Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 6 February 2015

Asymmetries and Uncertainties

This post starts off talking about the UK, but goes on to make more general points about why we may have wasted resources on a huge scale over the last five years, and why this waste may be continuing.

I presented my new National Institute Economic Review paper on the macroeconomic record of the UK Coalition government yesterday, and reaction mainly focused on my conservative estimates of the cost of the move to austerity in 2010 and 2011: a cumulated loss of 5% of GDP or £1500 for each adult and child. The basis for those figures is outlined here, and their conservative nature comes from taking OBR estimates for the impact of fiscal contraction, and assuming (rather improbably) that the output lost through austerity was entirely recovered by 2013.

The key issue with numbers of this kind involves monetary policy. Some argue that without austerity monetary policy would have been more contractionary: the ‘offset’ argument. Of course some of the large increase in UK inflation in 2011 was the direct result of austerity: the VAT increase is the obvious example. In addition, the inflation of 2011 was not foreseen in 2010, so it does not alter the fact that austerity was a policy mistake, but just influences any calculation of the size of the mistake.

The paper addresses the offset argument. I use Bank of England forecasts to suggest that monetary policy was not able to hit its target for forecast inflation for much of this period, implying that the Zero Lower Bound (ZLB) constraint was biting. If the ZLB constraint bites, there will be no offset. Not surprisingly, when that target for expected inflation was not met, the Quantitative Easing programme was expanded. There was only a brief period in 2011 when this was not true, which was the period in which 3 out of 9 MPC members voted to increase rates. So if we had not had 2010 austerity, then at most interest rates might have begun rising in 2011, which given lags might have reduced GDP to some extent that year. But crucially the OBR numbers that I use already embody some monetary offset, because they are based on empirical estimates of average multipliers over the past. To use these OBR numbers and then do some monetary offset involves double counting.

However, I want to stay with my ‘no austerity’ counterfactual to make a more fundamental point. If interest rates had been raised in 2011, and this had reduced GDP in 2011 and 2012, we would now be talking about the MPC’s 2011 mistake, rather than the government’s 2010 mistake. I would be calculating how much GDP had been wasted in 2011 and 2012 as a result of premature monetary tightening. I would be right to do so, because the costs of delaying a recovery from a deep recession dwarf any benefits from reducing inflation a bit following a commodity price shock.

This indicates a fundamental problem, which policymakers have still not taken on board. For whatever reason (resistance to nominal wage cuts being the most obvious), inflation ceases to be a good indicator of underutilised resources when inflation starts off low and we have a major negative demand shock. Policymakers are continuing to make this mistake today: core inflation is not too far away from target, and growth is quite healthy, so it is OK to do nothing (or in the Eurozone, it is OK to wait for ages before doing anything). However it seems quite possible that GDP continues to be quite a few percentage points below where it could be without inflation exceeding its target, so we continue to waste resources on a huge scale. This is money down the drain that we will never get back. It is like taxing households thousands of pounds or dollars or euros a year and burning that money.

One way to put this point is to go back to the basic rationalisation behind flexible inflation targeting. It is OK to have a target based on inflation alone, with no mention of the output gap, because you cannot in the long run keep inflation at target without also keeping the output gap at zero. This is sometimes called the divine coincidence. However if, at low inflation rates, inflation becomes a noisy, weak and asymmetric indicator of the output gap, then focusing on inflation is going to perform badly. In these circumstances it could be many years before it becomes clear that we have been continually running the economy under capacity, and needlessly wasting resources. Unfortunately even when that point of realisation arrives, for obvious reasons monetary policymakers are going to be reluctant to acknowledge the mistake.


20 comments:

  1. I don't see any coverage of this paper on the BBC.

    Maybe clicking on their news homepage, then having to go into something called 'Business' - not Economics' - which links to the options 'Market Data', 'Your Money', 'Economy', and 'Companies' suggests that this BBC, set up as the epitome of market failure, appears to like to think of itself as a business rather than the broadcaster set up with a hypothecated tax to bring information into the public sphere which businessmen and politicians whose parties are funded by businessmen would not like to have revealed?

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    Replies
    1. Maybe this is retribution because I was critical of Robert Peston's sources here:

      http://mainlymacro.blogspot.co.uk/2014/12/bond-market-fairy-tales-part-1.html

      I did extend an open invitation to him in this post:

      http://mainlymacro.blogspot.co.uk/2014/12/robert-peston-mr-market-and-me.html

      but it remains to be taken up. I suspect though that the real reason is that the views of a professor of macroeconomics who specialises in fiscal policy are not terribly newsworthy in the world of mediamacro.

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  2. “reaction mainly focused on my conservative estimates of the cost of the move to austerity in 2010 and 2011: a cumulated loss of 5% of GDP or £1500 for each adult and child.”

    Unfortunately, it wasn't represented in that article as conservative:

    “Using the independent Office for Budget Responsibilities estimates, he argued that GDP may have been reduced by up to 5%, or £1,500 per head.”

    and - in the absence of any other distributional information - what we really want anyway is the best estimate not the (possibly improbable) estimate which minimises the cognitive dissonance felt by those poor delicate austerian flowers.

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    1. His position is defensible. Using the most conservative estimate you can find, assuming it is not too poor, allows you to say that AT LEAST this amount of ressources have been wasted.

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    2. I'm not saying it isn't defensible, I'm saying it's undesirable. On the other side of the best estimate is an equally not too poor 'least conservative' estimate which would allow you to say that AT MOST this amount of resources have been wasted. [After correcting for my anti-austerian prejudices] I'd be equally disappointed by that one.

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    3. If you stick with the OBR numbers, then an alternative is to assume that the 2% of GDP lost by 2011 has simply continued to be lost, because monetary policy has not been able to stimulate additional private sector demand because the ZLB constraint still bites. By the end of 2014 this would give you 9% and counting. In a sense that is what this current post is hinting at.

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    4. Thanks! That gives me a range which I can roughly interpret as some sort of HDI.

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  3. " ... it could be many years before it becomes clear that we have been continually running the economy under capacity, and needlessly wasting resources." We already have a metric that does the job, it's called "unemployment". If you have unemployment greater than circa 2.5%, you have an output gap by definition. Insufficient spending is occurring to utilise the resources available. If the private sector is not spending, then the public sector needs to increase its deficit spending on public infrastructure repairs and maintenance, that will benefit the next generations as well as the current.

    Trying to target economy wide measures of inflation is pointless, it has to be monitored and controlled sector by sector. The UK housing sector is prone to bubbling inflation, which input element(s) are causing it, what fiscal tool can we design to control it, but keep it running at full volume capacity; how can we increase volume output while keeping the required "volume increases before price increases" output gap factor under control.

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  4. The text of the article is clear, but what I would really like is for others to come up with their own estimates. It seems strange to me that so few others have attempted to quantify the impact of UK austerity (Jorda and Taylor is an exception), or the US for that matter. I have discussed various estimates of Eurozone austerity here:

    http://mainlymacro.blogspot.co.uk/2014/09/the-entirely-predictable-recession.html

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  5. I just had a quick view on a NBER working paper (No. 20827) written by Alesina, Barbiero, et al. which investigates "austerity 2009 -2013". The authors end their abstract with: "In other words, we don't find sufficient evidence to claim that the recent rounds of fiscal adjustment, when compared with those occurred before the crisis, have been especially costly for the economy."

    Is their evidence different from your UK evidence?

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    1. From a quick look, they estimate a model in which expenditure based fiscal consolidation has little (or possibly positive) effects on output. In other words, they estimate multipliers of around zero. I find results like this difficult to rationalise, and I also note that Jorda and Taylor get quite different results using a different methodology.

      So, naturally, there is no effect for the UK in their study. In the analysis I did I take the analysis of the OBR, which uses multipliers that are certainly not zero. Again, the Jorda and Taylor study implies larger total multipliers than the OBR.

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    2. Thanks! It's again the question how large fiscal multipliers are, particularly close to the ZLB.

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    3. Don't bother paying $5 to download the paper, it is a typical piece of New Keynesian mumbo-jumbo. Linearise and trivialize with a DSGE model as Buiter wrote in "The unfortunate uselessness of most ‘state of the art’ academic monetary economics". Much better to move into the Post Keynesian MMT world http://bilbo.economicoutlook.net/blog/?p=6949

      "Rational expectations" have left the building ;-) . Acorn

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    4. Acorn: there is no DSGE, its just estimation. I think that is still allowed in the Post Keynesian MMT world!

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  6. Excellent work Professor over many posts, you along with Prof Michael Hudson are the only people, who I think provide me with as close a version of the truth as it is possible in these matters to get, now who do I see about getting my £1500 back, would a letter to Osborne be worth the effort.
    p.s. would not waste time with the BBC they are a lost cause.

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  7. I think this is an unusually excellent post. I have a question and a thought. If "resistance to nominal wage cuts being the most obvious" what are the less obvious reasons the change of inflation ceases to be a good indicator of the output gap ? I can think of resistance to price cuts being another (which resistance must be sector specific the incredibly cheap and powerful laptop on which I type reminds me).

    The comment is that your criticism of faith in the divine coincidence is, perhaps, a bit gentle. As you state the claim, it works for all fixed inflation targets. I don't think a -20% per year target would imply an output gap going to zero (given the lower bound on nominal interest rates). I don't think that a -2% target would either (given the resistance to nominal wage cuts). Finally, I am not sure about the ECB's "less than but not far below 2%" target.

    I guess I am just considering whether the weak in "inflation becomes a noisy, weak[*] and asymmetric indictor" might be replaced by worthless if the target inflation rate is low enough.

    * I note the shocking absence of an Oxford comma, at Oxford ! You not only disagree with Chicago macroeconomics, you disobey the Chicago style guide. Look out for colonel Hans Lander.

    https://www.youtube.com/watch?v=N4vf8N6GpdM

    Not at the level of what did the Romans ever do for us, but funny.

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  9. You say " It is OK to have a target based on inflation alone, with no mention of the output gap, because you cannot in the long run keep inflation at target without also keeping the output gap at zero. "

    I suspect this is an example of a model-based conclusion with limited (zero?) empirical evidence. Happy to be proved wrong but I was taught that you can't achieve two goals (low inflation, full output) with a single instrument. Is there an example of a pure inflation target policy that has eliminated the output gap (in either sense - positive or negative)?

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