Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 21 August 2014

UK 2015: 2010 Déjà vu, but without the excuses

Things can go wrong when policymakers do not ask the right questions, or worse still ask the wrong questions. Take my analysis of alternative debt reduction paths for the UK following the 2015 elections. There I assumed that the economic recovery would continue as planned, with gradually rising interest rates, achieving 4% growth in nominal GDP each year. I set out a slow, medium and fast path for getting the debt to GDP ratio down, and George Osborne’s plan. On the latter I wrote: “I cannot see any logic to such rapid deficit and debt reduction, so it seems to be a political ruse to either label more reasonable adjustment paths as somehow spendthrift, or to continue to squeeze the welfare state.”

Ah, said some, that is all very well, but you are ignoring what might happen if we have another financial crisis. That will send debt back up again. The implication was that the Osborne plan might make sense if you allowed for this kind of occasional but severe shock. In a subsequent post I showed that this was not the case. However this also illustrates a clear example of asking the wrong question. Rather than setting policy today on the basis of something that might happen in 30+ years time, we should be worrying about much more immediate risks.

The question that should have been asked is what happens if we have a rather more modest negative economic shock in the next five years. The list of possibilities is endless: deflation in the Eurozone, the crisis in Iraq and Syria gets worse, Ukraine blows up, things go wrong in China etc. We can hope that they do not happen, but good macroeconomic policy needs to allow for the fact that they might.

That is the question that was not asked in 2010. The forecast attached to the June 2010 budget didn’t look too bad. GDP growth was between 2% and 3% each year from 2011 to 2015 - not great given the depth of the recession, but nothing too awful. But suppose something unexpected and bad happened, and economic growth faltered. The question that should have been asked is what do we do then. The normal answer would be that monetary policy would come to the rescue, but monetary policy was severely compromised because interest rates were at 0.5%. So 2010 was a gamble - there was no insurance policy if things went wrong. And of course that is exactly what came to pass.

As I have always said, there was an excuse for this mistake. In 2010 there was another risk that appeared to many to be equally serious, and that was that the bond vigilantes would move on from the Eurozone periphery to the UK. This was a misreading of events, but an understandable confusion. By 2011, as interest rates on government debt outside the Eurozone continued to fall, it was clear it was a mistake. Policy should have changed at that point, but it did not - instead we had to wait another year, and then we just got a pause in deficit reduction rather than stimulus.

Today, there is no excuse. There are no bond vigilantes anywhere to be seen. No one, just no one, thinks the UK government will default. This means we are free to choose how quickly we stabilise government debt. However what is very similar to 2010 is monetary conditions. Interest rates may have begun to rise by 2015, but any increase is expected to be slow and modest. So there will again be little scope in the first few years for monetary policy to come to the rescue if things go wrong. A negative demand shock, like another Eurozone recession, will quickly send interest rates to their zero lower bound again, and we will have little defense against this deflationary shock. The tighter is fiscal policy after 2015, the greater the chance that will happen. In that sense, it is just like 2010.

So the right question to ask potential UK fiscal policymakers in 2015 is how will you avoid 2010 happening again? If their answer is to do exactly as we did in 2010 and keep our fingers crossed, you can draw your own conclusions.


  1. Let us review the BBC in economics.

    In 2010 there was Hugh Pym, now moved to Health.

    There was Stephanie Flanders, who left, in her own words, to see that "We'll be living with the after-shocks of the 2008-09 financial earthquake for a long time yet. I'm going to carry on writing and thinking about all of that, and the deeper forces shaping the global economy. Though we haven't worked out the details, I promise in future you'll still be able to find out what I'm thinking about the world, if you want to. But from now on, it won't be at the BBC. In many ways, I will be doing the same thing in my new job at JP Morgan Asset Management that I have been doing as Economics Editor: explaining what is happening in the economy and markets, and why it matters."

    Replacing them has been Kamal Ahmed who "Kamal joined the BBC after four and a half years as business editor of the Sunday Telegraph's award-winning team."

    And Linda Yueh, who said on the BBC in 2009 that interest rates must go up at some point soon, and who "has maintained her academic links as a fellow of St Edmund Hall, University of Oxford, as an adjunct professor at London Business School, and as a visiting professor at Peking University. She was previously economics editor at Bloomberg TV and a corporate lawyer resident in New York, Beijing and Hong Kong. She is also the author of several books."

    I see further bad signs of familiar BBC intellectual decline, as the state broadcaster continues to pose as a player in the neoliberal marketplace in the hope no one will notice its a state broadcaster.

  2. Perhaps you didn't notice that "bond vigilantes" do not take on Central Banks that issue sovereign currencies that float. They only take on countries that are USERs of someone else's currency, that they can't "print" more of, when they need it.

    A classic (failed) example being the EU Currency Union, where the States USE a foreign currency, the EURO; over witch, individually, they have no "monetary policy" control. If you can't spend ("print" for those watching on CBeebies) new money into existence, you have to earn; beg; borrow or steal it from somebody else, that is when the bond vigilantes can screw you. The moral being, don't join a "currency union" if you can avoid it. (Scotland take note).

    If the bond vigilantes tried to force up the interest rate on a Pound Sterling Gilt, by selling it left right and center, The BoE can step in and say it will buy unlimited quantities of that Gilt if the interest rate goes above 2.4% say. The market price of that Gilt will go up, such that the Gilt yields 2.39%. The BoE just has to threaten to do it, it may not have to buy any of it to achieve the rate it wants. The ECB did the same thing with "Outright Monetary Transactions" OMT. It just had to threaten the Bond market and the peripheral States interest rates dropped.

    Remember that a sovereign currency central bank is the ISSUER of its particular sovereign nation currency. You can't get Pounds Stirling from any where else except the BoE. Likewise, the only place you can get Euros from, is the ECB. Every body else is a currency USER and they don't have a bottomless pit of money like a Central Bank. You can have a financial shock every other year and the Central Bank can never run out of its own money. There is no Bill it can't pay in its own currency. It can't default in its own currency. (Unless it wants to). Also remember that collection of annual government budget deficits, the so called "national debt" is the the private sectors savings; Pound for Pound; Euro for Euro.

    All the best Acorn

  3. Simon,

    I’m baffled as to what makes you think “. A negative demand shock, like another Eurozone recession, will quickly send interest rates to their zero lower bound again, and we will have little defense against this deflationary shock.” Given zero interest rates and not enough aggregate demand, what’s to stop the state simply printing money and spending it? That would raise demand.

    The state can spend the money on public sector stuff, or a right of centre government might spend the money by cutting taxes while leaving public spending unchanged. That way household spending would rise. Either way, the problem is solved.

    1. Ralph, remember MOSLER'S LAW: "There is no financial crisis so deep that a sufficiently large tax cut or spending increase cannot deal with it."


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