Can we have our instrument back?

This is a rather long post about how one of the instruments of macroeconomic policy has been taken away, and replaced by a fetish about government deficits. It is not technical.

The latest Bank of England forecast has inflation returning to the 2% target by the end of 2017, which is in three years time. That is an unusually long time to be away from target. So what is the MPC proposing to do about this long lapse from target? Absolutely nothing. Tony Yates goes through all the detail, but remains mildly shocked. Much the same thing is happening in the US. In both countries the main discussion point is not what to do about this prolonged target undershoot, but instead when interest rates will rise. Two members of the MPC are voting to raise rates now! [1]

Cue endless discussion about whether the Bank or Fed think Quantitative Easing does not work anymore, or has become too dangerous to use, or whether the target is really asymmetric - 1% is not as bad as 3%. [2] All this is watched by a huge elephant in the room. We have a tried and tested alternative means of getting output and inflation up besides monetary policy, and that is called fiscal policy. We teach students of economics all about it - at length. But in public it has become like the family’s guilty secret that no one wants to talk about.

Once upon a time (in the 1950s, 60s and 70s) governments in the US, UK and elsewhere routinely used both monetary and fiscal policy to manage the economy. Governments did not stop using fiscal policy for this end because it did not work. Instead they found, and economists generally agreed, that when exchange rates were not fixed monetary policy was a rather more practical (and probably more efficient) instrument to use. They certainly did not stop using it because it caused the rise in inflation in the 1970s. That rise in inflation was the result of oil price shocks, combined with in many countries real wage resistance by powerful trade unions, and policy misjudgements involving both monetary and fiscal policy.

When, in the previous paragraph, I wrote ‘economists generally agreed’, I am talking about what could be described as the academic mainstream. However there were also two important minority groups. One, and the less influential, argued that the mainstream was wrong, and fiscal policy was better than monetary policy at stabilising demand. The other, often among those labelled monetarist, not only took the opposite view, but had a deep dislike of using fiscal policy. For example, many believed its use would be abused by politicians to increase the size of the state (and almost all in this group wanted a smaller state). For some there was the ultimate fear that politicians would run amok with their spending, which would force central banks to print money, leading to hyperinflation - we can call this fear of fiscal dominance. However, as I noted above, the rise in global inflation in the 1970s was not an example of fiscal dominance. I shall use the label ultra-monetarist for this second group: ultra, because it is not clear Friedman himself would be among this group.

These minorities aside, the mainstream consensus was that monetary policy was the instrument of choice for managing demand and inflation, but that fiscal policy was always there as a backstop. So, when Japan suffered a major financial crisis and entered a liquidity trap (interest rates fell to their Zero Lower Bound (ZLB)), the government used expansionary fiscal policy as a means of moderating the recession’s impact. At the time the results seemed disappointing, but following the experience of the Great Recession Japan’s performance in the 1990s does not look so bad.

The key event that would eventually change things was the creation of the Euro. For countries within the Eurozone, monetary policy was set at the union level, so to control demand within each country fiscal policy was the only instrument left. Unfortunately the influence of ultra-monetarists within Germany had always been very strong, and for various reasons the architecture of the Eurozone was heavily influenced by Germany. This architecture essentially ignored the potential use of the fiscal instrument. Instead the influence of monetarism led to what can best be described as deficit fetishism - an insistence that budget deficits should be constrained whatever the circumstances.

Within the Eurozone individual governments no longer had their own central banks who could in extremis print money. The worry among the ultra-monetarists who helped design the Eurozone architecture was that some rogue union members would force fiscal dominance on the union as a whole, so they put together fiscal rules that limited the size of budget deficits. This was both unnecessary, and a mistake. It was unnecessary because the Eurozone set up a completely independent central bank, and made fiscal dominance of that Bank illegal. It was a mistake because it completely ignored the issue of demand stabilisation for countries within the Eurozone - in practice it either took away the fiscal instrument (in a recession) or discouraged its use (in a boom [3]).

While the design of the Eurozone reflected the obsessions of ultra-monetarists within Germany, in the rest of the world the academic mainstream prevailed. So when the financial crisis hit, and interest rates fell to the ZLB across the globe, governments in the UK and US again used fiscal stimulus as a backup instrument to moderate the recession. The IMF, normally advocates of fiscal rectitude, concurred. The policy worked. But two groups were not happy. The ultra-monetarists of course, but also many politicians on the right, whose main aim was to see a smaller state, and who saw deficit reduction as a means to achieve that goal. Both groups began to warn of the dangers of rising government debt, which was rising mainly because of the recession, but also because of fiscal stimulus where that had been enacted.

What happened next was that the Eurozone struck back, although not in a calculated way. It turned out that it did contain just the kind of rogue state the architects had worried about: Greece. The fiscal rules failed to prevent excessive Greek government borrowing. Did this lead to fiscal dominance and hyperinflation in the Eurozone? - of course not, for reasons I have already given. But it did lead governments in the Eurozone to make a fatal mistake. What should have happened, and always does happen to governments that borrow too much in a currency they cannot print, is that Greece should have immediately defaulted on its debt. But instead Greece was initially encouraged to borrow from other Eurozone governments, perhaps because some countries worried that default might lead to contagion (the market would turn on other countries), but perhaps also because default would have hit commercial banks in the larger Eurozone countries who owned this Greek debt.

Eventually contagion happened anyway, and Greece was forced into partial default, although not until it had taken the poison of loans from other Eurozone countries which were conditional on crippling austerity. Equally important was the impact that Greece had on the use of fiscal policy in the rest of the world. Those ultra-monetarists and right wing politicians that had been warning of a government debt crisis used the example of the Eurozone to say that this proved them right. Many (but not all) economists in the mainstream began to believe it was time to reverse the fiscal stimulus, as did the IMF. 

From that point on, the idea that you could - and when monetary policy became ineffective should - use fiscal policy to stimulate the economy became lost. Even in 2009 it had been a difficult policy to sell publicly: why should government be increasing debt at a time that consumers and firms had to reduce their own debt? For those who had not done an undergraduate economics course (which included most political journalists), politicians of the right who said that governments should act like prudent housewives appeared to be talking sense. Greece and the subsequent Eurozone crisis just seemed to confirm this view. Deficit fetishism became pervasive.

Of course this about turn was just what both ultra-monetarists and politicians on the right wanted. The focus on government debt had an additional advantage in certain influential quarters. What had started out as a crisis caused by inadequate regulation of the financial sector began to appear as a crisis of the government’s making, which if you worked in the financial sector which had just benefited from a massive public subsidy was a bit of a relief. You could be really cynical, and say that austerity made room for another big financial bailout when the next financial crisis hit. 

But those with a more objective perspective watched the years after 2010 unfold with growing concern. There were no government debt crises in the major economies outside the Eurozone - instead interest rates on government debt fell to record lows. The market appeared desperate to lend governments money. The debt crisis was confined to the Eurozone. However austerity within the Eurozone, undertaken across the board and not just in the crisis economies, did nothing to end the crisis. The crisis only ended when the ECB offered to back the debt of the crisis countries. The offer alone was enough to halt the crisis, and interest rates on periphery country debt started to fall substantially. But austerity’s damage had been done, creating a second Eurozone recession. The fiscal policy instrument works, even when you use it in the wrong direction! Austerity delayed the UK’s recovery, and while growth was solid in the US, austerity there too meant that the ground lost as a result of the recession was not regained.

So those with a more objective perspective, including many in the IMF, began to realise the fiscal policy reversal in 2010 had been a big mistake. The world had been unduly influenced by the rather special circumstances of the Eurozone. Furthermore within the Eurozone the crisis that austerity had meant to solve had actually been solved by the actions of the ECB. It began to look as if austerity - in perhaps a milder form - had only been required in a few periphery Eurozone countries.

All this should have meant another policy switch, at least to end fiscal austerity and perhaps to return to fiscal stimulus. But deficit fetishism had taken hold. This was partly because it suited powerful political interests, but it was also because it had become the pervasive view within the media, a media that liked a simple story that ‘made sense’ to ordinary people. Politicians who appeared to deviate from the new ‘mediamacro consensus’ of deficit fetishism suffered as a consequence.

So as 2014 ends, we have at best an incomplete recovery and inflation below targets, yet central banks are either not doing enough, or have given up doing anything at all. A huge amount of ink is spilt about this. But if central banks really do believe there is nothing much they can do, with a very few exceptions they fail to say the obvious, which is that it is time to use that other instrument, or at least to stop using it in the wrong direction. Perhaps they think to say this would be ‘too political’. The media in the UK and US continue to obsess about government deficits, even though it is now clear to almost everyone with any expertise that there is no chance of a government funding crisis, so the obsession is completely misplaced. Within the Eurozone deficit fetishism has achieved the status of law!

There are some who say we cannot use the fiscal instrument to help the recovery, and get inflation on target, because debt will become a problem in 30 years time. It is as if a runner, who normally gets their fuel from eating carbohydrates but has run out of energy in mid-race, is denied a food with sugar (HT Peter Dorman) because a high sugar diet is bad for you in the long term. Others in the Eurozone say we must stick to the rules, because rules must be kept. But rules that create recessions with no compensating benefits are bad rules, and should be changed. Rule makers can make mistakes, and should learn from these mistakes. [4] It is perfectly possible to design rules that both ensure long term fiscal discipline, but which do not throw away the fiscal instrument when it is needed.

So every time someone writes something about what monetary policy could or should do to get inflation back to target, they should say at the outset that this goal could be achieved - in a more assured way - by a more expansionary fiscal policy. Political journalists who presume that more borrowing must be bad should get a severe telling off from their economist colleagues. For one thing that should now be clear is that rising debt since the recession has done no harm, but austerity policies that tried to tackle rising debt have done considerable damage. The 2010 Eurozone crisis was a false alarm. Macroeconomics needs to get its fiscal instrument back, and deficit fetishism has to end, but this is being prevented by an alliance between the political right, the ultra-monetarists, and I’m afraid the media itself.

[1] In the UK there is a certain irony here. When inflation was above target in 2010-13, most of the MPC was brave enough to avoid raising rates. Although they forecast that inflation would come back to 2% within two years, this forecast was met with considerable skepticism. Three members of the MPC in 2011 voted to follow their ECB colleagues and raise rates. Perhaps as a result, the Treasury wrote a paper in 2013 which said that on occasions like that (when inflation was above target in a recession) the MPC could be a little more relaxed about the speed at which inflation returned to target. The irony is that this latitude is being used (abused?) now, when inflation is below target and we are still recovering from a recession.

[2] Maybe in the US the target is asymmetrical - but shouldn’t be - but in the UK it is symmetric by law.

[3] In a boom, when fiscal policy should have been contractionary, budget deficits were low as a result of the boom, so the rules suggested no action was required.

[4] Equally those that lent money when they should not have lent money have to accept that they made a mistake.