“A Layman’s Guide to the Left’s Economic Debate”

By George Irvin

In the UK, a loose knit collection of left-wing academics, NGO heads, journalists and others is currently discussing a left alternative to Osborne’s increasingly disastrous Plan A. While all are agreed that Osborne has got it terribly wrong, there is less agreement about the nature of a truly different Plan B. Should one argue for slowing the pace of fiscal contraction, but at a pace which will not frighten the financial markets – a sort of Darling-lite budget – or should one press ahead full-steam for growth, arguing that this alone will restore budgetary health?

Since many of those involved in the debate are economists, the argument is at times tediously technical. Broadly speaking, it goes as follows. A government deficit has two components: the ‘cyclical’ component – which results from the growing spread between falling receipts (tax revenue) and growing expenditure (unemployment benefit) caused by an economic downturn – and the ‘structural’ component, the gap which may still exist when the economy returns to full capacity production. If there is still a large structural component when full capacity output is restored, some economists argue, then some form of fiscal consolidation will still be required – albeit, far milder than Osborne (or even Darling) anticipated. In the absence of such consolidation, financial markets might still attack Britain.

The reader will recall that the size of the structural deficit has changed over time: two years ago London’s Institute of Fiscal Studies (IFS) thought it might be just over £50bn, but today they think it’s at least twice that size. The alleged reason the structural deficit has widened is because the ‘output gap’ – ie, the gap between current output and full-employment output – has narrowed. The UK Treasury thinks the output gap is small (2.2% of GDP) because, they would argue, much of the UK’s previous production capacity is no longer available, or to put it a slightly different way, the trend line for potential output has been pulled downward by a recession.

The IFS Green budget (Feb 2011) thought the output gap was higher – but less than 4% – while the European Commission (Nov 2010) thought it to be 5%. (There is a long technical discussion of measurement problems at: http://www.ifs.org.uk/budgets/gb2011/gb2011.pdf – indeed, on one IFS measure, there’s no gap at all.) The Office for Budget Responsibility in its March 2011 report thought it was 3%. The National Institute for Social and Economic Research (January 2011) thought the output gap was probably higher than 4%, as indeed did the OECD.

Since a larger output gap implies a smaller structural deficit, technical arguments about how best to estimate the output gap may have important implications for policy. The phrase ‘may have’ is used deliberately. Some economists on the left believe, firstly, that the very notion of the output gap is highly problematical, and that, secondly, a go-for-growth strategy need not be constrained by a structural deficit.

Regarding the first problem, besides the considerable measurement difficulties raised in trying to forecast the output gap, the concept itself rests on the notion that any attempt to push growth past the full-capacity mark would set off accelerating inflation. In orthodox economists’ jargon, there is some ‘natural rate’ of employment and output at which inflation doesn’t accelerate -NAIRU (the non accelerating inflation rate of unemployment). Others argue that this ‘natural rate’ cannot be defined, or to use a phrase made famous by Joan Robinson, NAIRU is a ‘metaphysical’ concept. For that matter, they would argue that so too is the aggregate production function approach to estimating the output gap, an approach ridiculed in the famous ‘Cambridge debate’ some 40 years ago.2

If you’re feeling a bit confused at this point, it may be comforting to know that so too is much of the economics profession. But what of the second proposition – that a go-for-growth strategy need not be constrained by the structural deficit? Here the more left-wing would argue that, providing a growth strategy is investment-based and increases Britain’s capacity to produce for the home and overseas markets – as well as targeting sustainable energy, modern infrastructure and affordable housing – the structural deficit can be reduced to near-zero. With weak trade unions, there is negligible pressure for wages to rise faster than productivity, thus minimising the problem of domestically generated inflation.

Moreover, it can be argued that financial markets are highly unlikely to be panicked by a go-for-growth strategy for at least four reasons. First of all, Britain (which has never defaulted on its debt) has the longest average debt maturity of any OECD country.3 Secondly, given the current situation in Greece and Ireland, financial markets are beginning to recognise that Osborne-style fiscal consolidation is not the road to growth. Thirdly, Britain has a flexible exchange rate. Finally, suppose that as public investment expands, financial markets for whatever reason raise Britain’s borrowing costs outrageously. Under present conditions, we could simply resort to more quantitative easing (monetisation).

That’s the bare bones of the Plan B debate about the importance of the structural deficit. Over to you, the reader.

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