What does the now sustained recovery in the UK and the still tentative signs of recovery in the Eurozone tell us? According to some on the right, it says all is good in the world, austerity has been successful and we need to stay the course. According to some on the left, the recovery is not real, and anyway it is all because there are more people, or because of a house price bubble.
First austerity. As I have said many times, the current recovery tells us nothing about austerity. In the UK austerity helped delay the recovery by three years. We can argue about how much of the stagnation of 2011 and 2012 was due to UK austerity and how much to the Eurozone (austerity somewhere else), but no serious economist would argue with the statement that both played a significant part in delaying the recovery. That is why I wrote this over a year ago.
In the Eurozone austerity helped create a second recession. Here we can argue about the relative contributions of fiscal policy and inept monetary policy, but again no serious economist would disagree that austerity played a major role. Model based estimates suggest Eurozone GDP was around 4% lower in 2013 as a result of fiscal consolidation, and this restrictive fiscal policy was not confined to the periphery.
In the UK austerity was put on hold in 2012 and 2013, which helped allow the recovery in 2013 (see my April Fools day post or this from Jonathan Portes). However suspending austerity did not create the recovery, which was mainly down to lower consumer saving. This reduction in saving may have happened anyway, but both Funding for Lending and Help to Buy will have lent a helping hand. In the Eurozone austerity has continued. That will be a drag on growth, but it alone is not enough to prevent a recovery as consumers rebalance and monetary conditions in periphery countries ease a little.
|Underlying Primary Balances according to OECD Economic Outlook Nov 2013
What about the counter argument that the recovery is not real, or not sustainable. In some ways this rhetoric is worse than the ‘austerity works’ line: it is also wrong, but it is much less likely to succeed as rhetoric. The fact that growth in output per person (GDP per capita) is less impressive that GDP growth alone does not detract from the recovery because, in a demand led recession, population growth does not automatically cause GDP growth. Recoveries are often led by consumers, but as long as investment follows on and average incomes begin to rise then a recovery will become sustainable. The rhetoric will not work because, despite the unequal and uneven nature of the recovery, many people do feel more optimistic now than two years ago. It is much better for critics of the government to focus on the ‘wasted years’ of 2010-2012, and on the fall in median incomes (pdf) over the last five years. If they want economic issues for today and tomorrow, focus on inequality.
Does this mean that the macroeconomic debate (as opposed to the political debate) over fiscal policy is over? Here we should go back to basics. Tightening fiscal policy reduces output, and fiscal stimulus increases output, when interest rates are at their zero lower bound. So until interest rates start rising, austerity will still be a drag on growth. The macroeconomics says recovery could be quicker without austerity. But from a practical policy point of view, the influence of this basic logic on what politicians do seems as remote as ever.
So for me the interesting question on austerity has changed. Although it is occasionally necessary to go over the macroeconomic logic yet again to counter the rhetoric I discuss above, what I find more interesting is why policymakers did the wrong thing from 2010 onwards, and what lessons for the future that implies. Was it all an unfortunate consequence of Greek profligacy? Is it down to the influence of the financial sector, and is this a result of mistaken beliefs or vested interests? How do we avoid this happening again? One obvious answer is that we must start the next liquidity trap recession with lower levels of public debt. But even if we did, is that going to stop those ‘close to the markets’ insisting on the dangers of the large deficits and rising debt that are the inevitable result of a recession, and then go on to insist that we need fiscal contraction to avoid a funding crisis? If the answer is no, how can we immunise politicians from such calls?
Of course, just because the recovery and its development tells us little useful about austerity does not mean it is uninteresting - at least for a macroeconomist. For me a really big question for the next year or two is what will happen to inflation, particularly in the US and UK. This has not always been the case. From the start of the recession until recently consumer price inflation has been a misleading distraction. One of the clear lessons from recent history is that a focus on consumer price inflation when there are various temporary supply side shocks is dangerous. It led the ECB to raise rates just before a recession, and it almost led to higher rates in the UK. Monetary policy makers really should reflect on why they were distracted in this way.
In the absence of similar distractions in the future, inflation should become a better indicator of just how fast the recovery could potentially be - of how much spare capacity there is available. Yet the exact relationship between this spare capacity and inflation remains mysterious. Most theories say that inflation should remain below target if the economy is below trend, but should inflation be rising or falling? There are some (old and new) theories that suggest that inflation could become disinflation even though the economy is growing reasonably well. Given this uncertainty, for a macroeconomist what happens to inflation over the next year or two will be really interesting.
To sum up, the recovery is welcome: it is not an illusion, but neither does it atone for the sins of the past. Above all else, it must not lead to complacency. We have still a long way to go to repair all the damage caused by the recession. Even when that has been done, the problems that led to the financial crisis have not been fixed. With inflation targets still at 2%, and perverse fiscal responses, we remain dangerously vulnerable to any future large negative demand shock.