Higgsean worlds

I was a panelist after Treasury Secretary McLiesh's talk at the Waikato Economics Forum on Friday morning.

I'd made a few notes to myself for my opening 5 minutes. I never quite say what I'd written down. But this is what I'd written down.

Fiscal consolidation and ratchet effects

Covid has taught us two awful lessons.

First, when Parliament gives government a loose rein to deal with a crisis as it sees necessary, trusting that fiscal capacity will be used to necessary purposes, that flexibility will be abused. Core agencies may provide veiled, and sometimes not-so-veiled, warnings that spending is difficult to justify. But ultimately neither they, nor the Public Finance Act, provide discipline. 

Second, New Zealand may well sit in a Bob Higgs world. And I certainly hope we aren’t.

Let’s take the latter first before looking back to the former.

In the late 1980s, Robert Higgs argued, in Crisis & Leviathan, that public spending exhibits a ratchet effect. It is easy for spending to go up in a crisis. Much of it may even be justified for dealing with the crisis. But fiscal consolidation after the crisis maintains a larger government share of overall economic activity than before the crisis: a one-way ratchet effect.

That isn’t a very good world to be in. If you’re in that world, it is harder to get agreement on giving the government the flexibility it might need in dealing with a crisis. There are always tradeoffs between speed and oversight. If you can trust the government to do its best honest job and to retrench after the crisis, then you can afford to cut the government a lot of slack – and get closer to a first best. If you can’t, then those who do not want a permanent expansion in the size and scope of the state have to trade off losses from an inadequate crisis response against losses after the crisis from the permanent part of that increase.

Treasury’s charts in the BIM showed that we might not have been crazy, ex ante, to think we weren’t in a Higgs world. After the Asian currency crisis, Core Crown expenses retrenched, under a Labour government to almost 28% of GDP. The GFC and then Christchurch earthquakes saw them hitting 34% of GDP before retrenching to below 28% of GDP by 2017. 

And the Great Wellbeing Budget promised that every social problem in the world could be solved, with Core Crown Spend projected at 28.8% of GDP by 2023.

In early 2020, there was phenomenal agreement that the government needed to be given the room it needed for dealing with the crisis. It had authorisation to issue the debt necessary for dealing with it. And it had widespread support across the business community. Few atheists in that foxhole. Core Crown spend topped 35% of GDP. 

During the 2023 election campaign, the National Party’s aspirational goal was to get Core Crown spending down to 30% of GDP – above what Ardern’s wellbeing budget had promised. 

And Treasury’s briefing to the government suggested a mix of spending cuts and tax increases would be needed to fill the gap. Inflation, all on its own, increased Crown revenue through fiscal drag by perhaps a billion dollars from Q1 2021 to Q2 2022 – if we can trust Treasury’s tax calculator for changes that large.

Those who prefer a larger size of government have painted normal fiscal consolidation after a crisis as being terrible austerity, and that that austerity’s purpose is to deliver tax cuts. 

It is a dangerous partisan game. 

If returning Core Crown spending, after a crisis, to a level higher than it was before the crisis is going to be painted as austerity, good luck getting social licence for government to have the flexibility it needs to deal with the next crisis. 

Worse, in the crisis, our institutions proved unable to constrain the government against diverting debt raised for dealing with Covid into party-preference spending, like school lunches, and into destructive measures like Envirojobs. 

When New Zealand was running a substantially positive output gap and the country’s lowest unemployment rates on record, the government was running make-work schemes. 

While Treasury did provide some warnings against misguided spending, it also provided the Finance Minister with substantial cover for his initiatives. Measures of fiscal impulse in budget documents seemed designed not to enlighten, but to provide the Minister with a way to claim that massive deficits fuelled by non-Covid spending were, in fact, fiscally responsible – because he was spending slightly less than the year before.

It is hard to avoid the conclusion that the only real fiscal discipline that our institutions provide is the need for vote allocations to compete with each other for a limited pool of resources. When a strong focus on value for money drives Cabinet decisions, Ministries will provide evidence in support of that. When other drivers determine allocations, Ministries will target those other drivers. And when budget constraints disappear because government has taken on tens of billions of dollars in debt, there simply is no restraint. 

Because Secretary McLiesh's opening pointed to the Treasury's view on the criteria for successful fiscal stimulus, with some emphasis on the need to get spending now back down (the limited party), I quoted back what she'd said at the June 2021 workshop Treasury and the Reserve Bank ran on the lessons of Covid. The first sentence is pretty much word for word what the Secretary said this time. The second bolded sentence, well, I wonder whether they've reconsidered that part.

"The well-accepted objectives for effective fiscal stimulus are that it is timely, temporary, and targeted. Overall, New Zealand's fiscal response is meeting those objectives perhaps better than most."

My Twitter thread on the full conference is here.

After my session, I was reminded by an attendee that previous large structural deficits meant the end of two careers in politics for those who had to clean up the mess. That attendee wondered where the hell Treasury was when the structural deficits were being locked in, this time. 

I wonder that too. 

It's like Treasury entirely forgot that regardless of whether one accepts the economic merits of Keynesian fiscal stimulus, the political economy of it just doesn't work. Government has a much harder time scaling back spending in the upswing than it has in scaling up spending in the downturn. And so it just doesn't work.