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. 
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.  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. 
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.  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.
 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
 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.
 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.
 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.
In it you use the 'K' word, and of course with those currently in charge there is no way they can adopt anything resembling a fiscal response to the ongoing economic problems for the following reasons:
>It would run so strongly against their ideological stance and revulsion of Keynes.
>Would be an admission of the incorrectness of their austerity policies to date, and
>Would be detrimental to the attainment of their real and over-riding goal of a much smaller state;for which the financial crisis and the austerity policy is being used as the means of achieving this aim.
"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."ReplyDelete
Or to put it another way:
Fiscal should be used to give monetary its moxie back.
Sure, the Fed acts last, but it acts under constraint.
Why have you downgraded the requirement for counter cyclical fiscal policy at the zero lower bound to a presumption?ReplyDelete
>The right question is why has fiscal policy not been used to help end the recession.ReplyDelete
Because it would require either higher taxes or higher inflation.
Job creation without higher government spending: http://jobcreationplan.blogspot.com/
Prof Simon, Whence your assumption that fiscal stimulus should only be employed at the ZLB, i.e. when monetary policy cannot do any more?ReplyDelete
Monetary policy, i.e. cutting interest rates, DISTORTS the economy towards borrowing and lending and investment. Given that the recession was caused by excessive and irresponsible borrowing, to encourage borrowing is crazy, unless there is evidence that monetary policy works much faster than fiscal. Is there any such evidence?
Agreed, Ralph. Low interest rates seem to do more harm than good. I believe there is benefit in monetary policy that favors the saver. Interest income is solid stimulus, especially when politicians oppose fiscal stimulus.Delete
We could assume that a pre-crash problem was that there was more credit than good investment vehicles to carry it, and so the credit went to bad investments (i.e. houses). However, after the financial crash it is reasonable to think that a drastically reduced credit supply might become smaller than the demand for good quality investments. In this case stimulating credit and more borrowing would be beneficial.
We could add to that with the huge British household debt, reducing the pressure on the public's troubled finances is beneficial to keep their heads above water.
You're killing me, Simon.ReplyDelete
The BoE *did* keep interest rates at "pre-recession levels" through the first two quarters of recession (Q2 and Q3 of 2008). In Q3 of 2008 the quarterly fall in nominal GDP was the third worst on record and Bank Rate was at or above 5% every single day.
But that is excusable since forecast inflation was generally on target.
In the third quarter of recession (2008 Q4) the BoE consistently kept Bank Rate above the rate consistent with keeping forecast inflation on target; short term inflation expectations crashed well below zero (two year RPI breakevens were nearly -1%, yes negative, at the start of December).
The MPC specifically used the expected fiscal expansion as an excuse not to cut the rate further in November, but were also worried about their precious hawkish credibility having allowed the CPI rate to hit 5%.
Should we say monetary policy made the recession worse? Really, the fact that anybody has to ask is what is shocking.
I meant to also troll you on fiscal policy, which would at least have been on topic trolling rather than my usual fare... sorry.ReplyDelete
Fiscal policy - "counter-cyclical targeting the forecast and closing the output gap version".
March Budget 2010: Output gap in 2014-15: -1.9%
June Budget 2010: Output gap in 2014-15: -1.6%
In fact the output gap is lower in every single year of the forecast period in the June Budget versus Darling's March budget. Is there a better choice of the impact of fiscal policy?
So we can all celebrate, at least fiscal policy was not tightened in the June 2010 budget, am I right?
'In my column on Cameron's speech, I made the following comment: "The idea that treatment is right irrespective of what happens to the patient falls into the realm of witch-doctoring, not science. Moreover, this is true even if unexpected shocks caused the disappointing outcomes. Fiscal policy is one of the tools available to respond to such shocks." So we are saying the same thing, I believe.'ReplyDelete
I am supposing that Stephanie Flanders' point about the "affiliation" of the OBR was made with full knowledge of the limits imposed by the organization's remit.ReplyDelete
Though opinions on the shape of Robert Chote's ego and political preferences can vary, having watched testimony of his in front of the Treasury Committee and understanding the natural reluctance to give a completely disinterested reckoning of one's rather egregious forecasting errors, I think his leanings are rather clear and that Ms. Flanders' point stands.