Borrowing To Invest Easily Trumps Borrowing To Spend

The present has a natural advantage over the future. Nobody ever says, “c’mon, let’s live for next year!’ One of the great challenges of being human is balancing immediate temptations against rewards that may take years to arrive. We try, and often fail, to weigh the donut against the cardiac arrest; the fling against the long, happy marriage; the splurge on a car against a retirement income.

Economic policy makers face similar challenges, but on a larger scale. It is tempting to cut taxes or interest rates to stimulate demand just before an election, with disastrous longer-run results for inflation and market credibility. Spending money is always more politically palatable than working to the balance the budget – especially when the benefits of fiscal Puritanism will accrue to your successors.

As the scholar Jon Elster puts it: “Congress will, like St. Augustine, tell itself that balancing the budget is a good idea – in the future. But when the future arrives, it always does so in the form of a new present, to which the same reasoning then applies.”

Political elites have therefore established a range of ‘pre-commitment’ devices, to ensure that economic policy is conducted with a reasonable value attached to future years. Most obviously, monetary policy is handed over to an independent central bank, charged with balancing the needs of today with the demands of tomorrow. In theory, Congress can overrule the Federal Reserve. But, given the catastrophic consequences in terms of market confidence and borrowing costs, such an act is unthinkable in practice.

It is not just the institution itself that embodies and promotes pre-commitment , but the individual leading it. That is why the current obsession with the personalities of the candidates to succeed Ben Bernanke as Fed Chairman is not wholly misplaced. The credibility of the Fed is necessarily intertwined with the credibility of the Fed chair. Words spoken publicly by the Chairman often act as powerful pre-commitment devices. When Bernanke announced that interest rates would remain low so long as unemployment was above 6.5 per cent (and forecast inflation remained below 2.5 per cent ), nothing changed in the institution of the Fed – in its power, or governance. They were just words. But if the Fed were now to deviate from that verbal commitment, all hell would break loose. The markets know it. Bernanke knows the markets know it. And the markets know that Bernanke knows the markets know it. The Governor of the Bank of England, Mark Varney, has now followed suit, pledging to hold interest rate at 0.5 per cent until the jobless rate drops below 7 per cent.

This means that central bankers need to be the kind of people who parse their words with the greatest of care. For the Fed chair, careless words cost jobs. Alan Greenspan, that master of obfuscation, often managed to say nothing over the course of thousands of words. The worst labels that can be applied to a central banker are, then, ‘charismatic’, ‘swashbuckling’ or ‘outspoken.’ The best labels are ‘thoughtful’, ‘diligent’ – even ‘dull.’ In this job, caution is as important as cleverness. Monetary policy is not for the media star.

In fiscal policy, too, the temptations of the short-term are real. Like Ulysses ordering his men to tie him to the mast as protection against the lure of Sirens, so the political classes look around for fiscal restraining devices. Here the pre-commitment is typically of a gentler kind. Few argue against handing monetary policy to an unelected body: few would argue in favor of doing the same for fiscal policy. This is as it should be. The decisions of how much, and what, to tax and how much to spend, on what, are the bread and butter of democratic life.

Fiscal pre-commitments can may take the form of a constitutional amendment requiring a balanced budget – often over the economic cycle – or a public debt ‘ceiling’ of, typically, 60% of GDP. But these provisions can be suspended or overturned by the same parliamentary majority required to establish them in the first place.

Regular calls are made for a 28th amendment to the U.S. Constitution, requiring a balanced Federal budget. The latest advocates are Republican economists Glenn Hubbard and Tim Kane. They diagnose, correctly, partisan myopia on both sides in Congress that is detrimental to good fiscal policymaking. They suggest, sensibly enough, balancing today’s expenditure against an average of the last seven years’ revenue.

There’s nothing wrong, in principle, with what Hubbard and Kane call “a more binding solution,” especially given the atrophying of the DC political ecosystem. The problem is, not all government spending is equivalent. The real challenge is to ensure that a greater proportion of expenditure represents genuine investment, rather than simple transfers. Just as in personal life, borrowing to invest – in education, infrastructure, transport, science – is nothing like borrowing to spend, whether on entitlements or on subsidies to home owners. We need an investment budget at least as badly as we need a balanced budget. If we are to strengthen our fiscal commitments, we need to ensure we are committing to the right path.