The macroeconomic magic button

In a recent poston the Eurozone, I talked about an idea from Greek economist Yanis Varoufakis, where he imagined leaders were presented with a magic button that would end their countries macroeconomic woes. He said that leaders in the US and UK would surely press the button, but he was doubtful about Germany. I commented as an aside that I thought he was wrong about the UK, because that button exists, and it is called balanced budget fiscal expansion. (I think he is right about the US, if the only hand needed to press the button was the President. However my arguments below probably also apply to many Republicans.)

The idea is to temporarily increase government spending, and pay for it completely by temporarily raising taxes. There is no increase in government budget deficits or debt. This may seem like giving with one hand and taking with the other, but it has the effect of raising demand, because some of the taxes come from reduced saving, rather than lower consumption. Once demand rises, incomes increase, and theory suggests that in a closed economy the multiplier would be one. (For those who want more detail, see here, and for specific past proposals to implement this policy, see here for the UK and here for the US.) The only argument I have seen that it would not raise demand is if all consumers believed the tax increase was permanent. That seems highly unlikely.

Of course many of us would argue that debt financed fiscal expansion is also a magic button, but many other people do genuinely worry about government debt. With the balanced budget button they do not have to.

I have heard people say that the balanced budget multiplier might be quite a lot less than one in an open economy like the UK. But this depends entirely on where the extra government spending goes. If it is all spent on goods or services produced in the UK, the multiplier is still one.

So why is the government not pushing this button? The answer is that I do not know for sure, because as far as I know they have not addressed this question. That in itself is quite revealing. The obvious thought is that no Chancellor likes raising taxes, but that alone cannot be a full answer, because this government has raised taxes.(1)

Imagine, if you can, that as a price of joining the coalition, the Liberal Democrats had insisted on having the post of Chancellor rather than deputy PM. Would the LibDem Chancellor not have pushed this magic button? The benefits are clear. The cost? Some short term political embarrassment perhaps in relaxing austerity that was before deemed unavoidable. But there is a perfect excuse – the Euro crisis. Unlike their Conservative partners, the LibDems would not be burdened with claiming that fiscal stimulus didn’t work when they were in opposition.

So I am left with only one plausible reason why the current Chancellor has not pushed the magic button and that is because he does not want to. Why? Well an obvious problem with balanced budget fiscal expansion is that it increases the size of the state. Even though it is only temporary, as a Conservative this is not something you want to do. In addition, if one of the ‘benefits’ of a debt crisis is that it gives you a pretext to shrink the size of the state, then undertaking balanced budget fiscal expansion stops that goal being achieved. You would, in this sense, be wasting a crisis.

Postscript

I originally wrote this before the latest fall of 0.7% in second quarter GDP was announced. (Note for US readers, this is a quarter on previous quarter fall, not annualised!) When I saw the Chancellor talking about these figures, he was being filmed outside a government funded construction project, and I had the feeling he had been doing quite a lot of this recently. This was confirmed in this Stephanie Flanders piece. She notes that this particular construction project was agreed by his Labour predecessor, but then delayed by this Chancellor when he came into office. In addition, a major contributor to the recent GDP fall was construction, in large part because of a decline in public investment!


This reminded me of George Orwell's 1984, where he made famous the idea that the best way to disguise the true purpose of something was to call it the opposite, like the Ministry of Peace that wages perpetual war. Perhaps we are seeing the televisual equivalent. So do not be too surprised, if the UK economy carries on being this successful, to hear that the U.K. Treasury has been renamed the Ministry of Growth. 


(1) Recently the Chancellor has undertaken, with the Bank, various measures designed to stimulate private investment. These are welcome, although they are also generally consistent with the argument I'm making here. Although there may be doubts about some of these measures as an alternative to public investment, to the extent that the market for borrowing for private investment is currently distorted by excessive caution and the rebuilding of banks balance sheets, effective subsidies for borrowing make sense. However their uncertain overall impact means they are no magic button.