Annoying Anti-Stimulus Arguments: Numbers 1 and 2

Unfortunately this may be the beginning of a series. I will try and keep it short and to the point. I will also avoid mentioning anyone in particular who has made these arguments – you know who you are! These arguments are annoying because they keep being made, despite the fact that they have shown to be inadequate over and over again.

No. 1   Arguments that ignore the zero lower bound for interest rates.

                There are good arguments for saying that if monetary policy is free to do its job, then countercyclical fiscal policy is both unnecessary and welfare reducing. I have written on the subject. But having written those papers, I could see immediately the importance of that proviso about monetary policy. At the zero lower bound for interest rates (in a liquidity trap), monetary policy is clearly not free to do its job, and so different conclusions apply. See Eggertson and Woodford (2004). If the argument assumes that, despite the zero bound, monetary policy can do all that is required, then this should be said so explicitly, because it is somewhat counterfactual.

                For exactly the same reasons, these arguments against countercyclical fiscal policy do not apply to individual countries in a monetary union. If monetary policy is set by the ECB, it cannot ensure output is at its natural level (‘full employment’) in each individual Eurozone country. There is a large literature on this, which I have contributed to, but a standard reference would be Gali and Monacelli (2008). There, as in most of this literature, countercyclical fiscal policy in the face of country specific shocks is welfare improving.

No.2    Arguments that say stimulus is just Econ 101, and the profession has moved on.

                I have in the past been very critical of the gap between undergraduate teaching in macro and teaching at masters/PhD level. I think it is quite wrong to teach things to undergraduates that we then tell graduate students are incorrect. But the analysis of fiscal stimulus is not one of these. I know this because my work on fiscal policy uses microfounded New Keynesian models of the type Woodford and others analyse. It is not the same as old fashioned Keynesian analysis, but it can give similar answers for similar reasons. I gave an example here.

                So when I teach Keynesian theory to undergraduates, I am not thinking ‘this is nonsense, as they may find out when they are older’. I’m teaching them simple, non-microfounded models that are a rough approximation to many more advanced, microfounded models. If the argument is that these approximations do not hold in the case of fiscal stimulus, then the argument should be explicit about why. It is just not good enough to say we have better models now, without saying what those models are, and why they make a difference. 

If the argument is that New Keynesian models are wrong, say so, and say why. If the argument is that New Keynesian models would give different answers to Econ 101 reasoning, be specific about which models, and say why they give different answers. If the argument is that state of the art New Keynesian analysis does not support fiscal stimulus at a zero lower bound, then it is simply false: again, see Eggertson and Woodford (2004).

It is time the Bank of England started publishing interest rate forecasts

                In an earlier post I celebrated the announcement that the US Federal Reserve intended to publish interest rate forecasts. It has now done so. Here is the key chart.

The vertical axis in the level of expected interest rates. On the horizontal axis we have four points in time: the end of 2012, 2013, 2014 and the long run. Each dot represents the expectation of one of the FOMC members (roughly the equivalent of members of the Monetary Policy Committee in the UK).

                This tells us some important information that could only be guessed at beforehand. The majority of FOMC members expect interest rates to stay at almost zero for the next two years. Every member of the FOMC expects interest rates to be below their long run level (i.e. they expect monetary policy to be expansionary) in three years time. (We know it is expansionary because we also have FOMC inflation forecasts, so we can work out what real interest rates will be.) Now these forecasts are not necessarily better than others, but that is not the point. What they tell us is what these individuals are likely to decide to do if events (inflation, growth etc) turn out as they expect, and if they are being consistent. (More formally, this makes it easier for a central bank to demonstrate its credibility in the face of potential time inconsistency: see my earlier post for an example of what this means.)

                The Federal Reserve example also weakens two of the standard arguments against the Bank of England doing the same. The first argument is how you get all the MPC members to agree a forecast. As the above shows, you do not. Each member of the MPC says what they think. The second argument is that the public will confuse conditional forecasts with commitments. However, unless every MPC member has the same forecast (which seems unlikely), what you get is alternative opinions, so clearly this is not some kind of unconditional target for interest rates.

                The central bank of New Zealand has been doing this for years, and those of Sweden and Norway for some time now. Those central banks have not decided it was a horrible mistake because the public did not understand what it was doing. However, these were relatively small economies, so the Bank of England could brush their experience to one side. Now that the US has followed in their footsteps, I believe the Bank has to move in the same direction.

The Anti-Keynesian school

                Some comments on this recent post about Schools of Thought macro have raised interesting issues which I had not thought enough about, and which I want to come back to later if I can. Here I want to put forward an idea suggested by this from Jonathan Portes. We wrote these posts simultaneously and independently, and although I think Jonathan’s is consistent and complementary with what I had written, rereading it made me think a bit more about what I was really annoyed about.

Jonathan describes his puzzlement at being labelled a Keynesian when he thought he was just following mainstream macroeconomic theory and evidence. It discusses how misleading it can be to associate views about how the economy works with policy positions which may be rather specific in time, place and circumstance. Now I think these types of criticism, which I made in my original post, apply to at least some other schools of thought in macro. For example the label monetarist has many layers of meaning, from the very specific and policy related (money supply targeting) to the much more general and theoretical (money matters). These layers may be related, but they do not have to be.

Having said that, I think it is worth saying a bit more about the use of the specific term Keynesian, which both our posts focused on. It seems to me slightly unusual when used to denote a school of thought today, because it appears to be invoked more by those who disagree with it than those who agree. Jonathan’s post gave some clear examples of this. To caricature: we do not need to think too much about fiscal stimulus, because it’s a Keynesian policy. It is true that this kind of statement is more often made by politicians, journalists or bloggers than academics, but academics are not blameless here, and others often take their cue from them.

The source for dismissive statements of this kind probably goes back to the 1980s. At the academic level, it reflects the defeat of the Keynesians at the hands of New Classical economists, without noting that things have moved on rather a lot since then. At the level of policy in the UK, it may also reflect a perception on the right of past battles won.   

In contrast, those economists who use (New) Keynesian theory generally think they are just applying standard macroeconomic analysis. They are using the synthesis (e.g. the New Neoclassical Synthesis of Goodfriend and King) that I talked about in that earlier post. They do not think of themselves as members of a school of thought – they thought they were part of the mainstream.

                Is that just arrogance on their part? There are two reasons for thinking it is not. First, it is this synthesis model that is used by pretty well every central bank as the main tool for doing monetary policy. That does not make it right, but it does give it a pretty good claim to being mainstream macro. After all, it is mainly in central banks where macroeconomics is applied to the real world. Second, as the evidence that prices are sticky seems overwhelming (as Paul Krugman points out, the evidence from real exchange movements is clear), and it follows almost automatically that aggregate demand then matters, it is difficult to see how Keynesian analysis can either be controversial or ignored. (Furthermore, even if prices are pretty flexible, demand will still be important in determining output after a severe negative demand shock that takes us to the zero lower bound, as I argued here.)

                So I want to abolish the Keynesian school. Keynesian analysis should be part of the mainstream, and does not need to be embodied in a school of thought. However, for those that like schools of thought, I will replace it with a new one: the anti-Keynesian school of thought. It covers all those who attempt to dismiss Keynesian ideas like fiscal stimulus at the zero bound, or countercyclical fiscal policy in a monetary union, not through reasoned analysis, but by just labelling it Keynesian.

The Return of Schools of Thought Macro

When I first studied macro, it was all about ‘schools of thought’. Keynesians, Monetarists, New Classicals, and probably many more I cannot remember. Macroeconomists tended to take sides. Antagonists often talked across each other, and anyone not already on one side just got totally confused. I recall reading one textbook on international macro where each chapter represented an alternative ‘view’, with no clear idea of how each view or school was related to another. One thing that was pretty clear, however, was that most schools of thought could be identified with a particular ideological position.

                But then things began to change. The discipline appeared to become much more unified. It would be going much too far to suggest that there was a general consensus, but to use a tired cliché, most macroeconomists started talking the same language, even if they were not saying the same thing. I think there were two main reasons for this. The first was microfoundations: deriving the components of macro models from standard optimisation applied to representative agents. This gave macroeconomics the potential to achieve the same degree of unity as microeconomics. The second was the development of New Keynesian theory, which allowed an analysis of aggregate demand within a microfounded framework, and which integrated ideas like rational expectations and consumption smoothing into Keynesian analysis. To use the jargon, all models were now DSGE models.

                Goodfriend and King coined the term ‘New Neoclassical Synthesis’ (call it ‘synthesis’ for short), and other authors wrote along similar lines. So, even as recently as five years ago, I told masters students starting a macro course to forget anything they might have been told about alternative schools of thought: they were going to learn a unified framework that most macroeconomists – the mainstream – would sign up to. It was like the first half of David Romer’s popular textbook: start with Solow, but quickly replace a fixed savings propensity by an optimising intertemporal consumer to get the basic Ramsey model. Add endogenous labour supply to get RBC. Probably talk a bit about overlapping generations. Hopefully add to what was in Romer by doing some open economy stuff. Then add New Keynesian theory built around sticky prices. If the student went on to work in a central bank, they would probably encounter this framework as a central part of that institution’s forecasting and policy analysis.

I think this synthesis and the reasons behind it may have had one or two unintended and unfortunate consequences. Sometimes the emphasis on microfoundations became a bit of a fetish. (I have written about the shaky methodological grounds on which ‘microfoundations purists’ sometimes stand here.) Some have suggested that the emphasis on microfoundations meant too much time was devoted to elements that were easy to model within that framework rather than the things that really mattered. But I personally thought this synthesis had many more positive than negative consequences. I would not wish for every single macroeconomist to sign up to the synthesis: there is an important role for heterodox economists. However I liked the fact that the majority of macroeconomists used the same analytical framework.

                Just five years later and it seems rather different. I’ve encountered a much larger range of economics blogs in the last week or two (you can guess why), and it does feel like going back in time. Schools of thought in macro are definitely back. Since the recession it has become clear that the synthesis had not been adopted everywhere. In particular, in sections of the profession there remained a suspicion (to put it mildly) of New Keynesian theory, and partly as a consequence of this the amount of this theory that was taught to graduates differed widely.

                It is true that for some, schools of thought can be quite fun. Some students find the idea that academic macroeconomics consists of opposing forces locked in combat adds a degree of interest and motivation that might otherwise be lacking. However I am not persuaded that this spice was sufficient to offset misunderstanding. Personally when I was a student I found all the motivation I needed from socially destructive inflation, and widespread unemployment should do the same today. I do think that the schools of thought approach leads to an inexactness which can be misleading and annoying.

                Take the label Keynesian. Look up Wikipedia, and in the third paragraph you will find ‘Keynesian economics advocates a mixed economy — predominantly private sector, but with a significant role of government and public sector...’. Now I have a much more limited idea of what Keynesian economics is. For me, Keynesian macro is business cycle analysis based on aggregate demand and sticky prices. By this definition, the only ‘significant role for the public sector’ required is a central bank. Even in the rather unusual (I hope) times of a zero lower bound, Keynesian advocacy of fiscal stimulus implies is that the government brings forward its bridge building, and not that it permanently build more bridges. Does my preferred definition make me narrow-minded?

 Keynesian analysis as I define it implies that you need monetary policy, and occasionally countercyclical fiscal policy, to stabilise the economy, but that is not what is generally meant by a mixed economy! The extent of the public sector’s involvement in the economy will depend on microeconomics, not macro. Now it is true that those who tend to be antagonistic to state intervention may be uncomfortable with monetary and fiscal stabilisation policy, as I have suggested, but I am against ideology clouding economics, and I certainly do not want this connection hard wired as a school of thought.

                School of thought thinking also tends to bracket ways of looking at the economy with policy prescriptions, even when they are not inextricably linked. Take countercyclical fiscal policy, for example. Is that an intrinsic part of Keynesian thinking? For some time there has been general agreement among most macroeconomists that monetary policy was the stabilisation tool of choice, because of issues like implementation lags. This view has been strengthened by analysis over the last ten years that explicitly looks at welfare derived from a representative agent’s utility: the analysis of a simple basic case is contained in the Woodford paper I referenced here, and some of my own collaborative work has shown this result is surprisingly robust. So linking the routine use of countercyclical fiscal policy to what I think of as Keynesian theory is just misleading.

                  This sort of bundling together of ideas under one label at the very least causes confusion. (Here Jonathan Portes gives one recent example.) Worse still, it leads people to take sides on issues not because of the merits of the case, but because that case is associated with a school of thought whose other elements they do or do not like. I also miss the synthesis. I very much liked the idea that disagreements could be clearly located within a common framework. With the synthesis, I felt macroeconomics began to look more like a unified discipline - more like micro, and dare I say it, more like a science than a belief system. 

Optimism or Pessimism on the EuroZone Crisis?

On Monday Paul De Grauwe and others wrote a letter to the Financial Times in which they warned that the Eurozone was ‘on the road to macroeconomic disaster’.  They wrote:  “Today’s leaders, however, behave like cult followers who refuse to avail themselves of the treatment that will save their lives”. Yesterday Fred Bergsten and Jacob Kirkegaard at VoxEU sound a much more optimistic note about the ability of European leaders to see their way through the Eurozone crisis. They say “We therefore believe the Eurozone crisis – despite the superficial appearance of the opposite – is well on the way towards stabilisation and resolution.”

(A digression. It has just been announced that Fred Bergsten will retire from running the Peterson Institute this year. He established that Institute as a major voice in international macro. This is just a small personal anecdote. In 1998 I did some work with Rebecca Driver for the Institute on equilibrium exchange rates. At the time the Yen was around 160 140 per dollar, and our analysis suggested an equilibrium rate around 100. There was a small presentation of our work to some influential journalists at the Institute. One found the implications for the Yen incredible, and after grilling me, he turned to Fred and said ‘do you support this’? Many in his position would have been equivocal: something like ‘it’s an interesting view, but of course blah di dah’. After all, I was a relatively new academic hardly known in the US. Instead Fred replied ‘yes, I support it’.)

So two very different views, but one reason for this divergence may be that they are mainly looking at different crises. Although Bergsten and Kirkegaard note the competitiveness problem I discussed here, they focus on government debt. They note that, although the ECB has the capability of ending the crisis, to do so would create too much moral hazard. To quote: “Were the ECB to cap governments’ financing costs at no more than 5%, for instance, Eurozone politicians would probably never take the essential but painful decisions.” In other words, it is in the ECB’s perceived long term interests to allow a crisis to persist, because this will spur on institutional reforms that will avoid a similar debt crisis occurring in the future.

To some the idea of progress via crisis might seem far too chaotic. Why, for example, cannot the ECB systematically buy or sell government bonds in the market to achieve announced target interest rates for particular countries, and reduce interest rates for those countries that make progress in tackling debt problems, but raise rates for those that do not? In one sense this is what the market is doing, but while the market might have the general level of interest rates too high because of problems of multiple equilibria, the ECB could provide incentives in a more moderate and controlled way. Perhaps, but I doubt whether the ECB would want to play such an openly political role.   

 Under this view, the ECB’s policy is working just fine. European politicians are being forced to make changes (and in some cases are being forced from office when they do not), and institutional progress is under way. Because such changes are difficult politically they are bound to be slow and erratic, which is why the apparent crisis will continue for some time to come. But, so the argument goes, if at any stage the crisis appeared to be becoming critical, the ECB would step in to avoid this happening.

Paul De Grauwe and his colleagues are worried about a different crisis, a crisis of external imbalances. I think I’m right that as far as my discussion here is concerned, this is equivalent to a crisis of competitiveness. Eurozone countries running current account deficits have been losing competitiveness, and vice versa. To cure this crisis requires deficit countries to restrain demand, and surplus countries to expand demand. Now the first part of this cure is of course identical to the cure for excessive government debt – it requires fiscal austerity. The key difference is the second part, which involves expansion in surplus countries.

It is the absence of expansion in surplus Eurozone countries (which means Germany in particular) that leads De Grauwe et al to be so pessimistic. They see a “decade of economic stagnation entailed by current policies “. If European policy makers do not change course, they “will bear the responsibility for the implosion of the eurozone and, in the end, the failure of the whole European project”. Many others share this concern about a Eurozone recession: see Martin Feldstein for just one example.

We can put it this way. If the problem is simply one of government debt, and we have good reason to believe there is too much debt in most Eurozone countries (including Germany), then general austerity is the order of the day. Whereas the markets believe Germany will undertake austerity of their own free will, in other countries neither the markets nor the ECB believe this, so we need a continuing but controlled crisis to force these countries to act. However, if the problem is external imbalances and competitiveness, we have a danger of ‘competitive austerity’. We need more austerity outside Germany than within Germany to correct imbalances between the two. The more Germany adopts a contractionary fiscal policy the further countries outside Germany are forced to go. The end result is not only general stagnation within the Eurozone, but recession so acute in some countries that political turmoil may follow, possibly leading to the breakup of the Eurozone.

In other circumstances, competitive austerity might not be a problem, because the ECB could counteract any general stagnation by reducing interest rates. There are two reasons why this is not a way out today. First, by raising interest rates last year, the ECB appears to be too preoccupied by short term inflation, so they may not act when they should. Second, and more fundamentally, they are close to a zero lower bound, and so have lost the ability to prevent a second recession through monetary policy. So unlike the case where the problem is risk premia on government debt, the ECB cannot be sure to act effectively in a Eurozone recession.

This suggests that the key problem for the Eurozone is similar to that faced by the US, the UK and others. Too much austerity in the short term is holding back or even killing the recovery from the last recession, because monetary policy has lost its power in a liquidity trap. In these other countries this excessive austerity will ‘only’ result in significantly higher unemployment for many years to come. In the Eurozone the consequences could be more dramatic.   

UK Growth reveals a major macroeconomic policy error

The first estimate of UK growth in the last quarter of 2011 was negative. As these updated NIESR charts show, no other UK recovery has stalled in this way. Of course very little is ever certain, but we can be pretty sure that growth would have been significantly better if the current government had not imposed severe additional austerity measures beginning in 2010. (This is the counterfactual that matters, and just looking at GDP components can be a misleading way at getting at this for reasons I discussed here.) Of course growth might have been better too if the Euro crisis had not happened, but this government had no control over the Euro crisis, while it does decide fiscal policy.

                I do not have anything very new to say about this, in part because many people predicted growth would be harmed before the policy was introduced. (See, for example, this letter from 80 economists published during the 2010 election campaign.) What was the reason for this major macroeconomic policy error? For some I think it was a political calculation that it would be advantageous to get as much of the cuts out of the way early, well before the next general election. However I think others in the coalition were genuinely spooked by events in Greece and elsewhere. Unfortunately the key difference between economies in the Eurozone and those with their own central bank was not appreciated. Today the claim that if these additional austerity measures had not been introduced UK interest rates on debt would have suffered the same fate as many Eurozone countries looks pretty implausible. In Denmark we even have an example of a country that has recently undertaken stimulus measures, and where interest rates have continued to fall in line with other countries outside the Eurozone (see David Blanchflower here).

                So I believe we must add 2010 to a list of major macroeconomic policy errors made in the UK since the war. Like the failed monetarist experiment in the early 1980s, it is the result of a government adopting a policy which relied on a mistaken macroeconomic analysis that was not supported by the majority of academic opinion.  And like that earlier failure, it will leave unemployment significantly higher than it need to have been for many years.  

Comments on Comments

                I number of people have asked me why I have not replied directly to Scott Sumner’s criticism of this and subsequent posts of mine, particularly as he keeps claiming that I made some mistake. Well, for the record, I do sometimes make mistakes, and when they are pointed out I acknowledge them. However on this occasion my writing on this issue seems pretty consistent to me and as far as I’m aware error free. So, why no reply?

                Well, I did in fact leave a comment on Scott’s second post. Scott then wrote another post (rather than comment on my comment). I stopped at this point, partly because the subject matter appeared to be moving away from what Cochrane and Lucas said to other issues which were not obviously relevant to my original point. I think Brad DeLong nails it here. This is one of the problems with the ‘you were inconsistent here, and you have forgotten this here, but you are a professor at Oxford so I’ll give you the benefit of doubt’ sort of exchange. I think it can muddle rather than clarify an issue.

                So instead I wrote a few self contained posts which tried to throw light on some of the issues, but which also made sense on their own. The original quotes I looked at appeared to suggest that if taxes went up, consumption would immediately fall by the same amount (“it’s just a wash”). I pointed out in my original post that this will not happen because of consumption smoothing. What I had not anticipated is that some people might think that lower saving would automatically lead to an equal fall in spending on capital goods without any change in income (another wash). That is why I wrote the savings equals investment post, which explained why this would not happen. Some of the comments to my original post said hey, these guys are just assuming full employment, so I wrote this on that general issue. There also seemed to be some confusion in the debate on the difference between behavioural responses and equilibrium relationships, which Paul Krugman and subsequently Brad DeLong discussed, and which Chris Dillow brilliantly anticipated. As the debate went on, I thought I could clarify a point about multipliers and consumption smoothing (or ‘Old Keynesian’ and New Keynesian models), so I wrote this. I’m glad to see that John Cochrane is now less dismissive of fiscal stimulus, which leads Noah Smith to make observations about politics and macro that have some similarities to those in my original post.

                While I’m on the subject of comments, I should say something about comments on my own posts. I had not anticipated so many people reading my stuff, and therefore so many comments, and if I tried to answer them all I would have to neglect the day job. However I do read them all, and if there is a common theme that I would like to say something on, I’ll write a new post on it (like ‘Demand Denial and Ideology’). One exception is where someone points out an error in what I wrote, or something where in retrospect I think I have been misleading or unclear, in which case I think it is sensible to recognise that immediately by replying to the comment. So thank you to those who have left comments, as I do find them useful.  

The influence of macroeconomic ideas

Polly Toynbee says something very sad in the Guardian today. In talking about the Labour opposition in the UK, she writes

They have lost the Keynesian argument (for now): the paradox of thrift is just too paradoxical for the public. 

I agree that the line that the recession was caused by everyone (public and government) borrowing too much, and that just as consumers are now having to tighten their belts, so should government, plays well because it seems virtuous. On the other hand the idea that if consumers and government start to save more at the same time there will not be enough demand and so output will fall seems fairly intuitive, and certainly not rocket science. However I’m not really in a position to judge how someone unfamiliar with macroeconomics would see this argument, and I guess it is called a paradox for a reason.

                Obviously Toynbee is not implying that every macroeconomic idea that is incomprehensible to the layperson will be ignored by policymakers. What she does seem to be saying is that when macroeconomics enters politically contested waters, politics should look to what goes down well with the public rather than what most economists think is right.

                Is this true? Well just imagine the following. The opposition announces that it intends to cut most tax rates. It asserts that this will incentivise everyone to work harder, so tax revenues will actually increase. Now I’d like to think that if this happened in the UK today, the media would find it very difficult to get hold of an academic economist who would support the view that revenues would actually rise following tax cuts. The opposition would be asked at every turn, why do the experts not agree with you? As a result, although the policy might be popular initially, it would gradually lose votes. In addition, the opposition itself might begin to doubt their own claim.

                Now imagine another country where there is a small minority of economists who are prepared to support this view. The media would switch to describing the claim about revenues as controversial, and would revel in setting up confrontations between economists on opposing sides. The opposition gets elected and implements the policy. Similarities between this and the story of the Laffer curve and Ronald Reagan that Paul Krugman describes in  Peddling Prosperity are of course deliberate.

                It therefore seems to require a near universal consensus among economists to prevent bad but populist policies either emerging in the first place, or being enacted if proposed. We need to add at least two other factors that might be important. The first is the influence of academics on the civil service. Civil servants do try and weigh up the evidence, and will be influenced by whether a particular view is a majority or minority one among academics. However politicians can override civil service advice, particularly if they have an electoral mandate, as my little story about the first Thatcher government illustrates. Second, we need nowadays to factor in the role of think tanks which are established to promote a particular point of view, and which can often manufacture apparent expertise. (There is a very nice observation from Menzie Chinn on how many staff from various US think tanks went to the ASSA meeting in Chicago. George Monbiot follows the money financing UK think tanks.) Such think tanks can generate the appearance of ‘controversy’ among experts where little actually exists, as the climate change debate illustrates.

                What this all suggests is that the academic balance of opinion on macroeconomic issues carries very little weight when these issues are politically divisive. The chances of achieving the near consensus required for academic opinion to matter is also reduced by the two way interaction between politics and academic economics. Not only will politicians and their advisors seek out the academics whose views support their political prejudices, but unfortunately ideology sometimes seems to influence the academic debate. I have written about the influence of free market ideology on academic macroeconomics in the context of fiscal policy and Keynesian theory more generally, but in the past the influence has come from the left as well as the right.

                All this is very pessimistic from my point of view. Indeed, as the paradox of thrift is both a very old idea and obviously correct, it is enough to make someone who wants better policy despair. In another 75 years, will the paradox of thrift still be a ‘controversial’ idea in media terms? I think it may just be possible to tell a more optimistic story on this, but that will have to wait for another post when I'm feeling less gloomy. 

Counterfactuals and UK Growth in 2011

                Macroeconomists have a familiar complaint when it comes to how the media sometimes assesses the impact of particular policy measures. Popular comment often tries to link the measure to outturns and draw conclusions. For example, did the 2009 Obama stimulus package (ARRA) work? We cannot say that the policy did not work because U.S. unemployment did not fall through 2010, because there were lots of other influences on unemployment over this period. We have to try and work out what would have happened if the policy had not been implemented. That is what the CBO (the Congressional Budget Office - the independent fiscal council for the US) does, and it estimates that the impact on jobs was positive and substantial. (Fiscal stimulus works!)

                In the UK we can get into the same confusion. Was 2011 a bad year for growth because of the greater austerity announced in 2010? We will have the Office for National Statistics’ first guess at the outturn for 2011 as a whole soon, but they should not be too far from the forecast made by the OBR in November. The OBR (Office for Budget Responsibility) is the UK’s equivalent of the Congressional Budget Office, although it is much smaller and has a much more limited remit. Brian Ashcroft, in his new blog, runs through the OBR’s estimates with some nice charts. Overall UK GDP growth in 2011 is expected to be just less than 1%, but the contribution of government spending to that growth is expected to be positive. Does that mean additional austerity had nothing to do with the recovery stalling in 2011?

                The answer is no for a number of reasons. First, as Ashcroft notes, government spending in the UK and elsewhere is typically countercyclical. We normally focus on transfers like unemployment benefits when thinking about why the budget deficit goes up in a downturn, but there is evidence (for example this study by Julia Darby and Jacques Melitz) that government spending is also countercyclical. In other words, without austerity the contribution of government spending to growth might have been bigger still. Second, one of the government’s key austerity measures was an increase in VAT at the beginning of 2011. As this was preannounced, I would expect a lot of expenditure switching from 2011 into 2010, and indeed falling consumption (-1.1%) is the major reason why expected growth in 2011 is low. Third, people look forward and adjust their current plans accordingly. The OBR expects the direct effect of government spending to reduce growth in a major way over the next five years. That inevitably means job losses in the public sector: the OBR expects general government employment to fall by about 700,000 (about 2.5% of total employment) between 2011 and 2017.  It would be very surprising if this had not led to an increase in precautionary saving in 2011.

                What we really want to know is what GDP growth would have been if the new coalition government in 2010 had not announced additional austerity measures. To do that you need a macroeconomic model, like the one the OBR uses to make its forecast. In fact the OBR are the obvious people to ask, but unfortunately – and unlike their US counterparts - they are not allowed to tell you, or even do this kind of analysis. Read this to find out why.

Consumption smoothing and the balanced budget multiplier

Only for economists

                In some of the debate following this post, and then this, there often seems to be a big distinction drawn between models based on consumption smoothing, and the old fashioned balanced budget Keynesian multiplier. Even Paul Krugman felt it necessary to say that he ‘never said a word about the balanced budget multiplier’. Now of course the models are different. However I want to suggest that in the context of fiscal expansion in a recession caused by demand deficiency, the balanced budget multiplier story can be retold in a manner consistent with consumption smoothing.

                The most basic model of consumption smoothing involves two periods. Let period 1 be a demand deficient recession, and so output is determined in a Keynesian manner by aggregate demand. Period 2, which is much longer, is Classical, and nothing changes in period 2. (If having a two period model of unequal lengths is a worry, think of period 2 as being divided into a large number of sub-periods of equal length to period 1, but where every sub-period is Classical.) We keep monetary policy neutral by assuming the real interest rate is constant. Optimising consumers will then spend a fixed proportion of their permanent income in period 1: that is consumption smoothing. Let’s call this proportion c, which could be quite small. There is no investment, and the economy is closed.

                The government now increases government spending by G in period 1 only, and taxes rise by the same amount in period 1. The ‘direct’ or ‘first round’ effect is that consumption in period 1 falls by less than G, because the impact of higher taxes on consumption is smoothed via permanent income. That is as far as I needed to go in my ‘Mistakes’ post to make the point I wanted to make. However it is obviously not the end of the story, because higher output implies higher income. What happens to output eventually (call the answer Y)? Well consumption rises/falls by Y-G times the fixed proportion c, so we solve Y=G+c(Y-G), which of course implies Y=G, a multiplier of one. This is not only the same result as given by the Keynesian balanced budget multiplier, but the mechanics are identical. Consumption does not change at all: higher period 1 income offsets the higher taxes. We do not need to worry about any knock on effects in period 2, because permanent income ends up unchanged. So the simple Keynesian balanced budget multiplier need not be considered some ancient fossil that we are forced to teach undergraduate students, but a simple expression of what consumption smoothing implies in a particular context.

                We could get to the same result using consumption smoothing alone, by noting that consumption in period two is tied down by (classical) Y and permanent G. Second period consumption and the Euler equation then fixes period 1 consumption, as real interest rates are unchanged by assumption. So any change in government spending in period 1 leads to an equal increase in output.

Woodford, in section 2 of the paper noted by Krugman and myself, does something with similarities to this, but with more elegance. My period 2 becomes the steady state, a steady state in which (given the usual assumptions) the real interest rate equals the rate of time preference. With real interest rates fixed at this value in all periods, consumption is equal in all periods, so any temporary change in government spending leads to an equal temporary change in output. We get a multiplier of one. With this benchmark, it is then intuitive to see how the multiplier will fall if real interest rates are not constant but rise. Equally, if we are at a zero lower bound, the multiplier will be greater than one because higher output generates inflation, which reduces real rates.

Now I am not trying to say here that the simple, most basic Keynesian multiplier apparatus is in any sense ‘as good as’ consumption smoothing. In fact, if I was writing an introductory macro textbook, I would start with the two period consumption model and consumption smoothing, and mention the current income Keynesian consumption function only in passing. (My reasons for doing this are explained here.) All I want to suggest is one way of reinterpreting the balanced budget multiplier that is consistent with consumption smoothing. I think it is also nice that all this stuff ends up with the same result, a multiplier of one. If someone wants to argue that the multiplier is zero they need some additional argument, and as I suggested here, I have yet to see one that seems appropriate to the current situation.

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 25^th 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? 

Savings Equals Investment?

This post is for first year undergraduate students (and the occasional blogger) who appear confused.

Q: If consumers spend less and save more, does this mean investment must increase?

A: Absolutely not. Someone increasing their saving does not automatically imply that some firm will decide to buy more capital goods.

Q: But surely savings equals investment by identity in the national accounts.

A: Indeed. Total output = total income = total expenditure = Y. In the most simple model of a closed economy without government, income (Y) = consumption (C) + saving (S), but also expenditure (Y) = consumption (C) + investment (I). So S=I by definition. But here investment includes what is called ‘stockbuilding’ or ‘inventory accumulation’, which includes goods that firms wanted to sell but could not. To make this clear, lets split measured investment (I) into these two components: I=DK (buying new capital goods) +DS (stockbuilding). So if people consume less (C falls), but investment in new capital (DK) stays the same, measured investment rises because firms accumulate inventories of the goods that consumers did not buy (DS rises).

Q: But this situation cannot continue, as firms may be losing money.

A: Exactly. They will cut back on their output, incomes will fall, consumption may fall further, and savings will also fall, cutting back on the initial increase that we started with.

Q: When will this process stop?

A: When firms stop accumulating inventories i.e. when DS=0. Then, and only then, will S=DK.

Q: But how can this be? We have assumed that DK stayed the same, and we started with an increase in S?

A: You have not been paying attention. Each time firms reduce their output to match lower demand, incomes and savings fall. Eventually the initial rise in savings is reversed, because overall income has fallen.

Q: Got it. But textbooks make a big thing about aggregate savings equalling investment. If it is just an accounting identity, why is it important?

A: What the textbooks really mean is that we eventually end up with a position in which S=DK. And that is important, for the reasons we have just discussed. It is called the paradox of thrift. A desire by consumers to increase savings ends up just reducing output, and savings do not increase at all. (Of course they are still saving more of their income: S/Y has gone up, but because Y has fallen, not because S has increased.)

Q: But I thought with all this ‘just in time’ production stuff, firms did not hold many inventories any more.

A: Well we could short circuit the story by forgetting about inventories and having firms accurately forecast what demand will be, and therefore what their output should be. In practice what we call involuntary inventory accumulation can still be important when looking at quarterly movements in national output.

Q: But is it realistic to assume investment – I mean DK – stays the same if savings are initially higher? If there are more savings around, it becomes cheaper to borrow, which will encourage investment, right?

A:  It might, but it might not. In particular, if output is falling, firms may be reluctant to add to their capital stock.

Q: But won’t interest rates keep falling until they do? After all, the asset market has to clear.

A: Savers have an alternative, which is to just keep their savings as money.

Q: But they will put the money in a bank, and the bank will lend it.

A: Maybe, but the bank may just decide to hold on to the cash.

Q: It seems to be really important what people do with their additional savings.

A: Perhaps. But I think the key point is that, most of the time, the person doing the saving is different from, and has different motives to, the person doing any investing. A highly complex financial system links the two. And in that system, there will be lots of opportunities for the additional savings to be parked as money.

Q: Money seems very important here. It is why the extra saving does not have to find its way into more investment.

A: I think that’s right.

Q: If people hold the extra savings as money, will that not increase money demand. What happens if the central bank keeps the money supply fixed?

A: People hold money not just as a way of saving, but also to buy and sell things. And if less is being consumed, there is less need for money on this account. It is difficult to predict what will happen to the total demand for money, which is why central banks nowadays focus on determining short term interest rates rather than the money supply.

Q: That’s not what it says in my textbook. It says the central bank fixes the money supply.

A: Yes I know. I’m afraid it’s a bit out of date. Don’t ask me why.

Q: So if the central bank determines the interest rate, why don’t they ensure the interest rate is low enough to encourage firms to buy more capital goods?

A: That is what they would like to do. There are two problems. First, it may take some time for the monetary authorities to work out what is happening, and what the right interest rate is. (I could talk about real and nominal rates here, but let’s leave that for another day.) Second, nominal interest rates cannot go below zero, and maybe we would need negative interest rates to persuade firms to raise investment enough.

Q: My textbook also says that the classical model assumes interest rates adjust so S=I, by which I assume they mean S=DK. Does that mean the classical model is wrong?

A: Only if you think it applies at all times, and that there is no other reason why output cannot fall. However if we assume that the monetary authorities eventually are able to chose the right interest rate, then the classical model is fine when thinking about economies over a long enough time horizon.

Q: This all seems like common sense. I feel a bit stupid not to have understood this before.

A: Don’t worry, you are not alone.

Downgrading France

One of the problems with the rating agencies’ assessments of the debt of major country governments is that they are too newsworthy. As a result, they appear to be much more important than they actually are. Jonathan Portes, before he started his own blog, had a healthily unbalanced assessment of their competence here.

                Having said this, Stephanie Flanders (and subsequently Paul Krugman) is absolutely right to focus on something interesting in S&P’s justification for removing AAA from France and downgrading other Eurozone economies. To quote from S&P:

We also believe that the [9^th Dec] agreement is predicated on only a partial recognition

of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU's core and the so-called "periphery". As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.

It is good that the competitiveness issue that I discussed here is now considered as serious a problem as any fiscal profligacy. It is also good that the possibility that fiscal austerity could go too far is being raised. Until recently, the general view seemed to be: the more austerity the better.  

                However, there is a danger of inconsistency in all this. Let us focus on the competitiveness issue. To correct this problem, we need inflation in uncompetitive Eurozone countries to be below German inflation. To achieve this, we almost certainly need a period in which domestic demand in those countries is weak relative to Germany. That has already happened to a considerable extent. The key question, which I raised here, is whether what has been done already is enough, or whether the gap – in simplistic terms – between non-German and German unemployment needs to be greater still. If inflation forecasts are to be believed, competitiveness correction appears to be painfully slow, reflecting perhaps the difficulty in reducing inflation outside Germany when it is already very low.

                Of course it would be great if governments outside Germany could take measures that helped competitiveness without harming growth, but the group of such measures may be an empty set. It probably is the case that some measures may have more of an immediate impact on costs than others, and so if policy could focus more on the competitiveness problem that might help. But the real issue here is Germany.

                It is the outlook for Germany that makes everything so difficult. The OECD’s forecast is that German output will be below the level that will stabilise inflation over the next two years. This keeps German inflation low, making it that much harder for other countries to regain competitiveness. The Euro area desperately needs a much more rapid expansion in Germany, so that German inflation rises well above 2%. If the forecasts that this will not happen are correct, there is one policy instrument that is available that could turn this around, and that is fiscal expansion in Germany. (Yes, some more from the ECB would help too, but it is the relative position of Germany within the Eurozone that is key.) What S&P and others should be saying is: we need a large, quick but temporary increase in public spending in Germany to save the Euro.

Ideology and Demand Denial

Thanks to Chris Dillow and then others, my post Mistakes and Ideology in Macroeconomics was widely read and commented on. As Chris pointed out, it is possible to think in terms of mechanisms or complete models. My post was about one mechanism, consumption smoothing, which the texts I was looking at appeared to ignore. Many responses were along the lines of ‘what the authors of these texts had in mind is a model of this type, and in this type of model fiscal policy will be ineffective’. I’m happy to pursue this, not because I would be presumptuous enough to imagine I know what the authors ‘really meant’, but because I think it strengthens the idea that antagonism towards fiscal policy in the current situation has ideological roots rather than a sound basis in macroeconomic theory.

The most widely suggested model is one where there is never any demand problem: we are always at ‘full employment’. Then, of course, increasing one component of demand will have no direct effect on output, and higher taxes will have some negative impact on supply. Expansionary fiscal policy would be quite inappropriate in these circumstances.

If that is the argument, then I would insist on asking just how it is that the economy is always at full employment. The standard response, which is that prices are flexible, is not enough when we hit a zero lower bound for interest rates. As a suggested in another post, the ‘self correction mechanism’ by which demand shocks never impact on output requires a combination of price flexibility and monetary policy. (Actually, price flexibility is not even necessary – if the monetary authorities effectively targeted the output gap, for example.) This mechanism fails when we hit a zero lower bound.

Now an argument that said that the current recession was the result of a large negative supply shock rather than a demand shock, and we hit the zero lower bound because central banks misunderstood this fact, makes perfect sense in theory – it is just a little difficult to square with the facts, as many have pointed out. But this is a contingent argument. What the debate over fiscal policy has revealed is an underlying generic antagonism towards Keynesian analysis.

There is an asymmetry here. Keynesian economists do not deny that productivity or other supply side shocks can often be important. On the other side there appears to be, among many at least, a belief that Keynesian economics is never relevant. What this amounts to is what Krugman and others call demand denial. Yet the basis in economic theory for demand denial appears very unclear. Say’s Law, or maybe some kind of quantity theory with fixed velocity, would do it – but these were really bad ideas that the profession dismissed many decades ago.

Demand denial seems both surprising (an individual firm facing a fall in demand will reduce output), and hardly something to feel passionate about. So demand denial genuinely puzzles me. Keynes had a number of thoughts on this, as the following from the General Theory shows (‘it’ in the first sentence is a theory that involves demand denial).

That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commanded it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

Now beautiful though this passage is, a good deal has changed since 1936. New Keynesian theory is a ‘consistent logical superstructure’, so there is no intellectual prestige involved in denying its relevance (except, perhaps, to fellow believers). Yet two sentences still ring true. The first is the idea that austerity is virtuous. Some of the popular discourse around fiscal policy has moral overtones, perhaps stemming from the idea that governments, like individuals, have to practice self control. Now while I think seeing economics as a morality play is generally unhelpful, in the case of fiscal policy there is a problem of deficit bias: governments over the last few decades have tended, on average, to spend too much or tax too little. (Some particular evidence, and a fairly comprehensive discussion of reasons for deficit bias, can be found here. For lots of data, go here, click on ‘subject: Real GDP Growth’ and select the historical debt database.) However deficit bias is a long term problem and a recession is not the time to start dealing with it. 

The final sentence from Keynes also still rings true.  One explanation for demand denial is that it has ideological roots. In the real world we have the problem of ensuring aggregate demand matches supply, and this requires state intervention – normally monetary policy.  For those who want to argue that state intervention in the economy is generally a bad thing, it is embarrassing to acknowledge that there is one area where it is essential. But I get no joy in seeing ideology mess with economics, and so I would be more than happy to be convinced that there was another explanation for demand denial.