Sunday, October 25, 2009

conservative fiscal policy and meaning it

While the greatest dangers of the financial crisis may no longer be acute, chronic fiscal challenges remain for most western democracies. Demographic change in particular means that higher levels of saving and investment, both publicly and privately, are necessary if standards of living are going to continue to improve.

What are the options for ensuring this?

The #1 priority in my view is continuing with tax reforms which have been occurring in most jurisdictions (Alberta not being one of them) that encourage the shifting of income from consumption to savings and investment. Even if governments were to start diverting massive amounts of their tax revenue away from consumption by holding the line on services and building up financial and physical assets, tax revenue is only a fraction of a jurisdiction's total public and private income and the private sector's contribution, or lack thereof, to the capital stock, whether it be financial or be physical (property, planet, and equipment) has more impact.

But leaving aside further discussion of these tax reforms for another day and restricting our analysis to the income going to government, how can concerned citizens ensure that their governments are going to be genuinely conservative with the resources allotted to them? Although balanced budget legislation is a possibility and is the first proposal I will review, it is but one of many.

Balanced budget legislation

The two basic drawbacks to "no deficits" legislation are the same two problems we will encounter with a lot of proposals, and that is that 1) the policy deals with a flow instead of a stock and 2) governments can and do ignore such legislation. re point (1), a balanced budget requirement can help in that it sets a target minimum contribution to the stock of capital over a period, namely that it be non-negative (zero or higher). But there is nothing inherently problematic with a negative contribution (withdrawal) from the capital stock over some short period since that does not necessarily mean that the total contributions to and growth of the capital stock over the long term will not be superior to some other jurisdiction which makes a null or a positive contribution over every period. Nonetheless, even if the red/black distinction is ultimately an arbitrary accounting measure, it is still an occasional target, and as the Nudge book I mentioned in an earlier post points out, targets have value. The book's authors note how public urination facilities became a lot less messy when users where given something to aim for. Indeed, one could note that Alberta's current fiscal mess started when government revenues cycled upward and former Alberta premier Ralph Klein lost his target.

Legislation that limits government spending to inflation plus population growth

Again, this would set a target for a periodic flow instead of for the stock that actually matters, but it is a superior target to the balanced budget target since it does not mandate cuts at the worse possible time (during a recession) and mandates less spending proportionate to the economy at the best possible time (when the economy is growing quickly). In an interview with the Canadian Taxpayers Federation in September, then Wildrose Alliance leadership candidate Danielle Smith supported this target but added a proviso that spending also not exceed GDP growth. While this response had the virtues of garnering an A+ grade from the CTF and ensuring that the size of government shrinks relative to the economy not only when real GDP per capita is growing but also when it it shrinking, most economists would consider this additional restriction a mistake. The proviso ultimately undoes the advantage over the balanced budget target by being pro-cyclical: forcing government spending cuts when the economy is shrinking. While left leaning economists like Paul Krugman were demanding massive stimulus spending earlier this year, centrist organizations like the OECD were also urging national governments to pass large stimulus packages, and conservative economists like Greg Mankiw were not opposing the stimulus spending per se but rather acting as the voice for skepticism about how effective the particular proposed stimulus expenditures would be. It was generally recognized that "inaction on sound stimulus is indeed harmful." In almost no case was any prominent economist calling for prompt cuts to government spending. As another writer for the Economist notes, "Faced with growing demands on unemployment assistance, [when] states are forced to cut spending elsewhere... this is procyclical behaviour, which may act to increase unemployment further, forcing additional budget cuts, and so on." When one sets aside ideology for evidence based policy, the evidence from the Great Depression suggests that cutting back government expenditure at the same time that consumer expenditure is in decline creates the grave risk of an economic death spiral. Adding the GDP proviso is unnecessary, because when real GDP per capita growth (GDP growth less inflation and population growth) is negative that is by definition temporary (if real GDP per capita is in permanent decline the whole point of economics would be defeated). In other words, the size of government is also a stock, such that whether it is shrunk in every accounting time period is not ultimately germane to the real objective. Real GDP per capita will increase over the long term, meaning that over the long term the size of government relative to the economy will be reduced without adding a further constraining proviso to the inflation + population growth limit. I would also argue that the GDP deflator should be used in the place of "inflation" (I've equated the two in my discussion here) but that's a technical objection.

Legislation that requires a proportion of revenues (often a subset such as supposedly "non-core" revenues, e.g. natural resource royalties) be saved or invested

This target is part way between the above two targets, since while it shares with the inflation + population growth limit the advantage of not requiring cuts during a recession, under this target both spending and saving would grow in lockstep during boom times without an upper limit such that spending growth could still be very high. Again, when at economy is peaking an expansionary fiscal policy just encourages increased prices, and the increase in government purchases shifts resources away the private sector, a phenomenon known as "crowding out."

Combining a capital stock associated limit on spending (excluding infrastructure spending) with mandated revenue hedging

This proposal is my favourite since it has what I believe is an enormous advantage over the other proposals, namely, that governments will not be able to ignore the target because they simply will not have the money to violate the target. In the Alberta of 2007, for example, the government's positions in currency and energy futures would have been marked to market and the government thereby required to plow its windfall royalty income into international hedging markets. In 2009, we would see billions coming back to the province from these same markets. I would exclude infrastructure spending since this constitutes physical investment. While it is possible to invest poorly, and indeed the Alberta government has a consistent pattern of buying high and selling low by choosing to "buy" infrastructure assets when the market is at a top, it is still investment, and by mandating hedging the government's discretion to "buy high" will limited. Stock associated limits to spending could be akin to the covenants that bondholders demand from issuing corporations with respect to the health of their balance sheets as opposed to just their income sheets, or they could be the sort of constraints relatively sophisticated regulators apply to financial institutions (see Basel II), e.g. limits informed by Value at Risk modeling.

"Stock" associated limits to spending discretion may prove too complex to constitute a political campaign plank relative to a readily understandable limit like no more than inflation plus population growth, but hedging, while complex to explain in detail, is quite straightforward as a concept and the general idea that the citizens of Alberta are bondholders and shareholders in their government is also a fairly simple one. Should a politician's pay be tied to the size of the Heritage Fund à la a private sector executive's? The corporate analogy is worthy of consideration, not least because it could ensure more professional and competitiveness-oriented management.

I believe that this is THE challenge of our age. Do we leave something behind for the next generation or not? If we are serious we will not just talk about how we intend to start showing some willpower with respect to the cookie jar, we will explain how it will be placed outside of our reach.

UPDATE October 26:

The Wall St Journal notes that after posting a $1.4 trillion deficit in 2009, the US House of Representatives is now moving on spending bills that would grow domestic programs by a further 12.1% in 2010. The WSJ also observes that "real family incomes fell by 3.6% last year" and the point I wished to make about spending growth that is higher than GDP growth but no higher than inflation plus population growth is that this would or could maintain government services for consumers whose real incomes are falling. Although government would grow relative to the economy during this period of decline, there would no increase in real government services per person and the proportionate growth in government would be temporary. If government services are to be cut back as opposed to just kept from growing further, they should be cut back when real incomes are rising.

But I may have been imprudent to take issue with Danielle Smith in this context. As Don Martin observes in a revealing National Post column, "Ms. Smith was on an Ottawa talk show with me this week and, even though it was still pre-dawn darkness in Calgary, she batted every question out of the park..." The contrast with Sarah Palin being interviewed by Katie Couric (to take one of the most infamous episodes) could not be sharper. The takeaway fact with her is that she is one of the sharpest policy minds in politics, yet getting that most elementary of messages through the North American noise machine will be enough of a challenge without bothering with nuance. This morning Danielle ended up on the website of the Charleston (South Carolina) Daily Mail as "the Sarah Palin of Canada." How does this end up in the mainstream media? The Charleston Daily Mail writer uses the Canadian media as cover:
I figure the Canwest News Service knows something about Canada and the news service has declared Danielle Smith, the new leader of Alberta’s Wildrose Alliance, the Sarah Palin of Canada.
In fact the Vancouver Province writer who is cited here put a big question mark at the end of its "A Sarah Palin for Canada" headline, not a period. But with respect to which MSM outlet surrendered its gatekeeper role to the commercial appeal of another "Sarah Palin" headline that would indeed be Canwest since it was their writer who made a story out of a blogpost by 22 year old Colorado Springs blogger Adam Brickley. The meme was then picked up by Global TV Edmonton and the Examiner.

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