Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday, 22 May 2017

Still not getting it after all these years

I met Nick Macpherson, the most senior civil servant at the UK Treasury from 2005-16, for the first time (I think) a few weeks ago. It was at a conference about, among other things, getting economic ideas across to the public. He is also on twitter, and I saw the following exchange between him and Tony Yates.


To be fair to Nick, I get many people saying the same thing: we are at full employment, so we should not be running deficits. Let’s not on this occasion discuss how we can be at full employment when nominal wage growth is so weak, or into the distinction between current and total deficits. The main point that Tony makes above is that you cannot discuss what an appropriate fiscal policy setting should be without thinking about monetary policy.

There was one reason, and one reason alone, that we had fiscal stimulus in 2009. It was because nominal interest rates had hit their lower bound. A recession in itself is not a sufficient condition for a fiscal stimulus if monetary policy can do all the work of getting us out of the recession. [1] But when interest rates are stuck at their lower bound, monetary policy has lost its ability to regulate the economy, which means we are either stuck in a recession or are vulnerable to any negative demand shock. Unconventional monetary policy, although better than nothing, is far, far less reliable than conventional monetary or fiscal policy.

It is therefore a prime duty of government to ensure that, if interest rates have hit their lower bound, fiscal policy is solely directed at allowing monetary policy to raise rates. This idea is not new. It was always implicit in New Keynesian theory and what I call the Consensus Assignment. Paul Krugman, Brad DeLong and others have been going on about it at least since the financial crisis. The idea should be part of any fiscal rule, as Jonathan Portes and I suggest here, and this is still part of Labour’s fiscal credibility rule.

In the UK, at this very moment, we are once again at the lower bound for interest rates. That means fiscal policy is currently too tight. Whether we are at full employment is neither here nor there. Interest rates are at their lower bound because the negative influences on aggregate demand are more than monetary policy can handle. One of those negative influences is fiscal consolidation. That fiscal consolidation should wait [2] until interest rates are safely clear of their lower bound.

This is not one particular theory of monetary and fiscal policy interaction. It is the consensus theory. That it is not understood by the public is understandable given mediamacro. But not being understood by senior civil servants (and I doubt Nick is alone here) when they are free to speak their minds is much more surprising.

[1] I’m using consensus theory here, and abstracting from uncertainty.

[2] It can wait because there is no problem in financing the deficit, and because we print our own currency there has never been any such problem.  

20 comments:

  1. It would be interesting to know what policies Sir Nicholas would advocate at the moment to achieve (or maintain) full employment, combined with no structural current deficit....

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  2. "not being understood by senior civil servants (and I doubt Nick is alone here) when they are free to speak their minds is much more surprising"

    PLEASE tell me that choice of word ('surprising') is loose usage on your part rather than a considered statement.

    Because if not it reveals you are woefully if not terminally uninformed about the depth of senior civil service members' ideological impairment. You may be able to find a couple who are brave enough on isolated occasions to speak truth to power but the vast majority continue to maintain their focus on stoking the vast pension pot at the end of the rainbow.

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    Replies
    1. As habits are formed, neurological networks get reenforced, such that learning has more than figurative transformative effects. It also means there is a big price to pay when you instrumentalize speech instead of directing your effort at unveiling truth: you train yourself to be blind, one bad decision at a time, and it eventually happens that you will face problems and, instead of enjoying the wisdom gained by honesty and hardship, you will be hopelessly silent, baffled by events.

      If he does act as a puppet to his retirement, believe you me: he will pay the price, ten fold.

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  3. Just how many senior officials in the central state and in the BBC have been capable of watching Osborne change his economic policy in 2012 and have seen fit to ignore it?

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  4. Non-economist here. When you say "Let’s not on this occasion discuss how we can be at full employment when nominal wage growth is so weak...", you seem to be implying we're not at full employment, or not really at it - because if we were, then wage inflation would be higher (and presumably price inflation would be too). In what sense aren't we at full employment? I take it you're not talking about the gig economy...

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  5. That people such as Nicholas Macpherson express the view that they do should give you pause for thought.

    You may be perfectly right in what you say but can you dismiss the "Swabian housewife argument" so blithely? I'm sure you're not saying that deficits simply don't matter but what exactly are you saying? I can understand a view that says we should aim for balance over a business cycle, or even two business cycles, but when was the last time we ever came close to achieving that?

    The consequences of deficits over time must be a crowding out of substantive spending in favour of interest; a depreciation of the currency and a rise in interest rates generally.

    Also the idea that consolidation can wait until the movement away from the ZLB is somewhat naive; these are manipulated rates and the very reason they are being manipulated is to avoid the consequences that you deny as having much significance!

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  6. Why do you prefer running a larger deficit (enough to keep interest rates above ZLB) and lowering interest rates to cope with a shock to the alternative of running a smaller deficit and then increasing it to cope with a shock? Is it down to monetary policy's allegedly greater power as a stabiliser?

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  7. I wonder whether people are talking past each other because they see quite different goals. SWL sees the goal as maximizing output; the sound money crew sees the goal as avoiding any risk to the real value of debt. A state of mild economic depression with people on zero hours contracts etc poses much less risk to creditor interests than anything that could risk wage inflation. Rising interest rates could crash asset markets, there is a powerfull lobby that wants to avoid that.

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  8. Obviously Macpherson has not done his home-work. However, SW-L’s article is not flawless. Reasons are thus.

    Macpherson says there should not be a structural deficit at full employment. SW-L answers by saying that despite full employment (or something near full employment) we are still at the zero bound, ergo a deficit is needed to get interest rates up.

    Well OK, having got them up, SW-L would presumably say that no more deficit is needed. I beg to differ. That is, there is a very simple and fundamental reason why a deficit will be needed in perpetuity even given constant full employment. It’s thus.

    Given the 2% inflation target and given say 1% growth in real terms, the monetary base and national debt relative to GDP will shrink at 3% pa. On the not unreasonable assumption that the debt and base will remain constant relative to GDP (which is what they’ve actually done over the very long term), then that shrinkage in the debt and base needs made good every year, even given full employment. And that can only be done via a deficit. The actual amount of the deficit, assuming the above figures, and assuming the debt and base are say 50% of GDP will be (2+1)x50%=1.5% of GDP.

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  9. I'd appreciate your views on whether we genuinely have full employment given:

    - many employers have no problem recruiting workers to fill minimum wage jobs as they can easily fill these roles from workers in the EU.
    - many workers receive working tax credits, so in effect their employment is subsidised by the state.
    - many people are "self-employed" but in reality are not doing much work.

    I'd have thought the definition of full employment is that employers cannot increase their workforce without increasing pay. Is that fair?

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  10. «A recession in itself is not a sufficient condition for a fiscal stimulus if monetary policy can do all the work of getting us out of the recession.»

    This is based on the assumption that "monetary policy" will create bigger asset prices and spending fueled by the capital gains "wealth effect" will "trickle down" from the very rich to workers.

    «But when interest rates are stuck at their lower bound,»

    Which interest rates? There are at least a dozen that matter to commerce, at widely different levels. The rate at which the central bank lends to "friends of friends" corporates does not seem that interesting to me.

    «monetary policy has lost its ability to regulate the economy»

    Monetary policy does not "just" regulate the economy: it is large distributional impacts between property and work incomes.

    «Unconventional monetary policy, although better than nothing, is far, far less reliable than conventional monetary or fiscal policy.»

    «It is therefore a prime duty of government to ensure that, if interest rates have hit their lower bound, fiscal policy is solely directed at allowing monetary policy to raise rates.»

    So fiscal policy has nothing to do with stuff like roads or defense or science or health or bank bailouts and the consequent vast impact on distribution; it is just there to generate deficits or surpluses as required to enable monetary policy. Because outside the lower bound markets are perfectly efficient and fair and the only role of policy is to enable that.

    Not unexpected from New Keynesian Economists :-)

    «It is the consensus theory»

    Indeed :-).

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  11. Is there a view on how much fiscal expansion the UK economy could take without inflation rocketing? If we are at full employment, and given the huge infrastructure projects currently in place, where is the capacity? Are we reaching a new norm of full employment and output way below the norms of 2000, or 1990 or...? Has the UK economy gone through a paradigms shift comparable to the 1970s?

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  12. Simon,

    I agree with your argument but I worry that it is not compelling for the deficit hawks. Their point is based upon an implicit assumption that fiscal policy is a de facto policy decision for after the fact (of trend productivity growth). Many economists would argue it is not, but given it is a point of contention and difficulty to prove without actually trying fiscal expansion we're stuck with the disagreement.

    Let's assume that secular stagnation is inevitable, is it credible to manage the deficit down? Perhaps, but let's look at Nick's point. He mentions debt and devaluation, but even if government debt increases causing inflation and a depreciation of the pound then ultimately it will be current bond holders that lose out. UK holders would effectively transfer wealth to the government, and foreign holders would suffer losses, it's hard to see the problem? (Apart from sharing the pain of lower productivity across more generations?) If gilt rates rise then sure, start to watch the deficit, but then monetary policy would be more effective. I could almost understand reason for caution if gilt rates were above expected GDP growth, but they're not, and the UK government is not struggling to sell gilts.

    It would be interesting to see how this view contrasts to Nick's predecessors, and I'd also argue a greater degree of accountability for senior civil servants to the public accounts committee on macroeconomic decisions, something for which I wonder if a national audit office style expert function could be brought to bear?

    Anon

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  13. George Osborne's ideological fixation with trying to shrink the state by cutting public expenditure is only one half of the story. The use of unconventional monetary policy - in the main, QE - was equally, if not more, politically convenient.

    QE has opened a huge gap between the return on capital and the cost of capital which, not surprisingly, the capitalist rent-seekers have exploited, and continue to exploit, mercilessly. And this gap is being institutionalised because the economic regulators are making their determinations of the cost of capital as if conventional monetary policy were operating normally.

    Clearly these policies advantage capitalists at the expense of workers and consumers. But there is no mystery here. It's a simple case of "follow the money". The mainstream politicians know the score, it would be irrational for civil servants to derail the gravy train and the media hacks know on which side their bread is buttered.

    The interesting question now is will QE ever be unwound. Or will it simply "evaporate"? It has already been netted out in the Whole of Government Accounts.

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  14. Nick Macpherson's speech on Keynesian economics gives more details on Treasury thinking: https://www.gov.uk/government/speeches/permanent-secretary-to-the-treasury-on-the-general-theory-at-80

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  15. Germany-level hawkishness. He probably wants zero inflation forever, whatever the effect on unemployment.

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  16. Full disclosure- I'm a mainly macro zealot, so see this through the lens of one wishing to defend a counterattack...

    I wonder what you might say to the observer who says "well- what about Japan? They're at the lower bound, full employment, and have been trying to stimulate for years but it isn't working".

    My own view is that Japanese stimulus tends to be a matter of talking a big game but not actually delivering, and half measures aren't effective.

    For what it's worth, I came here expecting to read about rapid food for those with a Y chromosome, but then I realised I'd misread the title as 'manly micro'.

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  17. Interesting thing here is how he became so radicalised. If he means it with "#soundmoney" he thinks we're on a gold standard or similar. Also, surely someone shd ask him where's the inflation.

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  18. Also, regardless of fiscal policy versus monetary policy, if you run a small deficit whilst growth and inflation are high enough, then the ratio of debt/GDP comes down/doesn't rise anyway, so it's not entirely clear what the harm is. You don't have to run *zero deficit* in the good times to at least *stand still*.

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  19. Consensus, buddy consensus, scientific consensus, or what?
    Comment on Simon Wren-Lewis on ‘Still not getting it after all these years’

    You argue: “It is therefore a prime duty of government to ensure that, if interest rates have hit their lower bound, fiscal policy is solely directed at allowing monetary policy to raise rates. This idea is not new. It was always implicit in New Keynesian theory and what I call the Consensus Assignment. Paul Krugman, Brad DeLong and others have been going on about it at least since the financial crisis.”

    And: “This is not one particular theory of monetary and fiscal policy interaction. It is the consensus theory.”

    The consensus comprises a number of New Keynesian economists. Now it is known that both old and new Keynesian economics is axiomatically false.#1 It is also known that Walrasianism is false from supply-demand-equilibrium onward to DSGE.#2

    The consensus among scientists is that economics is a failed science and urgently needs a paradigm shift. The four main approaches ― Walrasianism, Keynesianism, Marxianism, Austrianism ― are mutually contradictory, axiomatically false, materially/formally inconsistent and all got the pivotal economic concept profit wrong. Because of this, economic policy guidance NEVER had sound scientific foundations.

    Within this dire context, the reference to a New Keynesian consensus does not cut much ice.

    Egmont Kakarot-Handtke

    #1 See ‘Mr. Keynes, Prof. Krugman, IS-LM, and the End of Economics as We Know It’
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2392856
    #2 See also ‘First Lecture in New Economic Thinking’
    http://axecorg.blogspot.de/2017/05/first-lecture-in-new-economic-thinking.html

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