In a tutorial somewhere in Oxford, where students are about to start a new year, having just finished learning the macro part of first year Principles.
Q: Before we start, can I ask you a question about the macro we learnt last year?
A: Of course.
Q: In the basic model, if interest rates stay constant, a fiscal contraction reduces demand and output in the short run, right. And governments around the world, including the UK, have been tightening fiscal policy because debt is too high. So they will reduce output in the short run, making the recession worse?
A: That is right. Their argument would be that they have to do this, because the costs of allowing debt to rise are greater. Their critics say that, at least for countries with their own central bank where there is no funding crisis, this risk from higher debt is virtually non-existent.
Q: But over the summer the UK economy has started to recover, and George Osborne says that this proves that his critics are wrong.
A: Well he would say that, wouldn't he? But the important thing is that you understand the macroeconomic analysis, and not get distracted by what politicians may claim.
Q: But you also told us at the start of the course that we should read the Financial Times to get an informed view of current economic developments.
A: I do remember that, yes.
Q: In their leader of 10th September 2013, the headline is “Osborne wins the battle on austerity”. So the ‘informed view’ is that George Osborne is right, and the recovery does prove his critics are wrong.
A: Are you sure that is what the editorial says?
Q: Yes, I’ve got a copy here. It says “an alliance of Keynesian economists and the Labour opposition has accused the government of choking off growth. The prophets of doom predicted years of stagnation with soaring unemployment and falling living standards. After a run of positive economic data, Mr Osborne has reason to feel vindicated.”
A: But it then surely goes on to say that a recovery is quite consistent with the critics who said austerity would reduce output in the short term?
Q: No, it basically says the recovery shows Osborne is right and his critics are wrong.
A: Hmm, that is odd. Let’s think what the basic model says. Fiscal contraction will reduce output in the short run. But what happens in the longer term?
Q: Well, in the medium run output is determined from the supply side. So as long as the economy is not hysterical and the recession does not affect supply then fiscal contraction will not influence output in the medium term.
A: It’s hysteresis, but otherwise yes. So what must that mean for economic growth once the ‘short run’ is over?
Q: Well, if the medium term level of output is unaffected by fiscal contraction, but output in the short run is lower, then that must mean output growth will subsequently be higher than it would have been without fiscal contraction.
A: Quite. And what do we know about how the UK economy had been doing in the years before the recovery began?
Q: I think it was the longest ever UK recession, with UK output hardly increasing since 2010. Unemployment stayed high, and living standards have taken a big hit.
A: Except maybe not for FT leader writers. So everything has been entirely consistent with the basic model, and with what critics of austerity who used basic macro said would happen.
Q: I guess that is why the editorial says “The anti-austerians grumble that the upturn would have come earlier had Mr Osborne eased up on the fiscal squeeze.” But then it says “this is impossible to prove as economic history offers no counter-factuals.”
A: To be honest, I’ve no idea what that means. But I can tell you that the empirical evidence that fiscal multipliers are positive is overwhelming, and also that they are larger when monetary policy finds it difficult to offset the impact of fiscal policy. Did the editorial not mention this?
Q: Nope. Instead it says “What we do know, however, is that the chancellor’s critics overstated the obstacles standing in the way of a recovery. Their position was too extreme and they have found themselves snookered.” So who were these critics?
A: I have no idea, but I doubt they were academic economists, who would obviously know about the basic textbook model you have been taught. I must say this editorial looks more like something that was drafted by one of George Osborne’s speech writers than anything written by a journalist with an economics training.
Q: Perhaps the FT does not believe in the textbook model you have taught us?
A: That would surprise me a lot. The model has been taught to students for half a century, and is accepted by the clear majority of academics. It is what central banks use when they try and stabilise the economy. It would be odd if the world’s top financial newspaper started taking a different view.
Q: So should we still be reading the Financial Times to get an informed view of current economic developments? Perhaps we should be reading editorials in the Wall Street Journal instead?
A: Oh god no! But I shall clearly have to reconsider my advice. Perhaps it’s time to try something else. I’ve heard there are quite a few good economics blogs these days.