The political, moral and intellectual bankruptcy of the current Conservative party

 

The UK is currently suffering a level of strike action not seen for decades. There is a simple reason for most of that - it is government policy. Take the continuing strikes in the rail industry. According to the Financial Times two weeks ago: “Employers had planned to offer a 10 per cent pay rise over two years to the RMT union, but were blocked by the government, which controls the industry’s finances, according to three people familiar with the matter” by adding tough new conditions at the last minute.

Or take the unprecedented strike by many nurses. Nurses have seen a large cut in their pay relative to those in the private sector since 2010. The government’s current pay offer will see that continue. Quite simply, nurses are being forced to strike because the government insists on reducing their standard of living compared to private sector workers as well as making their working conditions more intolerable. Now if for every nursing vacancy there were hundreds of applications then you could make a case for lower pay, but the opposite is true, partly because many nurses are leaving the NHS. It is a similar picture across the public sector.

Of course the government tries to assert that none of this is true. Instead they like to pretend that they are on the side of poor suffering Joe Public, and also like to claim that somehow it is the Labour opposition’s fault that we are seeing all these strikes. Given the level of misinformation we have in this country many (although for nurses certainly not a majority) will believe them. The reality is that the government thinks these strikes will work to their political advantage in returning some core Conservative support they have lost in recent months. In other words, they are making these strikes happen, despite the inconvenience this will cause and the damage it will do to the country, because they believe it’s to their party's political advantage.

Governing in a way that harms the country but boosts your flagging popularity is a good measure of political and moral bankruptcy.

But strikes are not an isolated example in an otherwise sea of policies the government is enacting to benefit the country. Take one of the most pressing issues of the moment, which is the crisis in the NHS. UK citizens are dying who would otherwise have lived because ambulance waiting times have sky-rocketed, A&E departments are overloaded and delays for many basic operations are at record levels. A key reason for this is a lack of beds and infrastructure, made acute by the number of patients being treated in hospitals with Covid, together with an inability to pass on patients to social care

Neither is an excuse for the government to do nothing! On the contrary, dealing with both is what any government is there to do. But where is the government action to create more NHS beds, and the staff that goes with them, following the emergence of Covid? What are the government’s plans to deal with the crisis in social care? Once again, by refusing to pay NHS staff more, and failing to provide the resources to attract more people into social care, the government is actively making things worse.

The new Prime Minister made a big speech announcing a new policy last week. But it wasn’t about the NHS or social care, or the growing poverty caused by the cost of living crisis. Instead it was about people crossing the Channel in small boats, mostly to claim asylum in the UK. Shortly afterwards some died trying to make that crossing in icy waters. Yet, as Lewis Goodall points out in this excellent summary, Sunak’s speech did not contain the one policy that could solve the problem of small boat crossings at a stroke, which is for the government to provide a means for asylum seekers from wherever they come to claim asylum safely.

Once again, the problem of Channel crossings is a problem of the government’s own making. By failing to provide any safe route for asylum seekers from all but a few countries to claim asylum in the UK, they create the demand for small boat crossings and the smuggler gangs that facilitate this. Why don’t they want to provide a safe route for asylum seekers? Because they want less asylum seekers in the UK compared to most other comparable countries. While some countries that have the same goal erect high barbed wire fences on their borders, we have the English Channel.

Those in the Conservative party, if they were being honest, would say they were just doing what their supporters want. Those in the Labour party who do not point out the truth about Channel crossings would say the same about the voters they need to attract to win the next election. There is some logic for such claims, because the UK’s FPTP voting system and our right wing press bias policy towards the interests of those who just want less people claiming asylum in the UK. But if this is the politicians’ excuse, why lie about it, and call those making the Channel Crossing ‘illegal migrants’? It means politicians are going beyond what they need to do to represent these voters. They are not only helping to put people’s lives at risk just for party political gain, but they are distorting or concealing the truth from those they represent. [1]

Take the biggest crisis facing the world today, climate change. What does the current government do? Opens a new coal mine. A government that lets people die just to win votes, or puts the future of humanity at risk for a bit more money today, is a good indication of political and moral bankruptcy.

It seems the government has given up on the business of governing, and instead its actions are determined only by what gains their party a few more votes. You might be cynical and say it is ever thus, but I think this is wrong. Whatever you might have thought about her vision, Margaret Thatcher did have ideas about how to make the UK a better place. Some of that might have been destructive, like reducing union power, but it was also constructive, like helping to create the Single Market for EU trade. There were of course some policies designed just to win votes, like selling council houses for example, but there was also a clear set of new ideas about how to improve the economy and individual opportunity.

The same is true for the Labour government of 1997-2010. Gordon Brown could list the many ways it had made lives better through specific policies in a conference speech. It too had a vision. If we call the vision of Thatcher neoliberalism, we could call Labour’s vision neoliberalism with a human face. Yet it is hard to imagine Rishi Sunak giving a similar speech about the achievements of Conservative led government since 2010. Austerity left the UK permanently poorer, put UK public services in a dire state, and yet UK taxes are at a record high. Brexit has bought further economic misery but hasn’t brought any benefits worth listing in a conference speech, with even immigration at record highs.

To describe all three governments as embodying neoliberalism misses these key differences, and therefore misses the political and moral bankruptcy of the current government. Yes, it still spouts neoliberal platitudes, but they have increasingly become clichés designed not to try and make the country better off with more opportunities for its citizens, but instead used as a mask for funneling money to friends, donors or potential future employers. So the UK’s private water companies are protected at the expense of sewage in our rivers and on our beaches. Energy companies are allowed to keep their record profits if they invest in producing more climate warming oil. Private companies with the right political connections are paid over the odds with public money to provide unusable PPE, then paid with public money to store it and then other private companies are paid with public money to dispose of it. I have described all this as a transition from neoliberalism to a form of plutocracy elsewhere.

Once we see austerity as the huge mistake it undoubtedly was, we can see that the bankruptcy of the current government did not start after a referendum in 2016, but from its very start in 2010. Wanting less public services and taxes without changing what the public sector does turned out to be as foolish as it sounds. With this, and nonsense like Britannia Unchained, Conservative ministers took the platitudes of neoliberalism [2] and thought that together they made a coherent and realistic vision, yet they remain in denial that this pursuit has done nothing but harm to the UK economy.

All this represents an intellectual as well as a political and moral failure. A failure to see that growth under Labour before the financial crisis matched that under Thatcher, and also more than matched growth in other G7 countries, yet with better public services and without the advantages of growing North Sea Oil revenues. A failure to recognise that increasing taxes to bring NHS spending up to European levels was popular. A failure to learn from the fact that the Global Financial Crisis reflected a lack rather than an excess of government regulation. All these showed at the very least the limitations and dangers of unbridled neoliberalism, yet these lessons were ignored

This intellectual failure didn’t end once the Conservatives were in power. After unjustly blaming, with the invaluable help of their press, immigrants for many of society's problems in opposition, Cameron set up immigration targets he either couldn’t hit or wasn’t willing to hit, yet his party used immigrants as a scapegoat for the effects of austerity. This played into the hands of populist Brexiters, who only had to link immigration to free-movement to make their case. After Brexit it seemed that the exclusive motivation of Conservative MPs became power for power’s sake, exemplified by the election of Boris Johnson. His own moral bankruptcy does not need retelling, although it is worth noting that public money is still being used to defend his lies over Covid partying.

When a government refuses to use our money to pay nurses a decent wage or relieve severe rationing in the health service, but instead spends it on defending the obvious lies of a disgraced former party leader, that is a pretty clear sign of political and moral bankruptcy.

It is true that the Covid pandemic would severely test any government. But the current government, including the current Prime Minister, failed that test repeatedly. Long term planning for a pandemic in the form of stockpiles of equipment was allowed to become useless under austerity. Once the pandemic started, an initial hope that the pandemic could just be ignored led to little contingency planning, yet that hope was scuppered once data arrived. Over the summer of 2020 Sunak championed spending public money that helped create a second wave of infection, and pushed Johnson to listen to a tiny minority of experts who were against lockdowns. Johnson himself, under the influence of some newspaper owners, began to distrust the centuries old methods of dealing with pandemics, so scientific advice was frequently ignored and lockdowns delayed. Tens of thousands died unnecessarily as a result.

If there is one image that sums up the moral bankruptcy of the current Conservative party for me, it is the massed ranks of Conservative MPs in the summer of 2021 sitting on the crowded government benches with hardly a face mask to be seen, even though the government’s own advice at the time was to wear masks in crowded indoor places. It was just like partying in No.10, except it involved nearly all Conservative MPs in an unashamedly public way. Here were our elected representatives putting their own personal convenience, vanity or warped ideology above the interests of those around them, and by implication above the interests of those they represented. The Conservatives have been labelled the nasty party with much justification, but since 2010 they have become a party whose only aim seems to be to look after themselves.

[1] At the end of the day it’s a policy that makes a minority suffer, and a few die, so that some voters can feel happier. The primary responsibility for those policies lies with the politicians that enact them.

[2] For example 'government should get out of the way', reward the 'wealth creators', or 'regulations hold back business'.

Monetary and fiscal cooperation: the case for a state dependent assignment

In December last year Mark Carney said

“In a global liquidity trap, central banks cannot be the only policy makers who do “whatever it takes.” There are clear gains from coordination, with other policies – particularly fiscal policy”

I of course agree, as would most academic macroeconomists. So would any sensible informed fiscal policy maker. But of course this didn’t happen in the Global Financial Crisis from 2010 onwards in some key major economies, including the UK.

Carney’s statement, which follows similar statements by the central bank governors of the Fed and ECB, goes against what I have called the ‘consensus assignment’. The consensus assignment has monetary policy looking after the stability of aggregate demand and inflation, while the fiscal authority looks after government debt. In the UK at least this consensus assignment is deeply embedded in the way the media thinks about policy.

In 2009 George Osborne gave a speech in which he said

“[New Keynesian] Models of this kind underpin our whole macroeconomic policy framework – in particular the idea that by using monetary policy to manage demand and control inflation you can keep unemployment low and stable. And they underpinned the argument David Cameron and I advanced last autumn – that monetary policy should bear the strain of stimulating demand….”

This is a statement of the consensus assignment. The irony of it was that shortly before the speech was given UK interest rates hit their lower bound.

Is the consensus assignment still the best way to run policy after short interest rates hit their lower bound? In 2010, in Europe and the UK at least, central banks acted as if it was. Indeed they went as far as to advise fiscal policymakers to embark on austerity. Carney’s statement is an implicit acknowledgement that central banks had been wrong to do that.

The trouble with unconventional monetary policy is not that it does not work, but it does not work reliably. The scandal in 2010 was that while the Bank of England was suggesting in public that unconventional monetary policy could replace conventional interest rate policy, in reality they had little clue how much effect any change in unconventional monetary policy would have. An unpredictable and unreliable instrument is not a good basis for a policy regime when a better instrument is available, and that better instrument is fiscal policy. I think negative interest rates fit into this category of unreliable instruments, simply because we cannot for obvious reasons assume linearity.

So how do we ensure as far as we can that fiscal policy makers will not repeat the mistakes of 2010 in the next recession? The first best would be to have better fiscal policy makers, but alas that is not always possible. There are three widely discussed possibilities.

1. The first is MMT. This in effect reverses the conventional assignment, with fiscal policy doing the demand and inflation stabilisation in all states of the world. If that happens debt looks after itself. I am not in favour of MMT, because I think independent central banks have been very successful at controlling inflation, and a government using fiscal policy would be less successful.
   
   
2. The second is Helicopter Money. If you are prepared to call Helicopter Money (HM) monetary policy, this preserves the consensus assignment by giving the central bank a new tool. HM is more reliable than unconventional monetary policy, because HM is just like a tax cut, and we have a lot of data on the impact of tax cuts on consumers. Like tax cuts, HM will not work if all consumers are Ricardian, but they are not.
   
   

HM is only possible with the agreement of the government, preferably well before it is actually needed. Two key things have to be agreed. The first is the distribution mechanism, where I suspect some governments would prefer something other than a reverse poll tax. The second is an agreement to back the central bank, by which I mean supply it with the assets it requires to claw back at least some of the HM when the economy recovers. The only difference between HM and a bond financed fiscal expansion is that probably some or all of the bond issuance is delayed until after the economy recovers.

Central banks worry that governments will renege on their commitment to back the central bank. My response is that any government that would not back their central bank so it can fight inflation is also a government that would be prepared to abolish its independent central bank, so the concern is of no interest. I suspect also central banks think HM looks like fiscal policy to most people, and they shouldn’t be doing fiscal policy.

I would add a further point on HM. It will not stop a government using what I call ‘deficit deceit’ in a recession: pretending the deficit is too high and requires spending cuts, because the government wants to scare people into accepting a smaller state than would be popular otherwise. HM would avoid this fiscal consolidation influencing output because its demand effects would be offset by the central bank. But a shrinking of the state beyond anything that is popular in normal times is also almost certainly sub-optimal, and can have devastating political as well as economic implications, like those we have seen in the UK, and you could argue HM encourages this.

3. The third, and most likely, is central bank advice. If the central bank thinks that a recession is coming where rates will hit the lower bound, it advises the fiscal authority that some fiscal expansion is required. This is fine if we are trying to combat a fiscal authority that is just ignorant on these matters. The central bank could also convince a fiscal authority that was worried about financing its debt, by for example agreeing to monetise the expansion needed by doing the corresponding amount of QE, or more simply to neutralise any failure by private agents to buy debt.
   
   

My concern here is with a government that said thanks for the advice, but we prefer to focus on reducing the deficit using spending cuts. Would the central bank be prepared to make its advice public? It might not do so if it was concerned that the government would reciprocate by starting to tell the central bank what do so. You could therefore argue that this strategy could be either ineffective, or may threaten central bank independence.

So how can you stop a government that is determined to use the rising deficit in a recession to shrink the state? Of course you cannot, but you can try and create the conditions that will put maximum political pressure on it not to. I suggest above that HM fails to do this, and central bank advice is unlikely to either.

What would be more effective is for macroeconomists and central banks to start being honest about the consensus assignment. As a near optimal policy regime that assignment is dead. Instead macroeconomics suggests what could be called a ‘state dependent assignment’. In most states of the world, central banks stabilise the macroeconomy just as they do now. However in an economic downturn of sufficient size (where ‘sufficient’ is to be defined) the assignment flips, and fiscal policy makers are in charge of stabilisation. In non-technical language, fighting recessions becomes the government’s job.

I think this is something that most academic macroeconomists and some central bankers have accepted implicitly but not explicitly. One reason is I think pedantic. Of course in the state dependent assignment the central bank does not stop trying to stimulate demand in a recession by at least keeping rates low, but there are compelling political economy reasons to highlight the responsibility of governments in this respect.

Those familiar with Jonathan and my paper on fiscal rules will recognise our knockout when rates hit their lower bound as one operationalisation of a state dependent consensus assignment. But it is not an ideal mechanism because switching the assignment should depend on forecast events. Others, like the IPPR and Resolution Foundation, have suggested alternative schemes that come under the umbrella of a state dependent assignment. There is a great deal of work required to figure out the best mechanisms, and also to think about who has control over when switches (both on and off) happen, and whether there is a role for the central bank and/or fiscal council in advising the government on effective stimulus packages.

To conclude, central banks are now recognising that fiscal stimulus is required in significant economic downturns. This is in contrast to the GFC, when many fiscal policy makers enacted austerity. One of the reasons they were able to enact austerity was the dominance of the traditional consensus assignment in the mind of the public. Our most effective way of preventing this happening again is to make a state dependent assignment the new consensus assignment.

Mediamacro myth 1: 2010 Britain faced a financial crisis

The idea that the Coalition rescued Britain from a crisis is routinely put forward as fact by both the Conservatives and Nick Clegg. Every time the media let such statements pass (as they invariably do), the language seems to get more florid: Clegg’s latest is that the coalition was born in the “midst of an economic firestorm”. [1]

The facts say this is pure nonsense. The economy had begun to recover from the recession, and this recovery might have continued if it had not been hit on the head by domestic and Eurozone austerity. As Larry Elliott makes clear (see also here), there was no sign of any market panic, either in the markets for Sterling or government debt. 

But the government’s budget deficit was very large, and debt as a proportion of GDP was therefore growing. If, through a separate myth, you have created the idea that the major (perhaps only) goal of aggregate fiscal policy is to reduce deficits, this seems like a serious problem. But the deficit was rising because of the recession. It always does rise in a recession and fall in a boom, as the chart below shows. It was particularly high in 2010 because this recession was particularly deep.

Any economist would cringe at the idea that policy should try and eliminate deficits and surpluses created by the economic cycle, because that would mean destabilising the economy. This is sufficiently well known (cyclical deficits and surplus are called ‘the automatic stabiliser’) that it could undermine the idea that the high deficit was an immediate problem. This is one reason why it is important to push another mediamacro myth - the idea of Labour profligacy, which we debunk tomorrow. [2]

So where is the half-truth that gives the ‘firestorm’ myth some credence? It is of course the Eurozone crisis, and the idea that the UK could suffer a similar fate to the Eurozone periphery. But academic macroeconomists understand that the situation of a country with its own central bank, like the UK, is quite different from a country without, because the central bank can (and in the UK will) act as a lender of last resort, so the government will never ‘run out of money’. That simple fact is sufficient to prevent any crisis happening for an economy like the UK. Greece was profligate, and had to default, but the crisis in the rest of the Eurozone ended the moment the European Central Bank agreed to act as a lender of last resort in 2012.

Why is it so important to keep up the pretence that in 2010 the UK economy was ‘on the brink’ of a financial crisis? Because only then can the pain of the subsequent few years be excused. The truth is that the failure to recover until 2013 was not the inevitable cost of rescuing the economy from crisis, but an avoidable choice by the Coalition government. The delayed recovery, and the damage that did to living standards, was at least in part a direct consequence of attempts to reduce the deficit far too early, and there was no impending crisis that forced the government's hand. [3]

Previous posts in this series

(0) UK mediamacro myths: an introduction

[1] There is something about Clegg that wants me to see him in the best possible light. So I imagine that, when confronted just after the 2010 election by briefings from the Treasury and the Bank about the dire economic situation, he really believed what he was reading. He did not realise that, from the Treasury at least, it is standard practice to say this to any incoming government. (One of the interesting untold stories of austerity is the extent to which it was encouraged by senior Treasury civil servants.) But I suspect my imagine of 'Clegg the naive' is, well, imaginary.

[2] If the financial crisis had permanently lowered UK GDP, or the tax potential of GDP, then that would also imply the need to reduce government spending at some point. But, as most economists agree, you do that when monetary policy can offset the impact of these cuts on demand. You do not choose to undertake austerity when short term interest rates cannot fall any further.

[3] The clear majority of macroeconomists agree that austerity when short term interest rates cannot fall any further will reduce output. The OBR calculate that austerity cut growth in financial years 2010-11 and 2011-12 by 1%, but there are good reasons for thinking this may be an underestimate. 

Default panic and other tall stories

People still say to me that the UK or the US had to embark on austerity, because otherwise the markets would have taken fright at the ‘simply huge’ budget deficit. How do they know this? Because people ‘close to the market’ keep telling them so.

What can I do to show that this is wrong? The most obvious point is that interest rates on UK or US government debt have been falling since 2008, but the response I sometimes get is that rates have only stayed low because of austerity policies. So how about looking at one very short period, around the UK general election of 2010. The election itself was on 6th May, but Gordon Brown only resigned on 10th May, and the coalition agreement was published on 12th May.

Labour were proposing a more gradual reduction in the deficit than the Conservatives, but the Liberal Democrats (the eventual coalition partners) were during the election closer to Labour. So if there was any default premium implicit in yields on UK government debt, it should have fallen between 5th May and 13th May, either because Labour were defeated, or because the LibDems capitulated on the deficit. Now you may say that the markets were anticipating a Conservative victory, but even if that is true, on 5th May there was some doubt about that, which should have been reflected in the price. The coalition agreement published on 12th May clearly states a commitment to “a significantly accelerated reduction in the structural deficit”, so that doubt should have disappeared by then. If there was a default premium in rates before 6th May, it should have fallen by 13th May.

Yield on 10 year UK government debt: source Bank of England

As you can see, rates were higher on 13th May compared to 5th May. More to the point, there was no noticeable decline in rates because fiscal consolidation was going to be greater. Now of course other things may have happened over these few days to offset any default premium effect, and you can always spin stories about how markets were concerned about a coalition government so maybe the accelerated deficit reduction was not going to happen, etc. But they are stories: in terms of the data, there is no obvious effect.

The more sophisticated defence of austerity, as here from the Permanent Secretary at the UK Treasury in reviewing William Keegan’s new book, is that there exists a ‘tipping point’ somewhere: some level of the deficit at which the markets will take fright. It is then suggested, with reference to the Eurozone crisis, once you reach that point it is very hard to return, because a vicious circle sets in. Interest rates rise, making any new debt more expensive to service, which raises the deficit itself, making default even more likely. As we do not know where that tipping point is, it is best to stay well away from it by taking precautionary action before it is reached. The problem with this argument is that having your own central bank makes a key difference, not just to the chance of a funding crisis, but to its dynamics as well.

Having your own central bank does not rule out the possibility of default. As Corsetti and Dedola explain, the costs of inflation created by monetising the debt may exceed the costs of default. Markets know that, so they may still at some point begin to suspect that default could happen. It therefore follows that the markets could get it wrong: they may begin to suspect default even when there is absolutely no intention within government to let this happen.

Suppose this fate had befallen the UK or US governments in 2010. The markets suddenly panic that the government may default, even though the government has no intention of doing so. Interest rates start rising on government debt. But both governments have a Quantitative Easing programme, which is designed to keep long term interest rates low, so their central banks respond by buying more government debt. The cost of servicing government debt does not rise, because additional money is created, so there is no vicious circle. There is plenty of time for the government to take whatever action it wishes to take to reassure the markets. And unlike the model of Corsetti and Dedola, because there is a recession and a liquidity trap, the extra money created does not immediately lead to inflation. [1]

Having your own central bank, which is already undertaking Quantitative Easing, does not just make a funding crisis a lot less likely, it also crucially changes the dynamics. If a crisis occurs, the government is not trapped in a vicious circle. This in turn means that there is no obvious reason to act in a precautionary way. So why did no one make this point nearer the time? The answer of course is that they did.

[1] If you think that in these circumstances a foreign exchange crisis will get you, you need to explain why Paul Krugman’s analysis is wrong. 

Alternative Eurozone histories

I missed this paper by Philippe Martin and Thomas Philippon when it came out last October, but thanks to Francesco Saraceno I have now read it. There is also a VoxEU post by the authors. It is particularly interesting for me because it undertakes analysis (using a model which is itself interesting but which would make this post too long to discuss) of a couple of alternative histories for the Eurozone which are related to two claims that I have made in the past:

1)    It is now widely accepted among macroeconomists (but not politicians or the media) that fiscal profligacy was only the major cause of subsequent problems in Greece, while elsewhere private excess was the main problem. I have argued that aggressive countercyclical fiscal policy before 2008 would have reduced subsequent problems.

2)    If the ECB’s OMT programme had been implemented in 2010, rather than September 2012, this would have substantially reduced the degree of austerity required outside Greece. As a result, these countries would have had a better recovery from the Great Recession. [2]

Put the two claims together and I would argue that the 2010-12 Eurozone crisis (rather than just a Greek crisis) need not have happened. OMT would have limited fears of contagion, allowing a quicker and more complete Greek default. There would have been no funding crisis outside Greece, and no need for the core Eurozone economies to immediately embark on austerity.

How does the paper address these arguments? In terms of fiscal policy, it imagines reaction functions for government spending and transfers that contain a (common) countercyclical element, but also a (country specific) positive drift term, in Greece, Ireland, Portugal and Spain. One counterfactual eliminates the drift. This does not exactly fit the scenario I had in mind, because I see actual policy as not being countercyclical but (Greece apart) having less drift. However the end result is the same: a counterfactual with much more fiscal tightening before the recession. An interesting result is that tighter fiscal policy could have substantially reduced the rise in interest rates spreads in Ireland and Spain. The pre-2008 employment boom would not have happened in Greece, and would have been substantially reduced in Ireland, but the impact in Spain would have been smaller but non-negligible.

It conducts another counterfactual which imagines macroprudential policies that eliminated the household leverage boom in each country. This has a significant effect in reducing the boom in Ireland and Spain. (There was no actual employment boom in Portugal.) By inference a combination of countercyclical fiscal policy with no drift, plus macroprudential policies, would have been ideal.

So claim (1) seems to hold up fairly well. Of particular interest is what would have happened to employment from 2008 under a purely countercyclical fiscal policy. In Spain it would have fallen as a result of the recession, but subsequently stabilised rather than continuing to fall as it did in reality. In Ireland employment would have fallen in the recession, but would have risen again from 2010 rather than continuing to fall. This is partly because countercyclical fiscal policy would have helped, but also because lower levels of debt going into the recession would have reduced the increase in interest rate spreads, easing monetary policy.

With a pure countercyclical fiscal policy the debt to GDP ratio in Greece would have stayed flat (because there would have been no boom), suggesting that the Greek crisis was essentially a result of fiscal profligacy. In Spain the debt to GDP ratio would have fallen to nearly 20% of GDP, rather than staying above 40% of GDP in reality. In Ireland public debt would have been largely eliminated. This indicates the substantial amount of countercyclical policy that was required to tackle what were very large domestic booms. (Fiscal policy would presumably have been less contractionary if combined with macroprudential controls.) It also tells us how foolish it was to have a Stability and Growth Pact which essentially ignored the need for such countercyclical fiscal policy.

Claim (2) is examined in its own counterfactual, which essentially eliminates the increase in interest rate spreads that occurred from 2008. The beneficial effects on all four periphery countries are substantial. This counterfactual is unrealistic for Greece, because OMT should never have been implemented for Greece - immediate default was the better and more sustainable option. However I think it is highly credible that, despite Greece, if OMT had existed in 2010 spreads in other countries would have stayed low. [1]

Francesco Saraceno draws the lesson that the real problems with the Eurozone are institutional, and I agree. The Stability and Growth Pact was misconceived (as some of us argued before the Eurozone was created), because it ignored the need for countercyclical fiscal policy. The ECB delayed acting as a sovereign lender of last resort for two years, creating a Eurozone crisis out of what should have been just a Greek problem. The conclusion I draw, unlike many economists, is that the concept of a European Monetary Union was not inherently doomed to fail. It was the way it was implemented that caused the crisis.

It would be very nice if this was all about history. Unfortunately exactly the same mistakes are continuing, with equally damaging effects. Fiscal policy continues to be pro-cyclical, meaning that we had a second Eurozone recession and no real recovery from that. Monetary policy is either perverse (2011), or 6 years too late (!) and continues to openly encourage fiscal austerity. That most policy makers in the Eurozone have still not understood past errors remains scandalous.

[1] The paper attributes this to the reduced risk of union break up. I suspect it does so because it wants to make interesting comparisons between Eurozone countries and US states. My own analysis has instead focused on the danger of a self-fulfilling funding crisis when there is no lender of last resort. That danger presumably exists for US states.

[2] An interesting question which I have not examined is whether, even if OMT had existed in 2010, it would still have been better for both Ireland and Spain to have written off some of their debt. 

Why did Osborne not try to protect the recovery in 2010?

I see that George Osborne is giving the RES lecture this year. This post might be useful background, just in case what he says goes beyond simplistic electioneering of the '0.5% inflation is welcome news' kind. 

In an earlier post I outlined how a credible austerity plan could have been enacted in such a way as to protect the recovery. This is not what I would have done. We needed fiscal stimulus not austerity in 2010, and the threat from the financial markets was non-existent. However some have difficulty accepting this last point, so what I tried to show in that post was that a worry about the financial markets did not excuse the coalition’s actions.

In particular I noted that public investment could have stayed high, but instead was immediately cut back, even though there was no necessity to do so because it was not part of the coalition’s primary fiscal mandate. According to the OBR net public investment was 3.3% of GDP in 2009, but only 1.9% by 2011. A total multiplier of 1.5 for public investment is quite plausible, so that alone could account for around 3% less GDP. Good projects, like flood defences or school renovation, that were ready to go were instead cut back

Was this just a random (but very costly) mistake, or was there some logic behind it? Osborne has repeatedly talked about monetary activism. In September 2009 he said:

“Monetary activism to keep interest rates low and stimulate the economy. Fiscal responsibility to restore confidence and rebuild our battered public finances.”

It is of course true that this assignment does indeed reflect the academic consensus, as long as interest rates are not at or close to the Zero Lower Bound (ZLB). At the ZLB you have Quantitative Easing (QE), but QE is just not reliable in its impact on demand, so it does not make the ZLB problem go away.  

Osborne or his advisors knew this. UK interest rates hit their ZLB in March 2009. Here is a key excerpt from Osborne’s 2009 RSA speech, made shortly afterwards:

“[New Keynesian] Models of this kind underpin our whole macroeconomic policy framework – in particular the idea that by using monetary policy to manage demand and control inflation you can keep unemployment low and stable. And they underpinned the argument David Cameron and I advanced last autumn – that monetary policy should bear the strain of stimulating demand….”

Now if it is true that New Keynesian models underpinned their macroeconomic framework, they should have also known that the Zero Lower Bound (ZLB) problem is a big deal in those models. Furthermore in basic New Keynesian models QE does nothing. In these models there are ways of mitigating the ZLB problem, but they involve departures from the inflation target, and Osborne has never shown any interest in doing that.

In his Mais lecture of February 2010 he acknowledges the arguments of those that said fiscal consolidation should wait until the recovery was assured. Here is a key passage:

“To be fair, a more sophisticated version of the argument for delay also takes into account the complex interaction between fiscal policy and monetary conditions. It says that at the moment, and for as long as policy and market interest rates remain low, fiscal tightening should be as gradual as possible because there is little scope for more accommodating monetary conditions to accompany it, either through lower market interest rates or through the reaction function of the Bank of England. And only as and when monetary conditions begin to tighten can the pace of fiscal consolidation be accelerated.

But even this, more nuanced, version of the case for delay is too complacent. For it brings me to the second consideration: the realities of financial markets.”

So there is no attempt to dispute the validity of the ZLB problem. No attempt to argue that with QE the ZLB problem was not real. Instead the argument is that there is a still greater danger, which is that the markets might suddenly lose confidence in UK government debt.  

This suggests to me that Osborne, and the coalition more generally, never really believed in the position that QE alone could deal with the ZLB problem. Taking that position would rationalise what they did – in particular cutting public investment was fine in macro terms because the hit to GDP would be compensated for by more QE. However if that was the case, you might have expected to see that position explicitly stated, and as far as I am aware it has not been.

Instead I think we are being too sophisticated in trying to find a macroeconomic rationale for coalition actions. For what it is worth, I think policy was based on two political, not economic, imperatives. The first was to reduce the size of the state, and the deficit was always a pretext for that. Here he was just copying his US cousins. As a result public investment as well as consumption had to be cut even though this was not part of his main fiscal rule. Second, austerity could not be back loaded, even though that would have made macroeconomic sense, because that would mean doing unpopular things just before an election. As a result public investment had to be cut quickly rather than kept high to protect the recovery.

Under this interpretation, Osborne did what he did for essentially political or ideological motives, and just ignored the risk of potential costs that then came to pass. This is not to suggest that he intended to waste almost £100 billion, but just that he did not give sufficient regard to that possibility. As he lost every adult and child in this country something in the order of £1500 each, he deserves full censure. He certainly does not deserve a reputation for economic competence, unless you are mediamacro and equate competence with deficit cutting. 

What does not seem plausible is that his actions were designed to prevent the financial markets believing the UK would default. If you are still not convinced of this, consider one final, almost bizarre, piece of evidence. He plans if re-elected to pursue almost the same policy again (austerity in the early years of the government) while UK interest rates are at (or at best close to) the ZLB, and when there is not even the hint of any funding crisis for UK government debt. Here is Tony Yates on the folly of this strategy.

Thus those who suggest that the coalition had to undertake 2010 austerity to appease the markets are thrice wrong. First, the UK was never going to default and the markets knew it. Second, if that had been Osborne’s concern he could have designed a much more recovery friendly plan. Third, it now seems clear that he never undertook 2010 austerity for that reason. In the UK, as elsewhere, fiscal austerity justified by an imperative need to reduce the deficit was and remains a massive confidence trick.    

  

If Clegg had become Chancellor

Just suppose George Osborne had been run over by a bus the day after the election and in his grief Cameron had given the Liberal Democrat leader a proper job. The reason for concocting this fantasy is that people still say to me that George Osborne - given the situation at that time - had to do more about the deficit. It is only in hindsight (following the 2011 insights of Paul de Grauwe, followed by OMT in 2012) that we know the Eurozone crisis was special and so UK austerity was unnecessary. I do not accept that view, but the point I want to make in this post is that even if you do, it does not excuse Osborne’s actions.

Suppose that in 2010 we had had a UK Chancellor who was seriously worried about market reaction to the deficit, but who was also concerned about the recovery. What might they have done? (I cast Clegg in this role, although Vince Cable might be able to play it with more conviction.) The first thing Clegg might have done is to get the ‘huge’ deficit number in perspective. Here is the data.

UK Net borrowing requirement, % GDP (Source OBR)

The size of the deficit in 2009/10 (10.2%) was unprecedented, but not so very different from the deficit in the ‘ERM recession’, and of course the 2009 recession was much larger. So panic was not required. (The nice Mr. King was already buying lots of government debt, so there was no chance of running out of money whatever the markets did.)

The second thing Nick Clegg might have done is ask Mr. Budd (temporary head of the newly created OBR) how confident he was about the forecast recovery. Alan Budd would have done what all good forecasters do, and emphasise how uncertain macro forecasts are. So there is a real possibility that the recovery might come to a halt, Nick might ask. Absolutely, Alan would reply, particularly given what is going on right now in the Eurozone. He would then ask Mr. King how confident he was that Quantitative Easing could save the day if that possibility came to pass. Mr. King would in all honesty say that while they would do their best, he had virtually no idea what impact this new monetary instrument would have, so he could not guarantee anything.

So Mr. Clegg is left with a dilemma: any action taken to reduce the deficit might put the recovery at risk. But all was not lost. First, the clever Rupert Harrison who used to advise George before that unfortunate accident had come up with quite a nifty fiscal rule that required hitting a target for the current budget in five years time. This had two advantages. First, austerity could be back loaded to give the recovery the best chance of taking off. Second, the rule did not include public investment. Now the chaps at the Treasury said that the multiplier from public investment was pretty high, so Nick asked them to keep those public investment numbers up for at least the next three years. (He might have added, given his colleagues knowledge, be sure to increase work on flood defenses.)

But both the guys at the Treasury, and Mr. King, might have said that postponing all the deficit reduction until after 2011 would not be credible. OK, Nick might have replied, but what should I do straight away: cut spending or raise taxes? The Treasury people would have said that if the aim was to protect the recovery, tax rises - particular on the better off - would be preferable, because some of those would come out of savings rather than reduce demand. So raise taxes first, perhaps on just a temporary basis, and replace them with spending cuts later on. Which taxes, Nick might ask? At this point Mr. Harrison might recall a conversation he had had with an Oxford academic. If you want to impress the markets that you have got what it takes to control the deficit, do something straight away that incurs large political costs. Did he have a specific suggestion? Nick asks. He did suggest increasing inheritance tax, Rupert responds sheepishly, but I think he had George in mind at the time. Sounds good to me, says Nick.

OK, I’m getting carried away here, but I hope you get the idea. An austerity plan could have been devised which tried to protect the recovery as much as possible. In particular, public investment could have been kept high, but what actually happened was it was cut substantially. What we got were fiscal actions that seemed to completely ignore the fact that we were just emerging from an unprecedented recession. When interest rates are at the Zero Lower Bound that is bad policy making and it had large costs.

The IMFs evaluation of 2010 austerity

The Independent Evaluation Office of the IMF has recently published its assessment of the IMF’s Response to the Financial and Economic Crisis. In many ways the IMF’s advice at the time mirrored the way the policy response to the crisis actually evolved. In 2008 and 2009 it recommended fiscal stimulus, and that is exactly what some countries, notably the UK and US, did. In 2010 it dramatically reversed its advice, and recommended austerity. At the same time the UK, US and Eurozone switched to austerity.

This independent evaluation argues the 2010 switch was a mistake. Here are some key quotes from the report (paras 32-34):

“The IMF’s call for fiscal expansion and accommodative monetary policies in 2008–09, particularly for large advanced economies and others that had the fiscal space, was appropriate and timely.”

“IMF advocacy of fiscal consolidation proved to be premature for major advanced economies, as growth projections turned out to be optimistic. Moreover, the policy mix of fiscal consolidation coupled with monetary expansion that the IMF advocated for advanced economies since 2010 appears to be at odds with longstanding assessments of the relative effectiveness of these policies in the conditions prevailing after a financial crisis characterized by private debt overhang. In particular, efforts by the private sector to deleverage rendered credit demand less sensitive to expansionary monetary policy, irrespective of its ability to maintain low interest rates or raise asset prices. Meanwhile, a large body of analysis, including from the IMF itself, indicated that fiscal multipliers would be elevated following the crisis, pointing to the enhanced power relative to the pre-crisis environment of expansionary fiscal policy to stimulate demand.”

“Many analysts and policymakers have argued that expansionary monetary and fiscal policies working together would have been a more effective way to stimulate demand and reduce unemployment—which in turn could have reduced adverse spillovers. Waiting longer to shift to fiscal consolidation might also have allowed for less aggressive monetary expansion, with less negative side effects.”

None of this will be a surprise to regular readers of this blog, but it is welcome nonetheless. Perhaps more interesting is the subsequent analysis of why the IMF got it wrong in 2010.

“In articulating its concerns [in 2010], the IMF was influenced by the fiscal crises in the euro area periphery economies (see Box 1), although their experiences were of limited relevance given their inability to conduct independent monetary policy or borrow in their own currencies.”

As the evaluation also notes, interest rates on US, UK and Japanese government debt were at historic lows. So the report essentially says that the IMF became spooked by the Eurozone crisis. That is why it is tempting to call the 2010 switch to austerity a Greek tragedy.

This is an assessment of the IMF’s view. Of course policymakers in both the UK and US had other motivations. We will never know if the switch to austerity in 2010 would have happened anyway even if the IMF had not changed its view, or whether it would have happened if politicians in Greece had not borrowed too much and attempted to deceive everyone else about this.

As the FT reports, Christine Lagarde has defended the advice the IMF gave in 2010. It was appropriate given the IMF’s forecasts of a reasonable recovery, she suggests. However that seems to miss the point. This report clearly suggests that the IMF were mainly misled by what was happening in the Eurozone and not by an overoptimistic forecast. If they had interpreted the Eurozone crisis for what it was, they would probably have concluded that the recovery was still fragile, and that therefore this was not the time for austerity outside the Eurozone periphery. Better still, they might have made their participation in the Troika conditional on a quick and full Greek default (as an earlier self evaluation by the IMF suggested), and better still on the ECB implementing OMT much sooner.

Another imponderable concerns macroeconomic theory. By 2011 Paul De Grauwe had provided a convincing explanation of why the debt crisis was confined to the Eurozone, and by the end of 2012 when the ECB’s OMT had ended that crisis it was clear he was right. If we had known in 2010 what we know now, would the IMF have taken a different view? I suspect not. Austerity is a sort of default mode for the IMF, for understandable reasons, and although there are many opinions within the IMF, it is still ultimately run by a political body. But at least we can be thankful that this IMF evaluation, untainted by political face saving or ideology, has given a clear verdict. The 2010 switch to austerity was a mistake. The conclusion is not qualified: it was a mistake in the UK, the US, and in the Eurozone as a whole. 

UK 2015: 2010 Déjà vu, but without the excuses

Things can go wrong when policymakers do not ask the right questions, or worse still ask the wrong questions. Take my analysis of alternative debt reduction paths for the UK following the 2015 elections. There I assumed that the economic recovery would continue as planned, with gradually rising interest rates, achieving 4% growth in nominal GDP each year. I set out a slow, medium and fast path for getting the debt to GDP ratio down, and George Osborne’s plan. On the latter I wrote: “I cannot see any logic to such rapid deficit and debt reduction, so it seems to be a political ruse to either label more reasonable adjustment paths as somehow spendthrift, or to continue to squeeze the welfare state.”

Ah, said some, that is all very well, but you are ignoring what might happen if we have another financial crisis. That will send debt back up again. The implication was that the Osborne plan might make sense if you allowed for this kind of occasional but severe shock. In a subsequent post I showed that this was not the case. However this also illustrates a clear example of asking the wrong question. Rather than setting policy today on the basis of something that might happen in 30+ years time, we should be worrying about much more immediate risks.

The question that should have been asked is what happens if we have a rather more modest negative economic shock in the next five years. The list of possibilities is endless: deflation in the Eurozone, the crisis in Iraq and Syria gets worse, Ukraine blows up, things go wrong in China etc. We can hope that they do not happen, but good macroeconomic policy needs to allow for the fact that they might.

That is the question that was not asked in 2010. The forecast attached to the June 2010 budget didn’t look too bad. GDP growth was between 2% and 3% each year from 2011 to 2015 - not great given the depth of the recession, but nothing too awful. But suppose something unexpected and bad happened, and economic growth faltered. The question that should have been asked is what do we do then. The normal answer would be that monetary policy would come to the rescue, but monetary policy was severely compromised because interest rates were at 0.5%. So 2010 was a gamble - there was no insurance policy if things went wrong. And of course that is exactly what came to pass.

As I have always said, there was an excuse for this mistake. In 2010 there was another risk that appeared to many to be equally serious, and that was that the bond vigilantes would move on from the Eurozone periphery to the UK. This was a misreading of events, but an understandable confusion. By 2011, as interest rates on government debt outside the Eurozone continued to fall, it was clear it was a mistake. Policy should have changed at that point, but it did not - instead we had to wait another year, and then we just got a pause in deficit reduction rather than stimulus.

Today, there is no excuse. There are no bond vigilantes anywhere to be seen. No one, just no one, thinks the UK government will default. This means we are free to choose how quickly we stabilise government debt. However what is very similar to 2010 is monetary conditions. Interest rates may have begun to rise by 2015, but any increase is expected to be slow and modest. So there will again be little scope in the first few years for monetary policy to come to the rescue if things go wrong. A negative demand shock, like another Eurozone recession, will quickly send interest rates to their zero lower bound again, and we will have little defense against this deflationary shock. The tighter is fiscal policy after 2015, the greater the chance that will happen. In that sense, it is just like 2010.

So the right question to ask potential UK fiscal policymakers in 2015 is how will you avoid 2010 happening again? If their answer is to do exactly as we did in 2010 and keep our fingers crossed, you can draw your own conclusions.

Being rude about austerity

How rude should I be about policymakers? Some may think this a strange question, but I personally have quite a high regard for them. Having spent some of my formative years working in government, I can certainly appreciate the difficulties they face. Sure, there are unspoken (in public) political imperatives that drive a lot of policy, but I don’t think politicians’ public concern with social welfare is entirely a facade, and it is certainly not among most of those who work for them – quite the opposite, in fact. So when I wrote this (see final paragraph) about belief in the confidence fairy, I did worry I was allowing rhetoric to get the better of me.

Now in mitigation, I have to say that the 2010 switch from fiscal expansion to austerity does make me very angry. I’d like to think that this is just because of the immense harm it is doing, but there is something else as well. It represents the abrogation of knowledge: knowledge which, largely through accident, I was particularly aware of. I think this is something that even economists who are not macroeconomists, and not just non-economists, do not fully appreciate. In the mid-2000s my main research was on monetary and fiscal policy interactions, and this was a field that appeared to be characterised by considerable common ground, and certainly not by alternative ‘schools of thought’. Some of this knowledge began to be applied in 2008/9, and even an institution like the IMF which was famed for its fiscal conservatism was quite happy applying that knowledge.

It is as if you are a doctor, treating a patient with proven but also state of the art medication. The patient is not well but the treatment you are applying is working. Then suddenly the hospital administrator tells you to stop, because the drugs are expensive and they would like to try some spiritual healing instead. And, in case you ask, the financial crisis did not suddenly render the sum of macroeconomic knowledge accumulated over the previous decades obsolete (whether embodied in textbooks or DSGE models).

But in a sense all this makes trying to be dispassionate about the reasons for the switch to austerity all the more important. So here is a list. I’ve talked about all of these before, but not in one place. These reasons for advocating austerity are not in order of their relevance (see Farrell and Quiggin (pdf) for the basis of such an assessment), but I am going to give them marks out of ten, where the lower the mark the more rudeness is justified.

“Our government cannot sell any debt.” Here I draw a sharp distinction between those in these countries, and those outside. For those inside, I think the choice between austerity and default (there was no other option) was very difficult, and I would only have minor criticisms: sometimes a failure to adopt the right fiscal mix, sometimes going further than was necessary, and sometimes being naive about the position and motivation of their creditors (perhaps through collective guilt). So 8/10: rudeness not appropriate. For those outside these countries (many in the ECB, Commission, Germany etc), a very different assessment – see below.

 “After Greece, it could be anyone next” or more simply “Panic!”. Many policymakers convinced themselves that markets, in refusing to buy certain countries debt, were behaving irrationally – after all we had just had a financial crisis where they also seemed to behave in this way (either before, or during, or both). In these circumstances, ‘confidence’ becomes the word of the moment, and appeasement to a particular reading of market sentiment understandable (although wrong). Here I give (6-2x)/10, where x is the number of years after 2010. I can forgive policymakers being confused in the panic of 2010, but by 2011 we understood much better what was going on, and the evidence by 2012 that this was a particular Eurozone problem generated by ECB behaviour became so clear that even the ECB understood. (As you can see, 2/10 means I can be rude!)

“We want our money back.” Again a reason that is only relevant to those who lent to certain Eurozone economies. A common enough human motive, generally coupled with a belief that creditors bear no responsibility for properly assessing risk. Not a good way to lend money (see 2007/8 and earlier), and certainly not a good basis for macroeconomic policy. (“Oh, did we play a major part in designing this system?”) Also largely self defeating. What comes into my head as I write is Destroyer of Worlds, and I don’t think that is far wrong. Does not deserve a mark.

“The recovery is well underway, so now is the time to deal with debt.” What this argument has going for it is that at some point it becomes correct. In addition there are policy lags, and forecasting is difficult. But it is also true in macro that timing is everything. The argument was wrong in 2010, because it failed to take seriously the asymmetric nature of the consequences of forecast errors. So (6-3x)/10. By now those who advocated austerity on this basis should have changed their minds, which some have done to their credit (and I mean that – it is difficult to admit mistakes).

“Monetary policy can take care of demand.” What I have called Zero Lower Bound Denial. There is perhaps some evidence that this belief was part of the UK Conservative Party mindset (see end of this post), but I think it is more prevalent among some bloggers, or economists who are not macroeconomists or who ‘missed’ the lost decade in Japan and who thought the Great Depression was just history. There, I’ve revealed my mark by my language again: 2/10. A slight variant in the UK is “without austerity, interest rates would have been higher”, which owes a great deal to hindsight (and higher VAT).

“We need to reduce the size of the state” (apart, perhaps, from the bit that buys military hardware). 0/10, not for the belief itself (that is mostly politics, with very little macro), but for duplicity. Chris Dillow might add, follow Kalecki, a view that the working class needs to be controlled, but I think that was UK 1981, not world 2010. Less than 0/10 for the variant that says what the state does in another country is a waste of money, because even if it happens to be true it combines duplicity with imperialism.

“What aggregate demand problem” or more succinctly Demand denial. A strange belief that should have died when J.B. Say realised his error, but which resurfaces from time to time and place to place. 0/10.

“Reducing debt is virtuous.” I hesitate to include this, because I do not seriously think any policymakers actually believe it (they are often the same people who happily spend or cut taxes in a boom). The macroeconomics is obviously silly – not everyone can run a surplus (so 0/10). Unfortunately this kind of economics as morality does seem to influence some people. The argument that “we cannot waste any time tackling the problem of debt” faces similar problems, and is also not really believed by many who make it.

So there you have it, and yes, I do feel much better having written this all down. But will it stop me being rude in the future?