One indirect comment I have received on the numbers set out in this post is that they ignore the possibility of major negative shocks hitting the economy. That is not really fair, because a major reason for aiming for such historically low levels of debt to GDP in the long term was to allow for such shocks. However it seems reasonable to ask what sort of shocks these plans might accommodate, so here is an illustration.
A key idea in my paper with Jonathan Portes is that if interest rates are expected to hit the Zero Lower Bound (ZLB), the central bank and fiscal council should cooperate to produce a fiscal stimulus package designed to allow interest rates to rise above that bound. So the key questions become how often such ZLB episodes might occur, and what size of stimulus packages might be required.
The chart below assumes that the next ZLB episode will occur in 2040. Thereafter they occur every 40 years. This is all complete guesswork of course. Each ZLB episode requires a fiscal stimulus package which increases the budget deficit by 10% of GDP in the first year, 10% of GDP in the second, and 5% in the third. For comparison, the Obama stimulus package was worth a little over 5% of GDP. So this is much bigger, but that package was clearly too small, and I’ve also allowed something extra for the automatic stabilisers.
These shocks are superimposed on the ‘medium’ adjustment path that I gave in the previous post. This involves much less austerity than George Osborne’s plans. Whether it is less draconian than the other political parties’ plans is less clear. For example with Labour, there is a commitment to achieve current balance by 2020. To get the total deficit we need to add public investment. Current plans have public investment at around 1.5% of GDP, but if investment was raised to 2.5% of GDP, this would be consistent with the path shown here.
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| Medium debt reduction path with shocks |
So the 2040 crisis starts with debt to GDP at just under 50%, and sends it back up to levels close to but below current levels. In the next crisis the debt to GDP ratio peaks at 50% of GDP. At the turn of the century we settle down to an average of around 30% of GDP, with the ratio never rising above 45%.
With a chart that ends in 2200, many will feel that this is all rather unreal. So perhaps we can compartmentalise discussion into two questions: is this long run average of 30% about right, and are we prepared for the next crisis? Although the 30% figure seems quite prudent by historical standards, our paper does give some reasons why you might want a lower long run average. However this debate really is for the future - it should have no impact on what happens before 2020.
Are we prepared for the next crisis? For the size and timing of the crisis I have chosen my answer would be a clear yes. In this recession UK debt to GDP has risen to higher levels, and there has been no market panic. Political leaders became obsessed with debt for two reasons: misunderstanding the Eurozone crisis (where OMT has clearly demonstrated the nature of the misunderstanding), and because austerity suited other agendas. I am a sufficient optimist to think that another 25 years is long enough to allow most people to figure that out.
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