Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday 26 March 2014

It’s the economics, not the politics

A reflection on rereading an old paper

Regular readers will have noticed that I’m not a great fan of the current government’s economic policies, or its Chancellor (with the very important exception of setting up the OBR). Some will assume that this reflects a political bias - indeed those who are political animals often cannot conceive that everything is not politically driven. If you are looking for evidence either way, this post is about that.

Yesterday I received an email advertising ‘The Economics of Austerity’, which is a collection of essays published by Edward Elgar and chosen by Suzanne Konzelmann. There are 47 in all, but as this includes pieces by Hume, Smith, Ricardo and Mill, you can see that this collection aims to give a historical perspective on the subject. To be honest the email might have got lost in my in-tray if I hadn’t noticed it started ‘Dear Contributor’. Sure enough, in the eight essays dealing with the period after the financial crisis, there was my name alongside others, including some guy named Krugman.

I should have been flattered, but instead my heart sank. The selected paper was originally published in OXREP in 2010, and I remember it now as being hopelessly optimistic. It was written before the Euro crisis, so before austerity became almost universal. Little over a year later I wrote a paper with the title ‘Lessons from failure: fiscal policy, indulgence and ideology’, which seems much more appropriate in the current environment. Yet I thought I ought to reread my OXREP article, to confirm just how dated it had become.

Actually it really is not that bad. The key points are still things I believe. The financial crisis was primarily a crisis involving financial regulation rather than monetary policy or global imbalances. The idea that the Great Moderation was due to improved monetary policy was sound, but it always came with a caveat involving large negative shocks, because of the zero lower bound (ZLB). The ZLB could be mitigated using what I now call a ‘forward commitment’ to higher future inflation, but time inconsistency would make central banks reluctant to pursue that. The obvious alternative was expansionary fiscal policy. If concerns over debt where a constraint, then an effective measure was balanced budget increases in government spending.

This last point is so important, yet it can get lost in the debate. If you want to plug a demand gap at the ZLB, temporary increases in government spending financed by temporary increases in taxes work, because a lot of the tax increase comes out of saving rather than consumption. As the tax increase is temporary and only happens while there is widespread unemployment, concerns about the incentive effects of higher taxes on labour supply are at worst irrelevant. This is basic macroeconomics. But then I wrote this:

“The main problem with fiscal measures to expand the economy which do not raise debt is political. Higher government spending, even if it is temporary, raises taxes and temporarily increases the size of the state, which is unpopular on the right of the political spectrum. Fiscal transfers that move money from unconstrained savers to those who are credit constrained also tend to involve transfers from the rich to the poor. Although useful from the point of view of stimulating effective demand, they may not be politically acceptable.”

Quite. What was missing was an equivalent paragraph saying that, even if there was no economic problem with raising debt, debt financed fiscal expansion might be resisted for political reasons. However, I now want to return to where I started. The OXREP paper was written before the current coalition was elected. It set out how I saw the macroeconomics. At the ZLB you could use unconventional monetary policy, but in addition you should use fiscal stimulus, whether debt was a constraint or not.

It was politics - and ideology - that got in the way of good macroeconomics, which is why the UK and global recession has been so prolonged. And it is that tendency that is personified by George Osborne. Even if debt was erroneously thought to be a constraint, we should have had tax financed increases in public investment rather than cuts. This extra investment could have been on politically neutral things, like flood defences.

Unfortunately austerity turns out to be part of a pattern. There is another example from the OXREP paper. When talking about an environment of low real interest rates, I noted the danger of housing bubbles, but also how specific fiscal instruments could be effective (relative to raising interest rates) in dampening these bubbles. A corollary, of course, is that these same instruments used in reverse can be used to make bubbles much worse, or indeed to initiate them, as in Help to Buy. House prices are now above their previous 2008 (bubble?) peak. Maybe this is good politics, but it is lousy economics.

So I do not think the complaint of political bias stands up. What you could perhaps argue is that I’m being politically naive: that all Chancellors maximise political advantage at the expense of national economic interest. The fact that Gordon Brown’s scorecard seems much better (including resisting Blair to stay out of the Euro) could just reflect opportunities and circumstances rather than anything else. It is certainly true that the position George Osborne inherited, as a result of the financial crash, was much more difficult than Brown’s inheritance. But go back to the time I wrote the OXREP article. At the end of 2008 Labour did undertake fiscal expansion, and it was opposed by Cameron and Osborne. As I noted here, Osborne in April 2009 argued that monetary policy should “bear the strain of stimulating demand”, seemingly oblivious to interest rates being as low as they could go. So Labour’s policy was consistent with the arguments in my OXREP article (which in turn reflected basic macroeconomics), while Conservative policy just ignored them. 

So thank you Dr. Konzelmann, for including me in such good company. But also thank you for making me reread the paper and revise my memory of it. [1]

[1] I fear I cannot also thank the publishers, who tell me that unfortunately I cannot have a complimentary copy, because of the large number of contributors. I’ll leave it to Hume, Smith, Ricardo and Mill to complain directly. I guess Keynes, who has 5 essays in the book, probably got a copy!


  1. Ah, it's fun to rewrite history to give it that "Keynesian" bias.

    At the time the 2008 fiscal stimulus was announced, Bank Rate was at 3%, not 0%. Is it now "basic macroeconomics" to do fiscal stimulus with interest rates at 3%, or do we need a bit more nuance there?

    Cameron's speech to the CBI on the evening of the PBR specifically called out his support for "monetary activism" as an alternative to fiscal stimulus. Cameron explained "monetary activism" as lower rates plus credit easing. The former is hardly anti-Keynesian, the latter is certainly an idea embraced by many New Keynesians from Prof Woodford down.

    But of course Cameron was "ignorant" of basic macroeconomics in opposing fiscal stimulus in 2008, sure. In 2009/10 Osborne's approach to macro was broadly similar to that of Mervyn King, another ignorant nobody who knows nothing of "basic macroeconomics". It is a wonder these people ever get into a position of power.

    1. I think by late 2008 many people could see what might be coming - and Darling and the Treasury should get your praise for doing so. The MPC were still worrying about inflation! In my OXREP paper I talk about why fiscal stimulus may be needed if there is a significant chance that we might hit the ZLB.

      The speech by Osborne I referred to

      (old link to speech broken - this one works:

      was to the RSA in April 2009, when interest rates were 0.5%. Zero lower bound or liquidity trap not mentioned!

      I never said Cameron was ignorant. He chose to ignore basic macro. I do not know what Mervyn King would have thought about a tax financed increase in public investment, but I know it did not happen under Cameron/Osborne.

      So how exactly am I rewriting history? And I'm afraid fiscal tightening reducing output at the ZLB is basic macro!

    2. Your post is pretty clear. Basic macro says fiscal stimulus at the ZLB. Cameron opposed fiscal stimulus in 2008. Ergo Cameron ignores basic macro, QED. You clearly want to make the link between the stimulus and being at the ZLB with that quote from Osborne, and it is revisionist because Bank Rate was 3% at the time of the stimulus.

      Cameron's CBI speech (I only have a broken link to hand, annoyingly) on the day of the PBR was calling explicitly for lower interest rates, which was a reasonable and "Keynesian" way to call for more stimulus.

      "I think by late 2008 many people could see what might be coming"

      This is a more nuanced argument, but the 2008 PBR itself contains no reference to the ZLB or a Keynesian liquidity trap, and as you say the MPC itself kept Bank Rate high enough to get that CPI rate coming down, so it is not clear who the "many people" are unless they were all called Danny Blanchflower.

  2. correct too thank you

  3. Simon,

    You claim “It was politics - and ideology - that got in the way of good macroeconomics…”. I suspect the problem was to a significant extent incompetence by economists: in particular the economists advising Osborne.

    The root problem is the tendency by everyone to equate national debts with microeconomic debts, like debts of a household or firm. The two are in fact chalk and cheese.

    You can’t blame politicians for not understanding the difference: most of them haven’t got a GCSE in economics. But one would hope economists in the Treasury could explain to Chancellors of the Exchequer that there is little difference in nature between national debt and money (monetary base to be exact).

    One would also hope that Treasury economists understand the point that if government borrows £X and spends it, and the BoE then QEs the relevant debt, then it is totally absurd to regard the relevant Gilts in the hands of the BoE as a debt of any sort. They are effectively just a book-keeping entry corresponding to a chunk of base money in the hands of the private sector. And that book-keeping entry is of no economic significance whatever.

    Unfortunately to judge by some of the nonsense we get from the economics profession on the subject of deficits, national debts, etc, I don’t have much confidence that Osborne gets good advice from Treasury economists.

  4. Another excellent post which highlights the absurdness of perhaps one of the most ideologically driven governments the UK has known...dismissing fiscal stimulus as an option when interest rates were being slashed, but more importantly continuing to do so through 2009-2012 at the ZLB when monetary policy was having little/no impact makes no economic sense. But its not about the economy and economic sense with Osborne and Cameron is it.

  5. I haul this from the BBC's archive, Stephanie Flanders 1 February 2011 blog:

    "If you heard my interview on the Today programme this morning (0840) you'll know that Larry Summers declined to make any strong predictions about the UK…but Summers allowed more content to slip into his assessment of the government's case for rapid budget cuts…in his view, we are in - or close to - what J M Keynes called a ‘liquidity trap’, in which there is a near infinite demand for liquid assets, and monetary policy is largely ineffective, because interest rates cannot fall any lower, and businesses and consumers want to save, not spend. In these extra-ordinary circumstances, he thinks that the usual rules do not apply, and fiscal policy has to step up to the plate to support demand. The implication is that the coalition is indeed taking a risk with the recovery, and putting their deficit targets at risk as well. Because, if Summers is right, the private sector may well not come to the economy's rescue: growth will be lower than forecast - and borrowing is likely to be higher.”

    I see that David Runciman has a book out called 'The Confidence Trap: A History of Democracy in Crisis from World War I to the Present'.

    From liquidity trap to confidence trap: what an unpleasant journey.

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  7. To stimulate consumption you do not have to increase the size of government, you could also redistribute stronger. The "rich" do not invest their savings in a recession, but the "poor" will mostly use the additional money for consumption, which would stimulate the economy. I wonder why this option is never discussed, am I overlooking something as a non-economist?

    Hard to say whether the right would object stronger to larger government or to more redistribution.

  8. Great stuff on "It’s the economics, not the politics "Bedrijfsovername & MBI & Bedrijfsopvolging


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