Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 2 May 2015

Myths: a reply to Tony Yates

In this post Tony was responding to both my mediamacro series and Paul Krugman’s Guardian article, but I’m going to focus on the former. That is because I think Tony only really has a problem with the first in the series, which was about the 2010 ‘crisis’. So his ‘third way’ is really 7/8th my way! He also argues that 2010 austerity was not a major problem because of developments in consumer price inflation, but that is an argument that I did not cover in the myth series, because it is not part of the narrative I was criticising. I will address it here.

First the 2010 crisis. Tony agrees that there were no signs of a crisis in the markets, but he rightly says that a crisis could have subsequently happened. If I wanted to be pedantic, I would say that this means he agrees with my criticism of the mediamacro narrative, which at the very least allows politicians to pretend that there was an actual crisis. There is rather a big difference between “we saved the economy from a firestorm”, and “we took prudent action because bad things might have happened”. So maybe 15/16th my way.

As there was no actual crisis, what were the chances of one happening? Eric Lonergan has written a very good response to Tony on this, but he makes an additional point which I have made in the past but which I can too easily forget. Because austerity damages the real economy, it increases domestic credit risks. To the extent that governments stand behind those extending the credit (banks), then austerity can actually increase government default risk. So austerity as a precautionary policy can actually make the outcome you are trying to prevent more likely.

I also think I take a different view to Tony on what might have happened if markets had suddenly taken fright on the deficit and stopped buying UK debt. We agree that the Bank could have just bought the debt - as it was doing anyway under QE. But could it control inflation at the same time? At first sight it seems obvious that printing more money to buy government debt would compromise the inflation target. But that will not be true if you are at the Zero Lower Bound (ZLB), and austerity is only a problem at the ZLB. Paul Krugman has written a paper on this, but it becomes irrelevant because of our second disagreement.

This is that although the lack of recovery from 2010 to 2012 was regrettable, it was also inevitable given that inflation was way above target. Tony sees the MPC as trying - and largely succeeding - in getting the optimal balance between inflation being too high and output being too low. If that is the case, the ZLB was not actually a constraint during that period - interest rates combined with QE were doing just what the MPC would have wanted. This view is also a position that I think most MPC members hold.

Here I think we need to take a step back and think about what good policymaking is. A good policy is one that allows for what might happen, and not just what eventually did happen. In a sense this is a trivial observation: we do not want policies that are OK 51% of the time, but really screw up 49% of the time. However I think, after the event when we know how the world did turn out, it is so easy to forget this key point. We do not want to take taxis that generally get us there a bit quicker by taking risks, but occasionally crash. If we are unlikely enough to take such a taxi, and we do not crash, we do not say to ourselves ‘good choice’.

As Paul emphasises in his reply to Tony, you wait until you are well clear of the Zero Lower Bound (ZLB) before embarking on fiscal tightening. You are about to hit the economy hard, so you want to be pretty sure that someone else will be able to make sure it can absorb that blow. In the case of Osborne in June 2010, we do not know if he even understood the risk, because his keynote speech on macroeconomic policy ignores the ZLB issue. But if he did, he certainly did not think to himself that inflation was going to rise to 5% in 2011 so austerity is OK. (The OBR forecast for inflation was below 3%.)

While on that subject, Martin Sandbu says that as Danish and Swiss rates are now negative, 0.5% was not the ZLB anyway. This is completely beside the point. It was absolutely clear in 2010 that the Bank regarded 0.5% as the lower bound, so they were not going to cut rates further. The Bank was independent, so the Chancellor had to work around what the Bank was actually going to do (and not what five years later we might wonder what it might have done). 

What this all means is that Tony’s argument about inflation is not an excuse for austerity, but an argument about how much in practice it cost. I addressed this argument in detail here. I will not repeat what I said, because I do not want to detract from the more fundamental point above, but the upshot is that the £4000 per household figure that I often quote for the cost of austerity already incorporates some monetary policy reaction to fiscal decisions, so could well include any raising of rates in 2011 if austerity had not happened. But whatever the cost, 2010 austerity was a first order policy mistake, because it took unnecessary and large risks with the economy. 


  1. There seems to be no reciprocal fear that by allowing the City to over-lend to the private sector in the boom years and then under-lend to the government in the bust years the supposed role of risk distribution played by finance in an economy ends up being a double dose of risk concentrated.

    1. I agree with this. Ideally an independent central bank would be able to offset increase credit risk with more unconventional policy or a helicopter drop, etc. But often we've seen the central bank being pressured to end unconventional policy too soon and so practically austerity does increase credit risk.

      What the non-Keynesians and austerians have done is replace "the boom" with recovery. Once the financial crisis was over and the economy had turned around, they went about cutting the deficit but there was still an output gap and high unemployment. They jumped the gun.

  2. "This is that although the lack of recovery from 2010 to 2012 was regrettable, it was also inevitable given that inflation was way above target."

    This is a circular argument. Inflation jumped because of austerity-induced VAT hikes (yes, I know they did not need new legislation as they came through the expiry of temporary cuts, but withdrawing support during a depression is austerity writ large), not because the economy was threatening to overheat.
    Fighting this,whether with public spending reduction or monetary contraction, is insane.

  3. One of the problems with the "austerity" debate is that around both public and private sectors there are activities which need readjustment and reallocation of resources. It is ongoing economic and technical etc. change as well as rebalancing money flows to meet rapidly changing needs. The "austerity" idea increasingly means no change or readjustment at any price and for any reason and means statis in a time of movement.

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  5. Simon,

    This is off topic, but how about publicising this anti-macromedia petition aimed at the BBC on your blog?

    1. Ralph, indirectly it appears, his blog has advertised the petition. :-). I'm off to sign the petition after making this post.

  6. Paul Krugman has over 1.3 million followers on Twitter; Art Laffer has 462 followers; N Gregory Mankiw has 13,900 followers. Since the death of Milton Friedman, there has been no right-wing economist that has a serious following such as that of Krugman.

    That said, Krugman has earned the emnity of the right wing press such as the WSJ. (The columnist Mike Royko once wrote that any fish would not be willing to be wrapped in a Murdoch paper.)

  7. "At first sight it seems obvious that printing more money to buy government debt would compromise the inflation target."
    ? How so, pray tell?

    1. I’d guess that Simon is just saying that when the words “print” and “money” appear in the same sentence, that produces a knee jerk reaction along the lines of “inflation”. Of course it’s silly to jump to the latter conclusion, but that’s what about 90% of the population does.

  8. Simon: two points:

    1. "At first sight it seems obvious that printing more money to buy government debt would compromise the inflation target. But that will not be true if you are at the Zero Lower Bound (ZLB), and austerity is only a problem at the ZLB."

    Does that mean you believe that QE was completely irrelevant, and that the Bank of England should not have bothered? That doesn't seem to match the Eurozone experience, where the meer threat of QE by the ECB seemed to help.

    2. We cannot really know whether "austerity" had any effect or not on X, because we don't observe the counterfactual path of X. The best we can do is extrapolate the trend of X, and compare X after the policy change to the previous trend. But X is a vector, and we can get conflicting answers depending on which x we use. If we want to know whether austerity prolonged the recession, should we look at output or employment?

    (As an aside, comparing Canada to the UK and US puzzles me. Unlike the UK and US, the Canadian federal government did a fiscal policy that is very much in line with what you would have wanted. It loosened fiscal policy at the beginning of the recession (mostly infrastructure investment, with a big emphasis on projects that could be started very quickly), and then tightened *after* the Bank of Canada had raised the overnight rate. But this is a supposedly very conservative government, certainly more conservative than the US president, who said that the US government needs to tighten its belt in bad times just like US households. Why the big difference? Maybe because our PM has an MA in economics? Maybe because prior to the recession we had a low debt/NGDP and biggish surpluses, so plenty of fiscal room to maneuver? Maybe we just got lucky in lifting off the ZLB earlier than others? Whatever the reason, it doesn't fit the left/right political economy narrative.)

    1. 1) No, QE was better than nothing, but it does not negate the ZLB problem. As I wrote a few months back, when the Eurozone recovers everyone will praise QE, and not mention that fiscal contraction has largely stopped.

      2) We now have tons of evidence that fiscal contraction reduces output when monetary policy cannot offset. And output, not employment, obviously?!

      3) I agree Canada is interesting. Perhaps all three of your reasons for the difference are valid.

    2. Thanks Simon:
      1. If QE was better than nothing, meaning dAD/dQE was positive, no matter how small, then it would seem to me that QE does negate the ZLB problem, unless the BoE runs out of bonds to buy.

      2. It's not obvious to me. We could look at the output gap, or the employment gap (or the unemployment gap) as a measure of the short run real effects of AD. AD policies can (in principle) give us "full employment" of resources, but cannot magically increase productivity. Suppose hypothetically we observe employment rise and output fall (both relative to trend). Do we say that fiscal tightening caused productivity to fall, or do we say something else caused an exogenous fall in productivity?

    3. 1. You are right that even if dAD/dQE is small, you can just do more QE. But there are three related problems. First, dAD/dQE may be declining in QE. Whatever premium on long rates is being reduced, it is finite. Second, because the size of this derivative is unknown, policy using QE is going to involve large errors. As a result, any central Bank is inevitably going to be cautious, which means they will do too little too late.

      2. We know dY/dG>0 - that is what our models and evidence tell us. A standard assumption is that employment follows output. I do not see what you are trying to get at here.

    4. 2. (I'm not explaining myself very clearly). The same models that tell us dY/dG > 0 (under certain conditions wrt monetary policy) will also tell us that dL/dG > 0 (under those same conditions).

      If at time t we observe dG/dt < 0, observe dY/dt < 0, and observe dL/dt > 0, (all relative to trend) does that confirm or disconfirm the model? It's not obvious to me.

    5. My reasoning is that, in 'the model', the transmission mechanism is G to Y to L. So if the G to Y works, but the Y to L does not, something odd has happened to productivity.

  9. Simon - do you think it's legitimate to link the cornerstone Coalition macro policy of combining austerity with QE with the rise in inequality? I would propose the following high-level argument:

    1. The coalition has taken billions of pounds out of the economy through its austerity program.
    2. At the same time, it has inserted billions of pounds into the economy through QE, a bulk of which has been used to purchase gilts from financial institutions, with the ultimate aim of providing them with liquidity to provide more finance to the real economy and stimulate growth.
    3. However, the govt can't guarantee this is what QE has been used for--there's a suggestion that QE is being used to shore up balance sheets, increase returns to shareholders and for remuneration packages.
    4. This overall combination has brought about an enormous transfer of wealth to the top 10% and made the UK more unequal than it was in 2009.


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