Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 3 December 2014

The OBR confirm the dangers of Osborne's gamble

A point I have repeatedly made about George Osborne’s plans for a new wave of austerity, confirmed in his Autumn Statement today, is that they risk making the same mistake as 2010. Short term interest rates will be only just above their lower bound in 2015, at best. Large cuts in government spending from 2015 on will reduce aggregate demand. So if something goes wrong (and the list of possibilities is long), monetary policy will not be able to come to the rescue.

The OBR conservatively calculate that austerity reduced growth by 1% in financial year 2010/11, and by 1% in 2011/12. As a result, the recovery in those years faltered. Are we going to be saying the same thing in 2016 or 2017?

It is a pretty obvious point, even if it appears beyond most of mediamacro. So it was good to see the OBR hinting at much the same in their forecast that accompanies the autumn statement. First, in discussing why their forecast of medium term growth is subdued, with the output gap closing very slowly, they say this (para 1.19):

“the Government’s fiscal plans imply three successive years of cash reductions in government consumption of goods and services from 2016 onwards, the first since 1948. The corresponding real cuts directly reduce GDP. The economy should be able to adjust to such changes over time, but it is unlikely to be a simple process when monetary policy is already very loose and external demand subdued.”

The words may be a little obtuse (‘unlikely to be a simple process’), but the meaning is clear. Monetary policy will not be able to offset all of the demand implications of a second wave of austerity even in the base forecast.

But the real concern involves risks, just as it did in 2010. In para 1.25 they first note that government consumption of goods and services falls to its lowest share of GDP since 1938. Then they relate that their forecast implies a sharp rise in the real share of GDP accounted for by business investment and a rising household debt to income ratio following higher house prices. They also assume that the UK will partially arrest the decline in export market share that was a feature of the pre-crisis decade. In the following paragraph they say:

“While these assumptions are mutually consistent – private spending would be expected to rise as a share of GDP when the share of household income and corporate profits derived from government pay and procurement falls – they do illustrate the challenge facing the UK economy in adjusting to the further fiscal tightening that the Government is assuming.”

Politicians are fond of talking about the challenges facing the economy, but this is one that the government itself proposes to create. It is a challenge the UK economy could do without.


  1. Simon

    You've commented times many on how Austerity was put on hold to generate a pre-Election economic boost.

    Chart 1.7, p25 here pretty much provides an open and shut case.

    I'm no economist and no media commentator, but it's blindingly obvious to me what has happened. And yet Mediamacro continues to accept, uncritically, the line that Plan A was adhered to and the result is the current growth that we are seeing.

    1. Well, i'll try to help you to understand the Osborne plan.
      First there is a difference between economy and finance.
      Economically the unemployment is going down which is good for the novice
      but financially the jobs created are low wages, part-time and self employ which need benefits to make ends meet which financially is bad as the tax revenue is down, the welfare is up
      That's the way i understand this politic of the tories.

  2. It seems that austerity in the first couple of years of a Parliament, followed by easing, is now official policy. I can understand the temptation, but to have it as policy seems extreme.

  3. What is the relevance of the ZLB in a now conventional, unconventional monetary policy world?

    1. James, once you are at the ZLB, conventional monetary policy, which would lower interest rates in a recession, is not available so you need fiscal policy, QE, and helicopter money to return the economy to full utilization.

    2. Agreed. Monetary policy is not defined by the manipulation of interest rates, so the ZLB is a red herring. "Hitting" the ZLB does not mean you have to move to fiscal policy, a responsible central bank should just do more monetary policy. Simples. I can't see why a monetary economist as good as SW-L thinks the ZLB is a constraint to monetary policy.

      Cards on table: I favour targeting nominal income growth forecasts. QE done with bad grace is better than no QE, but if done with good grace and better targets, it may not even need to done, paradoxically. It just has to be a credibly believed, irrelevant raising of a mythical ZLB and hand-wringing over "unconventional" monetary policy limits the effectivesness of monetary policy.

    3. "I can't see why a monetary economist as good as SW-L thinks the ZLB is a constraint to monetary policy" Because it is. And far better monetary economists than me think so. In fact a huge majority of academic economists think so. Simples.

    4. The "Queen of Hearts" defence. It is true because I say it is so.

      Surely interest rates do not equal monetary policy? There must be more to it than that. We see it every minute, every day. The economy moves one way or t'other, and if the Central Bank does not change it's outlook (as happens infrequently) then monetary policy will be tightening or loosening without interest rates changing at all.

      More, obviously, what is (now conventional) unconventional, monetary policy but non-interest rate management of monetary policy?

      What is "future guidance" but non-interest rate managment of monetary policy?

      Or more recently, when Bullard and Haldane turned around market expecations on October 14th and 15th respectively by merely stating that growing expectations of economic weakness ahead might mean more QE rather than less, monetary policy without interest rate management again was evidently at work.

      Words (and credible targets) can work wonders on expectations and thus on actions. Don't the huge majority of academic economists recognise the power of expectations on action?

    5. James, the first obvious point here is to raise the idea of Japan and Abenomics here. I think it's could be considered about as good a real world test bed as we can get for unconventional monetary policy and here the results don't exactly look good. They really do seem to have pulled out all the stops monetary policy wise, but it seems that all this monetary expansion was not able to offset a fiscal contraction in the form of a consumption tax rise.

      I think there's an important question here as to what the LM (or whatever generalised monetary curve) looks like in the new monetary policy world and what the various central bank instruments might do to change it. I think at this point we really don't know what effect monetary interventions have.

      My view is to ask why are we bending over backwards to find ways to address issues through monetary policy when we have a much better understood instrument in the form of fiscal policy.

    6. Not sure I'd agree about Japan. Firstly, unemployment is still falling nicely, capex is still rising and nominal wages are rising too for the first time in a long while. I think you'd have to argue that the economy is looking through the short term noise of that earlier consumption tax rise.

      Secondly, you have to think of the counterfactual: what would have happened if they had sat on their hands with no QE3?

      Third, fiscal policy is not simple, it is highly controversial because so political:
      Should it be tax and employer NI cuts or more public spending?
      How can you easily differentiate between already high cyclical deficit spending and even greater (suggested) counter-cyclical deficit fiscal policy?

      Who can or should instruct the Central Bank not to offset any additional deficit increases with monetary tightening?

      The one thing we have seen through this recession is monetary policy successfully offseting modestly tightening fiscal policy in the UK. And it offset quite strong tightening in the US, despite very loud predictions in early 2013 that it could not. Those proved wrong haven't yet revised their theories in the face of the evidence.

    7. James, think of it like this.

      You're digging a whole. You have a proper spade and a little toy one. You use the proper one because it's better. Some one takes away the proper spade. You are now in a worst position.

      Also, you have an interesting idea of success.

    8. On your first point: Japan is certainly doing ok and there are plenty of places that are doing far worse but I don't think that Japan's patchy record over the past few years can be called a success (although it doesn't look like a failure either). From what I can see, the VAT hike looks like it was a mistake, I'm quite thankful that Abe has been persuaded to postpone a further rise. I'll add at this point that a similar point could be made RE the UK, it looks good relative to the disaster area that is the Eurozone but it's still not great.

      Second: I've no doubt that had we not had QE things would be worse, no disagreement there.

      Third: Of course fiscal policy has political issues and if it we really had no other option than monetary policy then so be it. But beyond the awkward political difficulties there are not many compelling reasons not to expand fiscally. That there is so much political difficulty with fiscal expansion is something SWL is constantly lamenting on these pages.

      Fourth: The bank has an inflation target, it also seems to give a fair bit of leeway if there is a compelling reason not to tighten (as seen in 2011/2012). Surely if inflation is below target there's no reason why we can't loosen both fiscal and monetary policy.

      As a final question, something I often wonder about with market monetarist types is what particular instruments you think we could use to adopt your preferred target (in your case wage levels). Influencing expectations can work to a degree, but surely you need something a little more kick just to convince people you mean business.

    9. I would agree with you about the not very good successes, but better a US, UK, Japanese success than a Eurozone failure and those unemployment rates and impoverishment.

      A few years ago I finally understood the "in-joke" amongst those Market Monetarists about the folk like you (and I was) from the land of The Concrete Steppes. The penny dropped and I joined the MMers. Hint: it's about the power of expectations.

      Monetary economists as outstanding as Simon, or blind Central Banks, who can't change their views in the face of the evidence will be by-passed and left on the rubbish heap of history.

  4. It's the confidence fairy redux.

    Back to 1938 - Victorian Values see.

    WW1 debt has been paid off: the present generation thanks a previous generation for not saddling them with their borrowings.

    And as for BBC watch: on News 24 I saw Nigel Lawson (wants out of EU while being domiciled in France) saying how Osborne has done well to stick with the plan he's changed. And a surprise BBC appearance of Arthur Laffer to give Osborne the big thumbs up.

    Krugman blog August 7, 2012 'Poor Spokesmen':

    "Laffer’s extraordinary assertion that Estonia and Ireland are the leading examples of failed stimulus. Weren’t they supposed to be heroes of austerity? How incompetent do you have to be not to get that story straight?"

    George Osborne February 23, 2006, “In Ireland they understand this. They have freed their markets, developed the skills of their workforce, encouraged enterprise and innovation and created a dynamic economy. They have much to teach us, if only we are willing to learn.”

    Oh, and the BBC kept referring to the invisible bond vigilantes - who are presumably coming for us before the twenty four years of Japanese liquidity trap.

  5. A technical question, Simon. I presume that models are being used to create these forecasts. The OBR is saying in circuitous ways that Osborne's future cuts to spending are unachievable. But they way they talk makes it sound as though the cuts are an *output* of the model. Surely, as spending is largely determined by policy, they are an *input* to the model. Or do I misunderstand how modelling works?


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