Friday, 27 February 2015

Disaster

William Keegan, while discussing my NIER article on the UK government’s macro record, writes:

After the collapse of output of some 6-7% engendered by the financial crisis, output per capita grew by “just under 2%” from 2010 to 2013, whereas in 1981-84 and 1992-95 growth was over 8%. Wren-Lewis comments: “In short, the performance of the coalition government has been a disaster.” “Disaster” is a strong word from such a rigorous academic as Wren-Lewis, but I fully agree with him.

I like the idea - which is probably true - that rigorous academics generally refrain from calling things a disaster in print. Does that mean I’m not as rigorous as Keegan believes? I thought I’d try and justify my departure from this norm with some more data. It comes from a newly released dataset put together by the Bank of England. I’ve used it to calculate GDP per head over a much longer time horizon than I’ve shown before. Here it is.


It is a story of two trends: one from 1820 to WWI, and another from the end of WWII until the financial crisis. Now whether this really is a good way to describe how the economy evolved over the last two centuries I will leave to others, but it is remarkable how well this simple idea of deviations around a constant trend seems to work for the UK economy. To see this more clearly, here is 1820 to 1913 with the trend drawn in.


 The trend growth rate is just under 0.9% per annum. Here is the equivalent graph since 1950.


The trend growth rate, estimated from 1950 to 2010, is more than double that of the 1800s, at about 2.25%. Quite when and why the growth rate increased so much between the two world wars is a huge question, but my concern here is with deviations from these trends. Apart perhaps from two booms - the 1870s and the 1970s - large deviations from trend are short lived, with correction back towards the trend occurring pretty quickly.

The big exception, of course, is what has happened since the Great Recession. The deviation from trend just kept on getting bigger, and even with a fairly generous estimate for 2014 the best that can be said is that we might have started growing at trend again, so the gap has stopped getting any bigger. Even after the slump of 1919-21, GDP growth for the next four years was well above trend. What has happened since the financial crisis is unprecedented. This below average growth in GDP per head is one reason why real wages have been falling steadily over this period, which is also unprecedented.

It could of course be that what we are seeing is part of an adjustment to a new lower trend growth rate that was going on behind the scenes before 2010. That is what the methods used by the OECD and IMF (but not the OBR) assume. However they imply that 2007 was a huge boom in the UK, whereas all the other evidence says any boom was decidedly modest. It could be that these trends can suddenly shift after traumatic events. What is abundantly clear is that the last few years are no success story, and the constant drum beat in macromedia that the economy is doing well is completely inappropriate. A much better way of describing the last four years is to say it has been a disaster.


Thursday, 26 February 2015

Can helicopter money be democratic?

Helicopter money started as an abstract thought experiment: money would be created and just distributed to individuals by helicopter. If we think of a consolidated government which includes its central bank, then it is clear that in technical terms this is a combination of monetary policy (the creation of money) and fiscal policy (the government giving individuals money). Economists call such combinations a money financed fiscal stimulus. With the advent of Quantitative Easing (QE), it has also been called QE for the people.

Some have tried to suggest that central banks could undertake helicopter money for the first time without the involvement of governments. This is a fantasy that those who dislike the idea of government have concocted. Others who dislike the idea of fiscal policy have suggested that helicopter money is not really a fiscal transfer. That is also nonsense.

Helicopter money is a particular form of money financed fiscal stimulus. It has two key features among the class of all possible money financed fiscal measures. The first is that it involves a particular kind of fiscal policy. A helicopter would distribute this fiscal transfer randomly, but what most people have in mind is an equal distribution to every person (adult?) - a kind of reverse poll tax, or what economists would call a lump sum transfer. The second is that, once the apparatus for helicopter money had been established by the government, its use would be initiated by the central bank, whereas other fiscal transfers are initiated by the government.

I want to suggest that it is this second aspect that is critical. You could imagine the government making a transfer to every person, and you could also imagine the central bank distributing money to only those people who paid income tax the previous year. The fact that helicopter money is initiated by the central bank seems more like a defining characteristic. If helicopter money could be ordered by the government, we would say that the central bank was no longer independent.

This defining feature of helicopter money is also what makes it attractive from the point of view of macroeconomic stabilisation. It removes the Achilles’ heel of the consensus assignment. The consensus assignment allocates demand stabilisation entirely to monetary policy run by independent central banks, while fiscal policy’s role at the aggregate level is to focus on deficits and debt. The Achilles’ heel is that interest rates can no longer be used to control demand when they hit their lower bound. QE tries to fill that gap, but helicopter money would be much more reliable and effective. Of course governments could make the transfers themselves through deficit finance [1], but the evidence of the last few years is overwhelmingly that they become fixated with reducing deficits in a deep recession with the result that we get fiscal contraction rather than stimulus.

This last point raises a potential problem with helicopter money, which is that government may take the opportunity to offset its impact by raising taxes or reducing transfers, and we end up simply monetising part of government debt. One would hope that does not happen for three related reasons: first, governments are rather less agile than central banks, second, good governments should be working with fiscal rules that specify a medium term plan for deficits, and third the monetary stimulus is only temporary, so there would be little long term benefit in terms of deficit reduction if governments tried to play this game. [2]

If initiation by the central bank is the defining feature of helicopter money, and this policy always requires the cooperation of government, might it be possible to imagine a form of helicopter money that was more ‘democratic’? Why could the central bank not give the government the money, on condition that it was used to increase transfers or reduce taxes in some way? A left wing government might decide that, rather than giving money to everyone including the rich, it would be better to increase transfers to the poor. A right wing government might decide it should only go to ‘hard working families’, and turn it into a tax break. We could call this democratic helicopter money.

I can see two problems with democratic helicopter money. Suppose the government decided to use the money for a tax break that went to people with a very low marginal propensity to consume. If the central bank fixes the scale of the monetary stimulus beforehand, it makes that stimulus much less effective. If it increases the size of the stimulus following the government’s decision on how to spend it, this gives perverse incentives to government: think of inefficient ways to stimulate the economy, and we will give you more money.

One way to reduce such problems is for the central bank and government to cooperate over the size and form of any money financed fiscal stimulus. This could have added benefits. Most studies, and theory, suggest that the most effective fiscal stimulus tool is to bring forward public investment projects. With democratic helicopter money, the central bank and government could cooperate on this policy, rather than or as well as implementing a tax cut or transfer. However such cooperation creates a second potential problem, which is that it puts at risk the perception (and perhaps the reality) that the central bank was both independent and non-political.

Given these problems, why even think about democratic helicopter money? One reason may be political. A long time ago I proposed giving the central bank limited powers to make temporary changes to a small set of predefined tax rates, and I found myself defending that idea in front of the UK’s Treasury Select Committee. To say that the MPs were none too keen on my idea would be an understatement. Making helicopter money democratic may be what has to happen to get politicians to support the idea.

[1] Combined with QE, this could become a money financed fiscal stimulus. An alternative way of avoiding this deficit fixation is to get governments to adopt a fiscal rule where, when interest rates were likely to hit the lower bound, the central bank in cooperation with the fiscal council proposes increasing the deficit by adopting a fiscal stimulus package of a particular size. This is the proposal in Portes and Wren-Lewis (2014). If instead the stimulus package was money financed, it becomes helicopter money.

[2] None of these considerations, even collectively, rule out the possibility that governments could negate helicopter money in this way. This point and the previous footnote show that all we are really talking about here is the effectiveness of different institutional mechanisms of persuading governments to allow fiscal stimulus in a recession, and to avoid the adoption of austerity. 

Tuesday, 24 February 2015

Greece and primary surpluses

In my simple guide to the current macroeconomic position of Greece, I said that a major mistake made by the Troika was to insist on a pace of fiscal adjustment that was far too fast. It led to a collapse in the economy. Of course a collapse in the economy itself raises the deficit. So people who just look at the deficit, including many comments on that post, say ‘what adjustment’ and ‘just how many years does Greece need’.

It is easy to avoid this trap. The OECD publishes a series for the underlying primary balance, which is their guess at what the primary balance (taxes less spending excl. interest payments) would be if the output gap was zero. It is the first row in the table below: the estimated output gap is below. I’ve also shown the scale of the decline in GDP, just to show that the output gap numbers are pretty conservative. Unemployment in Greece is over 25%, and over half of all young people are unemployed.


2009
2010
2011
2012
2013
2014
Underlying primary balance
(% of GDP)
-12.1
-6.0
-0.7
2.9
6.7
7.6
Output gap (%)
4.3
0.2
-7.1
-11.6
-14.2
-12.7
GDP growth (%)
-4.4
-5.3
-8.9
-6.6
-4.0
0.8 

2009 was the peak underlying primary deficit, and it was huge, representing the actions of a truly profligate government. However what followed was complete cold turkey: within two years the underlying primary balance was close to zero. A pretty conservative estimate for the impact of fiscal consolidation would reduce GDP by 1% for each 1% of GDP reduction in the primary balance. In those terms, all of the current output gap in Greece can be explained by austerity.

As I have always said, some period involving a negative output gap was inevitable because Greece had to regain the competitiveness it lost as a result of the previous boom fuelled by fiscal profligacy. But slow gradual adjustment is more efficient than cold turkey. Paul Krugman explains one reason for this: resistance to nominal wage cuts. But there is another which is even more conventional. If we have a Phillips curve where inflation expectations are endogenous (either through rational or adaptive expectations) rather than anchored to some inflation target (as Paul implicitly assumes), then competitiveness adjustment can be achieved with a much lower cost in terms of the cumulated output gap if it is done slowly. (I gave an example here, then reacting to the idea that Latvia’s cold turkey adjustment had been a success.)

There are only two serious barriers to this more efficient adjustment path. The first is the willingness of some outside body to provide the loans to fund the gradual reduction in the government’s deficit. The second is getting those outside bodies to recognise this basic macro: austerity hits output, and gradual adjustment is better. I think the second turned out to be the crucial problem with Greece: as has been extensively documented, the Troika were hopelessly optimistic about the impact cold turkey would have.

So it is as clear as it can be that the current dire position of the Greek economy is the result of a huge mistake by the Troika. The size of the collapse in the Greek economy is similar to the fall in Irish output during the Great Irish Famine of 1845-53, and while the suffering in the latter is obviously of a different order, the attitude of some in the Eurozone is as misconceived as most English politicians during the famine. Of that event they say 'God sent the blight but the English made the famine'. In the future the Greeks may justly say ‘our politicians caused the deficit but the Troika made the depression’.  


Sunday, 22 February 2015

Helicopter money and the government of central bank nightmares

If Quantitative Easing (QE), why not helicopter money? We know helicopter money is much more effective at stimulating demand. Helicopter money is a form of what economists call money financed fiscal stimulus (MFFS). In their current formulation independent central banks (ICB) rule out MFFS, because the institution that can do the stimulus (the government) is not allowed to cooperate on this with the institution that creates money (the ICB). In a world where governments - through ignorance or design - obsess about deficits when they should not, it turns out that MFFS or helicopter money is all we have left to prevent large negative demand shocks leading to deep and prolonged recessions. So why is it taboo? 

One reason why it is taboo among central banks is that they want an asset that they can later sell when the economy recovers. QE gives them that asset, but helicopter money does not. The nightmare (as ever with ICBs) is not the current position of deficient demand, but a potential future of excess inflation that they are unable to control.

Here it is perhaps easiest to talk about monetary policy as putting money into the system when inflation is too low or taking it out when inflation is too high. QE creates money when interest rates are at their Zero Lower Bound (ZLB), but that money can be taken out of the system later if need be by selling the assets that QE buys. Helicopter money also puts money into the system at the ZLB, in a much more effective way than QE, but it cannot be put into reverse by central banks alone. The central bank cannot demand we pay helicopter money back. [4] 

If the government cooperates, this is no problem. The government just ‘recapitalises’ the central bank, by either raising taxes or selling more of its own debt. Economists call this ‘fiscal backing’ for the central bank. In either case, the government is taking money out of the system on the central bank’s behalf. So the nightmare that makes helicopter money taboo is that the government refuses to do this. [1]

What kind of government would this be? Inflation is rising, and the institution tasked with bringing it back under control makes a request that can be satisfied fairly painlessly by the government issuing some more debt. A government that refuses to do this is saying very publicly that it no longer cares about high inflation: it prefers an environment of low interest rates and high inflation and it is prepared to cripple its central bank to achieve this.

Now imagine a government with these preferences, and now put it in a world where the ICB does not need recapitalising and is selling assets and raising interest rates to do its job. Are we really meant to believe that such a government would ignore its preferences and let the central bank get on with it? Of course it would not - it would take away the central bank’s independence by forcing it to stop raising interest rates.

In other words, a government that would refuse to recapitalise an ICB is also a government that would have no hesitation in ending central bank independence. Holding assets is no protection for an ICB against this government of its nightmares. [2] 

The reason we have independent central banks is not to stop us becoming like Zimbabwe. It is to stop governments taking small risks with inflation for short term political gain. Like the occasion I was told that the Chancellor (at the time) knew full well that interest rates needed to rise now to reduce inflation, but there was no way that would happen until after the party conference. But this kind of government is not the kind that would deliberately sabotage its own central bank by refusing a request for recapitalisation.

Tony Yates writes of helicopter money: “Once government gets a taste for it, how could it resist not helping itself to more?” This is a statement about a government of nightmares that goes on a spending spree using money created by the central bank, and not about real governments in advanced economies. The idea that a perfectly sober government becomes a drunkard the moment it sees its central bank undertaking helicopter money is absurd. If ever we are unlucky enough to have a government that is a drunkard, an ICB with some assets to sell will not be enough to stop it raising inflation.

So this nightmare that makes helicopter money taboo is as unrealistic as most nightmares. The really strange thing is that ICBs have already had to confront this nightmare. It is more than possible that when central banks sell back their QE assets, they will make a loss, and so will be faced with exactly the same problem as with helicopter money. [3] A central banker knows better than not to worry about something because it might not happen. So the nightmare has already been faced down. It therefore seems doubly strange that the taboo about helicopter money remains.

[1] It is sometimes suggested that if the central bank runs out of assets, it can create its own, by issuing central bank debt. This would be effective if the nightmare government was unlikely to last, and a new government would later emerge that would recapitalise the bank. However it seems problematic as a solution for a permanently uncooperative government where inflation is too high, because the only way the central bank can pay the interest of the assets it issues is by creating more money. Corsetti and Dedola treat reserves as an alternative to debt issued by governments, but here the idea seems to be to rule out default as an option.

[2] An independent judiciary could protect an ICB. However it would be equally possible to write into law the duty of a government to ensure an ICB can do its job.


[3] The Bank of England obtained an almost complete indemnity from the government for QE losses, but other central banks have not (see Willem Buiter here).

[4] The central bank could just loan the helicopter money. But in practice this amounts to the same thing: a government that will not back its central bank will tell people not to repay the loan.  

Saturday, 21 February 2015

Greece: a simple macroeconomic guide

In reading this, which I will come back to, I thought something short and simple was required

In 2010 periphery Eurozone countries, including Greece, faced two problems: government deficits were too high, and as a result their economies had become uncompetitive. (Excessive deficits - public or subsequently socialised private - had allowed the economy to run too hot which pushed up inflation leading to a loss of competitiveness.)

The deficits needed to be reduced. Under flexible exchange rates this could have been done with relatively little cost in terms of unemployment because competitiveness could have adjusted to its appropriate level immediately via a nominal depreciation. The demand lost from lower public spending could be compensated for by more competitive exports. In a monetary union, this cannot happen, so a period of unemployment is inevitable to restore competitiveness.

The key macroeconomic question is how quick adjustment should be. Should competitiveness be restored quickly or slowly. Macroeconomics has a pretty clear answer which comes from the Phillips curve (of whatever variety) - slow is much more efficient. So it makes sense for some institution like the IMF to provide loans to the government to allow it to eliminate deficits gradually. There are lots of political and social reasons to make adjustment gradual as well, but this is just about the macro.

Those are general principles. When it came to Greece, the Eurozone made three key mistakes.

1)    Too much austerity too quickly, violating the logic of the previous paragraph. Sharp austerity can almost appear self-defeating in deficit reduction terms, as it plunges the economy into severe depression, making adjustment of any kind more difficult. The Troika has to take direct responsibility for this mistake.

2)    There was only partial (and delayed) default on Greek government debt (see below). This was clearly not in Greece’s interest, but it had benefits to other Eurozone countries.

3)    Adjustment was required in an environment of Eurozone recession and deflation, caused by needless fiscal austerity in the non-periphery countries. Restoring competitiveness is much more difficult if the countries you are adjusting with respect to have very low/zero inflation (because people resist nominal wage cuts).

That is the past, but it has direct implications for today. (2) means that the Troika were demanding Greece ran large primary surpluses in the coming years to pay back the remaining debt and adjustment loans. This makes correcting the error in (1) much more difficult, because it implies yet more austerity. In terms of macroeconomics it is a clear mistake. (If Greece could eliminate its negative output gap, it would be running a primary surplus of over 7% according to the OECD, which would be enough for everyone.)    

Now back to this Vox piece. It displays so much that is wrong with macro arguments coming out of the Eurozone at the moment. Examples:

a.    “For an economy in the dismal Greek situation, it essentially made no difference that it remained a member of the Eurozone ..” This ignores the basic macro in the second paragraph above. This denial of the importance of wage and price rigidities, which leads to the key cost of being part of a monetary union, has typified the Eurozone project from the start.

b.    “Since in all these cases painful adjustment was inevitable and costly, one should take the combination of the rescue packages and adjustment programmes as what they really are – a device helping to avoid a sudden fiscal and current account adjustment with even larger immediate pain.” It is of course true that with access to markets cut off, adjustment without any support from the IMF or elsewhere would in macro terms have been much more immediate and painful. But the implication is that the speed of adjustment matters, and in particular that it can still be too fast. The article makes no attempt to address this central issue. The message that comes across to Greece is that you should be lucky you got something.

c.    “During the past five years Greece indeed underwent serious reforms and fiscal consolidation. Progress has been remarkable …” What is remarkable is the extent of the collapse in the Greek economy. Some kind of recession was inevitable, but not a complete collapse in GDP, where over half of young people are unemployed. The article tries to suggest that this is just par for the course, rather than a function of the amount of austerity imposed.

d.    “A debt relief of public creditors could not substantially improve the comfortable state of the Greek government, let alone be justified easily vis-à-vis its lenders.” This is disingenuous. It is true that the effective interest rate on Greek debt is relatively low compared to other Eurozone countries, but nevertheless the lenders are demanding Greece run significant primary surpluses now, and they need not make this demand

I could go on and on, but this is meant to be short. To sum up, the problems displayed by this article amount to a neglect of the importance of wage and price rigidities, and the impact that fiscal austerity can have on demand leading to a needless waste of resources. In other words, a denial of basic Keynesian ideas.  

Thursday, 19 February 2015

Greece and educating economists

My first and most important point: pretty well every economist I have read who has expressed an opinion on the matter recognises that a deal which gives Greece at least some of what it wants is both desirable and feasible. Yes, there is some disagreement about how bad a breakdown would be for both sides, but little doubt that both sides would be better off with an agreement that significantly reduces the degree of austerity imposed on Greece. As these negotiations are essentially about economic issues and consequences, that relative unanimity is worthy of an unprecedented intervention from the US President. (Just in case you think that sounds too complacent, in the previous link Ashoka Mody does make it clear the mistakes that some individual economists and economic institutions made getting to this point.)

The second argument I wanted to make was how this example shows the importance of knowing economic history. Defaults are not day to day events, particularly if your focus is on advanced economies, so it is important to know about how these events have gone before, and in particular how debt forgiveness in the past has had positive impacts. This includes Germany’s own history. There seems to be a growing recognition that - at least in some places - economics teaching at both degree and post-graduate levels has involved too little economic history.

Some have used events like the financial crisis to call for a complete overhaul of how economics is taught. Heterodox economists want much more pluralism, and many other social scientists want economists to be much more familiar with what they know and do. I have some sympathy with both views, but - as an economist would say - only at the margin. The reason is very simple: to go even half way towards what these heterodox economists and social scientists want would involve throwing out much that is even more valuable.

That is my third point. What has it got to do with Greece? To be able to say intelligent stuff about what is going on at the moment (which you would hope an economics education would enable you to do), you need to know quite a lot of economic theory. A lot of macro of course, but quite a bit of finance, and also at least some game theory. (Although those who know their game theory should realise that at the moment the last thing on the mind of Yanis Varoufakis is being academically accurate when speaking to particular audiences!) And if you want to get into all those ‘reforms’ imposed by the Troika, you need a lot of micro.

One of the comments on an earlier post of mine said that economists should try and be less like doctors, and more like scholars. I completely disagree. For all our imperfections, economists know a lot of useful stuff. If the last six years has taught me anything, it is how wrong things can go when basic economics is ignored. Those with economic problems to solve know this most of the time (even if advice is often ignored), which is why economics is essentially a vocational subject, not a liberal arts subject.

Of course we are not as good as doctors, and make more mistakes, although sometimes we get blamed for things that probably would have happened anyway even if we had got it right. I rather liked this study entitled ‘The Superiority of Economists’. It ends as follows:

“Thus, the very real success of economists in establishing their professional dominion also inevitably throws them into the rough and tumble of democratic politics and into a hazardous intimacy with economic, political, and administrative power. It takes a lot of self-confidence to put forward decisive expert claims in that context. That confidence is perhaps the greatest achievement of the economics profession—but it is also its most vulnerable trait, its Achilles’ heel.”

When I read this, I think of Greek finance minister Yanis Varoufakis - academic economist, and former economics blogger - and hope on this occasion the confidence is retained, and that his Achilles’ heel is just a myth.


Wednesday, 18 February 2015

Endogenous supply and depressed demand

I noted in my last post that without fiscal austerity the US, UK and Eurozone could currently be at output levels that are above current estimates of potential or natural output. (For the US a chart is here.) In other words the output gap would be positive rather than negative. One response to that is to say without any fiscal austerity monetary policy would have raised rates. But are these estimates of potential output really independent of the path of actual output?

In a stylised view of macroeconomics the two are independent. Productive potential calculates how much you could produce if both labour and capital was fully employed using technology that itself is independent of current and past levels of output. You can say the same thing in a more kosher way by talking about natural output involving individuals working the amount they wish given real wages that reflect market clearing etc.

We know that stylised view is wrong for a variety of reasons. Labour that has been unemployed may become deskilled. Firms that are forced to cut back on investment in a recession may take time to rebuild their productive capacity. However there may be other ways it is wrong for reasons that are much more difficult to quantity. In particular, if investment falls in a recession, new technology that has to be embodied in new machines may fail to emerge, so the rate of technological progress may appear to decline.

These processes may not matter too much in normal (mild and short lived) booms and busts. However following a large recession they may become more important. As many have noted (e.g. Larry Ball here), estimates of the growth rate of productive potential made by organisations like the OECD and IMF have been revised down substantially since the Great Recession. The bigger the recession, the larger the fall in potential. As I noted here, to rationalise this as a gradual supply side reduction in the rate of technical progress (i.e. to avoid assuming technological regress), these organisations have had to also revise their view of pre-recession output gaps, to give what are frankly ludicrous numbers. It seems much more probable that estimates of productive potential are strongly influenced by actual levels of output.

If true, this is in one sense very optimistic. The process could be reversible. We could expand the economy by much more than most estimates of the output gap suggest, and estimates of productive potential would to some extent rise too. As I have said many times, given this possibility (and the huge costs of underestimating what potential is) we really should explore it by keeping policy as expansionary as possible until movements in inflation clearly tell us we have gone as far as we can. But this raises another puzzle. If we have the capacity to produce much more, why is demand so weak, when interest rates remain at the Zero Lower Bound (ZLB)? [1]

It is possible to construct sophisticated models of multiple equilibria where beliefs (animal spirits if you like) can shift us between equilibria. Roger Farmer is the most notable example of someone who has explored this possibility (see also David Andolfatto recently). Here I just want to make a simple observation about why we should take such possibilities seriously. The largest component of aggregate demand is consumption, and consumption depends on expected income, which can depend itself on actual output, and therefore on aggregate demand. The macroeconomy is therefore set up to allow self-fulfilling multiple equilibria.

That possibility is plausibly bounded on the up side. Goods have to be produced with capital and labour, and at some point workers at least will start demanding higher wages to work longer, generating inflation, which monetary policy reacts to by reducing demand. But the mechanisms that stop self-fulfilling beliefs on the down side are more problematic. Monetary policy finds it difficult to stimulate demand if interest rates hit the ZLB, particularly in a world of inflation targets. At the ZLB continuously falling inflation would become a liability (pushing up real interest rates), but thankfully inflation may become very sticky near zero. The unemployed may drift out of the labour force, or may become self-employed and produce much less, or real wages may fall such that firms start adopting more labour intensive techniques. For all these reasons, deficient demand may become persistent, to some extent disguised and not obviously self-correcting.

Just think about what has happened in the years following the Great Recession. Central banks and governments have steadily revised down their views of what the long run level of output is. It is hardly surprising in these circumstances, and with real wages stagnant or falling, that consumers would also revise down estimates of their long run income, and adjust consumption accordingly. In that way, demand appears to match a pessimistic view about long run supply.

You should not ask how sure I am about such stories, but how certain you are that they are wrong. If you are not certain, then the moral is the same: after a severe recession which appears to result in a loss of capacity, you use policy to explore the boundaries of just how much capacity has really been lost, and run the risk that inflation may rise as you do so. You do not sit back, tell yourself that below target inflation is probably temporary, and do nothing. And, of course, you do not plan for more fiscal austerity.  


[1] Some central banks, most recently the Bank of England, appear to be revising what they think the actual lower bound is. According to Britmouse, that means I should no longer talk about either the ZLB or fiscal policy. Or as the skipper of the Titanic might have said, that iceberg really shouldn’t have been there.