happen to inflation in the coming months and why? How is this likely to impact on economic growth?
  6. Referring to the economists’ letter (the first link above), what do you think they mean by “a green new deal and a focus on targeted industrial policy” and how would this affect economic growth?
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Has the tide turned for Keynesianism?

In 2008 and 2009, as the global recession deepened, so governments around the world turned to Keynesian policies. Aggregate demand had to be boosted. This meant a combination of fiscal and monetary policies. Fiscal stimulus packages were adopted, combining increased government expenditure and cuts in taxes. On the monetary policy front, central banks cut interest rates to virtually zero and expanded the money supply in bouts of quantitative easing.

The global recession turned out not to be a deep as many had feared and the Keynesian policies were hailed by many as a success.

But how the tide is turning! The combination of the recession (which reduced tax revenues and increased welfare spending) and the stimulus packages played havoc with public finances. Deficits soared. These deficits had to be financed, and increasingly credit agencies and others were asking how sustainable such deficits were over the longer term. These worries have been compounded by the perilous state of the public finances in countries such as Greece, Portugal, Ireland and Hungary. The focus has thus turned to cuts. In fact there is now an international ‘competition’ as to which country can wear the hairiest hair shirt. The new Coalition government in the UK, for example, is busy preparing the general public for deep cuts to come.

We are now seeing a re-emergence of new classical views that increased deficits, far from stimulating the economy and resulting in faster growth, largely crowd out private expenditure. To prevent this crowding out and restore confidence in financial markets, deficits must be rapidly cut, thereby allowing finance to be diverted to the private sector.

But if the contribution to aggregate demand of the public sector is to be reduced, and if consumption, the largest component of aggregate demand, is also reduced as households try to reduce their reliance on borrowing, where is the necessary rise in aggregate demand to come from? We are left with investment and net exports – the remaining two components of aggregate demand, where AD = C + G + I + (X – M).

But will firms want to invest if deficit reduction results in higher taxes, higher unemployment and less spending by the government on construction, equipment and many other private-sector goods and services. Won’t firms, fearing a decline in consumer demand, and possibly a ‘double-dip recession’, hold off from investing? As for export growth, this depends very much on growth in the rest of the world. If the rest of the world is busy making cuts too, then export growth may be very limited.

The G20, meeting in Korea on 4 June, wrestled with this problem. But the mood had definitely turned. Leaders seemed much more concerned about deficit reduction than maintaining the fiscal stimulus.

The following articles look at the arguments between Keynesians and new classicists. The disagreements between their authors reflect the disagreements between economists and between politicians about the timing and extent of cuts.

Articles
Time to plan for post-Keynesian era Financial Times, Jeffrey Sachs (7/6/10)
The Keynesian Endpoint CNBC Guest Blog, Tony Crescenzi (7/6/10)
Keynes, Recovered Boston Review, Jonathan Kirshner (May/June 2010)
How Keynes, not mining, saved us from recession Sydney Morning Herald, Ross Gittins (7/6/10)
The verdict on Keynes Asia Times, Martin Hutchinson (2/6/10)
The G20 Has Officially Voted For Global Depression Business Insider, Marshall Auerback (7/6/10)
Deficit disorder: the Keynes solution New Statesman, Robert Skidelsky (17/5/10)
Hawks v doves: economists square up over Osborne’s cuts Guardian, Phillip Inman (14/6/10)

Reports and data
OECD Economic Outlook No. 87, May 2010 (see)
Economics: Growth rising faster than expected but risks increasing too, says OECD Economic Outlook OECD (26/5/10)
Economy: responses must reflect governments’ views of national situations OECD (26/5/10)
Editorial and summary of projections OECD (26/5/10)
General assessment of the macroeconomic situation OECD (26/5/10)
Statistical Annex to OECD Economic Outlook No. 87 OECD (10/6/10)

Communiqué, Meeting of Finance Ministers and Central Bank Governors, Busan, Republic of Korea G20 (5/6/10)

Questions

  1. Summarise the arguments for and against making rapid cuts in public-sector deficits.
  2. What forms can crowding out take? Under what circumstances will a rise in public-sector deficits (a) cause and (b) not cause crowding out?
  3. Assess the policy measures being proposed by the G20.
  4. How important is confidence for the success of (a) fiscal stimulus packages and (b) deficit reduction policies in boosting economic growth?
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