Already this morning I have received several E-mails asking me to comment on the latest article in the Sydney Morning Herald (February 3, 2014) – Budget a matter of timing and nerve – by its economics editor Ross Gittins. I prefer not to write a full blog about this because it will distract me from my Eurozone book that is running to a tight deadline before publishing. But I will make a short comment on what I see as symptomatic among financial and economics journalists – a laxity in their terminology, which either deliberately supports or involuntarily plays into the hands of those who seek to redefine full employment as something that allows austerity to look acceptable.
Gittins is writing about the up-coming debate about the May Federal fiscal announcement (aka as the B-word, which I no longer use). It will be the first statement of fiscal position by the newly-elected conservative government (after the September 2013 federal election) and they have been talking tough. We will see.
Gittins writes in the context of the government’s claim to have an “an almighty cleanout and strike a lasting blow for fiscal sustainability” that:
… it has to go further and achieve a significant net improvement in the “structural” budget balance (the balance we would have if this were a normal year in the business cycle).
The reference to the structural defict being the “the balance we would have if this were a normal year in the business cycle” is pure fiction and is not even to be found in mainstream economics. This is either a fiction Gittins chooses to perpetuate because he doesn’t know any better (not likely) or that he does not choose to explain the concept properly (probably).
The result though is that the most important aspect of defining the division in the government’s fiscal balance between structural and cyclical – the concept of full employment – is lost.
What exactly might he be thinking about a “normal year in the business cycle”? A business cycle, which I prefer to call an ‘economic cycle’ because economic activity comes from a broader source than the business sector, is made up of a peak, a trough and some amplitude in between.
It could mean an economy started with high unemployment, saw some fall in the same as the economy improved, and, after the peak, saw unemployment rise again, without ever get close along the way to having enough jobs available for all those who want to work.
Further, underemployment might remain high throughout this ‘economic cycle’.
So what would a “normal year” be in that experience?
The following provides you with an accurate understanding of what a stuctural fiscal balance is. It has nothing to do with a “normal year” in an economic cycle. In fact, if the fiscal balance is all structural then it would be a very unique year and one that nations rarely attain, mostly because governments will not take responsibility for achieving full employment.
The federal fiscal balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the fiscal balance is in surplus and vice versa. It is a simple matter of accounting with no theory involved. However, the fiscal balance is used by all and sundry to indicate the fiscal stance of the government.
So if the fiscal balance is in surplus we conclude that the fiscal impact of government is contractionary (withdrawing net spending) and if the fiscal balance is in deficit we say the fiscal impact expansionary (adding net spending).
However, the complication is that we cannot then conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty is that there are automatic stabilisers operating. To see this, the most simple model of the fiscal balance we might think of can be written as:
Fiscal Balance = Revenue – Spending.
Fiscal Balance = (Tax Revenue + Other Revenue) – (Welfare Payments + Other Spending)
We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the fiscal balance are the so-called automatic stabilisers
In other words, without any discretionary policy changes, the fiscal balance will vary over the course of the business cycle. When the economy is weak – tax revenue falls and welfare payments rise and so the fiscal balance moves towards deficit (or an increasing deficit).
When the economy is stronger – tax revenue rises and welfare payments fall and the fiscal balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the economic cycle by expanding the budget in a recession and contracting it in a boom.
So just because the fiscal balance goes into deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.
To overcome this uncertainty, economists devised what used to be called the Full Employment or High Employment Fiscal Balance.
In more recent times, this concept is now called the Structural Balance.
The change in nomenclature is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation. I will come back to this later.
The Full Employment Fiscal Balance was a hypothetical construct of the fiscal balance that would be realised if the economy was operating at potential or full employment. You can see that this is different from the claim by Gittins that is is what would happen in some “normal year”.
In other words, calibrating the fiscal position (and the underlying fiscal parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.
So a full employment fiscal balance would be in balance (that is, zero) if total outlays and total revenue were equal when the economy was operating at total capacity.
If the fiscal balance was in surplus at full capacity, then we would conclude that the discretionary structure of fiscal policy was contractionary and vice versa if the fiscal balance was in deficit at full capacity.
The calculation of the structural deficit spawned a bit of an industry in the past with lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.
Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s. All of them had issues but like all empirical work – it was a dirty science – relying on assumptions and simplifications. But that is the nature of the applied economist’s life.
Things changed in the 1970s and beyond. At the time that governments abandoned their commitment to full employment (as unemployment rise), the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see my blogs – The dreaded NAIRU is still about and Redefining full employment … again!.
The NAIRU became a central plank in the front-line attack on the use of discretionary fiscal policy by governments. It was argued, erroneously, that full employment did not mean the state where there were enough jobs to satisfy the preferences of the available workforce. Instead full employment occurred when the unemployment rate was at the level where inflation was stable.
NAIRU theorists then invented a number of spurious reasons (all empirically unsound) to justify steadily ratcheting the estimate of this (unobservable) inflation-stable unemployment rate upwards. So in the late 1980s, economists were claiming it was around 8 per cent. Now they claim it is around 5 per cent. The NAIRU has been severely discredited as an operational concept but it still exerts a very powerful influence on the policy debate. In Australia, it dominates the Treasury and the Reserve Bank modelling.
Further, governments became captive to the idea that if they tried to get the unemployment rate below the NAIRU using expansionary policy then they would just cause inflation. I won’t go into all the errors that occurred in this reasoning. My 2008 book – Full Employment Abandoned with Joan Muysken is all about this period.
Now I mentioned the NAIRU because it has been widely used to define full capacity utilisation. If the economy is running an unemployment equal to the estimated NAIRU then these clowns concluded that the economy is at full capacity. Of-course, they kept changing their estimates of the NAIRU which were in turn accompanied by huge standard errors. These error bands in the estimates meant their calculated NAIRUs might vary between 3 and 13 per cent in some studies which made the concept useless for policy purposes.
But they still persist in using it because it carries the ideological weight – the neo-liberal attack on government intervention.
So they changed the name from Full Employment Fiscal Balance to Structural Balance to avoid the connotations of the past that full capacity arose when there were enough jobs for all those who wanted to work at the current wage levels. Now you will only read about structural balances.
And to make matters worse, they now estimate the structural balance by basing it on the NAIRU or some derivation of it – which is, in turn, estimated using very spurious models. This allows them to compute the tax and spending that would occur at this so-called full employment point. But it severely underestimates the tax revenue and overestimates the spending and thus concludes the structural balance is more in deficit (less in surplus) than it actually is.
They thus systematically understate the degree of discretionary contraction coming from fiscal policy.
The point is that, even with all the NAIRU chicanery, there is nothing about the structural balance that denotes a “normal year” in the economic cycle.
My Euro Options blog for today will come later today.
Please read the following blogs for further elucidation: