Chancellor George Osborne’s fiscal charter was passed in the UK House of Commons yesterday with a strong majority; 21 opposition Labour MPs abstained in defiance of shadow Chancellor John McDonnell who asked them to oppose the bill – only two weeks after saying he wouldn’t oppose it at the Labour Party conference.
Although the bill passed comfortably and in the process sowed division among and caused embarrassment for Osborne’s opponents, it is hard to find any commentator with a good word to say about it, from either side of the political spectrum.
The most common criticism, made by McDonnell when speaking against the bill in the Commons yesterday, is that it’s a “gimmick.” McDonnell’s adviser Danny Blanchflower, former member of the Bank of England monetary committee, described it as “a stunt that has really no place in economic policy” and “silly rules that have no economic benefit” (BBC Radio 4 Today programme 14/10/2015).
Commentators on both the left and the right seem to think that if a country is serious about keeping its deficit under control it will elect a government whose policy is to do just that. And if that government is serious about its commitment to the electorate, then it shouldn’t need gimmicks such as the fiscal charter to stick to its electoral promises.
Writing on the CapX blog, which is generally sympathetic to the Conservatives and in favor of budgetary restraint, Andrew Lillico wrote today that the fiscal charter “doesn’t really have any effect except to tell us what Osborne is intending to do, which he could have put in a Budget statement instead of into a law … although countries quite often try to pass laws requiring deficits to do this or that, laws don’t have much effect unless they are accompanied by (or reflect) a political culture that wants to keep the deficit down anyway, law or no law. It’s the will that counts, not the law” (http://www.capx.co/the-labour-partys-response-to-osbornes-fiscal-charter-iswell-embarrassing-embarrassing-embarrassing/).
The problem with such arguments is that they contain too many “ifs.” They are based on an imaginary world of entirely rational people in which normal human psychology is somehow abolished. They don’t describe the real world in which politicians repeatedly make the totally irrational – but at the same time intuitive, easy and popular – decisions which, throughout economic history, have left countries with too much debt.
Either meaningless or detrimental
To understand this point, we need to look at the period of time in the (hopefully not too distant) future during which the fiscal charter is designed to have its effect. Speaking on the BBC Radio 4 Today Programme yesterday, Stephanie Flanders, former BBC economics editor and currently working for J. P. Morgan Asset Management, provided another criticism of the charter from outside the conventional left wing spectrum. She argued that the policy would be detrimental if it prevented governments from increasing borrowing in a counter-cyclical manner in times of financial crisis. And if it didn’t, that would mean it would have no effect at all: “Either you have a big loophole in which case it really is quite empty, or or you’re actually limiting the ability for a government to respond to future downturns.”
This is plain wrong. The fiscal charter compels governments to run a balanced budget unless growth is below or expected to be below 1% per annum. So if the economy is in a serious mess, the fiscal charter won’t apply. The government is free to increase the deficit in a counter-cyclical manner – provided the economy is in recession. Keynes would have had no difficulty with the fiscal charter.
But that doesn’t mean that the policy is anodyne or will have no effect. In normal times when the economy is growing at 1% or more – or especially in the good times when growth is well above 1% – the government cannot run a deficit. So the policy is targeted specifically at any government which is lucky enough to find itself in power in the good times, and to prevent it from running up a deficit when the economy is strong. Again, Keynes wouldn’t have raised an eyebrow.
Why would any rational government run deficits in boom times?
Fraser Nelson, editor of the Conservative-leaning weekly the Spectator, tweeted mockingly about the fiscal charter in these terms: “If Labour can’t see absurdity of debt-addict Osborne sponsoring a ‘Charter of Budget Responsibility’ then all is lost.” What this completely neglects is the fact that deficits are cyclical, particularly following a banking crisis. Carmen Reinhardt and Kenneth Rogoff in their seminal work This Time It’s Different (2009) studied debt crises going back as far as the middle ages. The study is particularly impressive because it incorporates data on domestic debt, which had long been difficult to obtain and was therefore neglected. Studies of debt typically only focused on international debt, for which international statistics are – understandably – easier to obtain, and therefore underestimated the true extent of indebtedness which only an aggregation of international and domestic debt can capture.
Reinhardt and Rogoff’s work on banking crises covering around two centuries of international data show that, on average, government net debt increases by 86% following a banking crisis, mainly due to the impact of deleveraging on economic growth and the concomitant increase in benefit spending and decrease in tax take (counter-cyclical stimulus plans, although they grab the headlines, are much less significant contributors). Since Osborne took over government net debt has gone up by around 50%, but since the sub-prime crisis it has roughly trebled. So the UK’s net debt has increased far more than the c. 200 year average calculated by Reinhard and Rogoff, but then the boom that preceded this latest bust was a lot stronger and more internationally synchronised than past booms, due in part to increased share of world GDP accounted for by global trade. The UK was also affected by the slowdown in Europe due to the latter’s own debt crisis. Given these powerful global forces, the deficit was going to go up even more than usual, no matter what.
The point is that deficits go up when economies go into recession, so it is important to save when times are good. This is so obvious that it hardly seems worth saying. How could any rational government do otherwise? However the run up to the sub-prime crisis in 2008 demonstrated the exact opposite. Growth in the UK compounded at a stonking 5.3% per annum between 2000 and 2007, incredible numbers fueled by the leverage boom and associated rising house prices. In such an environment, tax take was increasing and less benefits had to be paid, so there was a massive economic tailwind which should have enabled the government to run a big surplus. Instead, public spending increased by 61%, and was 4 percentage points higher as a percentage of GDP in 2007 than it was in 2000. Such unsustainable largesse obviously made a significant positive contribution to the ruling party’s ability to get re-elected.
This testifies to many things – the irresponsibility of politicians and the venality of Tony Blair among them – but the main thing it demonstrates in my opinion is that politicians do not behave rationally in times of economic plenty. So, going back to Andrew Lillico and Danny Blanchflower, yes, rational people shouldn’t need “gimmicks” like the fiscal charter, but history shows us that governments are not always rational, and particularly irrational when it comes to dealing with economic cycles.
How easy it is to forget
Having been through one of the most painful debt crises in history, if not the most painful, surely we don’t need a gimmick like the charter to keep us on the straight and narrow when we finally emerge and start to grow again? The title of Reinhardt and Rogoff’s book is a quote of a sentence repeatedly uttered by economists, analysts and policy advisors in the run up to the debt crises analysed in their book. We may have recorded government debt defaults going back to 1340, yet despite over six and a half centuries of experience somehow governments never learn. Clearly, there is something very deeply ingrained in human psychology which prevents us from remembering past crises and avoiding the mistakes which led to them. Blair and Brown in 2000-2007 are part of a long, recurring history of people thinking that this time is different.
The reason why people’s memory operates in this way is nothing new, and has been well understood since the 70s, thanks to the brilliant experimental work pioneered by Daniel Kahneman and Amos Tversky, and developed by the talented constellation of behavioural psychologists they inspired. One such, Howard Kunreuther, observed that people in California increased their purchases of insurance policies covering losses arising from earthquakes immediately after an earthquake. Earthquakes are caused by the slow build up of pressure between tectonic plates, which the earthquake eventually releases. Rationally, the time when you are least at risk from an earthquake is just after an earthquake. The longer after the earthquake, the more at risk you are and the more sense it makes to buy insurance. But the passage of time after the the earthquake makes it less vivid (less “available” as Kahneman and Tversky put it) in your mind, and makes you less inclined to buy insurance the more you need it. Just after the earthquake, the risk is vivid in your mind, and you are more inclined to buy insurance when you need it least.
Our attitudes to deficits are very similar to our attitude to earthquakes. When we are suffering from the after effects of excessive borrowing we suddenly become highly focused on the budget. But by this point it’s too late, the deficit is going up whatever we do, purely through the cyclicality documented by Reinhardt and Rogoff (which of course doesn’t mean you don’t need to take action – otherwise you end up like Greece – just that the action you take, although necessary, is at its least effective at that time). When times are good, deficits are an abstract concept which has faded from memory, just like an earthquake 15 years ago. Kahneman, Tversky and their constellation of scientists’ experiments demonstrate that it is human nature to forget about past deficits, and to think that this time is different.
If these traits are so strongly ingrained in human psychology, how can a “silly” piece of legislation like the fiscal charter prevent it? As Blanchflower says, what’s the use of “tying yourself to a silly rule that no one’s going to obey?” Incredibly, Blanchflower seems to accept that there is nothing which can stop the human instinct for running deficits in good times. When asked by left-leaning Justin Webb if he could imagine a time when “there would be no deficit” Blanchflower’s answer was pathetic: “Well clearly you’d like to do that. You’d certainly like to be able to do … deal with things in a different way when the economy is booming.” Saying “you’d like to” is an admission of defeat. It’s like Saint Augustine saying “Lord make me virtuous – but not today.”
The fiscal charter offers a real solution in the face of Blanchflower’s platitudes. Just imagine, counter-factually, that we are in 2019 during a strong economic boom. Voters have forgotten the debt crisis, and fiscal discipline suddenly seems less important. “We can grow our way out of trouble”, “we can spend today the growing revenues of tomorrow” and other optimistic slogans are in vogue. Suddenly the Conservatives are nervous and voters are less scared of Labour; with swelling government coffers maybe it’s time to elect a government that knows how to spend?
The Conservatives feel they need to react, and, just like Blair and Brown, they start to increase spending on areas which are popular with voters. Suddenly it’s a race to see who can spend more. Now, without the fiscal charter, there is no downside: all the Conservatives are doing is spending more of the money that is suddenly so plentiful. It’s easy for people to think that’s a good thing. They build more schools. They cut taxes. They subsidise first time buyers. Who’s going to argue? As Kahneman and Twersky show, the concrete image of the new school or the new home is more readily “available” and easier to respond to than the faded memory of the last debt crisis.
But with the fiscal charter in place, the Conservatives would have to pass a law to repeal it. Now the “gains” from the spending must be weighed in the balance against the loss of the fiscal charter. Richard Thaler, one of Kahneman and Tversky’s most incisive followers, conducted experiments in which participants were given a number of identical coffee mugs and some money. They were then asked to trade against each other according to their perceptions of value. Thaler found that the average price at which participants offered to sell the mugs was half that of the average price at which they offered to buy them. In other words, participants attributed twice as much value to something they already had as they attributed to something they didn’t have, even though both were identical. In the same way, you will refuse to sell a vintage bottle of wine of wine you own for $100, but refuse to buy another identical one for $75. This is called the “endowment effect.”
The fiscal charter will make it harder to raise spending in good times thanks to that endowment effect. If you have a fiscal charter in place, you can only raise spending by giving it up. Because you have it, its benefits are more concrete and “available.” Without the fiscal charter, you hardly need to justify your spending in the good times. With the fiscal charter in place, the Prime Minister who seeks to run a deficit has to stand up in front of the House of Commons and ask it to change the status quo, to actively repeal something which has been in place for years. In such an environment it will no longer be easy to just lazily throw a few giveaways to the public to get elected. Without the fiscal charter, running a deficit in good times is the default option. With the fiscal charter, balanced budgets in good times becomes the default option. And as we know from Nudge (2008) by Cass Sunstein (another member of the Kahneman and Tversky constellation), people tend to go with the default option.
The endowment effect is an irrational but perfectly understandable piece of human intuition. History shows that we cannot rely on politicians or voters to remember history and implement its lessons in a rational way. We keep making the same mistakes because our minds are affected by gimmicks, not by reason. Gimmicks like the fiscal charter work well because they are in tune with real human psychology. And the beautiful quirk of this particular gimmick is that it helps us be more rational and less gimmicky.