Is there anyone left who really believes that George Osborne is
cutting public spending because he wants to be prudent with the
nation’s finances? Unfortunately I think the answer is far too
many.
Most macroeconomists have had deep suspicions or worse for some time,
as we could see what damage austerity was doing to the economy. You
might say that issue is past as growth has returned, but this would
be quite wrong. What is now becoming clear is that the fears that
some
economists had all along that delaying the recovery in demand would
lead to permanent damage to supply have indeed come to pass.
Those who were not macroeconomists should have realised what was
going on when the government started cutting taxes. How do you
explain cutting inheritance tax one day, and then trying to justify cuts in tax credits because ‘we have to get rid of the budget deficit’
the next, other than helping your own at the expense of the poor?
Even if that did not convince you, I suspect what will happen in the
next few years will leave you in no doubt. Everyone knows it is crazy to cut spending that would have generated more income
than it costs. Appearing to balance the books by paying for current
spending (or tax cuts) by selling off your assets is not being
prudent at all. Yet I suspect we will see more and more announcements
from the government that do exactly this in the next few years.
To take just one example, we have the announcement
of yet more cuts to HMRC, the government’s tax collectors, as part
of the new spending review. No doubt we will hear a lot of talk about
reorganisations to make the service more efficient. Just as we did
with the previous cuts. In March 2015 it took an average of almost 15
minutes to have your phone call answered by HMRC. For the government
that is a sign that the service needs less people! I do not
know if the OBR allow something for the impact of HMRC cuts in their
estimate of overall tax receipts, but if they have not done so
already I think they should start.
This is a very obvious example of apparent savings that in fact
reduce net revenue. Many more involve cutting public spending in a
way that increases costs to the private sector, leading to lower
productivity, lower incomes and then lower taxes. But for a
politician facing a tame media who just has an eye for the headline
numbers none of this matters.
The letter
that the Prime Minister wrote to his local council complaining about
its cuts has got some publicity. But what I found most revealing was
Cameron’s suggestion that the council pay from some ongoing
frontline services by selling more assets. The council leader in his
reply explains that using the income from these sales to pay for the
council’s running costs “is neither legal, nor sustainable in the
long-term since they are one-off receipts”. The Prime Minister
offered the services of No. 10’s policy unit to help the council.
It sounds to me that the council should in turn be offering some of
its wisdom next door at No. 11.
"What is now becoming clear is that the fears that some economists had all along that delaying the recovery in demand would lead to permanent damage to supply have indeed come to pass."
ReplyDeleteWell, maybe. But just because Delong/Summers write down a model in which they assume hysteresis happens doesn't make it true. And the channels which we worried about hysteresis happening in the 1980s (labour force exclusion) don't seem to apply in the UK this time as employment growth has been so strong.
Persistently low output is equally well explained by a persistent shock (or a shock with a "unit root"). Or ongoing problems in the financial sector, which have yet to be resolved (undercapitalised banks etc.). These are observationally equivalent to the hysteresis channel, and at least as plausible.
Do you think that cutting back on public investment had no impact on supply?
Delete"just because Delong/Summers write down a model in which they assume hysteresis happens doesn't make it true"
Delete-Very weak indeed. Equally it doesn't make it untrue...and if you contend it to be untrue you need to put forward evidence which helps support this viewpoint, as opposed to simply casting doubt on the existence/impact of hysteresis. Is there any evidence or sound arguments which would clearly indicate that hysteresis doesn't exist now?
The reasoning you provide above - 'employment growth has been so strong' - as an indicator of lack of hysteresis in the UK is farcical when you more closely analyse the true state fo the labour market, types of jobs created, working hours and contracts, not to mention the slight of hand by government on the true numbers involved (reclassifying types of employment, and unemployment) grossly distorting the true health of the labour market.
“These are observationally equivalent to the hysteresis channel, and at least as plausible.”
DeleteApparently not: http://faculty.insead.edu/fatas/CEPR_DP10902.pdf
Its also important to note:
Delete"Persistently low output is equally well explained...at least as plausible."
According to who? On what evidence?
This last point fails to acknowledge the numerous empirical studies undertaken into the impacts of austerity policies which all suggest the persistently low output has been caused by government policy choices, as well as other factors (such as those you mention), as opposed to just those other factors. SWL gets straight to the point in his reply to you on this - how can the austerity policies undertaken (most notable huge reductions in public investment spending) not have had an impact on UK growth rates??
@ MainlyMacro: that wasn't your original point. You claimed that low demand would lead to permanent damage to supply, without reference to the composition of such demand. From memory, the delong/summers model doesn't have public investment as the driver of hysteresis either.
DeleteAs it happens I am skeptical that the UK's current weak supply has much to do with public sector investment, as a good chunk of the investment which was cancelled related to stuff which shouldn't have a supply side effect yet (e.g. cancelling the Building Schools for the Future programme: the first of those schools would only recently have been completed, and their students would not have entered the labour market by this point). I mean, maybe the UK recovery is being choked off by potholes on the M1, but it seems unlikely.
@Simon: No I don't. I just pointed out that there are other explanations equally as consistent with the data as labour market hysteresis. We can argue about which are more likely, but to dismiss e.g. the possibility that the banking sector still has problems unrelated to aggregate demand requires evidence too, given all we know about how persistent banking crises are.
I think the DeLong and Summers framework would operate in exactly the same way for public investment, and have always wondered why they did not make this point. Why are you so keen to dismiss the idea that austerity had a permanent supply side effect without any evidence at all?
Delete@ MainlyMacro:
DeleteThanks a lot for the reply!
I am a little skeptical that such an effect is "becoming clear" - that we now have more *evidence* that hysteresis has occurred. This was your original claim. Aside from the observation that output has been lower than the pre-crisis trend - which could also be because of other things - I know of no such evidence (or if there is, it would be really interesting if you could link to it).
Put it another way. Suppose the government had chosen to keep public spending at pre-crisis levels (in real terms) but had chosen to cut other areas of spending instead so that the real PSBR was unchanged from that which actually occurred. Do you think that supply in this case would have been unaffected by "non-investment" austerity (i.e. do you think that the supply effects of austerity only operate through public investment?). Or do you think that persistently weak demand in and of itself can lead to lower supply permanently? If the latter, how?
(also, it's worth saying that temporarily low public investment shouldn't lead to a permanent effect on supply anyway. If future public investment were high enough, the stock of public capital would return to its previous trend line. So it doesn't seem likely that low investment can have a *permanent* effect, any more than temporarily low private investment has a permanent effect on the level of output in a Ramsey model).
@blenheim
DeleteWho says the other explanations are 'equally as consistent with the data'? Why avoid saying what numerous studies have concluded...that austerity policies have had a significant negative impact on growth and slowed the recovery? Instead focussing on other issues ( which I also think played a part).
@ Simon:
DeleteI am not disagreeing here with the statement that "austerity slowed the recovery". My argument is whether any such slowing happened through demand or supply (whether it affected the output gap or potential output). Normally we think fiscal (and monetary) policy affect demand, but leave supply alone - and hence austerity/higher interest rates are deflationary.
SWL's original claim was that prolonged lack of demand caused a permanent reduction in supply. There have been some papers claiming that this occurred in e.g. the 1980s in Europe, but through exclusion of the long-term unemployed from the labour market. This has not happened in the UK this time. There may be other reasons why hysteresis occurred, but I have seen no evidence or research on this, hence my question.
Why do we care about demand vs. supply? It matters, as if the hysteresis isn't symmetric (i.e. if the lost workers are lost forever) then the BoE will have to raise interest rates as the previously large output gap won't hold inflation down. This is why understanding whether hysteresis happens and how really matters for policy at the moment in the UK (it also matters if supply is affected through the channels I mentioned). If the output gap really is zero, and the budget deficit is larger than the sustainable level (as it still is) then this is also an argument for austerity now (even if austerity was a mistake over the last five years if the output gap was then large and negative).
As SWL hasn't provided any link or further evidence on this (and is talking about public sector investment, a temporary haitus of which doesn't have a permanent effect on output anyway); I suppose it was a throwaway remark rather than a thought-through comment. That's ok - this is a blog! But I commented as I thought he had a new insight which I'd missed somewhere.
The drop in public investment is projected to be permanent, but even if it was temporary it would have a persistent impact on the stock of public capital and therefore output. So cutting public investment is a sure fire way of hitting supply which I doubt any economists would argue with.
DeleteOther mechanisms are more speculative (in terms of not knowing their size). Lower investment caused by a persistent recession leads to lower embodied technical progress, so leading to lower productivity. A deep and prolonged recession can lead firms to cut back on training, again reducing productivity.
One final point. I'm sure the financial crisis itself has had some permanent supply side impact. But a reduction of 15% compared to previous trends? There is absolutely no evidence for such a large impact.
I do not do throwaway remarks.
@blenheim
DeleteI appreciate you taking the time to clarify and explain your position, but do not understand where you are coming from when you say "normally we think fiscal and monetary policy affect demand, but leave supply alone". Sure, they are demand management tools, but a fiscal consolidation policy of cutting G by large reductions in public investment spending (eg. On infrastructure, machinery, equipment etc) will then surely reduce the productive potential of the economy going forward? Fewer public investment projects also imply less contracts and revenue for private firms who may have been engaged in them...and less profits for these firms implies a reduction in investment in capital and potentially training of workers...again implying a loss in productive potential.
Is there a reason why you claim the reduction in public spending is only temporary? This government doesn't intend it to be so.
Lastly, is the budget deficit larger than the sustainable level? What indicators tell you so?
Back in the Sixties, it was called asset stripping when big corporations did it. Now the big corporations employ a Conservative government to strip the assets and hand them over at file sale prices. Naturally, the public sector gets to keep the dodgy bits, like a Royal Mail pension fund and the like.
ReplyDeleteThe UK is a centrally planed economy with one sub-national tax (Council Tax), which recovers circa 4.3% of government current receipts. Local government spends circa 24% of UK total managed expenditure. The Soviets and the North Koreans would be pleased at that level of centralised control. http://blogs.lse.ac.uk/politicsandpolicy/elective-dictatorship-democratic-mandate/ .
BTW. Bill Mitchell has written the intro to Warren Mosler's German edition of "7DIF". Hopefully, the German high command will read it and discover the error of its ways. This Mitchell / Mosler combo should be compulsory reading for sixth formers. It will tell you all the bits of macro-economics that should be understood before you do a Banking and Finance degree. http://bilbo.economicoutlook.net/blog/?p=32284#more-32284 .
All the best.
It is quite staggering that the concept of 'one-off receipt cannot be used to pay for ongoing year-by-year costs' is difficult to grasp, but the same things were doing the rounds when Osborne sold of East Cost for next to nothing to make the debt numbers look better. The difference between Osborne and Cameron, though, is that I suspect Osborne knows full well what he's doing.
ReplyDeleteI'm surprised that it hasn't had more of a reaction though - Cameron offering the services of the Number 10 policy unit to his own constituency council (and only his) is surely breaking the rules on keeping constituency and government matters separate?
Are you really surprised by the lack of reaction? Most of the media are more interested in whether Corbyn did or did not kneel before the Queen.
DeleteI suppose I shouldn't be by now, but I remain a foolish optimist.
DeleteIt does often seem as though Cameron's greatest achievement in government is lowering a significant number of people's expectations so much that turning up to parliament is considered an achievement worthy of re-election.
Hi Prof,
ReplyDeleteI was wondering if you could write something on the Chancellor's policy of cutting Corporation tax year-on-year.
As I understand it (and I'm happy to be corrected) the evidence for a boost in employment is non-existent and hence the argument for is very weak. I also find it difficult to stomach repeated corporation tax cuts when apparently balancing the budget is so important (!). And finally am I right in thinking that corporations hoarding cash is one of the big problems for the economy over the past few years and hence anything that discourages investment (i.e. effectively making investment more costly) is a bad idea.
Many Thanks
AFZ
As much as I enjoy the 'Mostly Politics' blog, this one is a bit silly.
ReplyDeleteWho on earth have you been talking to?
Just the voices in my head! Seriously, I see very little that is controversial here. The macroeconomics is straightforward, and its not my fault you do not like the political implications.
Delete''permanent damage to supply"? Really?
DeletePermanent damage to the supply of what?
Things that people only 'want' if the government is issuing more currency (or borrowing) to pay for it?
Such a strange remark I cannot begin to make sense of it. Perhaps it would have been clearer if I had said a permanent reduction in productivity.
Delete"Things that people only 'want' if the government is issuing more currency (or borrowing) to pay for it?"
DeleteThe question is do you want capitalism to work or not?
If not we will have communism.
I have just read the piece you put a link to some months ago, 'The ‘1981 statement by 364 economists’ revisited' by Robert Neild, and in it he says of Friedman that:
ReplyDelete"He did not mind being asked at short notice to take part in a debate, and typically would consent before asking what the subject was. If told that it was, say, capital punishment, he would say ‘Great, which side?’ and perform brilliantly whichever side he was on. Although forewarned, I found the way he avoided saying what caused the historical association between money and prices by means of prevarication and mockery so maddening that I lost my temper with him on the live programme. The shame I felt at making a public exhibition of myself imprinted the episode in my memory."
I don't see anyone of expertise, economic or rhetorical, coming out for the Tories at the moment. It's hard to imagine who that figure could be.
It's fewer people. Not less.
ReplyDeleteAnd you really have no idea whether HMRC reforms will save money or not. None.
Daft post.
Stephen Pinker writes " In cases where "less" and "fewer" are both available, such as "Less/fewer than 20 of the students voted", "fewer" is the better choice because it enhances vividness and concreteness. But that does not mean that "less" is a grammatical error."
DeleteOn the more important issue, I think the government has no idea either, which is kind of the point.
Today Osborne announced his latest asset stripping - the sale of £13billion ex-Northern Rock mortgages with a supposed gain of £280million. These have apparently been generating about £620million annual income of late.... http://waitingfortax.com/2015/11/13/so-just-how-good-is-that-cerberus-transaction/
ReplyDeleteI think the basic test should be whether the expected value of the income stream from holding these assets is greater or less than the expected value of the interest on government debt saved. Has the government published such an analysis?
DeleteThe quants at Cerberus versus George Osborne. I know who I'd put my money on for doing their sums correctly.
DeleteJust wanted to say please keep up the good work. Your posts are informative, thought-provoking and often fun, which is what makes for an excellent blog. Bravo!
ReplyDeleteThere was an excellent statistic last year about the proportion of the debt repayment that had been done via sell-offs rather than cuts. Non-sustainable, but politically effective. The curse of democratic short-termism.
ReplyDeleteLots of talk about "Hysteresis( what has Magnetic Friction got to do with Macroeconomics) Simon, your blog is very good(for a change) but pls answer MY question. Look forward to your reply lol
ReplyDelete"Hysteresis? "
DeleteRead:
http://bilbo.economicoutlook.net/blog/?p=30947
and
http://bilbo.economicoutlook.net/blog/?p=26163
All of this is just the same logic re Krugman 2003:
ReplyDeleteFirst, Krugman in 2003:
"There is now a huge structural gap — that is, a gap that won't go away even if the economy recovers — between U.S. spending and revenue. For the time being, borrowing can fill that gap. But eventually there must be either a large tax increase or major cuts in popular programs. If our political system can't bring itself to choose one alternative or the other — and so far the commander in chief refuses even to admit that we have a problem — we will eventually face a nasty financial crisis.
The crisis won't come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.
But at a certain point we'll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.
What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government's access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos. "
[Paul Krugman, New York Times, 10/14/2003 http://www.pkarchive.org/column/101403.html ]
Fast forward to Krugman, again in the NY Times, on November 26, 2012:
"Still, haven’t crises like the one envisioned by deficit scolds happened in the past? Actually, no. As far as I can tell, every example supposedly illustrating the dangers of debt involves either a country that, like Greece today, lacked its own currency, or a country that, like Asian economies in the 1990s, had large debts in foreign currencies. Countries with large debts in their own currency, like France after World War I, have sometimes experienced big loss-of-confidence drops in the value of their currency — but nothing like the debt-induced recession we’re being told to fear.
So let’s step back for a minute, and consider what’s going on here. For years, deficit scolds have held Washington in thrall with warnings of an imminent debt crisis, even though investors, who continue to buy U.S. bonds, clearly believe that such a crisis won’t happen; economic analysis says that such a crisis can’t happen; and the historical record shows no examples bearing any resemblance to our current situation in which such a crisis actually did happen.
If you ask me, it’s time for Washington to stop worrying about this phantom menace" [Paul Krugman, New York Times, 11/26/2012 http://economistsview.typepad.com/economistsview/2012/11/paul-krugman-fighting-fiscal-phantoms.html ]
Or is your viewpoint nearer Krugman2012 Simon? Trying to figure out where you fit.