Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 10 February 2015

Policy, risks and public discourse

Another post where I use the UK as an example to illustrate a more general point

Along with their normal forecast, the National Institute has also used their model NIGEM to analyse the macroeconomic impact of the different political parties fiscal plans post 2015, which is published in the latest Review. (Chris Giles has a FT write-up.) There is no great surprise here: the more fiscal austerity you undertake, and if monetary policy fails to perfectly offset the impact on demand, the lower output will be.

This is not the main reason why I am against further fiscal consolidation post 2015. If you go back to 2010, the OBR’s main forecast didn’t look too bad: the recovery was continuing, and interest rates were able to rise as a result. But good policy does not just look at central projections, but it also looks at risks. Then the risks were asymmetric: if the recovery became too strong, interest rates could always rise further too cool things, but if the recovery did not happen, interest rates would be stuck at their lower bound and monetary policy would be unable to keep the recovery on track.

In 2010 and beyond that downside risk came to pass, and the recovery was delayed. Fiscal policy put the economy in a position where it was particularly vulnerable to downside risks, which is why it was an entirely foreseeable mistake. Quite how large a mistake is something I discuss in my article in the same Review (see also this recent post). Exactly this point applies to 2015 and beyond. The problem with further fiscal consolidation while interest rates remain at their lower bound is that it makes the economy much more vulnerable to downside risks.

This is something that all economists understand, and economists do their fair share of complaining about how difficult it is to get policymakers, let alone the public, to recognise the importance of risk analysis. However in writing about the role of fiscal policy in creating a weak recovery not just in the UK but the world generally, I was struck by how little public model based quantification of this there was even after the event, let alone before. (For some of the few ex post studies related to the Eurozone, see here.) Central banks nearly all maintain models capable of doing the kind of risk analysis I am talking about, but how much of that work gets into the public domain, or is even seen by fiscal policymakers? In the UK there has definitely been technological regress in this respect, as I note here.

So we have a paradox. In academic macro there has never been so much quantified model based policy analysis, some of it analysing just the kind of robustness to risks that I have been talking about. Yet in public discussion of macro policy, it is quite rare to see this. Central banks tend to keep what they do to themselves, and they appear to have a taboo on analysing alternative fiscal policies. In the UK the OBR, which does the government’s fiscal forecasting, is not allowed to look at alternative fiscal policies in the short term. I think I know why this paradox has arisen, but that will have to wait for a later post.

  

13 comments:

  1. This comment has been removed by the author.

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  2. It is interesting to note how remarkably sanguine policy makers seem to be at the prospect of deflation. With such benign monetary policy conditions and improving employment levels I would be worried that expectations of falling prices become entrenched. Or are central banks quietly burrowing away behind the scenes?

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  3. Austerity, what austerity?
    Looking at IMF data I see only increase in government spending and pretty high fiscal deficits. So again, what austerity? You can argue that govermnent spending could have been higher but calling this austerity is misleading. Also, I don't see a big difference between US and UK policies: UK government expenditures have increased 9% during in 2009-2014 period and US have increased by 6.4%. During that period they both had high levels of fiscal deficits. So again what austerity?

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    1. Increased spending on what? Welfare payments? Unemployment benefits? NHS? All of which require additional spending as prosperity lessens.

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    2. You mistakenly identify the increased deficit for evidence of discretionary government spending and conclude 'what austerity?' However, the deficit (the difference between credits and debits procured against the Consolidated Fund) is endogenous. As George held down spending in 2010, the risk that the non-government sectors would fail to dis-save materialised (rather predictably). V fell, profits were squeezed, investment fell, wages stagnated, M3 balances didn't flow over tax lines and guess what, the deficit went up and the stabiliser started to kick in. You can't make claims about fiscal policy by simply looking at one variable.

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  5. In your VoxEU article you mention leakage in relation to fiscal policy. Specifically, you note that because your counter factual assumes everyone (EU, US, UK) maintained government spending, leakage isn’t an issue.

    Does this suggest a potential “chicken” game theory type explanation to fiscal policy in the crisis. GB and the EU were waiting for each other to start spending more in order to piggy back. Whereas there’s less leakage for the US so they had less austerity.

    One objection might be that GB is too small for its fiscal policy to effect the EUs decision?

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  6. "Then the risks were asymmetric: if the recovery became too strong, interest rates could always rise further too cool things"

    Lets say then what if consolidation didn't happen and Mervyn King raised rates in 2011.

    The demand effects of a rate rise on already heavily indebted households (paying more to borrow) and risk-averse firms (demanding to save more) would have been enourmously detrimental to demand in the economy. Probably enough to outweigh all the positives of a loose fiscal programme.

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    1. I talk about this possibility in my National Institute Economic Review article. To suggest that there would be complete monetary 'offset' implies that the Zero Lower Bound constraint was never a problem, which given QE is clearly wrong. Of course this issue is exactly why we should have more model based numerical counter factual analysis.

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    2. Simon, there is never going to be a "complete monetary offset", there isn't enough outstanding Treasury debt, that could be converted back into its original "reserves", as originally spent into existence, by the monopoly currency issuer; that was used to buy the Treasury debt instruments in the first place. That would have made any difference to this current, private sector, "Balance Sheet" recession. Monetary actions are the equivalent of "pushing on a string".

      Before you go for yet another useless "model based numerical counter factual analysis", perhaps it would be better to explain the difference between a currency ISSUER and a currency USER. Plus the difference between financial asset INJECTIONS and financial asset LEAKAGES in a fiat currency economy; the fundamentals of FISCAL policy; G+I+X and S+T+M, respectively. Forget the polynomials and concentrate on these basic accounting identities. (Acorn).

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  7. With his blogs on 'Insiders and Outsiders' Krugman has looked at the different choices made by economists with similar outlooks depending on whether they have been 'institutionalised' or not.

    I've noticed that since the Coalition began the phrase 'grown-up politics' keeps being used, a sort of Arnoldian attack on boyhood (or girlhood) I suppose.

    It is surprising how much error has come from maintaining an institutionalised view of things, and does certainly suggest this blog is right to focus its attention on institutional reform more than just the alteration of public opinion.

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  8. What I also find curious is why the "right" has abandoned the case for tax cuts. Government spending and fiscal stimulus are not synonymous. Clearly, part of the case for austerity is about shrinking the "size of the state", in the belief that this will raise trend growth. But this can be done in combination with a fiscal stimulus, if taxes are cut. I can only reason that this is not deemed politically feasible, and the only way to reduce government spending relative to GDP is through creating fear over debt levels. Sadly, that appears to be the net contribution of the Liberal Democrats to fiscal policy-making.

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  9. What about the risks of getting junk status or the country getting addicted to the stimulus money or not having a buffer to handle a costly future emergency?

    In any case, how high should the UK be aiming exactly? 2+ % of real growth may already be pretty generous. The population is aging (more retirees), environmental regulations are tightening and the West is losing its competitive edge over countries like China and no feasible amount of stimulus spending will change those trends. We don't live in the 1930s when stimulus spending could easily work with the favorable demographic trends of the time, nobody cared about the environment or dwindling natural resources, the Soviet Union shielded itself off from the global economy and the industrialised countries' had the ability to, sometimes violently, suppress economic competition from poor countries (the colonial possessions of the industrialised countries).

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