Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 17 July 2013

What Recession?

Tony Yates thinks there should be no more [sic] fiscal stimulus in the UK, because inflation is above target. As inflation is above target, there is no need to stimulate demand. Tony accepts that in principle at the ZLB fiscal stimulus can be a useful expansionary instrument, but in the UK at the moment it is not required.

So here is a table of CPI inflation in a few countries.

CPI Inflation rates (source: OECD Economic Outlook)

2007
2008
2009
2010
2011
2012
2013
2014
United Kingdom
2.3
3.6
2.2
3.3
4.5
2.8
2.8
2.4 
United States
2.9
3.8
-0.3
1.6
3.1
2.1
1.6
1.9
Euro area
2.1
3.3
0.3
1.6
2.7
2.5
1.5
1.2

The inflation target in the UK is 2%. So not only is there no case for any stimulus going forward, it also looks like the UK managed to completely avoid any recession in 2008/9! The US also had a small boom in 2011, and who knows why people in the Eurozone feel so depressed?

OK, this is a cheap point, but a valid one nevertheless: CPI inflation is a pretty hopeless indicator of the output gap when inflation is low. Other inflation measures do a bit better: here is the GDP deflator at basic prices.

UK Inflation: source ONS


Some of the low growth in the GDP deflator is because of low inflation in the government consumption deflator, and we know this is difficult to measure. However I’m not trying to argue that one index is better than another. Instead I just want to make the point that at low levels of inflation, inflation itself becomes a very unreliable measure of the output gap. This is true not just in the UK, as the IMF recently pointed out

One reason why UK inflation has not fallen further is UK labour productivity, which I have discussed before. Now if the decline in UK productivity growth was an irreversible supply side phenomenon then you could indeed argue that the current UK output gap was small (but not zero - see below), but is this remotely plausible?

Here is a chart of (logged) UK GDP since 1950. [1] I’ve added a trend line not because I believe productivity growth is always constant, but just so the following point becomes clearer. GDP growth does sometimes fall sharply: in 1980, and in 1990. But both these occasions were demand induced recessions. To argue that 2008/9 is different means that something quite extraordinary and unprecedented has happened. Now maybe that is possible, but given the costs of being wrong about this, we have to be pretty certain of your story to base policy on it. 


UK GDP, logged. Source - see [1]



So let us look at something we can measure with reasonable accuracy: unemployment.


UK Unemployment Rate: ONS

The increase in unemployment since 2008/9 is modest given the output fall - productivity again - but it is not small. I have heard no one argue that this increase in unemployment represents an increase in the NAIRU or natural rate. To the extent that low real wage growth has encouraged substitution from capital to labour, unemployment underestimates the extent of the output gap. (If unemployment continues to fall at the same rate it has over the last year - a rate the Employment Minister describes as encouraging - we should see a return to pre-recession levels sometime after 2025.)

So it seems to me that we are sitting in a freezing house, but because the thermostat says it is still warm, its occupants are trying to convince themselves that they are not really feeling cold, and the last thing they want to do is turn up the heat. (I admit not the best of analogies for the UK right now.) Just because we build models in which inflation always responds in a predictable and linear way to the output gap, does not mean that the real world behaves in the same way.

[1] I’ve spliced the recent ONS data revision from 1998 on to a time series from Lawrence H. Officer and Samuel H. Williamson, 'What Was the U.K. GDP Then?' MeasuringWorth, 2012.


2 comments:

  1. From memory, it was the Swedes in the 1930s who originally used an inflation target, but it was brought into common use first in New Zealand in the 1980s under Roger Douglas, from where it spread to most other (all?) western nations.

    Robert Shiller in his New Financial Order (2003) did a search of English language newspapers and found that 'inflation' was the most used economic word, apparently used even more than the word 'sex'.

    If Akerlof (2000) is right, then money illusion operates at low levels of inflation, and one-for-one inflation at levels, say, of 6-7% and higher. That gives plenty of scope for the Krugman 4% inflation target, and maybe even 4-6% band aiming at 5%.

    ReplyDelete
  2. Please note that the model of the economy featured on website www.economyuk.co.uk predicts that the unemployment rate will rise slightly over the next year or so. Note also that in this model it is not assumed that inflation always responds in a predictable and linear way to the output gap ! Inflation is computed as a function of a number of variables and to date the model has consistently predicted with a fair degree of accuracy the actual inflation behaviour of the uk economy.

    A research economist

    ReplyDelete

Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time.