Tuesday, 17 January 2012

UK Deja Vu?

Jonathan Portes has a nice chart comparing this recession to previous downturns in the UK. The most eye catching implication is the similarity between this recession and the 1930s. Although it appeared as if we were recovering more quickly, thanks to the rapid reduction in interest rates and fiscal stimulus immediately following the recession, additional austerity brought in by the new coalition government has coincided with a much slower recovery. Whether this is causal we cannot be sure, but in my view it would be very surprising if the additional austerity was not at least partly to blame.
I want to focus on a different comparison, between now and the recession of the early 1980s. These recessions were both severe, but their immediate causes were quite different. The recession that started in 1980 was the consequence of a very tight monetary policy designed to reduce inflation. RPI inflation averaged 18% in 1980, but came down to 5% by 1983. GDP fell by over 2% in 1980, and very slightly in 1981, but an unusual feature of the recession was that it was concentrated in the traded sector: manufacturing output fell by 15% over those two years. One possible explanation is ‘Dornbusch overshooting’: using monetary policy to reduce inflation in an open economy leads to a temporary loss in competitiveness that hits the traded sector.
The similarity with today lies in fiscal policy. In the 1981 budget, income tax allowances were not raised, despite rapid inflation. To put the same point using a bit of jargon, in 1981 the ‘automatic stabilisers’ provided by fiscal policy were switched off. Despite high and rising levels of unemployment, fiscal policy was tightened, as it was in 2010.
At the time I was working as a relatively junior economist in the UK Treasury, in charge of using the Treasury’s macroeconomic model to assess the economic impact of the budget. This sounds very important, but in practice it was not, because those in charge of policy did not believe the analysis that the model produced. Traditionally after every budget, the chief economic advisor, who was then Sir Terry Burns, presided over a discussion of all Treasury economists about the issues raised. Sir Terry began by presenting his analysis of why fiscal policy had to be tightened: the large budget deficit was in danger of making it difficult to hit (broad) money supply targets. When he finished, there was silence in the room. Given my role at the time, I felt I could not let this pass. I delivered a little speech suggesting the budget was totally inappropriate. It is what happened next that was noteworthy. It was like opening the floodgates: suddenly everyone wanted to speak, and with few exceptions the verdicts were equally damning. Sir Terry looked increasingly uncomfortable.
This pattern was mirrored in public through the publication of a famous letter to the Times signed by 364 academics. We are more used to such things today, but in 1981 this was a very unusual event, and to get so many distinguished academics (mostly economists) to express such a strongly critical view of government policy was a big deal. The 364 included Amartya Sen and the current governor of the Bank of England, Mervyn King. To look at the exact text of the letter is a bit of a distraction, as it included many statements which look decidedly odd today, and which I am sure many of the signatories at the time did not fully agree with. They signed it because they thought the policy was wrong.
I think it is therefore reasonable to use this letter as a proxy for the 1981 budget itself. In 2006 a number of journalists and commentators marked the 25th anniversary of the letter. Here I want to quote from the end of a piece written by Stephanie Flanders, because I think she is a reliable guide to what the verdict at that time was on the 364.

And the letter itself? Well, unfairly or not, the letter became something of a joke on the economics profession, as Lord Howe [Chancellor at the time] confirmed. "I've actually produced a definition of economists as a result: that an economist is a man who knows 364 ways of making love, but doesn't know any women."

Was it right, given hindsight, to switch off the automatic stabilisers in 1981? In very simplistic terms you can argue both ways. Growth did pick up after 1981. Inflation came down rapidly, perhaps more rapidly than was intended. Unemployment stayed very high for the rest of the decade, clearly suggesting that the deflationary shock in 1980/1 was so sharp that it generated hysteresis, raising the natural rate for some time. This is the point emphasised by Steve Nickell, who probably has done more work on the UK unemployment/inflation trade-off over this period than anyone else. However in one crucial respect 1981 was not like 2010, in that monetary policy was still operating freely. If switching off the automatic stabilisers in 1981 had allowed an easing of monetary policy, and given how uneven the impact of monetary policy had been, then perhaps it made sense. However the conventional view today is that monetary policy should do all the work if it can, and that fiscal policy should just allow the automatic stabilisers to operate.
                So it seems to me that the question of whether the 1981 budget, or the 364 economists’ protest, was right or wrong remains an interesting question. However the point I want to make here is that the view on the political right is quite clear. This piece by Phillip Booth in the Daily Telegraph from 2006, based on editing a collection of essays on the issue published by the Institute of Economic Affairs, is headlined ‘How 364 economists got it totally wrong’.
                So my speculative question is this. Was this verdict on the 1981 budget influential (explicitly or implicitly) when the Conservative party in opposition decided that more austerity was needed? (I have focused elsewhere on the role of Greek default in changing the policy consensus worldwide, but the Conservative Party opposed Gordon Brown’s countercyclical policy from the start of the recession.) Did the verdict on the 364 embolden the view that it was OK, and possibly even desirable, to go against conventional (in the UK at least) academic opinion? If this verdict on history was important in influencing policy in 2010, was it appreciated that being at the zero lower bound today made the two periods crucially different? 

3 comments:

  1. This comment has been removed by the author.

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  2. Why are the periods so different?

    The Bank of England think they are still able to boost demand in with tools of monetary policy - specifically, they can use QE which will boost nominal spending. They refrained from boosting demand through most of 2010 and 2011 because they have been concerned:

    a) that the ONS was significantly underestimating GDP growth, and
    b) that there was little or no supply capacity in the UK economy.

    In other words, they were worried that more demand would only be inflationary, not higher output. Indeed, they were so worried about supply capacity in early 2011 that they came close to raising interest rates to *slow down* demand growth.

    What (New) Keynesians have been unwilling to address is the fact that we are so obviously witnessing a failure of (flexible) inflation targeting - or at least, a failure of the practice of flexible inflation targeting in the UK.

    The inflation rate is *obviously* a bad proxy for demand at the moment; we have high inflation despite deficient demand.

    It is entirely unconvincing to hear talk of fiscal stimulus in this light, whilst pretending that monetary policy makers will sit idle and "do nothing".

    If the MPC say we are at (or close to) supply capacity, the government *knows* it cannot stimulate demand further because the MPC will "push back".

    If the government think the MPC's estimate of supply capacity is wrong, why don't they replace the MPC or change the monetary policy mandate?

    If the government thinks that QE is unable to boost demand, why do they keep approving its use?

    Why are you not talking about the Riksbank's apparently surprising behaviour in leaving a liquidity trap, with the Swedish government providing less than 1% of GDP in deficit spending? Yet the UK government runs deficits of 10%, 9%, 8%, and still we are stuck at 0%?

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  3. I don't think the fact that unemployment remained high in the 1980s is necessarily evidence of hysteresis. I think it's more likely that the natural rate was already increasing during the 1960s and 1970s, due to more generous benefits, the rise of the trade unions, declining educational standards, and increases in red tape. This increase was masked by nationalized industries (that would keep employing people for political reasons, e.g. coalminers) and by using fiscal and monetary policy to try and keep unemployment down. Remember, people believed in a stable Phillips curve then, thinking you could always keep unemployment down by accepting a bit more inflation. Ted Heath said something like, "unemployment is a greater social evil than inflation", clearly implying he thought there was a trade-off.

    In the 1980s, there was a swing to the other extreme, with fiscal and monetary policy focused on inflation. Also, the unproductive nationalized industries were broken up, which showed that the market-based natural rate was higher than it had appeared. I mean, you can achieve any level of unemployment you want in a socialist economy. As Britain became less socialist, it's natural that unemployment increased.

    I do think the experience of the 1981 budget had a strong influence on the present Tories. They did seem to think the situation was analogous, that 1981 had proved deficit-reduction to be the right response to recession (and that the recession was due to Labour overspending and encouraging debt) and that academic economists can be safely ignored. However, its worth noting that Mervin King endorsed the austerity program, and mainstream financial opinion seemed to agree with the coalition's policies.

    Also, it isn't obvious that the ZLB makes a big difference. The idea seems to be that with austerity, we can have more QE. Given that inflation has been way above target for the past couple of years, I'm not sure that the BoE could avoid raising rates in the face of fiscal stimulus.

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