How UK deficit hysteria began

Laura Basu has a good book just out on UK media coverage of events from the Global Financial Crisis (GFC) until 2015, which I have reviewed for Open Democracy. Among other things, it tells the story of how what Mark Blyth calls the ‘biggest bait and switch in history’ happened in the UK. Laura argues that it can be dated almost exactly to the Budget of April 2009.

That the right wing press would start talking about the horrors of the rising UK deficit is no surprise. Osborne had decided in the previous year to oppose the Labour government’s stimulus measures because he saw in the rising deficit a way to beat Labour. The puzzle is why a broadcast media, ever conscious of balance, pushed the same line, even though it was clearly advantageous to one side politically.

The following story is mine, not Laura’s. Before the GFC, the way that the broadcast media covered budgets had become quite formulaic. Each budget would present estimates of the deficit over the next five years, and with the help of the IFS commentators broadcasters would discuss not only what tax changes had been announced, but also what might be implicit in the projections. No doubt this framework suited journalists well, because it allowed easy analogies with households. If the IFS felt that the projections were over optimistic and therefore fiscal rules might be broken, they said so and that became one of the budget talking points. The state of the economy was hardly ever discussed, because the Bank of England seemed to be doing a pretty good job of keeping things stable.

That all changed with the GFC, when monetary policy ran out of reliable levers to manage the economy. However journalists wouldn’t know that from the Bank of England, who tended to talk as if Quantitative Easing was a close substitute to interest rates as a monetary policy instrument. They would know it from academic macroeconomists, but journalists were generally too busy to make the effort to talk to them. For whatever reason, they did not fully appreciate how much the world had changed as a result of the GFC.

So when in the budget of April 2009 the Treasury showed the full extent of the deficits that the recession (and to a smaller extent the government’s stimulus measures) had created, journalists behaved exactly as they would have done before the GFC. Compared to deficits seen before the financial crisis, the numbers were indeed large. But crucially, because the Treasury estimated that the GFC had reduced the trend level of GDP, fiscal savings were necessary as a result. When these took the form of efficiency savings, the IFS were rightly skeptical.

So the coverage was all about higher taxes and lower spending, and whether they would be enough to close the record deficit. At no point in the subsequent discussion does anyone ask whether the current deficits are large enough to create a strong recovery. The growth forecasts are taken as given, and only their fiscal consequences are discussed, as if the former had nothing to do with the latter: an assumption that is only appropriate if monetary policy is in complete control of the economy. The government’s line that these deficits were necessary to ‘support’ the economy was almost entirely ignored.

Furthermore, the issue of whether the markets would purchase all this extra debt was already being raised. This is City speak, seeing a recession as involving more government debt and therefore perhaps higher rates, rather than understanding that the recession was caused by more saving and less borrowing so there would be plenty of new savings to buy the additional debt.

In other words the broadcasters had a framework for commenting on the budget which was appropriate before the financial crisis, but totally inappropriate after it. What they should have been asking is whether the Chancellor had done enough to ensure the recovery that was forecast, or whether perhaps larger deficits might be needed. In retrospect, that was exactly the right question to ask.

At the time, the reason for these deficits was clearly spelt out by the IFS as well as the Treasury. "The Treasury's assessment of the fiscal damage wrought by the current economic and financial crisis is breathtaking," said IFS director Robert Chote. "It will require two full parliaments of mounting austerity to repair." But in a telling indicator of things to come, the headline paragraph loses the bit about the GFC. As Laura’s book shows, it became so easy for a media prone to amnesia to forget about the financial crisis and blame everything on Labour profligacy, as after a time most voters began to believe. But the fundamental mistake was focusing on the deficit as a problem rather than as an instrument designed to produce a strong economy. The mistake came from the media’s inability to see how the GFC had changed the macroeconomic rules of the game.

Economics reporting without any economics

Mike Berry explains in this article how the UK media began to see the increase in the deficit in 2009 as a serious problem, and sometimes as a crisis. The government were “court[ing] disaster by borrowing too much”. In terms of basic economics - the economics that anyone doing Econ101 (a first year undergraduate course) would know - there was nothing surprising or problematic about a rising deficit in a recession. It is what you expect to happen. The UK deficit hit record levels because it was a record recession. There was no evidence whatsoever that financing this deficit might be a problem: again basic Keynesian economics shows how in a recession an increase in the supply of government debt is accompanied by an increase in the private sector’s demand for financial assets. [1]

It was a case of economics reporting without any economics. It is a bit like a weather forecaster who reports the weather without any reference to the time of year. (In the Autumn they say ‘Its getting colder and colder - at this rate in nine months time all the rivers will freeze over’) Add politics and you have a dangerous mix, particularly when the partisan press has a significant influence on the non-partisan media.

I have sometimes put this down to a lack of economic knowledge among most political journalists. Of course political journalists talk about economics a lot, yet there seems to be a curious lack of interest in what those that study the subject have to say. I find the story of our ‘lost’ Brexit letter, which I summarised in this piece for The Conversation yesterday, rather scandalous: the mission to educate and inform thrown out of the window. [2]

Which I guess is one reason I started writing a blog. I say I guess because it all happened rather accidentally, so I never had any clear plan. Its success really did surprise me, and I soon realised that I had multiple audiences: many economists in the big economic institutions, but also many interested non-economists. It makes writing challenging and I know I often fail to adequately explain, but I was encouraged by whoever wrote the commentary on my blog in this knowledgeable list of the 100 top economics blogs.

But the people who most need to read economics blogs are I suspect one group that fail to do so: political journalists who talk about economics all the time, and the people who write and research economic news. It is not who appears on Newsnight debates that concerns me, but the unwritten assumptions of those who decide what is news, and write news bulletins. It was these people who decided that the growing deficit in 2009 was ‘courting disaster’, and made the tragedy of austerity possible.

[1] One comment I often get when I say this is that a good part of that deficit has proved to be structural. But if that is the case it is because a large part of the fall in GDP relative to trend following the recession seems to have been permanent. That means you do need to worry about the deficit at some point (after the recession is over), but your immediate focus should be on why GDP has departed from previous trends.

[2] In case you are unconvinced of this: the economic cost of Brexit is critical for most voters, the Remain campaign says this cost will be large but Leave dispute this, and who knows most about the basis and validity of the large cost claim?        

UK Growth has been even worse than we thought

That is one headline on the Office for National Statistics (ONS) latest data revisions. Output in the UK economy is now estimated to be currently almost 4% below its previous peak, compared to previous estimates of 2.5% below. Or alternatively, the headline could be that the UK never had a double dip recession: at the beginning of 2012 growth was flat rather than falling by 0.1% (not annualised), a 0.1% that has been reallocated to the subsequent quarter. The chart below shows the old and new data for GDP growth, quarter on quarter. So GDP went fall, flat, fall, which technically is not a recession. I’ll leave you to decide which the more informative headline is.*

As you can see the big revision is in how much GDP fell in the recession. GDP is now thought to have decreased by a little over 5% in 2009 as a whole, compared to the previous estimate of -4%. At this point I cannot resist telling a small story about this number, but for those who are fed up with my personal anecdotes there is a serious point about inflation to follow. I make a weak attempt to connect the two at the end.

Quarter on quarter changes to UK GDP (not annualised): ONS

At the beginning of 2009, I was asked to attend a breakfast meeting with the then Chancellor, Alistair Darling, along with some non-academic economists. I had never attended one of these before, so I did not know what to expect. I had not met Darling, but all the other economists invited appeared much more comfortable with the format and surroundings, so to be honest I was rather nervous. Academics in particular can appear out of touch because they do not have all the latest data at their fingertips.

Sure enough, one of the first questions Darling asked was just how bad we each thought things could get. I cannot remember what each person said, but the general view was that GDP could fall by as much as 3% in 2009. I was the last to give my opinion. I could have ducked out, but instead I remembered one thing from my earlier days as a forecaster. This was that forecasts typically underestimate the extent of large swings in GDP, particularly if they are globally synchronised. So I said that I thought things could be worse than that, and GDP could fall by 5%.

Impossible! was the immediate retort of one of the other economists: someone who is very well known and very sensible, although I will not say who it was here. This person then used their detailed knowledge of the data to say why it was inconceivable that GDP could fall by so much. One by one everyone else agreed that although things were bad, they could not get that bad, and 5% was an outlandish number. Just as I wished I had kept my mouth shut, or better still just not come, the senior economist from the Treasury who was there came to my defence: a fall that large could happen, and they described how it might happen. I of course take no pleasure in the fact that my forecast has been vindicated, and it was little more than luck, but it is one of those moments I will not forget.

Now for something more consequential. The chart below compares two different measures of UK inflation: the CPI (green) and the GDP deflator (blue). CPI inflation has been significantly above the 2% target since 2010. In contrast over the last year growth in the GDP deflator has been well below 2%. This is the deflator at market prices, so it includes indirect taxes. The dashed line is the GDP deflator at basic prices, which excludes these. The press release only includes numbers going back to 2010 for this series, but you can see that growth has been below 2% for the last three years. The dotted line is growth in the US GDP deflator - this moved in a more immediately understandable way after the recession, but over the last two years the UK and US measures have not been that different.

Alternative measures of inflation

The fact that output price inflation (which is what the GDP deflator measures) has been below CPI inflation is neither surprising, nor unique to the UK. What is less appreciated is that there is no reason from an economic point of view to focus on one series (the CPI) rather than the other (the GDP deflator) when setting monetary policy. At an intuitive level looking at the output price measure makes more sense, because policy has more control over things produced in the same country. At a deeper level, inflation matters because some prices are sticky, and the GDP deflator generally excludes volatile commodity prices. It should be less influenced by volatility in the exchange rate, so it may be better for that reason too.

I cannot help but reflect on how different UK monetary policy might have been if it had focused on output prices rather than consumer prices. In 2011 interest rates were almost raised (3 out of 9 MPC members voted for doing so), despite the lack of a recovery. Would this have happened if the target inflation measure had been below 2%, as growth in GDP at basic prices was? Since then Quantitative Easing has largely stalled, which would have been very hard to justify if the focus had been on output prices.

One of the reasons often given for focusing on the CPI (which has come up again in discussion of nominal GDP targets) is that this data is available quickly and is not revised. [1] Which brings me back to the beginning, because the GDP deflator numbers for the first quarter of 2013 and earlier have been significantly revised (and are smoother as a result). I have never understood this argument. We should start with why inflation is costly, and then think about how best to measure these costs. If measurements change because information gets better, policy should respond to that. If that causes problems, improve the measurement. Perhaps policy needs to obsess a bit less about this bit of data or that, and think more about the fundamentals of what it is trying to do. 

* I changed the text here from the original version to make the nature of the adjustment clearer. As one economic journalist put it, reallocating 0.1% of GDP between quarters makes no difference in terms of the economics, but revising away the double dip recession will play well for George Osborne politically. I think that says a lot about the quality of political debate.

[1] Another argument is that the CPI is easily understood by the non-economist. If this impresses, why not use wages rather than the CPI, as I suggested here. As wages are clearly sticky, there are good theoretical reasons to focus on this as a measure of inflation.