Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 12 February 2015

The austerity story in extensive form

My London Review of Books article is now available online. It is much longer than the normal blog post, so it allows me to put together a lot of points in one place. It tells the history of the macroeconomic policy response to the Great Recession. How in 2009 policy responded in the right way (in terms of direction if not magnitudes), but how in 2010 it all went very wrong with the move to austerity. It is told from a UK perspective, but similar stories can be told for the US and Eurozone. It says why austerity was a mistake, and how both politicians and most of the media have tried to avoid this conclusion.

Besides length, the other main difference is the effort I have made to write clearly for non-economists. (Whether I have succeeded you can judge, but to the extent I have the editorial team at LRB deserve a lot of the credit.) Of course I would like to do this all the time in my posts (unless I signal otherwise at the beginning), but I’m acutely aware that I often fail. Mostly it reflects lack of time. I try to always do one read through thinking how would a non-economist interpret this, but as anyone who reads through their own work knows, if it is something you have just written it is quite difficult to be objective. My ‘post the next day’ rule helps here, but I do not always stick to that rule! (Occasionally jargon can be descriptive: ‘automatic stabiliser’ and ‘lender of last resort’ spring to mind from the article.)

Writing a piece like this also makes it clear how difficult macroeconomics in particular is. Everything is, at least potentially, connected. To tell the story of fiscal austerity you do not only need to talk about the impact of spending cuts on demand and output. You also need to talk about monetary policy, and therefore Quantitative Easing. Not just to discuss potential monetary policy offset, but also why the Eurozone is different, which means talking about the relationship between short term interest rates and interest rates on government debt. I do this all the time when writing academic papers of course, but for a non-academic audience the rules for what you include and what you leave out have to be different.

The hardest thing is to switch off the academic part of me which is saying: you really should cover that, or that is a very imprecise way of making that point. For example in the LRB article I did not go into a discussion of whether, because UK inflation was high in 2011, interest rates might have increased if there had not been austerity. That discussion you can find in detail in my NIER article, but I decided including it in the LRB discussion was both unnecessary and distracting. However I did mention helicopter money (by request), because a natural question for a non-economist to ask is why the central bank is creating money to buy financial assets rather than giving it directly to people? (Actually that is a pretty good question for an economist to ask as well!) What I wrote was that financial assets can be sold again when the recovery is complete if the bank judges that there is too much money in the economy, but that of course begs the question of whether there are other means of reversing helicopter money. You just have to stop somewhere, and leave important issues out.   

The other thing that struck me writing both the LRB and NIER articles was how little depends on the benefits of hindsight. When I did my analysis of fiscal policy under Labour, the major criticisms did reflect subsequent events: in particular that the fiscal rules should have aimed for a gradually falling debt to GDP ratio. With the Coalition, the key mistake was obvious at the time. What has come with hindsight are in a sense details, albeit important ones: exactly why the Eurozone was special, the motivations behind the policy, and mediamacro. However I think the more interesting comparison, from a UK perspective, is between macroeconomic policy under the Coalition and the 1979 government under Margaret Thatcher. That would be an article I would like to write sometime.


35 comments:

  1. " . . . but similar stories can be told for the US and Eurozone."

    There was a difference in the use of monetary policy between the US and the Eurozone?

    "Simon Wren-Lewis says that there can’t be any controversy over the fact that the
    second Eurozone recession was due to contractionary fiscal policy. This is quite a
    startling claim: back in 2010, the US and euro zone had the same unemployment
    rate around 9-10%. And we had something like a controlled experiment, since the
    US and the Eurozone did roughly the same amount of austerity. (By some measures
    the US did a bit more.)
    The big difference between the two areas was monetary policy. The US did some
    monetary stimulus through QE and forward guidance, while the ECB did nothing.
    Now the unemployment rate in the Eurozone has gone up from 9% to 11.6%,
    while it’s gone down in the US to 6.3%. This huge divergence in employment outcomes
    over the last 3 years with monetary policy being the difference, not fiscal
    policy, seems very striking. But yet again very respected Keynesians say it’s that
    it’s obvious that fiscal policy explains what went wrong."

    http://www.adamsmith.org/wp-content/uploads/2015/02/therealproblemwasnominal2.pdf

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    1. However the fiscal story was similar, which is what the article is about. For some numbers, see

      http://www.voxeu.org/article/fiscal-policy-explains-weak-recovery

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    2. Postkey, you really should study the fiscal stimulus that was injected by the US Treasury under the EESA Act and the subsequent TARP program. The latter underwrote the FED TALF program against losses on non-recourse loans. In reality these were all funded by the US Treasury and hence were, by definition, fiscal actions. The only thing monetary policy has done in the US, as in the UK is raised stock market prices, which is what it was meant to do to make it easier for corporates to borrow. Unfortunately, so far, the corporates don't want to borrow because their customers ain't got no money to go shopping.

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    3. The writer at adamsmith.org fits well with others with similar counterfactual ideology, i.e. the evidence is strongly on the Wren-Lewis side as well as Keynes.

      In the US, the stimulus effect of the EESA and TARP, if any at all, was very limited. They were akin to emergency flotation devices to stop the ship from sinking from the

      The single stimulus of real consequence was the American Recovery and Reinvestment Act of 2009 http://bit.ly/1aHo6Uf estimated initially at $757 Billion. Unfortunately, that law came with a high political cost inflicted by the partisans of austerity.

      What makes 2010 notable in the US when it comes to austerity programs?

      In November, the Republicans won a majority of seats in the House of Representatives and on taking office in January forced austerity into being. They shut down the government. They blocked extended unemployment benefits and much more. They threatened to repudiate the government’s debt (that they incurred) if they didn’t get their way.

      They brought fiscal policy to a screeching halt in 2011 with a thoroughly reactionary program.

      The stimulus with its extended effect saved the United States untold pain even though Paul Krugman criticized it as too small, less than a third of what was needed. Other critics pointed out the inclusion of tax cuts in the cost despite minimal stimulus effect.

      The Republicans used false claims of the ineffectiveness of the stimulus to gain political power and have imposed austerity on the United States. Our roads deteriorate. Our bridges fall. Our vital rail tunnels need augmenting and replacement.

      Paul Krugman has addressed austerity and the claims raised by Postkey a number of times. This one a year ago does it well. http://nyti.ms/1EoXGow

      What we are dealing with are ideologues who create "facts.” The United States' recovery has proceeded more slowly than it should have gone largely because of the power of the austerity faction, i.e. the Republican ideologues.

      SW-L - great piece in LRB.

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  2. SW-L argument seems sound. I would go further: the alternative to a neo-Keynesian macroeconomic policy in Europe is to turn workers progressively into State-assisted slaves to protect (?) them from being overwhelmed by slave-condition workers from less-developing countries that have higher fertility rates and surplus population, or/and intentionally debased currencies (the undercover 'currency wars'). Eurozone has no policy for the full employment of its citizens, and that is quite shameful, or so it would have looked to Keynes' eyes. Northern countries are draining human capital from Southern ones along with the public and private savings for paying back a lot of unsound loans decided by the very rich in the North side. Keynes might have written nowadays 'The economic consequences of squeeze'.

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  3. Helicopter money can always be easily removed from the economy when necessary by the taxation system. It's the way the monetary system always has been spend to increase money supply tax to decrease it.
    I really can't understand why this isn't obvious. @bill40

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    1. But the central bank does not control taxes. It is all about a distrust of politicians to take away the punch bowl in a boom.

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    2. Re reversing helicopter money and Simon’s “distrust of politicians to take away the punch bowl in a boom” that’s only a problem because of the ludicrous system we currently have under which two quite separate bodies are responsible for stimulus: central bank and politicians. You might as well have car with two steering wheels each controlled by a different person.

      That problem is easily solved by having the BoE MPC or some similar committee decide the aggregate amount of stimulus (monetary and fiscal), with politicians retaining control over the proportion of GDP allocated to public spending and exactly how that spending is allocated. That’s the system advocated by Richard Werner and Positive Money. See bottom of p.10-12 here:

      http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

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    3. "That problem is easily solved by having the BoE MPC or some similar committee decide the aggregate amount of stimulus (monetary and fiscal), . . . "

      Theoretically, with floating exchange rates, under 'normal' circumstances, only monetary policy is 'effective' in 'stimulating' GDP.
      Hence, control of the economy was given over to a 'committee', the M.P.C..

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    4. Postkey,

      Re your claim that fiscal policy alone can’t give us stimulus, I’d guess a substantial majority of economists disagree with that. (Incidentally by “fiscal stimulus” I mean: government borrows £X, spends it and/or cuts taxes by £X and gives £X of bonds to the lenders). That is, a majority of economists think that while the latter borrowing does crowd out some private sector activity, the crowding out is not total, i.e. a finite amount of stimulus results.

      But whatever the truth of that, it doesn’t matter for the Werner / Pos Money system because, to repeat, the latter involves COMBINING monetary and fiscal policy. I.e. instead of “govt borrows £X, spends it and gives £X of bonds…”, what happens is “govt and central bank print £X and boost net spending (i.e. spending less tax) by £X”. So even if your “only monetary policy is effective” point is correct, it doesn’t matter for the Werner / Pos Money system.

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    5. This is what R.W. says.

      "Equation (22) indicates that the change in government expenditure ∆g is countered by a change in private sector expenditure of equal size and opposite sign, as long as credit creation remains unaltered."
      http://eprints.soton.ac.uk/339271/1/Werner_IRFA_QTC_2012.pdf

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  4. Some brutal feedback...

    As a non-economist, this one threw me. Mostly because you're trying to cover such a lot of ground. That has 2 effects: first - it's too long for comfortable reading, second - despite its length the many points made don't then get the attention or context they need to make good clear sense.

    I think perhaps you underestimate how readable (and useful) to a general audience your blog is ~ and that perhaps it's a shame that regular/shorter form of writing is hidden on a personal website instead of pushing it somewhere with a bigger audience.

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    1. Which I prefer when reading other peoples stuff partly depends on my mood. One of the advantages of well placed links in short pieces is that readers have the opportunity to go further if they wish.

      Having said that, I think the 'lots of ground' point is difficult to escape on this issue. I felt the story had to be told the way it was because of the preconceptions most readers unfamiliar with this analysis would have. It was important therefore to show that (a) we had fiscal stimulus in 2009, (b) that the Eurozone crisis was not indicative of what happens when you do have fiscal stimulus, (c) that plan A did change, (d) that 2013 recovery did not vindicate austerity, and (e) why the reader is not seeing this viewpoint in the media. I'm not sure what of those I could have left out, without any reader thinking yes, but.

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    2. Oh sure. And it seems border line cruel of me to be so flippant when it's not me that's made the effort to plan and construct histories and arguments and get them published. I do apologise.

      But preconceived ideas are overcome by chipping away at them over time (and of course it it helps if they're not constantly reinforced meanwhile). It's an uphill battle, so I only question the wisdom of taking it on with the long-form essay. That sounds like double hard work for all parties! I suppose I'd suggest five bite-size pieces are more effective than a longer piece making five points. But I don't suppose that was necessarily on offer.

      Still I hope some in mediamacro especially do make the effort to read it through and feel suitably stung by your criticism. That would certainly be for the good.

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  5. Great article, Simon. It's so hard to fight the mediamacro lunacy. Thanks for your role there.

    Everything you said is right on, including that the central bank cannot reverse helicopter money. Or can it? Does anything stop the Fed from selling bonds short (and destroying the proceeds), I wonder?

    This is a theoretical question, not an objection to the claim in your article, which is, just as you said in your blog post, oversimplified but essentially true.

    Thanks,
    -Ken

    Kenneth Duda
    Menlo Park, CA




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  6. Say you had a country with a GDP/capita of 100. But this economy is being propped up by a bubble. Investors inflate this bubble, without it GDP/capita would be only 80. Now something happens which exposes/bursts the bubble and GDP/capita temporarily falls to 70, so 70, not 80, because there's panic and a lack of trust. The government has to adjust to the new reality and decides to spend a little over what would fit an 80 GDP/capita economy. After a few years GDP/capita has climbed to 80 and is now slowly growing again, the government cuts back its spending to a level fitting a GDP/capita of 80. Your government also knows a huge wave of people is retiring right at this time, so it is extra careful with spending and borrowing.

    In comes an economist who says: "there's a lot of historic evidence that says you could've had a GDP/capita of 100 if only your government had spent more, it's basic Keynesian dynamics that every first year economics student understands, so why is your government so foolish?" You try to explain that if your government were to spend more it could not repair a breach of trust, because there is no breach of trust, trust has already been repaired after the bubble burst, the extra spending would basically be development aid, not economic stimulus. You get called an irrational "neoliberal" by said economist.

    The above is how it often feels like to be a continental European on this blog...

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    1. What evidence have you that the UK economy in 2007 was being propped up by a bubble? Yes, house prices were historically high, but they remain high now. To make this argument you have to say that productivity started falling around 2000, and those that study these things find no evidence of that. You have to explain why the labour market was not tight. You have to explain why inflation was subdued.

      Now I would not be so foolish as to say that I'm 100% sure that you are wrong. What I would say is lets see who is right. Expand the economy faster than now, and lets see when capacity constraints hit, and inflation starts rising. When that happens, we can easily slow things down. In this situation the cost of you being right and me wrong are not that great. However if I am right and you are wrong, the costs are huge.

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    2. House prices were skyrocketing during 2007. Especially in the South East - these regional disparities further evidence of dysfunction. Perhaps goods price inflation is not a good guide to bubbles. It obviously wasn't to the very big one that hit Japan. And credit and housing bubbles seem to be a problem in many industrialised countries, even those with high structural unemployment levels (an unpleasant subject explained away and sanitised through NAIRU.)

      There are structural issues in industrialised countries, I remember them being identified by economic historians back in the late 80s (eg Maddison) and relate to the end of a boom initiated by post WWII recovery.The Great Moderation was made possible by exceptional events - eg the entry of China and collapse of the Eastern Bloc (have you noticed how much is now made in China?). But I would bet that something is terribly wrong with the conventional approach to monetary policy in such an environment, and this was evident even before they were forced to abandon it at the zero lower bound.

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    3. @MM 09:33

      The other anon replying isn't me, but still has a small point with the housing prices. My parabel wasn't so much aimed at the UK though. You said that what works in the UK and US should work in the Eurozone and my parabel was mainly about Eurozone countries where Spain was propped up by a construction bubble, Greece by hidden government subsidies (those deficits that were higher than they admitted) and the Netherlands had a huge housing bubble. Furthermore the Eurozone countries generally have excellent worker protections (including costly sevarance packages, even for low-level workers), that is for those who are not on a temprary labor contract, once they retire (and a huge number have retired in the past couple of years or will retire soon), get sacked or their employer goes bust many of these jobs can finally be outsourced abroad or replaced by lower paid jobs. This could be particularly damaging to the GDP and employment rates of Spain and Italy. All of this does not automatically imply declining productivity after 2000, although I bet productivity growth has slowed since 2000 in many Eurozone countries.

      P.S. currently corporations have the nasty habit of piling up huge amounts of capital so unfortunately just waiting until inflation hits is not going to tell you when you've surpassed the capacity of the real economy.

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    4. The point is that if GDP was once 100, then all that economic activity actually happened, so it is indeed physically possible and can happen again. If you are going to say otherwise, you need to point to physical constraints that make what was once possible, now impossible. What are they? Or do we just settle for a lower standard of living due to some irrational lack of hysteria, or some such psychological musing?

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    5. Sure it would be physically possible, but not sustainable and would draw resources away from the economies of other countries. Like I said, it would be thinly veiled development aid.

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  7. "However I think the more interesting comparison, from a UK perspective, is between macroeconomic policy under the Coalition and the 1979 government under Margaret Thatcher. That would be an article I would like to write sometime."

    This would be an interesting historical analysis. I hope you manage to get hold of some good primary evidence. This could include what economists of the time were saying (many Post-Keynesians who have been effectively purged out of UK universities) and the transformation of UK economics departments into peripheral adjuncts of a totally US-centred profession and how this affected the diversity of ideas. There were of course a famous list of signatures opposing her policies. Thatcher viewed UK universities as the last bastion of Marxism, probably worse than miners and their union.

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    1. It's not that interesting. Every neo-liberal Conservative government starts off with a slash and burn the public sector, three year period. Then wiser heads notice that all this "austerity" is slowing down the private sector as well. Then they go back to the fiscal injection levels the private sector economy demands (the propensity to save when the economy is slowing). The economy has a burst of activity to try and get back to the trend GDP growth line.

      Thatcher did it; Major did it and Osborne has done it in spades. Osborne will do it again, if re-elected; laissez faire neo-liberals just can't help it. They still think we are on the Gold Standard and are still pining for a return the Victorian era. (Acorn)

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  8. Simon
    No matter that your conclusions are right, but why confuse readers with false explanations? I am talking about the source for government debt.
    First you note correctly: " When the government borrows more it sells its own debt (often called ‘gilts’), mainly to financial institutions including banks. " It is mostly banks, government barely borrows any from persons.

    But then your explanation goes: "but the demand for debt is also increasing because financial institutions have more funds to invest since the private sector is saving more, which is the reason we have a recession in the first place"

    This is so wrong, and it leads readers to wrong conclusions.
    Source for government debts is mandated banking reserves which they can not lend except to government. Banking reserves are all deposits from banking clients mandated to sit at Central Bank. Instead of siting there, by buying government debt they can earn some yield, that is why governments can forever grow their debts without ever paying it off.

    The interest rates for government debt is almost the same as the rate that government asks from banks when thy need to borrow from Central bank. Official interest rate is what banks also asks from government, it goes both ways.

    Where those deposits that end up in bank reserves come from? Bank issues credit out of thin air and when it returns to bank it becomes deposit which have to go into reserves and then what is above mandated rate it can be swaped for government debt. As banks can have inexhaustible sources of credit so do government have inexaustible source for debt, because banks can earn some income isntead of leting it sit at Central Bank.

    Deleveraging process is what turns that inexaustible source into shrinking one which forces government to offer higher rates. Just stoping the process prevents from rising the interest rate on government debt. Government do not borrow someones savings but mandated banking reserves that must exist there in large quantities when private debt is large.

    Please investigate money flow in banking system and then use correct descriptions.

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  9. I think the LRB article is outstanding. It is very convincing. I think it is very clear.

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  10. It's pretty easy to conclude (as a non-economist) that pro-longed austerity was destructive. The question that doesn't seem to go away in the UK (where there was no pro-longed austerity) is whether in 2010 this was as obvious as it looks now. The question is that; with Europe (and the UK) in recovery and after the severe devaluation of GBP was there inevitability in low interest rates, falling demand and lower inflation. Maybe, but I don't remember anyone forecasting that interest rates would remain at 0.5% for the duration of this parliament. I will now read the LRB article and hope to be enlightened.

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  11. I loved the LRB article, but it was elegantly summarizing ideas I've read here, and at other bogs - Krugman, Thoma, Deolong, Dean Baker and others. You guys do a good job at explaining the basics of macroeconomics to lay people like me.

    Regarding austerity. Moral prejudice is the Nemesis of sound macro. It fuels mediamacro. It colors German views of Greece and the monetary theology of goldbugers. Macro should be tecnical not moralizing. But prejudice is hardwired in us. It kept us from getting killed by other tribes long ago. The struggle against is an imperative.

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  12. I loved the LRB article, but it was elegantly summarizing ideas I've read here, and at other bogs - Krugman, Thoma, Deolong, Dean Baker and others. You guys do a good job at explaining the basics of macroeconomics to lay people like me.

    Regarding austerity. Moral prejudice is the Nemesis of sound macro. It fuels mediamacro. It colors German views of Greece and the monetary theology of goldbugers. Macro should be tecnical not moralizing. But prejudice is hardwired in us. It kept us from getting killed by other tribes long ago. The struggle against is an imperative.

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  13. Dr Wren-Lewis,

    Thank you for your wonderful article!

    I think that one reason it is difficult to talk about government debt with non-economists like me is that it is hard to see to what extent government debt is a problem unless you have something else to compare it against.

    I have the impression that the aggregate effect of private debt is a worse problem than government debt, because it was the former that caused the economic collapse of 2008. I also have the impression that (at least in the U.S.) the trade deficit is a worse problem than the federal budget deficit, and may in part be a cause of the federal budget deficit, because the trade deficit creates a hole in domestic demand that can be filled only through government deficit spending or unsustainable increases in private debt.

    If my impressions are correct, it might help the public to better understand government debt if economists explicitly made these comparisons when explaining things to the public.

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    1. I'm American who lives in Korea, a country that manipulates the Won for exports. China does the same. Now Sweeden cut rates below zero like Denmark. The US has a too strong reserve currency , hence the trade deficit. Iphones in Korea are crazy expensive but popular.

      Germany benefits from a weak Euro._If they were Marks their exports would far more expensive.

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  14. I think you underestimate another reason mediamacro tells what you (and I) conceive of as the wrong story: it is a better *story*. It is easier to sell, it is easy to understand, and it comes with a ready-made analogy where the government is compared to those 'bad people' who borrow for 'bad reasons'. (For, as we know, the infinitive 'to borrow' can be conjugated in the simple past tense as follows: 'I borrowed, you may have made some unwise choices, he/she/it is an irresponsible wastrel'.)

    I know less about British press (although I have read my share of British tabloids) but in the US the truth matters significantly less than whether people can 'relate' to the story, assuming that you can get at least someone to attest to the truth of whatever you're printing. And so mediamacro tells the story that people can relate to.

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    1. I wonder if vaccine scares are a useful analogy. (Here is the story about MMR in the UK, which is the one I'm familiar with, but as Ben Goldacre says vaccine scares crop up everywhere, but at different times and about different issues, because they are generated by a local press media:

      http://www.badscience.net/2008/08/the-medias-mmr-hoax/)

      The macroeconomic case is less clear cut, because the discipline is less cohesive and more prone to political ideology, but the vaccine scares point clearly to a basic problem - the irresponsibility and unaccountability of the print media.

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  15. There needs to be a serious discussion in the media of how to resolve the mediamacro problem. How does this not get from the opinion pages (say Krugman) to the front page? You have some good explanations for how it happens, but how can it be challenged? Who is making the effort?

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  16. Hi Simon - I really enjoyed your piece in the LRB. However, I felt you were a bit unfair to the Coalition Government. You discussed the concept of "automatic stabilisers", and indeed the Government recognised the importance of letting these stabilisers work in targeting the cyclically-adjusted structural deficit rather than just the deficit as a whole (e.g. through general tax rises, or cuts in unemployment benefits). The bigger mistake (in hindsight) was - as you say - cutting capital spending when it was not necessary to meet the primary fiscal target, and arguably counterproductive in meeting the aspiration to reduce debt as a proportion of GDP by 2015-16. But overall, I thought the article was a superb presentation of difficult economic ideas for a general audience, and I look forward to more of the same!

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  17. Nice Post, Thanks for your very useful information... SW-L argument seems sound. I would go further: the alternative to a neo-Keynesian macroeconomic policy in Europe is to turn workers progressively into State-assisted slaves to protect (?) them from being overwhelmed by slave-condition workers from less-developing countries that have higher fertility rates and surplus population, or/and intentionally debased currencies (the undercover 'currency wars'). Eurozone has no policy for the full employment of its citizens, and that is quite shameful, or so it would have looked to Keynes' eyes.

    ReplyDelete

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