Wednesday, 10 June 2009

A mini-paradox

Most economists agree that some of the effect of fiscal (and monetary) expansion arises from expectations. There are arguments about how strong the effect is, but expectations of future policy almost certainly have some effect on current decisions on both investment and consumption.

I believe that a hyperbolic discounting effect occurs here, and thus expectations of the next couple of years are disproportionately more powerful than expectations of the years following. This is one reason why the theory of Ricardian equivalence does not work. Mostly the supposed future tax increases are far enough in the future - and also uncertain enough - that they are almost completely discounted by most decision makers.

So it's interesting to see the competition that Stephanie Flanders highlights between Gordon Brown, Andrew Lansley and the NHS Confederation. Lansley is at pains to stress that the Tories will cut spending, while Brown is keen to point out that Labour will not. Of course as Stephanie indicates, the differences are not that great - the argument is mainly an illusory one about real versus nominal spending. But the tone is important: Brown clearly wants to be seen as someone who continues to invest in public services, while the Tories want to be seen as making fiscally responsible spending cuts.

One point to note is that they are only talking about 2011 onwards, so there will clearly be some discounting of expectations - but then 2011 isn't what it used to be. In 19 months we'll be in it.

So if people believe Brown's rhetoric, an expectation of expansive policy should boost economic activity now - just what we need.

On the other hand, if they believe Lansley, they'll expect both lower government debt and less economic growth, both of which keep gilt yields down (although there is another paradox embedded here - if growth turns out to be really low, government debt as a percentage of GDP might actually be higher).

Currently we appear to be seeing both of these effects: Chris Dillow points out that gilt yields are very low, lower even than US Treasuries. But we also have a number of indications of economic recovery.

Who do bond traders believe? Who do they think will be in power after the election? And anyway, why should they know any better than anyone else? I have no good answers to this, unfortunately. But maybe the answer is that the government in power will make little or no difference to the total level of spending, which is driven by a different kind of politics. And maybe the markets have enough confidence in future British growth to assume that a government of either colour will be creditworthy. That's a reassuring thought.

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