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Structural deficit nonsense

There’s one thing George Osborne is going to tax in next week’s Budget – my patience.

I say this because his fiscal mandate – the framework for his fiscal policy – is nonsense. His aim is “to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period.” This contrives to make policy depend not upon one unknown variable, but two.

One unknown is simply the state of the economy in five years’ time. If we fall back into recession by then a balanced budget would be inappropriately tight. Granted, the OBR isn’t forecasting this. But this means the forecast of a balanced budget by then means little more than “the public finances will be OK if the economy is” – which isn’t terribly illuminating.

But there’s a second unknown – that phrase “cyclically adjusted”. The basic thinking here is reasonable: if the economy is weak, we’d expect to see a deficit because tax revenues will be weak. Moving from this to a concrete measure of the cyclically adjusted balance is, however, another matter.

To do so, we need to know the size of the output gap – the extent to which GDP is below its potential level. If the economy is at its potential level, then all of the deficit is structural. But if the output gap is big, then more of the deficit is cyclical, which means the cyclically adjusted deficit is small, and so there’s less need to tighten policy to eliminate it.

However, the output gap cannot be measured directly. Put it this way. Do you know by how much your company could increase production without having to raise prices because of higher costs? I suspect you don’t. And if you don’t know the output gap for your firm, how can anyone know what it is for all companies?

The idea that the output gap is measureable is a form of the central planning fallacy that was debunked by Friedrich Hayek years ago. It assumes that the fragmentary, dispersed and contradictory knowledge of millions of people can be aggregated by a single mind. But it can’t be. For this reason, the idea of the output gap is, as Paul Ormerod has said, “mumbo-jumbo.”

Here, I have a suggestion. Why not base economic policy upon what we know rather than what we don’t? And there are two things we do know.

First, inflation is low. CPI inflation is below target; prices in the shops – where market forces prevail – have risen just 0.2 per cent in the last year; wages have risen only 1.1 per cent in the last 12 months; and manufacturers’ prices haven’t risen at all in the last six months. All this tells us that rising inflation isn’t going to kill off the economic recovery any time soon. This increases the chances that we might be able to grow our way out of the deficit.

Secondly, gilt yields are still low – below zero for longer-dated ones. This tells us that the people who are lending to the government aren’t worried about high borrowing. And if they’re not worried, why should anyone else be?

Both these facts point to the same conclusion – that, for now at least, Mr Osborne doesn’t need to tighten fiscal policy.

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By Chris Dillow,
10 March 2014

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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