Friday Flyer: How to do a fiscal consolidation

How does a government reduce its public debt burden relative to national income, which is what I mean by a fiscal consolidation? There are a number of obvious instruments that might bear immediate fruit: reduce the flow of government deficits by increasing taxes or reducing government expenditure or to develop expenditures that increase output by more than the increase in the deficit. The latter is of course the search for the holy grail of a multiplier greater than one and the former is often termed ‘austerity’.

But there are problems with each of these solutions. If we increase taxes too quickly we may reduce demand directly as the government sucks expenditure out of the economy or we may induce counter-productive responses as households and firms withdraw from expansionary plans as net returns fall. Changing the path of government expenditures which are planned over a multi-year horizon may prove quite difficult and damaging: a part-built hospital or half a Forth bridge or closing a school in Year 10 may not be particularly helpful to anyone. Though I realise that some people have called for holes to be dug, Keynes put it best:

“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 (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. 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.”

The simple arithmetic of reducing debt burdens is clear. We can almost exactly account for the level of debt to GDP in terms of the fiscal position prior to interest rate payments on debt, the so-called primary surplus or deficit, the interest payments on public debt, and on the growth in the real income and inflation. Table 1, taken from the November 2016 National Institute Economic Review, shows how these reductions were undertaken in two 20th century episodes, after WW1 and WW2. It seems that a successful consolidation occurs when the government simply runs a primary fiscal surplus equal to the interest payments of debt so that the overall fiscal position is in balance. The rate of the consolidation then depends on the rate of growth in real income and inflation. The modest deflation of the 1920s limited the rate of the consolidation and the more pronounced inflation in the 1950s allowed an acceleration.

Key: y is real income; π is inflation, s is the primary surplus and ε is a residual. The overbars represent average contributions over the sample period.

The key decision is not about running huge fiscal surpluses to pay back debt but about when it is safe to run a primary surplus large enough to meet interest payments on debt. That key judgement might be forced upon a government if markets do not wish to lend anymore or the interest rates on debt rise. If you are very lucky the central bank may be able to hold interest rates down because there is no inflationary threat under a credible regime. Or even better should a sharp increase in productivity growth increase the tax base without also increasing interest rates. But the decision about when to move to the state where the primary surplus is equal to interest rate payments on debt is a key staging post to a successful fiscal consolidation.

But I think there is a more subtle point: over the course of any planning horizon there is a significant chance of a negative shock to economic growth. And this will tend raise debt to GDP. Obviously if there is an equivalent possibility of a positive shock this will tend in an equivalent manner to lower debt to GDP. But the constraint of the level of government debt is an upper limit not a lower bound. This means that unless there is some belief in an eventual fiscal consolidation, markets might force the fiscal choice before the optimal moment. Therefore to stop a momentum or expected drift towards this upper limit, some commitment to a surplus rule needs to be on the horizon not beyond it. That perhaps is the proper role of any fiscal rule.