Tag: output gap

On 25 November, the UK government published its Spending Review 2020. This gives details of estimated government expenditure for the current financial year, 2020/21, and plans for government expenditure and the likely totals for 2021/22.

The focus of the Review is specifically on the effects of and responses to the coronavirus pandemic. It does not consider the effects of Brexit, with or without a trade deal, or plans for taxation. The Review is based on forecasts by the Office for Budget Responsibility (OBR). Because of the high degree of uncertainty over the spread of the disease and the timing and efficacy of vaccines, the OBR gives three forecast values for most variables – pessimistic, central and optimistic.

According to the central forecast, real GDP is set to decline by 11.3% in 2020, the largest one-year fall since the Great Frost of 1709. The economy is then set to ‘bounce back’ (somewhat), with GDP rising by 5.2% in 2021.

Unemployment will rise from 3.9% in 2019 to a peak of 7.5% in mid-2021, after the furlough scheme and other support for employers is withdrawn.

This blog focuses at the impact on government borrowing and debt and the implications for the future – both the funding of the debt and ways of reducing it.

Soaring government deficits and debt


Government expenditure during the pandemic has risen sharply through measures such as the furlough scheme, the Self-Employment Income Support Scheme and various business loans. This, combined with falling tax revenue, as incomes and consumer expenditure have declined, has led to a rise in public-sector net borrowing (PSNB) from 2.5% of GDP in 2019/20 to a central forecast of 19% for 2020/21 – the largest since World War II. By 2025/26 it is still forecast to be 3.9% of GDP. The figure has also been pushed up by a fall in nominal GDP for 2020/21 (the denominator) by nearly 7%. (Click here for a PowerPoint of the above chart.)

The high levels of PSNB are pushing up public-sector net debt (PSNB). This is forecast to rise from 85.5% of GDP in 2019/20 to 105.2% in 2020/21, peaking at 109.4% in 2023/24.

The exceptionally high deficit and debt levels will mean that the government misses by a very large margin its three borrowing and debt targets set out in the latest (Autumn 2016) ‘Charter for Budget Responsibility‘. These are:

  • to reduce cyclically-adjusted public-sector net borrowing to below 2% of GDP by 2020/21;
  • for public-sector net debt as a percentage of GDP to be falling in 2020/21;
  • for overall borrowing to be zero or in surplus by 2025/26.

But, as the Chancellor said in presenting the Review:

Our health emergency is not yet over. And our economic emergency has only just begun. So our immediate priority is to protect people’s lives and livelihoods.

Putting the public finances on a sustainable footing

Running a large budget deficit in an emergency is an essential policy for dealing with the massive decline in aggregate demand and for supporting those who have, or otherwise would have, lost their jobs. But what of the longer-term implications? What are the options for dealing with the high levels of debt?

1. Raising taxes. This tends to be the preferred approach of those on the left, who want to protect or improve public services. For them, the use of higher progressive taxes, such as income tax, or corporation tax or capital gains tax, are a means of funding such services and of providing support for those on lower incomes. There has been much discussion of the possibility of finding a way of taxing large tech companies, which are able to avoid taxes by declaring very low profits by diverting them to tax havens.

2. Cutting government expenditure. This is the traditional preference of those on the right, who prefer to cut the overall size of the state and thus allow for lower taxes. However, this is difficult to do without cutting vital services. Indeed, there is pressure to have higher government expenditure over the longer term to finance infrastructure investment – something supported by the Conservative government.

A downside of either of the above is that they squeeze aggregate demand and hence may slow the recovery. There was much discussion after the financial crisis over whether ‘austerity policies’ hindered the recovery and whether they created negative supply-side effects by dampening investment.

3. Accepting higher levels of debt into the longer term. This is a possible response as long as interest rates remain at record low levels. With depressed demand, loose monetary policy may be sustainable over a number of years. Quantitative easing depresses bond yields and makes it cheaper for governments to finance borrowing. Servicing high levels of debt may be quite affordable.

The problem is if inflation begins to rise. Even with lower aggregate demand, if aggregate supply has fallen faster because of bankruptcies and lack of investment, there may be upward pressure on prices. The Bank of England may have to raise interest rates, making it more expensive for the government to service its debts.

Another problem with not reducing the debt is that if another emergency occurs in the future, there will be less scope for further borrowing to support the economy.

4. Higher growth ‘deals’ with the deficit and reduces debt. In this scenario, austerity would be unnecessary. This is the ‘golden’ scenario – for the country to grow its way out of the problem. Higher output and incomes leads to higher tax revenues, and lower unemployment leads to lower expenditure on unemployment benefits. The crucial question is the relationship between aggregate demand and supply. For growth to be sustainable and shrink the debt/GDP ratio, aggregate demand must expand steadily in line with the growth in aggregate supply. The faster aggregate supply can grow, the faster can aggregate demand. In other words, the faster the growth in potential GDP, the faster can be the sustainable rate of growth of actual GDP and the faster can the debt/GDP ratio shrink.

One of the key issues is the degree of economic ‘scarring’ from the pandemic and the associated restrictions on economic activity. The bigger the decline in potential output from the closure of firms and the greater the deskilling of workers who have been laid off, the harder it will be for the economy to recover and the longer high deficits are likely to persist.

Another issue is the lack of labour productivity growth in the UK in recent years. If labour productivity does not increase, this will severely restrict the growth in potential output. Focusing on training and examining incentives, work practices and pay structures are necessary if productivity is to rise significantly. So too is finding ways to encourage firms to increase investment in new technologies.

Podcast and videos

Articles

OBR Data

Questions

  1. What is the significance of the relationship between the rate of economic growth and the rate of interest for financing public-sector debt over the longer term?
  2. What can the government do to encourage investment in the economy?
  3. Using OBR data, find out what has happened to the output gap over the past few years and what is forecast to happen to it over the next five years. Explain the significance of the figures.
  4. Distinguish between demand-side and supply-side policies. How would you characterise the policies to tackle public-sector net debt in terms of this distinction? Do the policies have a mixture of demand- and supply-side effects?
  5. Choose two other developed countries. Examine how their their public finances have been affected by the coronavirus pandemic and the policies they are adopting to tackle the economic effects of the pandemic.

With promises by the newly elected Conservative government to increase investment expenditure on health, education, innovation and infrastructure, it was expected that Rishi Sunak’s first Budget would be strongly expansionary. In fact, it turned out to be two Budgets in one – both giving a massive fiscal boost.

An emergency Budget

The first part of the Budget was a short-term emergency response to the explosive spread of the coronavirus. An extra £12 billion is to be spent on the NHS and other public services. Whether this will be anything like enough to cope with the effects of the pandemic as businesses fail and people lose their jobs remains to be seen. (See the blog A global supply-side shock: the impact of the coronavirus (COVID-19) outbreak.)

A key issue is just how quickly the money can be spent. How quickly can you train health professionals or produce more ventilators or provide extra hospital beds?

This emergency part of the Budget was co-ordinated with the Bank of England’s decision to cut Bank Rate from 0.75% to 0.25%.

This combined fiscal and monetary response to the crisis was further enhanced by the agreement of central banks on 15 March to boost world liquidity by increasing the supply of US dollars through large-scale quantitative easing. The US central bank, the Federal Reserve, also cut its main federal funds rate by one percentage point from 1–1.25% to 0–0.25%.

The planned Budget

The second part of the Budget is to raise government investment by 9% in real terms over the next four years, bringing overall government expenditure to 41% of GDP, financed largely by extra borrowing. As the IFS observes, “That is above its pre-crisis level and bigger than at any point between the mid 1980s and the start of the financial crisis.”

But despite this rise in the proportion of government spending to GDP, in other respects the spending plans are less expansionary than they may appear. Increases in current spending on health, education and defence had already been promised. This leaves other departments, such as social security, facing cuts, or at least no increase. And when compared with 2010/11 levels, if you exclude health, government current spending per head of the population will around 14% lower, or 19% lower once you account for spending that replaces EU funding.

The Chancellor’s hope is that, by focusing on investment, there will be a supply-side effect as well as a demand-side boost. If increases in aggregate demand are balanced by increases in aggregate supply, such a policy would not be inflationary in the long run. But in the light of the considerable uncertainty of the effects of the coronavirus, the plans may well require significant adjustment in the Autumn Budget – or earlier.

Articles

Podcasts and Videos

Official documentation

Questions

  1. To what extent is this Budget ‘Keynesian’?
  2. Is the extra government expenditure likely to crowd out private expenditure? Explain.
  3. Demonstrate the desired long-term economic effect of the infrastructure policy using either an AD/AS diagram or a DAD/DAS diagram.
  4. How is the coronavirus pandemic likely to affect potential GDP in (a) the short run (b) the long run?
  5. Why is public-sector debt likely to soar over the next four years while annual government debt interest payments are likely to continue their gentle decline?
  6. What is missing from the Budget that you feel ought to have been included? Explain why.

With many countries experiencing low growth some 12 years after the financial crisis and with new worries about the effects of the coronavirus on output in China and other countries, some are turning to a Keynesian fiscal stimulus (see Case Study 16.6 on the student website). This may be in the form of tax cuts, or increased government expenditure or a combination of the two. The stimulus would be financed by increased government borrowing (or a reduced surplus).

The hope is that there will also be a longer-term supply-side effect which will boost potential national income. This could be through tax reductions creating incentives to invest or work more efficiently; or it could be through increased capacity from infrastructure spending, whether on transport, energy, telecommunications, health or education.

In the UK, the former Chancellor, Sajid Javid, had adopted a fiscal rule similar to the Golden Rule adopted by the Labour government from 1997 to 2008. This stated that, over the course of the business cycle, the government should borrow only to invest and not to fund current expenditure. Javid’s rule was that the government would balance its current budget by the middle of this Parliament (i.e. in 2 to 3 years) but that it could borrow to invest, provided that this did not exceed 3% of GDP. Previously this limit had been set at 2% of GDP by the former Chancellor, Philip Hammond. Using his new rule, it was expected that Sajid Javid would increase infrastructure spending by some £20 billion per year. This would still be well below the extra promised by the Labour Party if they had won the election and below what many believe Boris Johnson Would like.

Sajid Javid resigned at the time of the recent Cabinet reshuffle, citing the reason that he would have been required to sack all his advisors and use the advisors from the Prime Minister’s office. His successor, the former Chief Secretary to the Treasury, Rishi Sunak, is expected to adopt a looser fiscal rule in his Budget on March 11. This would result in bigger infrastructure spending and possibly some significant tax cuts, such as a large increase in the threshold for the 40% income tax rate.

A Keynesian stimulus would almost certainly increase the short-term economic growth rate as inflation is low. However, unemployment is also low, meaning that there is little slack in the labour market, and also the output gap is estimated to be positive (albeit only around 0.2%), meaning that national income is already slightly above the potential level.

Whether a fiscal stimulus can increase long-term growth depends on whether it can increase capacity. The government hopes that infrastructure expenditure will do just that. However, there is a long time lag between committing the expenditure and the extra capacity coming on stream. For example, planning for HS2 began in 2009. Phase 1 from London to Birmingham is currently expected to be operation not until 2033 and Phase 2, to Leeds and Manchester, not until 2040, assuming no further delays.

Crossrail (the new Elizabeth line in London) has been delayed several times. Approved in 2007, with construction beginning in 2009, it was originally scheduled to open in December 2018. It is now expected to be towards the end of 2021 before it does finally open. Its cost has increased from £14.8 billion to £18.25 billion.

Of course, some infrastructure projects are much quicker, such as opening new bus routes, but most do take several years.

The first five articles look at UK policy. The rest look at Keynesian fiscal policies in other countries, including the EU, Russia, Malaysia, Singapore and the USA. Governments seem to be looking for a short-term boost to aggregate demand that will increase short-term GDP, but also have longer-term supply-side effects that will increase the growth in potential GDP.

Articles

Questions

  1. Illustrate the effect of an expansionary fiscal policy with a Keynesian Cross (income and expenditure) diagram or an injections and withdrawals diagram.
  2. What is meant by the term ‘output gap’? What are the implications of a positive output gap for expansionary Keynesian policy?
  3. Assess the benefits of having a fiscal rule that requires governments to balance the current budget but allows borrowing to invest.
  4. Would there be a problem following such a rule if there is currently quite a large positive output gap?
  5. To what extent are the policies being proposed in Russia, the EU, Malaysia and Singapore short-term demand management policies or long-term supply-side policies?

The Bank of England’s monetary policy is aimed at achieving an inflation rate of 2% CPI inflation ‘within a reasonable time period’, typically within 24 months. But speaking in Nottingham in one of the ‘Future Forum‘ events on 14 October, the Bank’s Governor, Mark Carney, said that the Bank would be willing to accept inflation above the target in order to protect growth in the economy.

“We’re willing to tolerate a bit of an overshoot in inflation over the course of the next few years in order to avoid rising unemployment, to cushion the blow and make sure the economy can adjust as well as possible.”

But why should the Bank be willing to relax its target – a target set by the government? In practice, a temporary rise above 2% can still be consistent with the target if inflation is predicted to return to 2% within ‘a reasonable time period’.

But if even if the forecast rate of inflation were above 2% in two years’ time, there would still be some logic in the Bank not tightening monetary policy – by raising Bank Rate or ending, or even reversing, quantitative easing. This would be the case when there was, or forecast to be, stagflation, whether actual or as a result of monetary policy.

The aim of an inflation target of 2% is to help create a growth in aggregate demand consistent with the economy operating with a zero output gap: i.e. with no excess or deficient demand. But when inflation is caused by rising costs, such as that caused by a depreciation in the exchange rate, inflation could still rise even though the output gap were negative.

A rise in interest rates in these circumstances could cause the negative output gap to widen. The economy could slip into stagflation: rising prices and falling output. Hopefully, if the exchange rate stopped falling, inflation would fall back once the effects of the lower exchange rate had fed through. But that might take longer than 24 months or a ‘reasonable period of time’.

So even if not raising interest rates in a situation of stagflation where the inflation rate is forecast to be above 2% in 24 months’ time is not in the ‘letter’ of the policy, it is within the ‘spirit’.

But what of exchange rates? Mark Carney also said that “Our job is not to target the exchange rate, our job is to target inflation. But that doesn’t mean we’re indifferent to the level of sterling. It does matter, ultimately, for inflation and over the course of two to three years out. So it matters to the conduct of monetary policy.”

But not tightening monetary policy if inflation is forecast to go above 2% could cause the exchange rate to fall further. It seems as if trying to arrest the fall in sterling and prevent a fall into recession are conflicting aims when the policy instrument for both is the rate of interest.

Articles

BoE’s Carney says not indifferent to sterling level, boosts pound Reuters, Andy Bruce and Peter Hobson (14/10/16)
Bank governor Mark Carney says inflation will rise BBC News, Kamal Ahmed (14/10/16)
Stagflation Risk May Mean Carney Has Little Love for Marmite Bloomberg, Simon Kennedy (14/10/16)
Bank can ‘let inflation go a bit’ to protect economy from Brexit, says Carney – but sterling will be a factor for interest rates This is Money, Adrian Lowery (14/10/16)
UK gilt yields soar on ‘hard Brexit’ and inflation fears Financial Times, Michael Mackenzie and Mehreen Khan (14/10/16)
Brexit latest: Life will ‘get difficult’ for the poor due to inflation says Mark Carney Independent, Ben Chu (14/10/16)
Prices to continue rising, warns Bank of England governor The Guardian, Katie Allen (14/10/16)

Bank of England
Monetary Policy Bank of England
Monetary Policy Framework Bank of England
How does monetary policy work? Bank of England
Future Forum 2016 Bank of England

Questions

  1. Explain the difference between cost-push and demand-pull inflation.
  2. If inflation rises as a result of rising costs, what can we say about the rate of increase in these costs? Is it likely that cost-push inflation would persist beyond the effects of a supply-side shock working through the economy?
  3. Can interest rates be used to control both inflation and the exchange rate? Explain why or why not.
  4. What is the possible role of fiscal policy in the current situation of a falling exchange rate and rising inflation?
  5. Why does the Bank of England target the rate of inflation in 24 months’ time and not the rate today? (After all, the Governor has to write a letter to the Chancellor explaining why inflation in any month is more than 1 percentage point above or below the target of 2%.)
  6. What is meant by a zero output gap? Is this the same as a situation of (a) full employment, (b) operating at full capacity? Explain.
  7. Why have UK gilt yields soared in the light of a possible ‘hard Brexit’, a falling exchange rate and rising inflation?

In their manifestos, the parties standing for the UK general election on May 7th state their plans for fiscal policy and, more specifically, for reducing public-sector net borrowing and public-sector net debt. The degree of detail in the plans varies, especially with regards to where cuts will be made, but there are nevertheless some very clear differences between the parties.

The Institute for Fiscal Studies has examined the public finance plans of the Conservatives, Labour, Liberal Democrats and SNP and has published a briefing note (see link below) and an accompanying press release. It accuses all four parties’ plans of being short on detail over specific cuts (especially the Conservatives), and over borrowing requirements (especially Labour):

None of these parties has provided anything like full details of their fiscal plans for each year of the coming parliament, leaving the electorate somewhat in the dark as to both the scale and composition of likely spending cuts and tax increases. In our analysis we have used the information provided in each manifesto, plus in some cases some necessary assumptions, to shed light on the four parties’ plans.

But despite the lack of detail, the IFS claims that there are big differences in the parties’ plans. These are illustrated in the following three charts from the IFS Briefing Note.



According to Carl Emmerson, IFS deputy director:

“There are genuinely big differences between the main parties’ fiscal plans. The electorate has a real choice, although it can at best see only the broad outlines of that choice. Conservative plans involve a significantly larger reduction in borrowing and debt than Labour plans. But they are predicated on substantial and almost entirely unspecified spending cuts and tax increases. While Labour has been considerably less clear about its overall fiscal ambitions its stated position appears to be consistent with little in the way of further spending cuts after this year”.

So what would be the implications of the plans of the various parties for fiscal policy and what, in turn, would be the implications for economic growth and investment? The various videos and articles look at the briefing note and at what is missing from the parties’ plans.

Videos

Voters ‘in the dark’ over budgets BBC News, Robert Peston (23/4/15)
Election 2015: Main parties respond to IFS deficit claims BBC News, James Landale (23/4/15)
Election 2015: ‘Not enough detail’ on deficit cut plans, says IFS BBC News, Paul Johnson (23/4/15)
IFS: Electorate ‘left in the dark’ by political parties ITV News, Chris Ship (23/4/15)
Voters Left In Dark Over Spending Cuts, Says IFS Sky News (23/4/15)
Post-election austerity: parties’ plans compared Institute for Fiscal Studies, Press Briefing (23/5/15)

Articles

IFS: election choice is stark Economia, Oliver Griffin (23/4/15)
Election 2015: Voters ‘left in the dark’, says IFS BBC News (23/4/15)
The huge choice for voters BBC News, Robert Peston (23/4/15)
IFS manifesto analysis: fantasy island of Tory deficit reduction plan The Guardian, Larry Elliott (23/4/15)
Tories have £30bn black hole in spending plans, says IFS The Guardian, Heather Stewart (23/4/15)
Ed Miliband will leave Britain an extra £90bn in debt, IFS finds The Telegraph, Steven Swinford (23/4/15)
IFS despairs as it finds no party’s imaginary numbers add up The Guardian, John Crace (23/4/15)
Reality Check: Why should we trust the IFS? BBC News, Sebastian Chrispin (23/4/15)
IFS: Households can expect lower incomes, whoever wins the election BBC News, Brian Milligan (28/4/15)

Briefing Notes
Post-election Austerity: Parties’ Plans Compared Institute for Fiscal Studies, Briefing Note BN170, Rowena Crawford, Carl Emmerson, Soumaya Keynes and Gemma Tetlow (April 15)
Taxes and Benefits: The Parties’ Plans Institute for Fiscal Studies, Briefing Notw BN 172, Stuart Adam, James Browne, Carl Emmerson, Andrew Hood, Paul Johnson, Robert Joyce, Helen Miller, David Phillips, Thomas Pope and Barra Roantree (April 2015)

Questions

  1. What detail is missing about cuts in the Conservative plans?
  2. What detail is missing in the Labour plans on borrowing requirements?
  3. How do (a) the Liberal Democrat plans and (b) the SNP plans differ from Conservative and Labour plans?
  4. Find out the public finances plans of (a) the Green Party; (b) UKIP; and (c) Plaid Cymru. How different are these plans from those of other parties?
  5. Define ‘austerity’.
  6. How would a tightening of fiscal policy affect economic growth (a) in the short term; (b) in the long term?
  7. How would an expansion of the economy affect the budget balance through automatic fiscal stabilisers?
  8. What is meant by the structural deficit? How could this be reduced?
  9. Would the structural deficit be affected by austerity policies and the resulting size of the output gap, or is it independent of such policies? Explain.