Osborne & the deficit: 4 questions
George Osborne makes a curious remark here:The overriding objective of fiscal policy must be to provide the credible deficit reduction plan that allows the Bank of England to keep mortgage rates as low as possible for as long as possible. That will do more to sustain a recovery than anything else.This raises 4 questions:1. What’s the mechanism through which deficit reductions would allow mortgage rates to stay low? One possibility is the Keynesian one - they would depress demand, and the Bank would keep rates low in response. Another possibility is some form of the fiscal theory of the price level, which says that expectations of future government deficits affect inflation now.If Osborne believes the former, he should concede that his Labour critics have a point - spending cuts would tend to hurt the economy. If he believes the latter, he should distance himself from those who have claimed that quantitative easing is inflationary - because you can’t (pdf) believe in both (pdf) monetarism and the FTPL.2. Would low mortgage rates really “do more to sustain a recovery than anything else”? Yes, personal debt exceeds households’ bank deposits by £454.9bn, which suggests that households would get an extra disposable income of £4.5bn a year for each percentage point fall in interest rates, relative to what they would otherwise be. But this is only 0.3 per cent of GDP. And there’s a danger that this would be saved rather than spent if highly indebted households use their windfall to pay off debt; I suspect this is a big reason why the savings ratio rose last year.Of course, it’s possible that low mortgage rates would eventually lead to increased borrowing. But how is this consistent with the claim that “Britain’s new economic model must be built on saving”?If Osborne means that a low Bank rate would stimulate corporate borrowing, then he might have a point - though I fear the interest elasticity of capital spending is low - but then, why talk about mortgage rates?3. Doesn’t Osborne’s claim put a limit onto the size of the fiscal squeeze? Bank rate is already as low as it can go - which means mortgage rates are near their lowest feasible level. This means that if the economy turns out weaker than expected this year - sufficiently so that the Bank keeps Bank rate at 0.5% - there’s simply no room for lower government borrowing.Granted, Osborne might mean that deficit cuts will reduce shorter-term gilt yields and hence fixed rate mortgages. But the effect here is small; short-dated yields depend far more upon interest rate expectations and overseas yields than they do upon government borrowing. 4. Is it wise to pre-announce this intention? Imagine it’s the day after a Tory election victory. FX markets figure: “the Chancellor wants interest rates to be as low as possible, so let’s dump sterling.” The pound then falls - possibly a long way, if rising interest rates in the US and euro zone cause carry traders to short sterling. This in turn would limit the Bank of England’s ability to hold rates low. In this sense, Osborne’s policy would be self-defeating.