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.