The FT reports that George Osborne wants to make unicorn farming compulsory:
The new fiscal mandate is expected to enshrine in law one area of common ground between the Tories and Lib Dems: that the cyclically adjusted current deficit should be eliminated by 2017-18.
This is imbecilic.
One problem is that the cyclically adjusted current deficit cannot be observed precisely. To calculate it, we must know how far away output is from its trend or potential level. But we cannot know this. As Paul Ormerod says, the idea of an output gap is just mumbo-jumbo. Comapnies don't know how much extra output they could squeeze out of their existing resources until they try to do so. And if companies can't know, nor can macroeconomists. In this sense, the idea of a structural or cyclically adjusted budget balance is a mythical concept. Targeting it is like unicorn farming.
One possibility is that there was more spare capacity in 2012 than the OBR thought, and this has pushed down inflation. This interpretation merely corrobates my claim that the output gap is unobservable and uncertain.
Another possibility is that inflation is low because of spare capacity in the world economy. But if this is the case, then perhaps the UK economy can continue to grow insofar as inflation won't choke off the recovery. If so, the UK's output gap is irrelevant.
Whichever it is, we shouldn't worry about the idea of a cyclically adjusted deficit.
Two other things make me think Osborne's idea is a daft one.
One arises from the basic national accounts identity that financial balances must sum to zero. The government can therefore only run a surplus if others are running a deficit.
But what if the ongoing Asian savings glut (evidenced for example by China's massive current account surplus) and balance sheet repair in the euro area cause the rest of the world to continue to run a financial surplus?* For the government to run a surplus would then require the domestic private sector to run a deficit. But as Richard says, this is far from certain. Latest figures show that business investment and mortgage approvals are falling, suggesting that households and firms are disinclined to go on the sort of spending spree that would take them into a financial deficit. If the government tries to cut spending when foreigners and the private sector want to run financial surpluses, the result can only be one thing - weaker economic activity.
My other gripe lies in the plan to eliminate the deficit by a given date.
The problem here is that recessions are pretty much wholly unforecastable. It's possible therefore that the economy could fall into recession then. If so, then a cyclically adjusted deficit would be wholly warranted in order to support demand. Legislating for a balance in 2017-18 thus tries to criminalize counter-cyclical policy. That's stupid.
Now, you might think that, in saying all this I'm merely being a Keynesian.
Wrong. In fact, I'm writing in a Hayekian spirit. Hayek famously and correctly argued that economic knowledge was inherently fragmentary and dispersed and so central agencies could not possibly know very much. I'm echoing him. I'm saying that the OBR cannot know enough about the productive potential of millions of firms to know what the output gap is. And it hasn't got enough knowledge of the future to predict recessions.
In presuming otherwise, Osborne is thus not only anti-Keynesian, but anti-Hayekian. I thus agree with Simon - that he is illiterate and plain dumb.
* "The rest of the world's financial surplus" is just another name for the UK's current account deficit.