Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 5 May 2014

Central bank advice on austerity

As I wrote recently, the economic debate on the impact on austerity is over bar the details. Fiscal contraction when interest rates are at their zero lower bound is likely to have a significant negative impact on output. Of course the popular debate goes on, because of absurd claims that recovering from austerity somehow validates it. Next time you get a cold, celebrate, because you will feel good when it is over! Which means more articles like this will have to be written.

An interesting question for an economist then becomes why austerity happened. There are some groups who have a clear self interest in promoting austerity: those who would like a smaller state, for example. While arguments for ‘less government’ are commonplace among the more affluent in the US, in Europe there is much less natural antagonism to government. As a result, as Jeremy Warner said, you can only really make serious inroads into the size of the state during an economic crisis. Large banks also have a direct interest in austerity, because they need low debt to make future bank bailouts credible, enabling them to carry on paying large bonuses from the implicit state subsidy that this creates. So, from a cynical point of view, for this and other reasons those close to finance will always talk up the danger of a debt funding crisis just around the corner.

However there is a large middle ground who genuinely believes austerity was required to prevent the chance of a funding crisis, particularly after Greece. Yet Quantitative Easing (QE) fundamentally changes this. If the central bank makes it known that QE drastically reduces the chance of a debt funding panic, and anyway they have the means to offset its impact if it occurred, any contrary advice from the financial sector might be defused. The middle ground might be persuaded that fiscal stimulus is possible after all.

Now this was never going to happen at the ECB. It takes every opportunity to promote austerity. It took two years of continuing crisis to get it to introduce OMT. I do not follow the US closely enough to know what, if anything, the Fed said about the impact of QE on the prospect of a bond market panic, but I do know Bernanke was not afraid to warn of the dangers of excessive austerity in his final days in charge of the Fed. Which brings us to the UK, and the coalition agreement of 2010. The Conservatives may well have advocated their austerity programme whatever the Bank of England had said: it was a golden opportunity to reduce the size of the state. However their coalition partners, the LibDems, had campaigned on a more gradual deficit reduction plan similar to Labour. Mervyn King’s advice during this period is often credited with helping persuade the LibDems to accept the Conservatives’ proposals. (See, for example, Neil Irwin, or for more detail Andrew Lydon).

So why did King advocate austerity, rather than telling politicians that with QE in place, a funding crisis was both much less likely and less damaging. We may get a clue from something recently published by the Bank, as part of its stress test scenario for UK banks (HT Britmouse). The application is to 2014 rather than 2010, but it may still indicate what the Bank’s thinking might have been four years earlier. It talks about “concerns over the sustainability of debt positions” leading to a “sharp depreciation in sterling and a build-up of inflationary pressures in the UK.” As a result, monetary policy is tightened and long term interest rates rise - presumably because QE stops.

In one of my first blog posts two and a half years ago I wrote that “austerity is not even a sensible precautionary policy when we have QE”. Does this scenario give me cause to doubt that verdict? It does not, for two reasons. First, what makes a funding crisis so scary when you cannot print your own currency is that it is a bit like being blown off a cliff. Once interest rates start rising because of fears of default, this in itself makes default more likely. We have a clear nonlinearity, such that it may become too late to retrieve the situation once the process begins, as periphery Eurozone countries found out. Depreciation in the exchange rate when rates are floating is not like that. The further the exchange rate falls, the more attractive the currency becomes, because trade in goods ties down the medium term level of the currency.

The second reason why a loss of confidence in a currency is not like a debt financing crisis is that the former cannot force default, whereas the latter can. That makes all the difference. Without QE the markets have to worry about what others in the market think. The government may not intend to default, but if they cannot roll over their debt, they do not get that choice. With QE the government cannot run out of money, so the markets no longer need to worry about a self-fulfilling market imposed default. All that matters is what the government will do, and there was never any serious chance that the UK would default on its debt whoever won the election.

However it is possible to see why the Bank might still have worried in 2010. Output had only just stabilised after the worst recession since WWII. They wanted to keep interest rates as low as possible to help a recovery. Yet inflation was more than 1% above target, partly as a result of the depreciation of 2008. The MPC believed their remit was to target 2% inflation two years ahead. If sterling had fallen further, they would have found it very difficult not to raise rates. Yet Mervyn King would not have wanted to go down in history as the Governor who raised rates during the depths of a recession.

I think this says a lot about whether we had the appropriate monetary policy framework. (For further discussion of the economics see this post and links therein.) But my main point is this. It is all speculation, because as far as I am aware the Bank said very little officially. The Governor let his views be known in private, and publicly endorsed the government’s austerity plan after the election (much to the annoyance of some MPC members), but there was no open debate about the issues. The Bank could have initiated this debate, but chose not to.

So when the next recession hits, and interest rates go to zero and budget deficits increase, will anything be different? The central bank is in a position to make it clear what the risks of a market panic really are when QE is in place - indeed you could say that it has a responsibility to do that. Or instead it can publically argue that it still has all the tools it needs to manage the economy, and advocate austerity in private. Mervyn King once said (pdf) “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.” Is this always going to be the case? 


  1. «Large banks also have a direct interest in austerity, because they need low debt to make future bank bailouts credible, enabling them to carry on paying large bonuses from the implicit state subsidy that this creates.»

    There is a much better reason related to executive compensation than that, and applies to all businesses, not just to banks.

    Executive compensation is composed largely of bonuses/prizes dependent on improvements in some quantity, like sales or profits, starting from some absolute baseline.

    Resetting the baseline downwards periodically makes it much easier to show substantial improvements from a baseline that has been reset to low.

    In the financial industry for example compensation amounts to 50% of net earnings, most of that 50% going to executives and traders. what do you think is preferred by them over 10 years as a series of earnings on a capital base of say 100?

    A) 15 15 15 15 15 15 15 15 15 15 => total 150
    B) 25 25 25 25 25 25 25 25 -40 -40 => total 120

    In the case A bonuses total 75, in the second 100... In case B the two years of huge losses almost wipe out the capital of the company, but the government stands ready to refill it and the bonus pool.

    Also in case B it is much easier in the next 10 year period so show improvements over a much reduced baseline.

    Executives and traders in financial industries or nor understand very well that their compensation is proportional to the volatility of the underlying business, and that periodic resets of the baselines make hitting targets so much easier.

  2. «Once interest rates start rising because of fears of default, this in itself makes default more likely. We have a clear nonlinearity, such that it may become too late to retrieve the situation once the process begins, as periphery Eurozone countries found out.»

    Our blogger is probably thinking of Michael Pettis' masterpiece on this subject, "The volatility machine" which I think is pretty much essential reading.

    Too bad that it is largely in the "institutionalist" tradition instead of the "New Keynesian" one :-).

  3. On the austerity vs. exchange rate vs. inflation topic I think that the position of the Bank of England may be hard to understand without looking at the usual graph of UK oil exports and imports:

    It is the great "misfortune" of the UK that the end of oil exports and the beginning of huge oil imports happened much at the same time as a quadrupling of oil prices and a major recession.

    The misfortune is that the fall in oil production is a massive reduction in the *real* resources available to the UK economy, and thus, on its own, to the real standard of living of the UK.

    Instead of receiving real resources from other countries in exchange for oil exports, the UK now must export real or financial (London house deeds for example) resources to buy oil.

    That is worth quite a few GDP percentage points.

    The decision of the establishment has been to cut the average standard of living of UK residents by 10-20% (depending on how to measure it), and to charge the cuts mostly to the median income and lower income residents, especially those with smaller endowments of property, because they are "improductive", while protecting and boosting the incomes of the upper income residents (the City and professions and managers) especially those with larger endowments of property, because they are "productive".

    Austerity has been the means to achieve this asymmetric repurposing of shrinking resources. Indeed median and lower standards of living have been reduced over the years by 10-20%, mostly by letting both asset and goods and services inflation rush ahead while strict fiscal policies kept median and lower incomes constant in nominal terms.

    I do agree that with the end of oil exports and the quadrupling of oil prices and the global recession the average UK standard of living had to come down; but the main impact might not have been on median and lower income residents.

    Then let's note that UK policy has been to have only half austerity: fiscal austerity, but not monetary austerity, which is is in the best "New Keynesian" tradition, the one that teaches that:

    * neoclassical microfoundations show that unregulated markets deliver the optimal real resource allocation and distribution of income;
    * inter-temporal demand misallocations due to nominal price rigidities drive the economy to a suboptimal equilibrium below full employment;
    * to stabilize the economy back onto the optimal equilibrium with the best distribution of income determined by unregulated markets, interest rates should be reduced to boost asset prices relative to money, so that the stronger balance sheets of the productive wealthy induce them to spend more, and that "trickles down" to the unemployed;
    * therefore only monetary policy is needed to stabilize the economy on the optimal equilibrium, and fiscal policy only has distortionary effects that prevent the achievement of full employment.

    Some relevant quotes:

    * “fiscal conservatism and monetary activism”
    * "What New Keynesian theory does need is that falls in real interest rates stimulate aggregate demand [ ... ] What explains cyclical unemployment is real interest rates being at the wrong level."


  4. «It talks about “concerns over the sustainability of debt positions” leading to a “sharp depreciation in sterling and a build-up of inflationary pressures in the UK.” As a result, monetary policy is tightened and long term interest rates rise - presumably because QE stops.»

    As to this and the oil story, I'll quote again Tony Blair's interesting article from 1987 (10 years before becoming PM and doing the very same):
    «First, her arrival in Downing Street coincided with North Sea oil. The importance of this windfall to the Government’s political survival is incalculable. It has brought almost 70 billion pounds into the Treasury coffers since 1979, which is roughly equivalent to sevenpence on the standard rate of income tax for every year of Tory government. Without oil and asset sales, which themselves have totalled over £30 billion, Britain under the Tories could not have enjoyed tax cuts, nor could the Government have funded its commitments on public spending. More critical has been the balance-of-payments effect of oil. The economy has been growing under the impetus of a consumer boom that would have made Lord Barber blush. Bank lending has been growing at an annual rate of around 20 per cent (excluding borrowing to fund house purchases); credit-card debt has been increasing at a phenomenal rate; and these have combined to bring a retail-sales boom – which shows up dramatically in an increase in imported consumer goods. Previously such a boom and growth in imports would have produced a balance-of-payments deficit, a plunging currency and an immediate reining-back on spending, with lower rates of growth.

    Instead, oil has earned foreign exchange and also produces remittance payments from overseas investments bought with oil money.»

  5. This is a truly excellent essay. Particularly the point about the positive feedback effects (self-accelerating) of depression panics, vs. the negative feedback effects (self-correcting) of currency depreciation)

  6. Reading between the lines of the Telegraph article to which Simon refers, it looks to me like Mervyn King fell for the fallacious and popular argument that “the debt is higher than normal, therefor it must be reduced” (via austerity or via “consolidation” to use the fashionable jargon.)

    The argument that something is higher than normal, ergo it is too high is of course nonsense. The intelligent question to ask is: “What’s the OPTIMUM size of anything in any given set of circumstances”.

    And advocates of Modern Monetary Theory (which is largely Keynsianism write large) have an answer to the latter question, thus. The optimum size of the debt is whatever size maximises numbers employed without exacerbating inflation too much. And that “debt size” might be 200% of GDP (as in Japan) or it might be far lower. The actual size is wholly immaterial.

  7. King will already go down in history as helping to make the worst recovery in a hundred years; and given the decline in the newspaper industry, their peculiar views of history will not be enough to save his reputation as those in the previous generation who benefitted from their approbation during the MTFS.

  8. To be fair to Mervyn King at least he'd stopped fixating on low unemployment feeding thru into inflation by 2010 (only just mind you)

  9. Because the bank of England is only really accountable to the Chancellor it does not have to be clear ro many others, unlike most of the rest of the worlds central banks who are more accountable to wider economic interests- who often appoint members of the board.

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