Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 30 March 2013

The View from Brussels

When incomplete ideas get embodied in institutions and the people in them

As I have said before, its too easy to be rude about austerity. It is harder to put yourself in the mindset of reasonable individuals who take a different view, and pinpoint exactly - in ways that they will understand - why their view is wrong. So this paper from Marco Buti and Nicolas Carnot (HT Philip Lane) is useful because it shows us that mindset. [1]

The argument in the paper is essentially this. “We recall that large adjustments are needed
in most economies to restore sustainable fiscal positions, not because of the arbitrary will of the markets or of EU institutions.” So the debate is about the precise speed of adjustment, and the Commission is trying to strike the “right balance”. In particular, it recognises the need for different speeds in different countries. I think this view characterises the position of many international organisations, including the OECD, and many in the IMF.

There is a big mistake being made here. It essentially involves the prioritisation of issues. Fiscal adjustment is seen as the overriding priority. Issues involving the state of the economy are secondary: they are one factor in judging the appropriate speed of adjustment. This is the wrong way around.

The major priority at the moment should be doing something about the demand led recession in the Eurozone (and other countries like the UK). The budgetary position of some countries is a secondary factor that may influence the country by country balance of any fiscal actions required to deal with this priority.

This point about priorities is not an expression of political preferences. It is about what basic macroeconomics tells us. The recession is a problem right now. If it is not dealt with now, the loss of resources is permanent and irretrievable, and in addition there is likely to be a more permanent scarring effect through hysteresis. Given the imbalances within the Eurozone, and the political tensions generated by creditor/debtor relationships, the costs of a recession could be greater still. Budget consolidation is a permanent, long term issue, and there is clearly a right and a wrong time to deal with it. Recessions are the wrong time, not just because it conflicts with other priorities, but because it may not even work, because of hysteresis effects, or political effects, or banking effects.

So why is this obvious to me, but not to those running policy? To repeat, my own view is in no sense about the relative importance, in some abstract sense, of deficit bias versus avoiding recessions. As regular readers will know, on deficit bias and long run goals for debt I am something of a hawk. I just do not see why we cannot avoid recessions and bring down government debt.

In some cases those running policy take a different view because of ulterior political motives, but not in all cases. I’m prepared to give those in the Commission, and other international organisations like the OECD and IMF, the benefit of the doubt on this. I believe an important influence on their mindset is that they are working in a framework in which overall demand stabilisation is not their problem. That is monetary policy, not fiscal policy. It is very revealing that in the Commission paper two phrases do not appear at all: they are  ‘zero lower bound’ (ZLB) and ‘liquidity trap’. Too few in government have recognised that when we hit the ZLB, the rules of the macroeconomic game fundamentally change, and the institutions of government - and those in them - have to adapt too.

This is hardly a novel point, but as Paul Krugman keeps stressing, it is absolutely central. It is why I get annoyed by those who insist that, if only we did monetary policy differently, all would be well - what I call ZLB denial. Few (unfortunately not all) deny the central role and importance of monetary policy in getting us out of recessions. When monetary policy fails - which it patently has, mainly [2] because of the ZLB - fiscal policy has to take its place. Countercyclical fiscal policy becomes as important as monetary policy normally is. Institutions, and habits of thinking, that are set up for normal times must adapt. The IMF recognised this in 2009, but I’m not sure the OECD or European Commission ever did.

We can see how this failure to change priorities influences the subsequent discourse by looking at two issues that are covered by the paper: OMT and Germany. The paper recognises the importance of OMT in altering market expectations. But they then say “As is clear as well however, the OMT announcement per se does not address the underlying sustainability concerns.” Of course OMT does not directly change the outlook for future primary balances. However it is a game changer in allowing periphery countries to change priorities. When you cannot sell your debt, this has to take priority over recession concerns (although fiscal consolidation can still be designed to try and avoid recession). What OMT allows countries to do is change priorities. If it had been implemented earlier, priorities could have been changed earlier. The paper does not see this, because for them fiscal consolidation remains the key priority.

The paper says “In Germany, the fiscal stance is now broadly neutral [3], hence consistent with
the call for a differentiated fiscal stance according to the budgetary space”. Which makes perfect sense (albeit using the rather tortured language of international organisation space), except at the ZLB. At the ZLB we need overall fiscal expansion in the Eurozone. The differentiation point still stands, so from an overall Eurozone perspective the Commission (and the OECD, and the IMF) should be arguing for substantial fiscal expansion in Germany. However, if your priority is fiscal consolidation, advocating doing nothing can seem quite radical and brave.

Right at the end there is a hint of recognition, but in a way that reinforces my point. To quote in full:

“A dedicated stabilisation fund could improve the conduct of fiscal policies throughout
the cycle by enforcing tighter policies in good times and providing additional leeway for cushioning downturns. Such a tool could strengthen the existing automatic
stabilisers while maintaining a credible rule-based framework. It would be particularly useful in the current predicament characterised by large cyclical differentials across the zone as well as a not insignificant average output gap. However, according to the Commission blueprint such a tool should only be considered in the longer term in the context of full fiscal and economic union.”

In other words countercyclical policy at the overall Eurozone level would be useful right now, but it needs to wait until we have the institutional change that can accommodate it. [4] Which tells me that those in the Commission think institutions are very important, but it does not tell me why existing institutions (and those within them) have to be behave in such a blinkered way.

[1] This can be seen as a companion piece to two others that looked at the power austerity has over politicians, and why some economists are suspicious of Keynesian fiscal stimulus. This post is about economists working in policy institutions.

[2] Unfortunately the ECB often gives the impression that as long as consumer price inflation is around about 2%, then nothing else (like other measures of inflation, or a recession) has anything to do with them. However I doubt very much that if the ECB had done what the Fed is now doing, a Eurozone recession would have been avoided.

[3] Whether this is true is another matter: see here for example. The latest OECD Economic Outlook has the German debt to GDP ratio falling steadily since 2011, despite a widening output gap.

[4] That institutional change will come too late for the current recession. I take a critical view of whether fiscal union for the Euro is either feasible or desirable here.

Friday 29 March 2013

Reactions to Textbook Mundell Fleming

Some of the reactions to my earlier post, like Paul Krugman’s, have been that we no longer teach Textbook Mundell Fleming (TMF), but instead teach something along the lines I was suggesting. Which is great. [1] Of course I never meant to suggest everyone is taught TMF, but enough are to make the post warranted.

Another line, which I attempted (unsuccessfully) to head off in the original post, was UIP does not fit the data, so why build a core model that uses it? There are three replies to this:

1) Although UIP does terribly in the short run, its deficiencies in the longer term may not be so bad. Menzie Chinn sent me a summary of his own work that suggests this, which is here. In my two period model, where the first period is a Keynesian short run, then its the longer term predictive power that is relevant. Having said this, I also in my lectures stress that UIP is not well supported by the data, and that some people believe you can make money by betting against it (e.g. the ‘carry trade’).

2) However I do not think there is a more empirically based alternative that is satisfactory. Some people suggested a random walk for the exchange rate, and indeed - as Nick Rowe points out - we can recover TMF from UIP this way if expectations are formed on that basis. But a random walk model is inconsistent with almost any macroeconomic theory involving exchange rates that we might care to teach.

I know many people react negatively to rational expectations, but really all I’m arguing for here is common sense. Take again the example of a temporary (first period) fiscal expansion in a two period model without any backward dynamics. Unless the model contains hysteresis, we know the second period exchange rate will not change relative to the no fiscal expansion case. So to assume that agents expect any change in the first period exchange rate to carry through into the second period is the height of irrationality. I really do believe we should not be teaching models to undergraduates where people are that dumb.[2]

3) Its what macroeconomists use. I know many people do not like this, but I have always felt strongly that the core of first or second year undergraduate macro should be consistent with the macro that, say, central banks use. It is bound to be simpler, but it should be consistent. Of course we should emphasise its deficiencies, and mention alternatives, and also generally say something about the history of how we got here. The problem with too much undergraduate macro is that it is history in the wrong sort of way - its just out of date. [3]

In my earlier post I tried to emphasise the inconsistency between TMF and UIP, and not go on about the fixed money supply assumption. However, just as teaching up to date macro involves using the IS part of IS-LM along with, say, a Taylor rule, so it should be possible to adapt TMF to a world where central banks set interest rates if the model was any good. Yet if we dropped the LM curve from TMF, and assumed instead that interest rates were the policy instrument, we would conclude that an independent monetary policy in an open economy with flexible exchange rates was impossible. According to TMF, central banks cannot set interest rates to anything other than world interest rates. Why do we want to start students off with a model that suggests this?

And so finally to the LM curve itself. I have yet to hear a remotely convincing justification as to why this remains in the first macro model that we teach students. What great insight do students get when we pretend that the central bank fixes the money supply? I’ve talked about the muddles teaching the LM creates before - David Romer presents seven advantages of doing something more realistic here. [4] Is it really the conservatism of textbook writers that means that we are condemned to carry on confusing students, and cannot we do anything about this?  

[1] I always recommend students read Krugman, Obstfeld and Melitz when they get confused about open economy macro, but I had my sights trained on other macro texts.

[2] Yet I do teach a backward looking (static expectations) Phillips curve alongside a New Keynesian Phillips curve (NKPC). Why the double standard? I can suggest three reasons: (1) using static inflation expectations is not so obviously silly if the monetary authorities give us little clue about what they are doing, which describes the world a few decades ago, (2) there are empirical features (e.g. Phillips curve loops) which are difficult to rationalise with the NKPC (3) firms and workers do not spend large amounts of money trying to predict future inflation.

[3] So, for example, I’m happy mentioning TMF as a lead up to UIP. Saying something like “originally economists modelled capital flows as a function of only interest rate differentials, but this either ignored expected capital gains, or made a very naive assumption about exchange rate expectations. We now know better.” For much the same reason you might mention that the original Phillips curve did not have an expected inflation term in it, but we now know better.

[4] Oddly, although Romer carries through his arguments to an open economy, he does not embrace UIP: in fact I do not think he even mentions it.

Tuesday 26 March 2013

Why we should stop teaching Mundell Fleming

For economists

I have complained before about IS-LM being the first macromodel most students encounter, when no major current central bank fixes the money supply. The textbook version of Mundell Fleming (TMF) [1] is the first, and often the last, short run open economy model students are taught, and it shares the same deficiency. However the problem with TMF is even greater. It is inconsistent with Uncovered Interest Parity (UIP), and if we use modern macro as our yardstick, this makes it simply wrong.

Lets take a topical issue: the impact of a temporary increase in government spending. We should be immediately worried that TMF makes no distinction between temporary and permanent increases. It says both have no impact on output. So every student learns that fiscal policy is ineffective under flexible exchange rates. For a temporary increase in spending this is incorrect.

The logic of the TMF proposition is usually demonstrated by shifting various curves, but it is in fact trivial. In TMF money demand must equal a fixed money supply. If money demand depends on prices, output and interest rates, and the first is fixed in the short run and the last is tied to world rates, then output cannot change either. This complete crowding is achieved through an appreciation in the real exchange rate.

But why should domestic interest rates equal world interest rates? UIP tells us they need not. A temporary increase in government spending will raise output, which given a fixed money supply will raise interest rates. This will lead to an appreciation, but the temporary nature of the shock means that the long run exchange rate is unchanged. So the current appreciation implies an expected depreciation, which offsets the additional return offered by higher interest rates. The result is a short run equilibrium where output and domestic interest rates are higher. There is partial crowding out through an appreciation but not full crowding out.

Now you might say what is so great about UIP. But at least UIP is based on something: a simple arbitrage theory. As far as I can see the TMF assumption that domestic and world interest rates are equal has no equivalent foundation.

We only get some crowding out in the experiment above because the money supply is fixed. If interest rates are fixed instead then we get none. With fixed interest rates, UIP implies the current exchange rate is unchanged when government spending increases, so there is no crowding out. We get exactly the same result as with fixed exchange rates - the complete opposite of what TMF suggests.

Now you might plead in mitigation for TMF that at least it gets the impact of a permanent increase in government spending right. I think this is a very weak defence. A permanent increase in government spending, assuming it increases aggregate demand, is crowded out because in a small open economy the real exchange rate equates the demand and supply of domestic output in the long run, which is a more basic result than anything in TMF. [2]

Another weak defence of teaching incorrect theories is that they are simpler than better theories. However it we combine this basic idea about the determination of the medium/long run real exchange rate with UIP, we have a complete theory of the small open economy which is no more complicated than TMF. So why does TMF survive?

Perhaps one reason is an addiction to two dimensional, and preferably static, diagrams. Yet the system I’m describing can be represented by just two equations and two periods. The first equation is the familiar aggregate demand curve. It is static, so we have

y = f ( g, r, e )

where g is a shift variable like government spending, r is the real interest rate and e is the log of the real exchange rate. Use stars to denote second period (medium/long run) values:

y* = f( g*, r*, e* )

Now here I can say that r* is equal to the world real interest rate rw (because of UIP and a constant real exchange rate), and y* is determined by some classical supply side, so this equation determines the second period real exchange rate - the basic result I mentioned above.  The only other equation I need is UIP:

e = e* + rw - r

where e is defined so that an increase is a depreciation. Policy determines the short term domestic real interest rate, and therefore the short term real exchange rate.

The aggregate demand curve is already familiar to students, and the adaptation to an open economy is intuitive. UIP is easy to teach: any interest rate differential is offset by expected capital gains or losses. So it seems to me something like this should become our standard introductory short run open economy macromodel. And TMF should disappear.

[1] It is well known that in open economy macro everything important must have a three letter abbreviation.
[2] It is a basic result that may be inconsistent with PPP, but that is another story.

Sunday 24 March 2013

Taking a bet on house prices (with our money)

In overall terms the UK budget was more of the same. There were some very minor tax cuts in the short term (worth around 0.1% of GDP), matched by some reductions in spending which may be largely accounting tricks. From 2015 there was some additional public investment, financed by reductions in current spending, but again very small numbers. More politics from this totally political Chancellor.

So nothing here that will do anything substantive to help stimulate demand in the economy. As the Chancellor would say, don’t take my word for it - ask the OBR (para 1.7). Ditto for the monetary policy changes (although it is worth reading Andrew Rawnsley’s amusing take on this). But there was one rather interesting and potentially significant measure that might have some impact. The government will provide a buyer with up to 20% of the value of a new-build home valued at £600,000 or less, and initially this loan will be interest free. In addition, the government will provide guarantees for much of the portion of a mortgage above 80% of the value of a new or existing home. So, on the assumption that the biggest mortgage most can obtain at the moment involves 75% of the value of the house, the government will either directly provide an additional 20%, or insure a mortgage provider that does the same. Both measures will be available for three years.

One way to see this is as follows. Before the financial crisis, mortgages worth 95% of the house value were quite common. Since the crisis, 75% is the new normal. This requires first time buyers to spend much more time saving before they can buy a property, which is one factor behind the overall increase in UK household saving. This is a clear example of how additional risk aversion by banks can reduce demand in the economy. This new measure tries to undo this effect, so that we go back (for a time at least) to the pre-crisis status quo.

However another way of seeing it is as follows (see Martin Wolf for example). The reason banks are only lending 75% is that they think there is a significant possibility that house prices may have substantially further to fall. Although recently the market has stabilised after an initial decline, many (like the IMF) think that UK house prices are still overvalued. If prices fall by 20%, by providing only a 75% mortgage banks are still covered if the buyer defaults on the loan. With this new scheme, it is the government (which means us [1]) who will lose out. [2]

Will this help the recovery? More people wanting to buy houses will in itself do nothing to stimulate the economy, but higher prices could have some positive effect on house building, as builders rush to build (or finish building) before the scheme ends. In addition, an increase in housing turnover tends to raise spending on items like furniture. [3] Rising house prices may convince house owners more generally that they need to save less (for reasons that are rather more complicated than a simple wealth effect), or banks that they are more creditworthy. Finally, those that no longer have to save their 25% have some extra money to spend.

I suspect your views about this measure will depend a great deal on how you see the world before the financial crisis. If you see it as a world with too much personal debt, based on an erroneous belief that house prices could never fall, then the idea that the government wants to return us to that world may seem crazy. However, if you think that the current crisis is down to a broken banking system that has become excessively risk averse because of mistakes it made outside the UK housing market, then this measure is helping to correct an important distortion that is keeping the economy depressed.

Everyone agrees that the underlying problem with the UK housing market is a chronic shortage of supply. The first best solution is to raise that supply, producing substantially lower (and therefore more affordable) house prices, but there may be too many vested interests in high (and largely untaxed) land values to make that achievable. The current measure addresses a secondary form of inequity, between higher income earners with inherited wealth (who can afford to buy property in their 20s), and higher income earners without inherited wealth, who have to wait many years until they have saved a deposit before they can buy.

What this measure clearly does show up is how ludicrous the current government’s position on borrowing is. We are told that there is no room for additional government spending on infrastructure financed by borrowing, because the markets would not tolerate it (despite interest rates on that borrowing being really low). Yet this scheme involves additional government borrowing, to be invested in rather risky housing equity, and that is apparently no problem, because it is off balance sheet. Yes I know, as Tim Harford points out, George Osborne’s Labour predecessors played similar tricks, but they were not using these tricks to justify prolonging a recession.

And what about the argument that it bad to increase borrowing when debt is so high. This measure encourages the already highly indebted UK household sector to do exactly that! [4] Why does virtually no one in the media ask why it is apparently OK to encourage the private sector to borrow to spend its way out of recession, but the government is not allowed to do the same? Surely it should now be clear that this is a government with at least as strong an anti-state, anti-poor ideology as Mrs Thatcher, but with rather less honesty about what it is doing.      

[1] Often referred to as ‘taxpayers’ in the media, but with this government more likely the recipients of the future government spending that will be cut as a result.

[2] Of course the scheme itself will boost house prices, so immediate losses are unlikely. A real
danger is that this scheme gives the government a financial interest in keeping house prices high. To avoid house price falls (and the losses from defaults that would follow), the current 3 year scheme may become permanent, providing a very undesirable subsidy for homeownership.

[3]  As Chris Dillow points out, increasing housing turnover also raises tax receipts from stamp duty - the significant tax the government levies on house purchases. As this scheme is off balance sheet, it might even help the Chancellor reduce the official borrowing figures.

[4] Whether the UK household sector is over indebted is a complex question - see for example Ben Broadbent here

Friday 22 March 2013

The Power of Austerity over Politicians

In an earlier post, I reported some speculation by Coen Teulings on why politicians seem to ignore the majority of economists when it comes to austerity. (On the minority of economists that do support austerity, see here.) Mark Thoma responded that it was because austerity gave politicians the chance to pursue ideological goals, and of course he is right for some. I had made the same point on my ‘final verdict’ on the UK Chancellor George Osborne, and the motivations of the many on the right in the US and Europe are even more transparent. Yet that original post began with a discussion of the Netherlands, where there appeared to be a political consensus in favour of austerity. Even where the strong austerity proposed by the right is opposed by the left, in both the UK and US for example, the opposition could be fairly described as tepid. Paul Krugman and others have often lamented the amount that Obama seems prepared to give in trying to compromise with Republicans, and the left in the UK hardly presents a united front on the issue. Borrowing continues to be something to avoid discussing in public.

So I think there is more to this than just an excuse for some to whittle down the size of the state. Or to put it another way, we need to explain the weakness of the opposition to austerity from those who do not have this ideological goal. This is not to underestimate the influence that those with an ulterior motive and lots of money can have. I used to think that the idea that the Great Depression was a liquidity trap that expansionary fiscal policy rescued us from was received wisdom both among economists and politicians. But I should have known better from my own experience. Duncan Weldon reminds us of how the disaster that was Margaret Thatcher’s adoption of monetarism in the early 1980s has been turned into a myth of her triumph over those foolish economists.

Politicians can be misled, or can allow themselves to be misled. It is natural for academic economists to focus on the dissention within their own ranks, either in the form of influential papers that were enthusiastically received by politicians eager to believe in expansionary austerity, or economists who appeared to leave their academic selves behind them when discussing this issue. And I guess if all economists could form a united front, with everyone singing the same tune, that might begin to alter political attitudes. But this is a pipe dream, and even the smallest deviation from unanimity allows a media that craves division to portray the profession as ‘divided’.

I also agree with Henry Farrell and Mark Blyth (the former reviewing the latter’s new book ‘Austerity: The History of a Dangerous Idea’ here) that its wrong to try and find a motive for everything in terms of interests groups. Ideas have a power of their own. But for ideas to have power they need to resonate. Let me try this out as to why austerity resonates with politicians even when there is no hidden agenda.

I start with human nature, and the constant debate within ourselves between current consumption and future wellbeing through saving. What for economics is just an intertemporal optimisation problem is for most people often a battle of wills between our schizophrenic selves. In this battle, spending now is often the temptation of the devil, and saving is the virtue. Now for politicians this becomes a battle over whether to succumb to deficit bias. Promising tax cuts or spending increases without spelling out the implications in terms of paying for any additional borrowing is what politicians do more often than not. 

Most of the time they can get away with it, but I suspect they either feel guilty about the implicit deception, or fear they will be found out. So when the market starts to punish fiscal profligacy, it is as if a parent has discovered the child’s guilty secret. (The market is seen by many as a mysterious deity.) The politician wants to repent (or at least be seen to repent), and atone for past sins. After eating too many pastries, we go on a crash diet. After deficit bias, we have austerity.

More cynically, when the market focuses on debt sustainability, it is much harder to pretend that tax or spending decisions financed by borrowing do not involve intertemporal trade-offs. Deficit bias becomes much more difficult, so political fortunes will be maximised by taking the path of apparent virtue. The electorate, many of whom are recovering from over indulging themselves, will empathise with political 'self restraint' and reward apparent virtue.

So here are we Keynesians, telling politicians that they don’t need to go on that diet just yet - they can put it off until times are good. Indeed, now is just the time to eat more pastries - it will make you feel better, they are very cheap at the moment, and you might even lose weight in the long run! It sounds too good to be true, and just the kind of tale the devil might spin. Give in, and the all seeing parent/god that is the market will find you out again. So the politician ignores these siren voices, and buckles down to austerity.

Thursday 21 March 2013

The 2013 Budget and UK Monetary Policy

The Budget yesterday included an important update to the remit of the Bank of England’s Monetary Policy Committee (MPC). Depending on who you listen to, this is either an important change that could offer a considerable additional stimulus to the UK economy, or a major disappointment. So which is it?

The document reaffirms flexible inflation targeting, and rejects alternatives such as nominal GDP targets. However the Treasury wants to make it clear to the MPC just how flexible it can be. It can, for example, ‘see through’ (i.e. ignore) any short term increase in inflation for a lot longer than the two years that has so far been part of the MPC’s mantra. It can create ‘intermediate thresholds’ as part of forward guidance. In short, it believes flexible inflation targeting is quite compatible with the MPC doing what the US Fed is currently doing. [1]

I think Britmouse has it exactly right when he writes:

“I see nothing at all in the new remit text which compels the MPC to do anything different to current policy.  It is all about judgement.  Neither did the old remit prevent the MPC from giving forward guidance if they so desired.”

To see why this is important, read the minutes just released of the last MPC meeting, where the committee voted 6 to 3 not to undertake any further Quantitative Easing. In para 27 it sets out the arguments for providing more stimulus, which include:

“inflation expectations were relatively stable; wage growth remained weak; there remained a degree of slack in the economy; and the potentially positive response of supply capacity to increased demand meant that higher output growth would not necessarily lead to any material increase in inflationary pressure”

Which all sounds pretty compelling. But then the next paragraph sets out the reasons for doing nothing, which basically boil down to

“Inflation was above the 2% target and was likely to stay above it for an extended period, and there was a risk that could lead to inflation expectations drifting upwards with adverse consequences for wage and price setting behaviour. Further monetary stimulus might increase that risk. It might also lead to an unwarranted depreciation of sterling if it were misinterpreted as a lack of commitment to maintaining low inflation in the medium term”

In other words, any attempt to use the very flexibility that the Treasury emphasises the MPC has risks a loss in the credibility of the medium term inflation target. So 6 of the 9 member committee decided it was best not take take that risk. I cannot see anything in the new guidance issued by the Treasury yesterday that would have influenced any of the 6 who voted to do nothing to change their minds.
Now I guess the Treasury is hoping that the new governor will persuade some on the committee to vote the other way (although note that the current governor was one of the minority who voted for additional stimulus). But surely the key question is why they need persuading in the first place. Why are possible risks to the credibility of the medium term inflation target allowed to outweigh the current almost 100% certainty that we have chronic demand deficiency which no one else is going to do anything to change. Perhaps a remit that places medium term inflation stability at its core, and says nothing about eliminating demand deficiency, might just have something to do with it. 

[1] In addition, it also believes that flexible inflation targeting allows the MPC to consider deviating from the inflation target if there is a “development of imbalances that the FPC may judge to represent a potential risk to financial stability”.

Sunday 10 March 2013

The Unlikely Friends of Austerity

Sometimes economists who support austerity have clear ideological or political motives. However I often come across economists who do not have these motives, and yet are deeply suspicious of the idea of Keynesian stimulus. In other words, they are economists who are quite happy to acknowledge market failure, and embrace the idea that governments have an important role in helping to correct that failure, and yet they are unhappy with what Jeffrey Sachs calls ‘crude Keynesianism’. (For a detailed critique of this Jeffrey Sachs piece, see this post from Mark Thoma.)

Where does this suspicion come from? Often there seems to be a view that the austerity/stimulus debate is a distraction from focusing on more important, longer term problems. Oddly this view is asymmetric: I do not think anti-austerity economists deny that there are also important longer term problems. I also think longer term issues are more difficult to fix at times of austerity, so in that sense the short and long term solutions are complements, not substitutes. There is the notion that some have that we need a crisis to get things done, but perpetuating and mis-diagnosing the crisis is precisely what those who want to use debt scare stories to reduce the size of the state are trying to do.

A particular and important example is a concern about high or rising government debt. Government debt is almost always a long term problem, whereas deficient demand should just be a short term problem. As regular readers of this blog will know, my current views about the (un)desirability of government debt in the long run are quite radical, but I have no problem combining this with a belief that in certain circumstances fiscal policy should be used to stimulate (or in the Eurozone, also cool down) the economy. [1]

There is an understandable concern about debt and markets. That concern should not be dismissed lightly. I remember being asked by economists working for the UK government in 2009 just how far can we let debt rise before markets panic? I knew that my answer, which was that in a balance sheet recession there was a higher demand for government debt (particular when it was accompanied by a flight to safety), was based on a solid macro model. But though I thought the chances of my being wrong were small, I also knew the costs of my being wrong could be very high, which should make anyone cautious. Now I am much more confident, because events have vindicated the model. [2] However I recognise that some people are hyper risk averse, or believe markets are totally fickle, which is partly why I have always stressed that fiscal expansion can be done without issuing more debt. So if this is your real concern, become an advocate for balanced budget fiscal expansion or other, more innovative, changes in the fiscal mix.

I suspect an equally important reason why economists are sometimes unenthusiastic about fiscal stimulus is that they have been trained to misread the problem we are currently dealing with. This is not just the idea that monetary policy rather than fiscal policy is the stabilisation tool of choice. More fundamentally, it is the line promoted - consciously or unconsciously - in almost every textbook that economic downturns are ultimately self correcting. We have a business cycle because prices are sticky, but eventually prices are flexible, so we are bound to get back to full employment once prices adjust (which cannot be that long).

The best thing to say about this message is that it is incomplete. It should say that what gets us back to full employment is monetary policy. Having an appropriate monetary policy is a necessary condition for returning to full employment. A monetary policy that, for example, kept real interest rates constant would not get us back to full employment following a permanent negative shift in aggregate demand. The moment you understand this, the seriousness of the zero lower bound coupled with inflation targets (which put a lid on inflation expectations) becomes apparent. We are not dealing with a normal recession that will end pretty soon, we are dealing with something that could last much longer.

So for someone like me, what I see at the moment is very simple. We have demand deficiency, and the normal means of correcting it is broken. We luckily have a backup system, but the levers of that system are being pushed in the wrong direction. What is worse, this backup system is not some mysterious or controversial mechanism - it is what we teach to students day in and day out. So to push the levers in the wrong direction just makes a mockery of macroeconomics.

[1] There is a concern about transition and persistence. That fiscal expansion today will be politically difficult to undo, and so will increase the longer term political challenge. I think that is one good reason for focusing on government spending rather than tax cuts or transfers, and more specifically on government investment, in any stimulus package. There are of course other good reasons for doing this.

[2] And because we have Quantitative Easing.

Saturday 9 March 2013

Causing recessions

If a car driver falls asleep at the wheel of his car, do we say they caused the accident that follows? Of course we do: it would be absurd to say otherwise. We take it as given that it is the driver’s responsibility to keep control of the car.

Now imagine that the Fed or the MPC had kept interest rates at their pre-recession levels from 2008 onwards. Would we say that monetary policy had made the recession worse. Of course we would. We expect monetary policy to do everything it can to bring the recession to an end. That is exactly what Milton Friedman thought about the Great Depression.

Yet when it comes to fiscal policy, it seems people suddenly take a different view. Some ‘neutral’ path for government spending and taxes is defined, and only if they differ from these paths do we say fiscal policy made the recession worse. Has austerity reduced UK GDP by 2.5%, as the IMF suggest, or by 1.4%, as the OBR suggest? But this asks the wrong question. The right question is why has fiscal policy not been used to help end the recession. That is the question Keynes posed in the General Theory following the Great Depression.

The moment that monetary policy hit the zero lower bound, fiscal policy should have been used to first limit the size of the recession, and then bring the recession to an end. The former happened under the previous Labour government in the UK and Obama in the US, and it worked. My quarrel with what happened afterwards is not that fiscal policy was restrictive compared to some neutral path, but that it did not continue to do whatever was necessary to sustain the recovery. Quite simply, when monetary policy could no longer do the job, fiscal policy should have taken on the stabilisation role. [1]

I’m reminded of this point by Robert Chote’s letter to the Prime Minister. Stephanie Flanders says that “in the most important arguments with Labour - over the role of austerity in thwarting recovery, and the scope to boost growth in the short term with higher borrowing - the OBR is still on the coalition's side.” If you were to take from this statement that the OBR had sided with the government on the policy debate over austerity, then I think you would be dead wrong. 

Why do I think you would be dead wrong? Why I am pretty sure that the OBR have never said anything about ‘the scope to boost growth in the short term with higher borrowing’ in such an unqualified way? I can be pretty sure of this, because the OBR are not allow to examine alternative policies to those of the government. So they cannot take sides in the way suggested. [2] I know this because, when the OBR was set up, I argued strongly - with Treasury officials, the Treasury Select Committee and others - against this restriction on what the OBR can do. (The argument is set out here.)

While I disagree with this restricted OBR remit (which I hope will change in time), it does have a silver lining - it allows the OBR in its infancy to focus on the other things it has to do, and avoid getting sucked into a political debate. It is unfortunate that Stephanie Flanders in this post suggests the OBR is taking sides on policy when its mandate precludes it from doing so. [3]

Often the questions we ask are more revealing than the answers we give. Questions like “was it the Eurozone crisis rather than fiscal policy that really caused the UK double dip”, or “is the weak US recovery down to greater uncertainty or restrictive fiscal policy”, or “budgets were in surplus in Spain and Ireland before the recession so what more could they do” in my view miss the point, much as the statement “it was oil prices rather than monetary policy that caused 1970s inflation” would miss the point. Whatever shocks have caused weak demand in this recession, if monetary policy is constrained, fiscal policy should be trying to offset these shocks. [4] In these situations, the presumption should be that fiscal policy is countercyclical. If it is not, that is a failure of policy. The driver is falling asleep at the wheel.

[1] Inflation could well have been higher for a while as a result, but as I argued here for the UK, that would have been an acceptable cost.

[2] They can of course comment on the scope for additional borrowing while maintaining the government’s fiscal mandate, but that is quite a different thing.

[3] I hesitate to suggest that such a good journalist as Stephanie Flanders might have been misleading here, but I'd also hate to think she was only criticised from one side, and hopefully I'm being a little more polite. In addition,  when the government criticised her for not celebrating the slow growth in UK productivity, she was of course completely right and they were completely wrong.

[4] Of course I also understand that fiscal policy can be incapacitated just like monetary policy can be. If you cannot sell government debt, or interest rates on that debt are high and rising, then debt financed fiscal expansion is just not possible. But fiscal policy is potentially a lot more flexible than monetary policy: there is balanced budget fiscal expansion, or changing the tax mix to create intertemporal incentives. If monetary policy cannot do the job, fiscal action is second best, but it is a quite versatile second best.