Saturday, June 08, 2013

Lone Voice of Sanity Successfully Silenced

Ever since the beginning of the current economic crisis, the government's orthodoxy that cutting expenditure to match tax receipts is the only option has been echoed by all official voices - the Treasury, the National Bank - except one. The CPB, the state agency responsible for analysing the economic impacts of government policy through advanced economic modelling, consistently insisted on pointing out that reducing expenditure doesn't do anyone any good if that reduces GDP more than debt. If contractionary austerity is, well, contractionary - and the CPB's models show it is -  maybe it should be left for better economic times.

Insiders knew, however, that the secret of the CPB's sucess was fickle. After all, like every government agency there is a limit to its independence, and that limit is the term of appointment of its chief. Coen Teulings, the man who was director of the CPB from 2006 until last April, took responsibility for the unpopular findings of his staff, resisting pressure from the government to downplay the results of the agency's modelling. Now that is term is over, however, he has been replaced by Laura van Geest, someone who comes straight from the heart of orthodoxy: the Treasury Ministry. Following the appointment of former top-Treasury civil servant Klaas Knot to the Presidency of the National Bank last year, this is the second time that an independent agency's conformity to orthodoxy is safeguarded by putting a Treasury staffer in charge.

The most surprising thing is how little time it took for this decision to matter. Teulings left on May 1, but Van Geest's appointment doesn't start until August 1. In the interim, however, the mood has already changed. This week, the CPB released a Policy Brief called "Prudent debt level: a tentative calculation", which magically finds that the prudent (maximum) level of debt is in the 61%-86% range. Above that, the authors claim, "the gains of holding a larger buffer to ward off negative shocks [exceed] the cost of transitioning to a lower debt level", the cost of transitioning being evaluated at a 8-year time horizon.

While this has the merit of not being prima facie stupid (it doesn't have a Reinhart-Rogoff-style threshold level of debt above which bad things start to happen immediately), it misses one thing: it uses an average/ordinary 8-year time horizon, based on the way the economy has historically worked, which is very much not the same as the current 2013-2021 time horizon. The next 8 years are likely to be decidedly not average, just like the last 6 years weren't. The authors recognise this, to some exent. That is why they make caveats such as this one:

In the press release:

Caution is advised in using these debt levels as anchors for policy, as the costs of deviating from these numbers are small in this range while the benefits may be significant.

And in the brief itself:

Caution is advised in using these prudent debt levels to anchor policy. Note for example that, by Table 1, an increase in debt of a 10% from such a prudent level reduces lifetime earnings by just a few percentage points. This is relatively small if the debt increase averts a financial crisis. Also, adverse economic circumstances may lead to temporarily higher debt levels, which can be prudent.

[Footnote:]  This can be understood by seeing that the cost of debt reduction increase in a recession. Then, the prudent debt level, that at which the gains of debt reduction equal the costs, rises as well.
Result: We end up with a study that is not so much stupid as it is misguided, but that conveniently ends up supporting the orthodox line that the Netherlands should get to work cutting its expenditures in order to reduce its debt down to the 60% of the Stability and Growth Pact. So yes, we're still all doomed.

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