The Illogical Golden Rule

by Ramanan on 12 April 2015

There’s a nice article by Wynne Godley written in 2005 for The Guardian on the fiscal policy golden rule. There are two things wrong about the golden rule. The first is to think that capital expenditure is somehow superior to current expenditure. This is the reason one frequently hears “wonks” stressing on government infrastructure spending. The other is to ignore changes in private sector behaviour and foreign trade performance.

From the article:

Criticism of the fiscal policy regime has focused too much on whether Gordon Brown will break his self-imposed Golden Rule and not enough on whether the rule is acceptable. The Golden Rule states that the balance between receipts and current expenditure should be zero over the cycle, exempting public investment, which does not ‘count’ for the purpose of making this calculation.

A relatively minor objection to this arrangement is that there exists no relevant difference between, say, capital expenditure on school building and current expenditure on teachers. Both are equally necessary for education and both absorb resources (pound for pound) to roughly the same extent.

More fundamentally, the budget balance is equal to the difference between the government’s receipts and outlays, but it is also equal, by definition, to the sum of private net saving (personal and corporate combined) plus the balance of payments deficit.

If the private sector decides to save more, the government has no choice but to allow its budget deficit to rise unless it is prepared to sacrifice full employment; the same thing applies if uncorrected trends in foreign trade cause the balance of payments deficit to increase.

A sensible target for the budget balance cannot be set unless it is integrated into a view about what will happen to autonomous trends and propensities in private net saving and foreign trade. Moreover, as those trends and propensities change, it will never be possible to determine viable targets for the deficit that are fixed through time such as, for instance, that it should never exceed some number such as 3 per cent of GDP or that it should on average be zero.

Coming back to the medium-term future of the British economy: if, as seems quite possible, there is now a growth recession initiated by a fall in personal expenditure, the government will have no option but to allow the deficit to rise well beyond what the Golden Rule permits. The authorities will look ridiculous if they move the goalposts again, so the rule will have to be jettisoned. I don’t think it will be long before discretionary fiscal policy, once discredited by a few serious errors in the Sixties and Seventies, has to be rehabilitated.

Leave A Comment

Frequently, discussions about debt sustainability have discussions about the importance of the interest rate and growth in debt sustainability analysis. See for example, today’s Paul Krugman’s post on his blog. It is concluded that as long as the rate of interest is below the rate of growth, the ratio public debt/gdp doesn’t explode. Unfortunately, this result is erroneous.

John Maynard Keynes’ biggest disservice to the profession is to not start with the open economy. In my view, debt sustainability is tightly connected to balance of payments.

Imagine a nation whose exports is constant. If output rises, it will have adverse effects on the current account balance of payments because of income induced increase in imports. This will have an adverse effect on the international investment position of the nation: the net international investment position will keep deteriorating unless output is slowed down or some measure is taken to improve exports. In the case of rising exports, there is a similar constraint, except it is weaker but dependent on the rate of growth of exports.

If the ratio net international investment position/gdp keeps deteriorating, either the public debt to non-residents or private indebtedness to non-residents or both have to keep rising, all unsustainable.

There are some complications. A nation’s balance of payments also depends on how assets held abroad and liabilities to foreigners affect the primary income account of balance of payments. Also, the exchange rate can depreciate (or be devalued in fixed-exchange rate regimes) improving exports and reducing imports. However assuming that exchange rate movements do the trick is believing in the invisible hand. Foreign trade doesn’t just depend on price competitiveness but also on non-price competitiveness. These complications are highly interesting but do not affect the fundamental fact that a nation’s success is dependent on the success of corporations to compete in international markets for goods in services.

Even the conclusion that the government should contract fiscal policy and aim for a primary surplus in its budget balance or else the ratio public debt/gdp keeps rising if the rate of interest is greater than the rate of growth is erroneous. Consider a closed economy. An expansion in fiscal policy will automatically raise output and gdp and hence tax collections to prevent the ratio public debt/gdp from exploding. The public sector balance may hit primary surpluses but not due to contraction of fiscal policy or targeting a primary surplus in its budget balance.

In short, although the rate of interest and the rate of growth are important in debt sustainability analysis, it is not as easy as is usually presenting in macroeconomics textbooks and in the blogosphere. For a more detailed analysis see the reference below.

Reference

  1. Godley, W. and B. Rowthorn (1994) ‘Appendix: The Dynamics of Public Sector Deficits and Debt.’ In J. Michie and J. Grieve Smith (eds.), Unemployment in Europe (London: Academic Press), pp. 199–206

Updated 8 Apr 2015, 6:52 am UTC.

Leave A Comment

Severin Reissl’s Critique Of Steve Keen’s Black Box Economics

3 April 2015

Economics is a strange subject. A lot of times we learn a lot from others’ errors and even if you see the errors, there’s sometimes a lot to learn from others’ critiques of the same because sometimes it is difficult to see all the pitfalls even if one sees a few. Severin Reissl from the University […]

READ MORE >>

The U.S. Net International Investment Position At The End Of 2014 [Updated]

1 April 2015

The U.S. Department of Commerce’s Bureau of Economic Analysis today released accounts for the United States’ international investment position. The U.S. is sometimes called the world’s biggest debtor and its net international investment position is now (at the end of 2014) minus $6.9 trillion. Here’s the chart from the BEA’s website. A few points. The importance of […]

READ MORE >>

Disappointing Start, Mr. Bernanke

30 March 2015

Ben Bernanke has a new blog at Brookings. In his second post, Why are interest rates so low?, Bernanke “explains the rationale behind the Federal Reserve’s continued policies”. We should be thankful to Bernanke for his leadership qualities to have kept interest rates low to help the world economy recover from a crisis. The latest […]

READ MORE >>

Respect For Identities

27 March 2015

The accounting identities equating aggregate expenditures to production and of both to incomes at market prices are inescapable, no matter which variety of Keynesian or classical economics you espouse. I tell students that respect for identities is the first piece of wisdom that distinguishes economists from others who expiate on economics. The second? … Identities say […]

READ MORE >>

Thomas Palley — More Jobs, Still Weak Wage Growth: The Federal Reserve Must Wait

11 March 2015

Thomas Palley has a new op-ed titled More Jobs, Still Weak Wage Growth: The Federal Reserve Must Wait on the AFL-CIO page (here) and on his own web page (here). … The [February employment] report is another in a string of strong employment reports, but it also contains depressingly familiar news about weak wage growth and […]

READ MORE >>

Thomas Palley — The U.S. Federal Reserve And Shared Prosperity

25 February 2015

Thomas Palley has a new Op-Ed for The Globalist titled The U.S. Federal Reserve and Shared Prosperity in which he argues against ““pre-emptive inflation tightening” that sacrifices wage growth and full employment versus “testing the waters” that gives wage growth and full employment a chance.” He asks the Fed to abandon its 2% inflation target with many compelling […]

READ MORE >>

Derailed: Wynne Godley On The Euro Area

20 February 2015

I am in favour of Britain having much closer ties with other European countries, provided that appropriate institutions are created and the whole thing is brought under effective political control. But I have never been able to understand what it is that those who support the Maastricht Treaty think they are going to get out […]

READ MORE >>

Anthony Thirlwall’s New Book On Keynesian And Kaldorian Economics

28 January 2015

During the global economic and financial crisis Keynes became popular again but Nicholas Kaldor’s ideas and the mention of the man himself didn’t take off as much. It’s unfortunate, as Kaldor played a huge role in the development of Keynesian economics itself. Kaldor’s own ideas are a subject of its own. Anthony Thirlwall is releasing […]

READ MORE >>